High yield: the devil is in the details

The use of high yield financing is a staple feature of leveraged buyouts, but participants in deals may not appreciate the need for precisely tailored covenants. Valerie Jacob, co-managing partner of Fried, Frank, Harris, Schriver & Jacobson, highlights the keys to investor protection.

Since the advent of high yield financing in the US in the late 1980s and in Europe more recently, high yield has been a staple of most post-leveraged buyout balance sheets. Although market windows open and close, high yield notes have weathered various recessionary storms and continue to be an integral part of the arsenal of financial buyers for targets with a non-investment grade credit rating (BB+ or lower for Standard & Poor’s or Ba1 or lower for Moody’s) after the acquisition. In some instances acquisitions pressured by either timing concerns or market volatility may resort to the use of bridge or mezzanine financing, but high yield notes will subsequently be planned for the take-out of such financings as the more permanent piece of the capital structure.

The covenants in high yield notes generally restrict the issuer from a broad range of financial actions such as: incurring debt; issuing certain types of preferred stock; paying dividends; buying back stock or subordinated debt; selling assets; entering into mergers; engaging in affiliated transactions; creating unrestricted subsidiaries; creating liens; or entering into sale and leaseback transactions. In contrast to senior or mezzanine financings – which contain maintenance covenants that can be breached by ongoing changes in business performance – all the covenants in high yield notes are ‘incurrence’ based and therefore only restrict voluntary actions. 

High yield covenants are generally designed to protect investors against credit deterioration, transfers of value to equity holders and loss of ranking vis-a-vis the issuer’s assets. Even though the covenants are ‘incurrence’ in nature, they could place material operational restrictions on issuers that need to be understood at the outset.  

Although there is a standard covenant package in the US and Europe, each high yield issuance must be individually crafted. Due to the expense and difficulty of obtaining waivers for routine or even not-so-routine corporate events, covenants need to reflect the needs of the issuer and its future growth plans, the current marketplace and the expectations of other stakeholders in the company, including equity holders.

Covenants should be modified and adapted for the particular circumstances. Obviously they need to reflect the credit rating of the issuer and the market conditions at time of issuance. The cost of an increased interest rate because of ‘loose’ covenants may be more than the company and equity sponsor (or other debtholders) can endure and, depending on the market, may result in an unsuccessful offering. Failure to integrate the covenants with each other and with the covenants in the issuer’s senior credit facility, and also with the stated business needs of the issuer, could result in serious problems and loss of flexibility in future. Accordingly, as with many things, the devil is in the details.

In negotiating the high yield covenant package, the private equity professional will need to focus on the long-term business plans of the issuer. Companies being acquired as platform entities for the roll-up of future add-on acquisitions will need to negotiate sufficient baskets to the debt, lien, investment and dividend blockage covenants to be able to consummate that strategy. Other entities may need the flexibility to enter into joint ventures or have their subsidiaries expand internationally on a stand-alone basis.

Additionally, if the private equity investors plan to sell assets as part of the financing strategy, specific carve-outs will be necessary, particularly if the proceeds of an asset sale are meant to be repaid to the investors to redeem a portion of their equity investment. Often it is covenants overlooked by the equity investor and its advisors, such as the limitation on investments, dividend blockages and restriction on sales of assets that end up limiting the company’s operating flexibility – particularly when a company is performing well. 

This article addresses certain covenants one should consider in connection with the following areas:

· The exit strategy of the equity participants.
· The creation of joint ventures or the making of minority investments.
· The entering into of affiliate transactions.
· The effect of the issuance of the high yield notes at an operating company level rather than at the holding company level.
· The use of non-wholly owned subsidiaries in the business.
· The ability to operate subsidiaries in foreign jurisdictions on a stand-alone basis, particularly to incur lines of credit and other debt.
· The creation of special purpose entities for accounts receivables financings.
· Restructurings.

Exit Strategy

One of the key factors to consider in structuring a high yield financing for a private equity investor is the exit strategy (particularly possible timing) given the high costs of repaying or refinancing the high yield notes within the first few years after issuance. Typically, a ten-year high yield instrument will be non-callable for five years, or four years with a seven or eight year note. Upon a change of control, the noteholder has the option to put the notes to the surviving entity issues at 101 per cent of the principal amount. More importantly, the issuer will have no right to redeem the notes upon a change of control, although in the past certain transactions have granted call rights to the issuer at a make-whole premium.

