High Yield Bond Covenants

Gareth NoonanDirector, European High Yield Capital Markets

1

High Yield Bonds – Structural Overview

A company’s debt capital structure is typically divided into several constituencies

Senior debt

Subordinated debt

Senior Debt – Usually provided by a bank or other lending institution pursuant to a Credit Agreement

Lowest cost

Variable interest rate

Secured by all/most assets

Yearly amortisation of principal

“Maintenance” covenants require the company to meet 90% (+ or -) of its projections

Subordinated Debt – Usually high yield bonds

Higher cost - compensates for lack of protections that senior lenders have

Fixed interest rate

Unsecured

Senior Secured Guarantees

Senior Subordinated Guarantees

2

High Yield Bonds – Structural OverviewTypical Contractual Subordination

OPCOOPCO

Bondholders agree to “turn over” to banks anything they get from obligors until banks are paid in full

OPCO

Senior Secured Bank Debt

Senior SubordinatedNotes

Parent HoldingCompany

3

High Yield Bonds – Structural OverviewTypical Structural Subordination

OPCO

Bondholders claims to assets and cash flow of business are limited to dividends from Opcos. Banks won’t allow Opcos to pay dividends unless they know they are covered first

Senior NotesParent Holding

Company

Senior Secured Bank Debt

4

Why Do Bond Investors Need Covenants?

Covenants protect bondholders against a diminution in value of their investment through

Credit deterioration

Loss of “equity cushion”

Loss of control over assets

Loss of seniority position

Covenants increase the chance of capital gains for bondholders because they force the company to

Deleverage (or, more accurately, limit the company’s ability to releverage)

Reinvest earnings

– The typical restricted payments covenant requires the company to retain 50% of net income in the business and allows 50% to be dividended out to stockholders

As a result, covenants lead to credit improvement which increases chance that bonds will trade above par

5

Who is Subject to Covenants?

The Company and its Restricted Subsidiaries are subject to the covenants, even if the Company is the only signatory to the indenture. Each covenant begins with the phrase

“The Company will not and will not permit any of its Restricted Subsidiaries to…”

Unrestricted Subsidiaries are not subject to any of the covenants

The covenants place a firewall between the issuer and its Restricted Subsidiaries, on the one hand, and the Unrestricted Subsidiaries on the other hand

Issuer

Restricted Sub Restricted Sub Unrestricted SubRestricted Sub

Restricted Group

6

Specific Covenant Issues

Each deal is different, but in every deal the two most important covenants are Debt incurrence Restricted payments

Other covenants are less crucial but are important too. The other covenants typically include

Change of Control Affiliate transactions Mergers Asset sales Anti-layering Liens Dividend stoppers at subsidiaries

All of these covenants are “incurrence” tests

Whereas “maintenance” covenants are customary in bank deals, failure to maintain specified leverage/cash flow ratios will not cause a default under a high yield indenture

7

Restricts incurrence of debt (subject to certain exceptions) unless either A ratio test is met, or A “Permitted Debt” basket is granted

There are two possible ratio tests Fixed Charge Coverage Ratio

(EBITDA/Interest Expense)– Typically 2.0x– May ratchet up

Leverage Ratio(Debt/EBITDA)– Typically around 6.0x– This is the preferred ratio for media and telecom companies

Purpose of the ratio test is to allow the Company to incur more debt as the credit improves

The ratio tests utilise the Company’s EBITDA and interest expense over the last four quarters

Bond covenants do not use projections LTM results are adjusted so that they are a more meaningful yardstick for measuring

the Company’s ability to service more debt in the future

High Yield TermsCovenants – Debt Test – Ratio Tests

8

Definitions are key (Consolidated Net Income, Consolidated Cash Flow)

Pro forma adjustments to the LTM numbers are important

Typical adjustments include: Pro forma for acquisitions and divestitures as if they had occurred at the beginning

of the period Pro forma for increases and decreases in debt as if they had occurred at the

beginning of the period Eliminating impact of “extraordinary” items; Eliminating other “unusual” items that

are not indicative of future operations; “unusual” is in the eye of the beholder

Some companies want to more aggressively adjust their historical numbers to Include anticipated future cost savings from acquisitions Exclude “unusual” or “nonrecurring” charges Make other adjustments that would not pass muster with the SEC under Regulation

S-X

High Yield TermsCovenants – Debt Test – Adjustments

9

High Yield TermsCovenants – Debt Test – Carve outs

All debt covenants also include a concept of “Permitted Debt” (which can be incurred even if the ratio test cannot be satisfied)

Will usually be a $/euro amount sufficient to fund total interest expense for at least 6-12 months

Other carve outs:

Bank carve out (with ratchet down)

Existing debt

Capital leases

Inter-company debt

General basket

Others

10

The purpose of this covenant is to protect bondholders’ access to value by limiting undesirable asset transfers such as

