Originally published in Global Turnaround , April 2007.
This article addresses the prospects of recoveries for high yield bondholders in Europe, in the event that there is an adverse change in the credit climate. The structure of high yield bonds in Europe has changed since the 2001-2003 downturn (the "Last Cycle"). The impact of these structural changes, together with the explosion in debt issuance in recent years as a result of increased levels of M&A and private equity activity and the arrival of a number of new debt products, will mean that bondholders face a different landscape compared to the one they faced in 2001 – 2003. High yield bond defaults are close to a 25 year low; even if the credit climate remains benign however, it is hard not to conclude that default rates can only go in an upward direction over the next eighteen months.
Recoveries in the Last Downturn
It was only in the late 1990s that European companies began issuing high yield bonds. In the past these bonds were called "junk bonds" because of their below investment grade ratings but they were attractive to some buyers who prized the high interest rates on offer. Almost as soon as the high yield bond market had become established in Europe, participants encountered challenging conditions (to put it mildly). Fitch1 reported that high yield defaults during 2002 stood at 25.1 percent (as opposed to under one percent currently). A staggering 89 percent of European cable and telecoms high yield related bonds were in default according to Fitch.
A number of US bondholder participants in the distressed debt community were dismayed to find that the European high yield model differed significantly from the US model. In early European high yield transactions, bonds would often not benefit from guarantees given by the operating companies within a group and the issuer would be a holding company of the main group holding company. Senior lenders would be structurally senior to the bondholders and benefit from significant security and guarantees from the issuer group’s operating companies. The senior lenders’ leverage in negotiations with bondholders was consequently very strong. By contrast, the US model at the time placed the issuer as the main holding company of the group and the bondholders typically received guarantees from the main operating companies. Given these structural differences it is hardly surprising that recovery rates for European defaulted bonds between 1985 – 2001 were, according to Moody’s, 22 percent of par in comparison to 43 percent of par in the US2. The ability of US debtors to use Chapter 11 insolvency procedures as opposed to the uncertain outcome of ad hoc out of court restructuring techniques or the application of value destructive insolvency laws prevailing in Europe may also have been factors in the disparity of recovery rates.
Treatment of Shareholders
US Chapter 11 procedures and European legal regimes dealt with shareholders in restructurings in different ways. In many European countries, shareholders were able to extract a "ransom" value for their consent to restructure a company. In the States, bankruptcy plans can be adopted by debtors if US bankruptcy courts use their powers to "cram down" dissenting shareholders. Notwithstanding the rash of insolvency legislation across Europe in recent years, "cram down" provisions have not been entrenched in local legislation and value in restructurings is likely to continue to leak to equity holders in a way that would not be the case in the US.
Resurgence in High-Yield Issuance
European high yield has made a spectacular come back from the nadir of 2002/3. There was approximately $40 billion of high yield issuance in 2006 according to Moody’s. The changes in the European high-yield model, which lead to the inclusion of upstream guarantees from operating companies, has allowed the high-yield product to compete with other debt products such as mezzanine debt, hybrid securities, second lien notes and payment in kind (PIK) notes. Leverage structures in the last few years have, however, become increasingly "borrower friendly" as a result of intense competition between lenders to participate in lucrative LBO financings.
Typically, the trustee of most high-yield bonds will now be required to enter into an intercreditor agreement with other creditors which will provide that the claims of the bondholders on an insolvency will be subordinate to the claims of lenders which are senior in the structure to the bondholders. Whereas in the past it was often the case that senior lenders were content to rely on their structural superiority to the bondholders without requiring the trustee of the bonds to sign an intercreditor agreement, now it is standard practice for all creditors to agree to the terms of subordination contractually. As well as including provisions regarding the order of payments of proceeds on insolvency/security enforcement, the intercreditor agreement will constrain the bondholders, and any other tranche of debt junior to the senior lenders (such as mezzanine debt), from taking immediate enforcement action in respect of any guarantees from operating companies following the occurrence of an event of default under the bonds or other junior debt. Intercreditor agreements now require the bond trustee to stand still and desist from taking such enforcement action for many defaults until a period of at least 179 days has elapsed after the occurrence of a bond default. If there is an event of default under the senior loan, lenders are likely to be proactive and either some kind of restructuring plan will be agreed during the bond standstill or enforcement action will be taken.