Accordingly, if the investor wants to sell the business (or receives an unexpected but attractive offer subsequent to issuance) and the new investors do not want to assume the indebtedness outstanding under the notes (which is likely, either due to the interest rate or the covenant package negatively impacting the acquiror’s business), the acquiror will have to make a tender offer for the notes. The tender price is usually based on US Government bonds or their international equivalent plus a spread, which is often a costly 50 basis points. If a tender offer does not work or is impractical, the issuer will need to defease the notes, which could be even more expensive. 

· Definitions: 

· Several definitions in the high yield covenant package are key to understanding the limitations on and the triggers for having to make a change of control offer in the event of an exit. There are several conventional steps that can be taken to anticipate an exit for a private equity investor. The definition of ‘change of control’ should differentiate between pre- and post-initial public offerings, facilitating an exit through an IPO and subsequent secondary offering for the financial sponsor.

· The definition of ‘permitted holder’ (which is defined to include those parties who are in control or control by whom will not trigger put rights) should be broad enough to prevent the inadvertent change of control due to shifting equity interests among the initial institutional owners or equity sponsors, especially given the growing frequency of ‘club’ deals where one sponsor may desire to sell out to a co-investor and, in some cases, certain management investors. Moreover, transfers among affiliated funds should not cause a change of control event.

· To facilitate exits through mergers, including mergers with public companies, the definition of a ‘change of control’ can be broad enough to exclude mergers with another company where one of two events occurs post-merger: either shareholders of the company which issued the high yield notes emerge with the majority of common stock and voting rights after the merger, or much like a post-IPO change of control provision, no single party controls more than a certain percentage (e.g. 35 per cent) of the shares of the combined entity unless permitted holders own a greater percentage of the shares. 

· Non-call period; make-whole call

· The private equity investor should consider its investment horizon and possibly shorten the term of the notes to have a shorter non-call period or negotiate to include a make-whole call right at any time. Although the pricing for a make-whole call at any time is expensive and has not always been accepted in the marketplace, it creates a ceiling on the cost of refinancing or repaying the notes. The issuer will always have the ability to tender for the notes at a price less than the contractual make-whole amount. In negotiating such a make-whole call provision, it is important that the make-whole rate assumes the notes are to be redeemed at the first call date.

· In a recent European transaction, the equity sponsor was able to negotiate the ability to redeem the notes at a fixed price during the non-call period upon the occurrence of a so-called exit event, which was defined as the sale of the business or an equity IPO of the issuer. The redemption price was 103 per cent of the accreted value in the second year, 102 per cent in the third year, 101 per cent in the fourth year and 100 per cent in the fifth year and thereafter. It is too early to determine whether this provision will become standard in the marketplace or just an historical exception tailored to address a particular situation of a company that had been on the market for some time.

· Rating Decline: 

· For issuers with a credit rating close to investment grade (BBB- or higher by Standard &Poor’s and Baa3 or higher by Moody’s), one can consider coupling the change in control trigger with the requirement of a “Rating Decline.”  In this instance, the noteholders would not be entitled to put the notes unless, after giving effect to the change of control, the notes are rated below investment grade or, if not investment grade at the time of the event, the credit rating on the notes is decreased.

Joint Ventures

Issuers in particular industries such as healthcare, telecom and media, and issuers with foreign operations, often enter into joint ventures (including minority investments) in the normal course of business. It is important in structuring a high yield covenant package for any company which could during the life of the notes make investments in other entities (or have others make investments in its subsidiaries), to have the continued flexibility to do so. Many recent deals contain permitted investment baskets for unlimited investments in majority owned subsidiaries. But even if the issuer has such a basket and only intends to invest in joint ventures where it has majority control, many covenants (other than the limitation on investments) can be implicated. The following covenants could affect a joint venture or minority investment:

· Limitation on Restricted Payments: 

· In order to invest in, or advance money to, a joint venture entity, the company will need a specified ‘permitted investment’ category for ‘permitted joint ventures’.

