United States: Recent Trends In Latin American High Yield Offerings

The Latin American high yield market showed remarkable growth in 2012, with 34 issues totaling $14.1 billion, versus 28 in 2011 totaling $12.5 billion. 1 Historically low yields led many first time issuers to the market, particularly in countries outside of Brazil and Mexico, including a total of four Peruvian first-time issuers. A review of the covenant packages in 35 Latin American high yield offerings during 2012 and the second half of 2011 reveals a number of significant trends.

Generally, Latin American high yield bonds saw the tightening of certain covenants, including the reporting obligations and the asset sale covenants discussed below. In addition, a growing number of issuers have been encountering tighter restricted payment covenants, a marked change from a few years ago. In the vast majority of recent issuances, the restricted payment build-up basket was tied to 50% of consolidated net income, with only a small number of issues (fewer than one in six) using 100% of consolidated net income as the starting point, which had become the norm immediately before the 2008 financial crisis. However, certain issuer-friendly provisions that are common in the U.S. high yield market, such as the change of control drag-along rights discussed at greater length below, were included in more Latin American transactions in 2012.

On other fronts, Latin American practice remained divided. For instance, the coverage ratio and the leverage ratio were used with equal frequency in the debt limitation covenant packages reviewed, with roughly one third using a coverage test, another third using a leverage test, and the remaining issues including both tests. Of those issues that used a coverage test, approximately two thirds permitted incurrence at 2.0x, with the remainder having higher requirements (the highest at 2.5x). Leverage ratios, meanwhile, fluctuated between 3.5x and 6.0x, for issuers rated B-/B3 to B+/B1, and between 3.0x and 4.8x, for issuers rated BB-/Ba3 to BB+/Ba1.

While it remains difficult to predict market conditions in the coming months, we expect the following significant covenant trends to continue in 2013:

Increased Reporting Obligations

In the wake of the U.S. Securities and Exchange Commission’s changes to Rule 144A in 2008, which substantially reduced the holding periods applicable to the sale of restricted securities, high yield debt offerings in Latin America have been predominantly structured as “144A for life” transactions. A “144A for life” transaction does not allow for the use of other exemptions from registration other than Rule 144A or Regulation S and does not mandate any follow-on registration that would result in issuers becoming subject to the SEC’s reporting requirements. In these transactions, investors frequently sought to impose a contractual obligation to publicly disclose information on a basis similar to U.S. domestic issuers, but many Latin American issuers were able to successfully resist such efforts and limit their reporting obligations to the delivery of audited annual and unaudited quarterly financial statements.

Recently, however, we have seen investors renew their efforts to impose more robust reporting obligations. Given the limited amount of information available from many Latin American issuers (as compared to U.S. issuers), which are often not subject to public reporting requirements under local laws, investors are now typically insisting that issuers deliver a management report similar to the discussion that would be included in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the relevant offering memorandum. Several high profile transactions in 2012, including offerings by Peruvian sugar producer Coazucar and soft drink manufacturer Aje, included this provision. In addition, some covenant packages now call for issuers to provide English language copies of all filings with local regulators and, in a few cases, to provide an updated narrative description of the issuer’s business. We have also seen investors pushing Latin American issuers to hold quarterly earnings calls. Although quarterly earnings calls have long been a feature of the U.S. high yield market, the practice is rare in Latin America, and issuers are largely resisting that request at this point.

Investors are clearly looking for ways to ensure there is a steady flow of information on Latin American high yield issuers, and that information should help support a healthy trading market for the issuers’ debt securities.Despite the additional burden that heightened reportingobligations may pose for Latin American issuers, itis worth noting that an informed and engaged investorbase would prove beneficial in the long run, as it will helpmaintain investor interest and confidence in the issuer andmay reduce the amount of investor education required ifthe issuer returns to the market for future offerings. At aminimum, we believe the practice of including a managementreport along the lines of an MD&A with auditedannual financial statements is becoming increasinglycommon and will likely continue in the near term.

Tightening of the Asset Sales Covenant

Asset sales covenants are another area in which recent trends favor investors. In general, a typical asset sale covenant requires that (i) the issuer receive fair market value in exchange for any asset sold, (ii) a specified percentage (typically 75% to 85%) of the consideration received be in the form of cash or cash equivalents, and (iii) the net proceeds from the sale be used to repay existing debt, purchase replacement assets or repurchase the relevant bonds at par. In short, the covenant requires the issuer to either deleverage, thereby reducing its debt service burden, or to replace assets so its ability to generate cash flows is not diminished.

