Popular wisdom has it that “if it ain't broke, don't fix it”. In recent times the balance of popular wisdom within the market for European high yield bonds has been that, if not completely broke, the product has at least a number of rather annoying running problems.
Most notably, as discussed in this magazine in February this year, the issue of structural subordination, where bonds are issued by a vehicle within a group's corporate structure resulting in legally inferior rights in the event of bankruptcy, irrespective of the terms contained in the bond's indenture, is foremost in high yield investors' minds.
The mezzanine note is intended to give sponsors another alternative
In the opinion of many issuers too, or at least their financial sponsors, the high yield product is long overdue a thorough service. For many, flexibility upon exit is key; for some, above all else. Why, ask these issuers, should I pay a premium to bondholders, impacting my returns directly, simply to pay them back?
Much tinkering has taken place as a result, with the introduction of ‘upstream guarantees’ (a legal refinement which addresses the structural subordination issue), for example, into some more recent bond issues, most notably for Brake Brothers in April. However, there has been resistance to such moves amongst the senior debt community, and many of the revised structures to have emerged have generally been the result of protracted negotiations, if not outright trench warfare.
The managers of the bond issue for Legrand in February this year, for example, shelved their plans to introduce such structural refinements citing “timing issues”. Furthermore, the issues surrounding flexibility upon exit have remained largely unchanged.
Half mezz, half high yield
Until now, that is, following the issue of so-called “mezzanine notes” worth the equivalent of £290m for UK DIY chain Focus Wickes, led by Royal Bank of Scotland and ING. The notes, sold in order to refinance some senior debt and a mezzanine bridging facility, are best described as a hybrid product: not a standard high yield bond, nor a traditional mezzanine loan.
How do they work? Simply put, they combine some of the structuring features of ‘European-style’ mezzanine with the financing terms of high yield bonds to provide an instrument which works effectively for everyone: borrower, sponsor and investor included.
More specifically, from a defensive perspective, mezzanine notes work in a very similar way to mezzanine: although the issuing vehicle is different from the borrower of the senior debt facilities, upstream and parent-secured guarantees ensure that not only do the notes get a leg up the return of capital hierarchy, but they will also secure a negotiating seat at any restructuring table thanks to a share of the collateral on offer.
Most importantly, this ensures that the notes effectively rank ahead of trade and other creditors, with the exception of the senior debt, a key benchmark from an investors' perspective.
The banks kept the control they wanted, the high yield investors got the yield and the sponsors got the exit flexibility
But that is not all. Issuer and sponsor interests -Focus Wickes is controlled by UK private equity firms Duke Street Capital and Apax Partners – are dealt with too. For a start, the covenant structure is classically bond-like in its style. But more importantly perhaps, new exit provisions have also been included.
Although the issue has a regular eight-year maturity with non-call provisions for four years and a declining redemption premium thereafter, exceptions for “exit events”, a first for European high yield, have also been included. This effectively permits the issuer to repay or refinance the notes at any time beyond one year from the point of issue for a reduced premium so long as the repayment is the result of an exit for the sponsor.
That such provisions have been included, and accepted, has come at a cost. The yield on the notes at the issue price is 12 per cent and 11.25 per cent for the Sterling and Euro notes, respectively. In the words of one of the note investors: “Some of the real gains to be had on past high yield issues have been from their prepayment terms. The sponsors have already incurred one lot on Focus and we know they don't want to pay another. At the issue yield, if there's an exit in the next three years as the market expects, then we'll have done well enough.”
Despite this, even the yield offered has been considered and dealt with by taking a leaf out of mezzanine's book. The cash coupon on the Sterling notes is 10 per cent, whilst for the Euro tranche it is 9.25 per cent. Issuing both tranches at a discount bridged the difference between yield and coupon, meaning that the yield is constituted by both a cash-pay and accruing yield. This also rather neatly reduces the cash cost to the issuer as the accruing portion is effectively funded out of the sponsor's return upon exit.
Strong demand from buyers
The senior lenders too were happy with the overall package as they realised that, despite these enhancements, the structural package is still not as strong as that typically associated with traditional mezzanine, which would have been the alternative product in this financing.
Crucially, the noteholders cannot enforce on their guarantees until a standstill period of 179 days has elapsed and there is a permanent standstill on noteholders' right to enforce their security. “What we wanted were unfettered rights to dispose of the business following a covenant breach”, commented one senior debt provider.
Nevertheless the proof of the pudding is in the eating. How strong was demand for the product that ultimately emerged?
According to sources close to the deal, it was very strong. Order books were ultimately more than twice oversubscribed, and the issue was placed with in excess of 100 accounts from all quarters, with a healthy aftermarket observed by the managers.
In the view of the aforementioned senior lender: “There was something in this deal for everyone: the banks kept the control they wanted; the high yield investors got the yield; and the sponsors got the exit flexibility.”
Interestingly, the same debt provider also ultimately invested in the mezzanine notes but “on the same basis as we would consider a high yield investment.” In other words, ignoring the structural enhancements entirely.
Not a product for everyone
So can we expect to see such techniques employed in a majority of future European high yield issues?
Nicholas Coates, who leads RBS' High Yield Group, is quick to pour cold water on such an idea. “This transaction is a reference point [for the market]. I don't believe for a minute that the mezzanine note security structure and the diluted call provisions are simply going to be dumped into future high yield bonds. That would not be appropriate. The mezzanine note is intended to give sponsors a further choice: it's another alternative.”
So, while definitely an innovation, mezz notes are not for every investor, nor indeed for every deal.
But the question has to be asked: if you were a high yield investor looking at the precedent this product sets, why would you accept something inferior in any future transaction, both in terms of the yield / prepayment trade-off and the security structure? To say that the high yield wheel has been reinvented would take the analogy a step too far, but it at least has been given a significant redesign.
Market participants may look forward now to some smoother running henceforth.