· ‘Permitted joint ventures’ may be a (non-wholly owned) restricted subsidiary, of which the company owns a certain percentage of the equity and/or has specified control rights and which operates in the same line of business as the company.

· The definition of ‘permitted investments’ may allow investments of up to a certain dollar amount or a certain percentage of tangible assets, in any one year or outstanding at any one time, in permitted joint ventures. As described above, many recent deals do not, in effect, restrict investments in majority-owned subsidiaries.

· One could structure a joint venture consisting of a majority owned subsidiary as an unrestricted subsidiary not subject to the covenant package and excluded from the calculation of EBITDA. The trade off is that any transactions with such an entity would need to comply with the affiliate transactions covenant and any funding or subsequent investments in such a subsidiary would need to be made pursuant to a permitted basket or after satisfying the restricted payment test. Moreover, it would be common to exclude the cash flow of the unrestricted subsidiary from a number of the financial definitions since that subsidiary is no longer a member of the credit family.

· Limitation on dividend blockages:

· Most joint venture agreements contain provisions restricting distributions to the venture partners. Therefore, a carveout would be required that prohibits the company from entering into agreements restricting distributions from a subsidiary to the company or other subsidiaries. A carveout could be limited to joint ventures up to a certain size of the issuer’s assets or blockages of a certain percentage of cash flow. Other deals may carve out restrictions contained in joint venture agreements generally, so long as they are customary or entered into in the ordinary course of business. However, joint ventures are so highly negotiated and stylized that few such arrangements could easily be seen as customary.

· Limitation on subsidiary capital stock:

· This covenant prohibits third parties from owning any capital stock of a company’s subsidiaries. This would prohibit creating joint ventures from existing subsidiaries.

· The covenant is often limited to restrictions on third parties from owning the preferred stock of a company’s subsidiaries. Even this may be problematic because joint ventures often have very complex, tax driven, distribution schemes which may be deemed preferred rights. Accordingly, some transactions in the market do not limit the incurrence of common or preferred stock by subsidiaries other than by application of the debt incurrence covenant.

· Any covenant restricting the issuance of the capital stock of subsidiaries will prohibit a subsidiary from accessing the public markets.

· Limitation on affiliate transactions:

· A special carve out may be needed from the affiliate transaction covenant for arrangements between the issuer and the joint venture, depending on the nature of the company’s ownership.

· Limitation on asset sales/transfers:

· One should consider obtaining the ability to invest the proceeds of asset sales in a permitted joint venture rather than being required to reduce senior debt levels.

· Transfers of assets to a joint venture or minority investment may be covered by the asset sale covenant and would be limited by the normal requirement that cash be received as consideration of the transfer. Often in the formation of joint ventures, capital stock of the entity is received as the consideration. Additional investments in the joint venture after its creation would need to be similarly considered in connection with negotiating the asset sale covenant.

Affiliate transactions

In any high yield covenant package, affiliate transactions will be required to satisfy certain fairness standards such as independent director approval or a fairness opinion from a third party appraiser or investment bank. Given the changes in corporate governance procedures in the past year or so, one should consider permitting any affiliate transactions which are approved by an audit committee comprised of independent members and meeting the other standards imposed by the SEC and NYSE or Nasdaq.

· Payment of fees:

· In any high yield issuance where the equity is held by a controlling private equity investor, one must ensure that carveouts are in place for monitoring, management, advisory, consulting or other fees paid to the private equity investor. In most deals, changes to any such arrangements (to the extent adverse to noteholders) would need to satisfy the affiliate test. Accordingly, private equity investors may want to build in the flexibility to increase fees or enter into other related party transactions at the time the notes are issued, subject to fairness standards. An equity sponsor should keep in mind that the actual payment of fees might impact on the ability of representatives of the equity sponsor to be deemed ‘independent’ under the NYSE or Nasdaq rules in future.

· Loans:

· In most senior subordinated deals, the definition of ‘senior debt’ carves out any debt owed to affiliates. This could impact the willingness of an affiliate to loan money to the company in the future in, for example, a workout situation.