When opting to repay existing debt with the proceeds from an asset sale, issuers were traditionally permitted to repay senior debt, whether such debt was secured or unsecured. In the last year, however, we have seen this provision narrowed, with investors more frequently restricting issuers’ ability to repay unsecured senior debt. The most flexible of the new provisions allow issuers to prepay unsecured senior debt provided the obligations under the relevant bonds are also ratably reduced, while stricter provisions only permit secured debt of the issuer and its subsidiary guarantors or unsecured senior debt of non-guarantor subsidiaries (which would be structurally senior to the bonds) to be reduced. Offerings by Peruvian retailer Maestro and Brazilian meat producer JBS included the former approach, while several transactions in 2012, including Chilean pharmaceutical company CFR, took the latter approach. While the specific limitations vary depending on the deal context, this tightening of the asset sales covenant has become popular with investors because it reduces the risk that free cash will flow out to other creditors, particularly those that would, in a bankruptcy proceeding, be pari passu with the bond holders.

Restrictions on Intercompany

Debt for Mexican Issuers

Virtually all high yield covenant packages provide issuers with a basket to incur unlimited intercompany debt. However, in the wake of the restructuring of more than $1.0 billion of debt for Vitro, Mexico’s largest glassmaker, high-yield Mexican issuers have felt pressure to accept covenants limiting the use of such intercompany debt in Mexican restructurings. Under the Mexican Bankruptcy Law (the Ley de Concursos Mercantiles), Vitro was allowed to vote intercompany debt – some $1.9 billion in intercompany loans made after Vitro initially defaulted in 2009 – in favor of a restructuring plan that third-party creditors argued was more favorable to equity holders than to them.

Since the Vitro decision, investors have been demanding more protection from high-yield Mexican issuers to address this inherent risk in Mexico’s bankruptcy regime. For instance, several issuers that came to market in the fall of 2012, including hotel operator Grupo Posadas, agreed to include provisions requiring that intercompany debt incurred under the debt covenant vote together with thirdparty creditors in the event of a Mexican restructuring. While some issuers that came to market after the Vitro decision (including Mexican home builders Corporación Geo, Homex and Urbi) did not include such provisions, and repeat issuers with solid businesses may resist them, we expect that investors will continue pressing for the language. Moreover, since these provisions do not impose an additional burden on issuers, and it is difficult to formulate a pre-default business rationale for not including them, investors may suspect, with some justification, that resistant issuers may be seeking a means of undercutting their creditors in the event of a restructuring. As a result, we expect that Mexican issuers – particularly first-time issuers and issuers that have defaulted in the past – will find it increasingly difficult to push back on this point.

Convergence with Certain U.S. Practices

Not all of the recent trends in the Latin American high yield market have favored investors, as certain issuer- friendly U.S. practices are becoming more common as well. For example, one particular issuer protection that has long been a feature of the U.S. high yield market – the change of control drag-along right – is now being used more widely in Latin America. In the U.S. high yield market, the change of control provision, which gives investors a put right at 101% in the event of a change of control, also typically provides for a redemption right on the part of the issuer if a specified percentage of bond holders (usually 90% to 95%) participate in the change of control offer. Issuers want this provision in order to squeeze out minority hold-outs, particularly when the 101% change of control offer is below the market price of the bonds and the change of control occurs during the no-call period, when the issuer would otherwise have to pay an expensive premium for the remaining bonds.

The Latin American high yield market has historically resisted this change of control drag-along provision (except in Brazil, where drag-along rights are already the norm). The change of control “put right” provides each investor the opportunity to rethink his or her investment in the event of a change in the ownership or management of a company. By agreeing to drag-along rights, investors would allow themselves to be forced to sell, potentially at a discount, which some investors viewed as contrary to the spirit of the change of control provision. Although still bitterly contested, change of control drag-along rights have become more common in Latin America, with a large number of 2012 transactions in Brazil, Mexico, Guatemala and Colombia including such provisions. Going forward, we expect this type of issuer protection to become increasingly common.

Looking ahead to 2013, we believe further convergence of the Latin American and U.S. high yield markets is likely, with greater flexibility for Latin American issuers in certain areas. For example, we may see more covenant packages with expansions of the add-backs to the calculation of EBITDA based on pro forma adjustments from projected cost savings. In the U.S. high yield market, these add-backs have been allowed for quite some time (but are now often capped), and we have seen them included in a small number of Latin American transactions in 2012. In addition, although it is currently rare for Latin American issuers to be allowed to treat certain designated non-cash consideration as “cash” for purposes of the asset sales covenant, it is conceivable that within a few years (or even months) Latin American issuers will start insisting on it, as many U.S. high yield issuers now do.

Final Thoughts

As discussed above, the Latin American high yield market saw record issuance volumes in 2012, with a number of covenants returning to more conservative standards while other provisions have moved in an issuer-friendly direction. Although it remains unclear whether 2013 will be another record year in the Latin American high yield market, further convergence with U.S. high yield practices – both those that favor investors and those that favor issuers – is likely, but as we have seen from the fallout of the Vitro restructuring, regional and national concerns will continue to drive certain trends.

Footnotes

1 Based on a review of senior notes offerings pursuant to Rule 144A and Regulation S by sub-investment grade rated corporate issuers in Latin America (excluding project bonds and perpetual bonds).

Previously published in Latin American Law & Business Report, Volume 21, Number 2 – February, 2013.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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