Dividends/repurchases of equity

Retiring debt that is subordinate to the bonds before retiring the bonds

Investments in entities that are not Restricted Subsidiaries

Company

Restricted Sub Restricted Sub JVRestricted Sub

Restricted Group

Third PartyInvestor

60%

40%

Investments are usually the subject of a separate covenant in bank deals

High Yield TermsCovenants – Restricted Payments

11

The basic test prohibits all of these asset transfers (known as “Restricted Payments”) unless

Total Restricted Payments are less than 50% of “Consolidated Net Income” since the closing of the high yield deal; and

Company could incur $1 of additional debt at time of making the payment

– i.e., Fixed Charge Coverage was 2.0x or higher (or Leverage Ratio was 6.0x or lower)

No default has occurred and is continuing

Customary exceptions include

Permitting limited repurchases of management equity in connection with stock option plans

– Subject to a dollar cap per annum

Permitting new equity proceeds to immediately flow back out and repurchase old equity or to make a restricted investment

High Yield TermsCovenants – Restricted Payments

12

High Yield TermsCovenants – Restricted Payments - Permitted Investments

Any investment in the issuer or in a restricted subsidiary is permitted

Any investment in a person, if as a result of such investment such person becomes a restricted subsidiary

Any acquisition of assets solely in exchange for the issuance of equity

Others – Note these covenants allow issuers to make investments (but not pay dividends) even if the main “basket” is negative

Sometimes limited by including a “Permitted Business” standard

13

This covenant gives each bondholder a separate put right at 101% of par if a “Change of Control” occurs

Bondholders are investing in the existing equity sponsor and Board of Directors

Bondholders want to have the option to exit the deal if a new person or group takes over the company

Merger of two public companies may not trigger the change of control (unless you have a single stockholder or group that controls the surviving company)

The definition of “Change of Control” may vary

Typical provision is tripped if

Any single person or “group” acquires more than 35-50% of the company’s outstanding voting stock

– Exception for original deal sponsor and entities controlled by that sponsor

A new Board of Directors is elected without the blessing of the incumbent board

Typically not a “Change of Control” if the sponsor sells down to below 50% (or sells out) but may be in some cases

High Yield TermsCovenants – Change of Control

14

This covenant protects against disguised dividends by preventing the company from entering into non-arm’s-length transactions with its affiliates such as

Paying excessive management fees to deal sponsors

Selling assets to stockholders for less then FMV

Overpaying stockholder/employers through excessive salaries

Affiliate transactions are not prohibited, but must be arm’s-length and approved by disinterested directors

Fairness opinion also required if transaction is large enough (involves payments >$5-10M)

High Yield TermsCovenants – Affiliate Transactions

15

The purpose of this covenant is to make sure that the Company’s balance sheet stays in balance

Company can sell assets, but must get

FMV

Mostly cash (75-85%)

– Exception to this for “Asset Swaps” is common

Must use the proceeds to either

Repay senior debt or

Reinvest in [long-term] assets useful in the business or

Make an offer to repurchase the bonds

In other words, if assets shrink, must replace with new cash-flow generating assets or reduce debt

High Yield TermsCovenants – Asset Sales

16

High Yield TermsCovenants – Liens and Anti-layering

Liens

Protect seniority position

Senior noteholders don’t want more secured debt ahead of them -- in particular, they don’t want the next senior note deal to be secured

Senior subordinated noteholders don’t want liens securing any other senior subordinated debt

Anti-layering

Prevents issuer from layering debt between the senior and subordinated debt

Only used in senior subordinated deals

Ensures that subordinated debt occupies the second class slot (and not the third or fourth)

Lien and anti-layering covenant issues are complicated by structures which include second lien loans and bonds

17

High Yield TermsCovenants – Dividend Stoppers

Dividend Stoppers (“Pinching the straw”)

Protects the flow of cash from the subsidiaries

Dividend stoppers can create structural subordination (no access to cash flow)

Important in holding company deals where bank debt is at the operating company

18

High Yield TermsCovenants – Merger Test

Applies to mergers where the issuer is a party

Does not apply to subsidiary mergers

Applies to a transfer of “all or substantially all” of the assets

Bonds should follow the assets

Prevents the assets from moving as a whole unless the credit can handle it

Merger or sale of all assets okay if:

The surviving entity assumes the bonds

The surviving entity can incur ratio debt

19

High Yield TermsCovenants – Reports & Other Covenants

Reports

Requirement to make public disclosures of results

SEC form?

Quarterly versus semi annual

Website posting

Bloomberg

Bank covenants

Other Covenants

Sale/Leaseback

Sale of equity of subsidiaries

Additional amounts

Payments for consent

Permitted business

20

Topics for a Second Meeting

Subordination and Inter-creditor Issues

Guarantee Structures and Limitations

Optional Redemption Terms

Floating Rate Note Structures

Senior Secured Notes

2cnd Lien Notes

PIK Note Structures