Operating company offerings

Many private equity investments in the US are structured so the equity is invested in a parent holding company and the high yield debt is issued by an operating company subsidiary. Generally, this structure permits the flexibility in future to issue structurally subordinated debt at the parent level, which will be treated as equity on the balance sheet by the operating company after the proceeds of the parent entity debt are contributed to the subsidiary. It also permits the senior lenders to receive a pledge of the stock of the entity that operates the business. In Europe, however, issuing high yield debt at the operating company continues to be controversial and is not common practice, although recent transactions have provided for operating company subsidiary guarantees and collateral on a junior basis (in each case somewhat limited in operation).

· Limitation on restricted payments:

· Operating company issuers with a holding company parent require special carveouts to permit the operating company to make cash distributions to the parent holding company to pay taxes, the cost of professionals, the costs of SEC or other compliance requirements and the salaries of personnel and other operating expenses. The operating company, however, should only fund the parent company expenses related to the operating company and not expenses related to other subsidiaries of the parent company.

· Issuers may also want to consider requesting a carveout to permit distributions to a parent company to pay dividends on the parent’s stock after an IPO.  This provision might be limited to a maximum percentage (e.g., 6 per cent) of the proceeds received in the IPO.

· A carveout will be required for the payment of dividends to the parent to ensure sufficient funds for the reacquisition of management and employee stock, limited to a certain annual or aggregate total amount.

· Equity clawback:

· The company should be able to repurchase the notes under the normal equity clawback provision as a result of issuances of equity at either the operating company or parent company level. In such instances, proceeds from the sale of parent company capital stock should have to be contributed to the operating company. One should focus on whether the requirement for the infusion of equity is limited to common equity issued only in a public offering or is more broadly permissive to include proceeds from the issuance of preferred stock and equity (whether common or preferred) issued in a private placement.

· Change of control:

· The definition of ‘change of control’ should, depending on the circumstances, include the change of control of the operating company as well as the parent company.

· Financial statement requirements:

· Companies which are subsidiaries of holding companies will need to provide consolidated financial statements of the holding company instead of the issuer’s financial statements. This will facilitate the initial public offering of the parent company in future. The provision of the parent’s financial statements should be acceptable as long as the parent guarantees the operating company notes and has no other material assets or debt. The SEC financial statement requirements for a parent and its subsidiaries are complicated and require calculation of the materiality of the parent’s and individual subsidiaries’ assets and results of operations as compared to the consolidated group.

· Under SEC rules, in transactions in which a subsidiary issues the notes, the parent guarantor has no or few independent assets or operations, no subsidiary of the parent guarantees the notes and any subsidiaries of the parent are minor (up to 3 per cent of assets or operations), separate financials of the parent independent of the issuer will not be required. In other instances, depending on the materiality of the subsidiaries and whether subsidiaries are wholly owned, either condensed consolidating financial information as footnote disclosure or full guarantor financials will be required.

· Future restructurings:

· Most high yield packages do not permit the creation of a holding company structure in the future without consent of a certain percentage of the noteholders. Consideration should be given to including the flexibility to create a holding company structure at the outset.

Wholly owned v non-wholly owned subsidiaries

Covenants that require companies to operate with only wholly owned subsidiaries as compared to non-wholly owned subsidiaries could have significant ramifications on a company’s business operations. The flow of funds and other assets among the members of the consolidated group will be restricted, which could impact the ability to incur debt and consummate joint ventures and other acquisitions.

· Limitation on indebtedness:

· For cash management and state and local tax planning purposes, the company may need the flexibility to have a free flow of funds among all its subsidiaries (including those not wholly owned), whether or not such subsidiaries guarantee payment on the notes. In such cases, the permitted debt exception for intercompany indebtedness needs to include debt issued by the company to its subsidiaries and by subsidiaries to other subsidiaries, whether wholly or non-wholly owned and whether or not the notes are guaranteed.

· Limitation on restricted payments:

· Subsidiaries should be able to pay dividends to all their shareholders pro rata, regardless of whether the subsidiaries are entirely owned by the company.  The pro rata carveout would not permit preferred stock returns and a special carveout would be needed if the issuer thinks minority investors could receive preferred distribution rights.

· If the credit quality of the issuer permits the free flow of funds among the company and all its subsidiaries, the definition of permitted investments needs to permit all investments among the company and its subsidiaries, whether wholly owned or not.