Enforcement by the Senior Lenders
Given the increased complexity of capital structures compared to the Last Cycle and the consequent increase in the number of stakeholders who need to agree a financial restructuring there is a serious prospect that stakeholders will, on occasions, fail to reach agreement on a restructuring plan. If no restructuring is agreed the senior lenders have the option of enforcing security. In order to encourage an attractive bid, the senior lenders are typically permitted under an intercreditor agreement to instruct a security agent to release the guarantee or security claims of all creditors junior in structure to the senior lenders (such as the bond claims). If a business is sold in a distressed state either as a result of a security enforcement or as a result of an insolvency process it is likely to be purchased for a depressed price often at a value that may barely cover the full amount of the senior debt. Accordingly value flowing to the more junior parts of the debt structure in these circumstances is likely to be fairly minimal.
Changing Nature of Investors in Mezzanine and Second Lien Debt
London has become a centre of activity for the hedge funds and proprietary desks of the investment banks that specialise in this area. Many of the distressed debt specialists have been forced by lack of supply of distressed debt to enter into the regular primary or secondary "non distressed" debt market. It is to be expected given the significant investment returns generated by distressed strategies (such as debt equity swaps) that these funds will revert back to the distressed market if the supply of distressed opportunities increases.
Many distressed investors are likely to choose to enter the market higher up the capital structure than was formerly the case in the last down turn. Sophisticated distressed debt specialists will often look to invest in the part of the capital structure where the "value breaks", namely in the tranche of debt where it is apparent the distressed company’s ability to pay back its debt will cease. If the "fulcrum credit" is the second lien or even the senior tranche, it is likely that high yield bondholders will be negotiating with robust distressed debt specialists who have little (or no) inclination to compromise in their negotiations with junior tiers of debt. Distressed specialists may well either be holding senior claims or be in alliance with the senior lenders which, if the intercreditor is drafted correctly, will allow the distressed specialists to arrange for the enforcement of security and require the bond trustee to release the bondholders’ guarantees (whether the bondholders like it or not). A recent example of this is the case of Schefenacker, a German automobile parts company. Under a proposed Company Voluntary Arrangement in the UK (see www.schefenacker.com) the bondholders of Schefenacker’s €200 million 9½ percent Senior Subordinated Notes, were originally offered (in return for the cancellation of their notes) five percent of the equity of Schefenacker, or the prospect of receiving nothing if the CVA fails and a security enforcement takes place. The Schefenacker story is not yet complete as the creditors’ meeting which was originally scheduled on 30 March has since been adjourned and a revised proposal is likely to follow in early May.
Impact of Credit Default Swaps
It is possible that if there are low recoveries on offer some bondholders may decline to involve themselves in restructuring negotiations. Other bondholders may not wish to become involved because they have purchased credit default protection. The occurrence of a number of agreed "credit events" such as a "bankruptcy event" would allow the purchaser to receive a full payment of the nominal amount of the bond from the credit default seller. With this protection in place the bondholder will have little incentive to work with the debtor to avoid or mitigate the impending troubles (in fact, arguably a reverse incentive applies; a bondholder in these circumstances has every incentive to sit on its hands).
There has been an oft heard lament from the distressed debt investors in the last few years—risky credits are being mispriced and distressed assets are trading at high prices unjustified by the financial risks of holding them. Recent stock market jitters have caused a temporary reassessment of the risks of holding certain risky assets but it is too early to conclude that the credit climate has reached a significant inflexion point.
If, or perhaps when, the credit climate changes, European high yield bondholders may well encounter well organised opposition from creditors ranked above them in the capital structure. In the Last Cycle the fight for value often occurred between the high yield bondholders and the company (fighting on behalf of the equity) with the senior lenders standing mainly on the sidelines jealously guarding their position. In the next cycle bondholders are likely to face the prospect of distressed debt investors, holding mezzanine debt and/or second lien debt, in alliance with the senior debt ready to press the trigger on a security enforcement process.
It is often easier to threaten a security enforcement process than to execute one. Documentation has often been put together at break neck speed; intercreditor agreements may not be quite as clear on the rights of the senior lenders as they should be and the laws of the various jurisdictions where enforcement may take place may not be conducive to effective enforcement. Any security enforcement process carries the risk that it destabilises the business, or the process becomes mired in litigation and it comes as no surprise that the original CVA proposal for the Schefenacker bondholders has been withdrawn and that a more generous offer may be on the table. In the next distressed cycle creditors will need to be painstaking in their review of the documentation and to take very detailed advice on the prospects of success of any security enforcement process.
1 One-Quarter of European High Yield Market Defaults in 2002, Fitch Ratings, 17 March 2003.
2 Default & Recovery Rates of European Corporate Bond Issuers, 1985 -2001, Moody’s Investors Service, July 2002.
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.