07.22.2016

De-Risking Brexit: The Shape of Covenants to Come? (by XTRACTResearch)

In this Special Report we consider the possible impact of the 23 June 2016 Brexit referendum outcome on the nature of future high yield bond covenants.

In particular, we speculate on potential refinements to covenants that could protect bondholders against the risk of UK-related adverse consequences.

We also point out that some of the features referred to below have precedents in certain existing bonds where there were circumstances which can be considered analogous, to varying degrees.

Our basic thesis is to look at a European group that wants to issue high yield bonds and which has some material UK business. The general concern will be a deterioration of the UK part of the business as a consequence of anticipated or actual Brexit. The significance of that concern will obviously depend on the specific industry sector and the contribution that the UK business makes to the group as a whole. That will be a matter to be considered on a case-by-case basis.

DISCLOSURE ISSUES

In addition to Risk Factor language1 , and before turning to details of covenants themselves, some points as to disclosures occur to us.

For any group (and not just a European one) which has UK business of any degree of materiality, we would certainly expect to see a more detailed breakdown of the UK business’s contribution to revenues, EBITDA, assets etc. This should be split out separately and not simply included in figures for Europe as a whole. This should appear in the summary financials or the MD&A.

We would also expect the MD&A to include specific commentary on the management’s assessment of the impact of the anticipated and actual departure of the UK from the EU. That should include any impact already observed (e.g. effect on order books etc. and effects of exchange rate volatility).

As to the future impact, inevitably that will be very difficult to predict at this stage with any degree of precision – but it is reasonable to expect some description of the management’s outlook, contingency planning and any risk mitigation. Management must be focusing on these matters and so should explain them although this will be tempered by a wish not to disclose details that would be overly commercially sensitive and of help to competitors. In respect of quarterly reporting post-issue date, similar information should be required to be given each time to ensure continuing understanding of any Brexit impact evolution.

COVENANT ISSUES

In appropriate cases, the following possible refinements to high yield bond covenants occur to us. Very importantly, we do not suggest that such changes to covenants should be some aspirational new postreferendum “market standard” for indiscriminate application. The proper test for such modifications should be whether or not they are appropriate for the particular issuer group.

Should the UK business be outside the Restricted Group?

The disadvantage of excluding the UK business from the Restricted Group would mean that it is not fettered by the covenants at all and would have great freedom of action, including as to incurring and securing its own debt, disposing of its assets, the payment of dividends and the making of investments etc.

It is more probable that the UK business should be within the Restricted Group – but there be an element of ringfencing, where appropriate. Within the Restricted Group – but ring-fenced?

Typically, high yield bond covenants allow inter-company loans, asset transfers and investments within members of the Restricted Group without limitation. This is achieved through standard formulations:

• Allowing intercompany debt (as a permitted debt item under the Indebtedness covenant);

• Allowing guarantees by Restricted Group members of third-party debt incurred by other Restricted Group members (to the extent such third-party debt is allowed by the Indebtedness covenant);

• Excluding from the “Asset Sale” definition asset transfers among Restricted Group members (for the purposes of the Asset Sales covenant); and,

• Allowing unlimited investments (including loans) among Restricted Group members (as a “Permitted Investments” item for the purposes of the Restricted Payments covenant). In suitable cases, in future one might expect to see UKrelated risks mitigated by ring-fencing the UK Restricted Group members from the other Restricted Group members in the following areas:

• Capping the amount of debt that may be incurred by the UK Restricted Group members under the Indebtedness covenant. This could include sublimits on the amount of Ratio Debt (i.e. debt incurred under the 2x fixed Charge Coverage Ratio) and the amounts under at least some of the Permitted Debt baskets that may be incurred by the UK business. It would also be important to capture, among other things, the ability of non-UK Restricted Group members to guarantee whatever debt the UK members are permitted to incur (to limit the nonUK members’ exposure through credit support for the UK business) and the intercompany debt (i.e. intra-Restricted Group members) permission. Normally, both of these are uncapped – and so, if not captured within any limit, they could provide indirect means of circumventing other aspects of ring-fencing.

• In the Permitted Investments definition, imposing a cap on the amount that can be invested by nonUK Restricted Group members in the UK ones. Remember that “Investments” is widely defined to cover new equity subscriptions, asset injections, loans etc.

• Modifying the Affiliate Transactions covenant to regulate transactions between non-UK Restricted Group members on the one hand and UK members on the other, for example, by subjecting them to the disinterested directors’ approval test if above a certain amount and to the independent fairness opinion test if above a higher amount (in addition to the covenant’s normal regulation of dealings between the Restricted Group and related parties). Existing comparisons We do point out that there are some existing bonds with bespoke covenant modifications for situations which may be broadly comparable. Two deals with Greek-related risks contained covenants designed to address the threat of Greece leaving the Eurozone (but not leaving the EU). That situation is, however, analogous to some degree to the present one.

The essential concern was the risk of the Greek part of the business suffering on a Grexit from the Eurozone (in particular through the effect of devaluation of a reinstated Drachma on revenues or cash reserves and debt-service ability) and the aim was to limit the related risks for bondholders. Fage: In late 2012, Fage Dairy did a tap issue of Additional Notes to its original 2010 issue of 9.875% 2020s. The terms of the original covenants were amended to align with covenants for the Additional Notes which specifically addressed the Grexit concerns. Basically, the covenant changes were to limit cash and asset leakage from the non-Greek business into Greece. Among other things, the updated covenants: restricted loans, asset disposals, dividends, investments to Fage Greece; restricted the ability of other Fage group entities to provide loans, guarantees and other credit support to Fage Greece; regulated inter-group transactions between Fage Greece on the one hand and the rest of the Fage group on the other hand3 .

The Fage Notes had a bespoke “Limitations on Investments, Loan and Advances” covenant, to which other covenants cross-referred. The language used in appended to this Special Report. Frigoglass: In the Frigoglass 8.25% Senior Notes due 2018, issued in May 2013, the Indebtedness, Restricted Payments/Permitted Investments, Affiliate Transactions and Asset Sales covenants were all modified to regulate the Greek-incorporated Parent Guarantor (Frigoglass SAIC) more tightly. The intention was to limit the Parent Guarantor’s leverage and the accumulation/upstreaming of cash or assets at the Parent Guarantor level, so as to help preserve the credit worthiness of, and recoveries from, the Dutch issuer and the non-Greek Subsidiary Guarantors.

Constellium: Apart from the Grexit-related examples above, Constellium’s recent issue of $400mm Senior Secured Notes due 2021 had (partly in response to investor pushback during marketing) various features to limit the extent to which part of the Constellium Restricted Group could support the Wise Metals business (also within the Restricted Group). The limits were principally through the Indebtedness and Restricted Payments/Permitted Investments provisions. In effect, they regulate the risk of the healthier business subsidizing the underperforming business to the detriment of investors principally relying on the credit of the healthier business. This too could be considered an appropriate comparison.

There are no clear indications of how covenant packages may respond to Brexit. However, we hope that these observations give food for thought to all market participants and also show that perceived problems in some existing issues have been dealt with and enabled those issues to come to market.

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