· The company should be able to guarantee the debt of non-wholly owned subsidiaries.

· Limitation on asset sales/transfers:

· In some transactions, transfers of assets should be permitted among the company and all its subsidiaries, whether or not wholly owned.

· Limitation on dividend blockages:

· Dividend blockages in instruments governing joint ventures or non-wholly owned subsidiaries need to be permitted (with agreed limitations). Otherwise, the creation of a joint venture or the admission of minority investors in a subsidiary will be severely limited or prohibited.

· Limitation on subsidiary capital stock:

· If flexibility is given for the free flow of funds among the company and its subsidiaries, subsidiaries need to be permitted to issue capital stock to any third party as long as the proceeds are used as dictated by the asset sale covenant.

· Guarantees by non-wholly owned subsidiaries:

· Many transactions require all domestic subsidiaries to guarantee the high yield notes. However, it is unlikely that a minority investor in an issuer’s subsidiary will want that subsidiary to guarantee the notes. Accordingly, issuers should not agree to provide guarantees by all domestic subsidiaries, but should agree to only provide guarantees by non-wholly owned subsidiaries that also guarantee the senior bank debt.

· The notes should also contain a provision releasing the guarantee of a subsidiary which becomes a non-wholly owned subsidiary, provided that such subsidiary guarantees no other indebtedness.

· As stated above, guarantees of the notes by non-wholly owned subsidiaries may have significant implications for the issuer’s financial statement and reporting obligations. 

Foreign Subsidiaries

Issuers with operations in multiple jurisdictions need to ensure the high yield covenants provide sufficient flexibility to permit foreign subsidiaries to operate their business that may be interdependent on but not integrated with the company. Although all the covenants govern actions taken by all restricted subsidiaries, the following covenants should be specifically considered as they apply to the company’s foreign operations.

· Limitation on indebtedness:

· Foreign subsidiaries often have their own financing needs as stand-alone entities. Identified permitted debt categories for foreign credit lines, inter-foreign subsidiary debt and acquisition debt financing should be considered.  Foreign subsidiaries should be able to refinance debt denominated in local currencies without regard to the debt’s value in the local currency of the issuer.

· Limitation on liens:

· In tandem with the categories of permitted debt for foreign subsidiaries, appropriate carveouts will need to be considered for liens accompanying the specific debt instruments.

· Limitation on guarantees:

· Because of negative US tax implications, foreign subsidiaries cannot guarantee high yield notes issued by their US parent. Accordingly, any high yield covenant package should exclude foreign subsidiaries from the requirements to provide guarantees. US parents commonly pledge 65 per cent of the capital stock of foreign subsidiaries to secure obligations under their senior credit facility.

· If the issuer is a foreign entity, foreign subsidiaries often cannot guarantee the high yield notes issued by its foreign parent as a result of local law.

· Financial assistance: Based on an EU directive, all EU jurisdictions prohibit the use of a target’s assets to purchase the target’s shares. To varying degrees, this prohibition has been held to prevent credit support by the target for any debt used to finance the acquisition of the target’s shares. In some jurisdictions, a violation of these ‘financial assistance’ prohibitions can result in the acquiror’s directors who authorize the transaction incurring criminal or civil sanctions. The exceptions are limited and vary from jurisdiction to jurisdiction (e.g., ‘whitewash procedure’ in England and the use of a GmbH instead of an AG in Germany).

Corporate benefit laws: If a guarantor puts its assets at risk by guaranteeing a debt without deriving a benefit from the loan, the guarantee may be unenforceable or the extent of enforceability may be diminished.

· Capital protection rules: In other jurisdictions, guarantors of shareholder obligations may be subject to the same limitations as distributions to shareholders; i.e., no distributions other than the surplus over stated capital. In other jurisdictions, guarantees are only enforceable to the extent permitted under a net asset test.

· Limitation on restricted payments:

· Given the cash and investment needs of a foreign subsidiary, it is important to include in the definition of ‘permitted investments’ and ‘cash equivalents’ the local currency and monetary instruments of foreign banks.

· Limitation on dividend blockages:

· Debt incurred by foreign subsidiaries will often restrict the ability of the foreign subsidiary to dividend or otherwise distribute money or other assets to the issuer. Accordingly, a general carveout to the dividend blockage covenant may be needed in addition to the basket under the debt test to enable the foreign subsidiary to incur debt.

Accounts receivable financings

Unless thought of in advance, the normal high yield covenant package would restrict the creation of a financing subsidiary formed for the purpose of providing accounts receivable financing. The company will need the flexibility to invest in an ‘accounts receivable subsidiary’ to engage in the purchasing, financing and collecting of accounts receivable obligations of customers of the company. In many transactions the accounts receivable subsidiary may not engage in any transactions other than the receivables financing, may not have any debt guaranteed by the company or the company’s subsidiaries, and must be a qualified special purpose entity or special purpose entity in accordance with GAAP.  Companies should retain the flexibility to create the ‘accounts receivable subsidiary’ as a restricted or unrestricted subsidiary. The issuer should also consider any other types of asset that could be used for a securitization during the term of the bonds to determine if additional flexibility would be helpful.

· Limitation on restricted payments:

· A special carveout from the restricted payments covenant may be needed for the transfer of accounts receivable by the company to the SPE as a capital contribution or in exchange for debt issued by such SPE.

· Limitation on indebtedness:

· The company should consider having a specific permitted debt category for the accounts receivable financing.

· Limitation on asset sales/transfers:

· A special carveout is required from the asset sale covenant to permit the transfer of accounts receivable from the company to the SPE.

· Limitation on affiliate transactions:

· A special carveout may be required for transactions between the company and the SPE. However, nothing special would be needed if there were already a general carveout for intercompany transactions.

· Limitation on liens:

· A permitted lien is required to allow liens on the assets of the SPE or liens arising out of any sale of accounts receivable to or by such SPE.

Restructurings

Although investors do not enter into a transaction concerned about the mechanics of a future restructuring in the event of unforeseen difficulties, it is important to have certain flexibility in the covenants so that the private equity investors may not be required to obtain the consent of the noteholders for certain restructuring transactions.

· Limitation on restricted payments:

· The notes should permit the private equity investor to repay subordinated debt or redeem capital stock with the proceeds of similar securities, whether or not the company is in default or has a negative restricted payment basket.

· Limitation on affiliate transactions:

· The transaction with affiliates covenant should carve out the sale of equity to affiliates.  Otherwise, the company will have to satisfy a fairness standard to sell equity to affiliates which may be difficult in a work-out situation.  Moreover, the fact that additional equity is being infused into the company is a positive event for the noteholders and should not be restricted.

· Change of control

· Typically, the equity group is grandfathered from the change of control provision. However, the grandfathering provision needs to be carefully scrutinized to be able to permit additional equity investments by the sponsor or sponsor affiliates, transfers of equity to sponsor affiliates and changes in the make-up of the sponsor group in a ‘club’ investment as long as some or all of the lead investors remain involved in the company.

· Limitation on indebtedness:

· The private equity investor may want to seek a basket to the debt covenant in the event the private equity investor increases its equity investment during a work-out even if the company does not satisfy the debt coverage ratio at the time of the additional investment.

· In addition, the general size of the debt baskets, particularly the amount of the secured debt baskets, obviously become very important in the context of a work-out situation.

· The definition of ‘senior debt’ in a senior subordinated debt offering will usually specifically exclude debt to an affiliate. Accordingly, a private equity investor will not be able to lend money to the company on a senior basis in the context of a work-out situation unless the provision is negotiated in advance.

Conclusion

The negotiation of the appropriate high yield package for a particular issuer is complex and should be based on the needs of the particular company, equity sponsor and market conditions at the time of issuance with sufficient protection for the noteholders. What was appropriate in one precedent may not be appropriate, needed, sufficient or even achievable in the marketplace in another instance. Covenants need to be crafted, modeled and tested before completion. The business strategy needs to be discussed with all participants in the process so that appropriate changes can be addressed. Importantly, a change in one covenant will have a rippling effect throughout the balance of the covenants. The global nature of the marketplace and a particular issuer’s businesses will also require experienced tailoring of all the covenants to ensure flexibility in multiple jurisdictions, protection for all the stakeholders in the issuer and the ability to achieve a successful business strategy.