February AFME investors’ letter has had virtually no effect, study shows

12 Nov

Thou shalt not conspire to replace the special servicer with one more likely to allow a struggling mortgage-payer to avoid admitting default.

DebtXplained, an organisation which provides in-depth data on the trends in the structure of bond issuances of most shapes and sizes, has released the results of a survey on the effects of February’s AFME Investor Letter.

“Have covenant protections improved since the February letter?” is the question under examination. The results of its analysis indicate the overwhelming trend is in the opposite direction to that the AFME investors who subscribed to the letter would like to see. The list of subscribers includes all the luminaries of the institutional investment universe, and can be found in Appendix A.

These investors laid out their concerns over the growth in “carve-outs”, particularly in the indebtedness covenant, where provision for indebtedness has vastly expanded. It noted also the increased use of soft capped or dynamic baskets for “Dynamic Debt”, and of the inclusion of “Contribution Debt”.

Dynamic Debt is where leverage can be hiked up, and even written down, through pre-specified exogenous policies.

Contribution Debt is a feature largely of the portfolio companies of private equity sponsors. This ‘basket’ contains the debt that is permitted so long as it equals the value of cash contributions made to the issuer’s equity capital, after the security’s issue date. Thus the private equity sponsor can counter-balance new loans incurred simply by buying more shares in the company.

The full list of issues highlighted by the AFME petitioners is fairly extensive and can be found at http://www.afme.eu/uploadedFiles/Content/Divisions_%28Public%29/High_Yield/Investor%20letter%20Latest%20Version.pdf.

The overwhelming conclusion reached by DebtXplained is that:

“There is not a single covenant out of those raised in the AFME investor letter in which there has been a material tightening of provisions.”

The report highlights the key aspects in which loosening of covenant standards continues apace. Of particular concern are:

  • The inclusion and securing of debt baskets. Secured contribution and acquisition debt baskets are in the majority of 2015 deals. Within the subset of secured contributions, increasingly these baskets are uncapped, rather than being ratio capped or percentage capped. This was a decisive change in 2015.
  • Moreover, the use of cost-saving synergies has expanded beyond the remit of purely acquisitions, and EBITDA provisions have been ‘streamlined’ to include many other areas of overlapping operations. In September 2015, incredibly, 100% of contracts contained cost saving synergies which were not limited to acquisitions.
  • Capacity for the payment of dividends. A leverage-based dividend basket is in the majority of 2015 deals. In an increasing number of deals, asset sale proceeds are permitted to be paid as dividends. Where fixed charges apply to assets which are used as security on loans, the selling off of the company’s material capital is clearly not desirable for the bond subscribers.

This trend spiked in September, 2015, to 100% of deals; though in the six months immediately preceding, this clause was less in evidence, the general trend line is clearly moving upward.

  • Within ‘grower baskets’, there has been a return to using total assets as a starting-point to calculate the permitted percentage of debt to accumulate; as opposed to EBITDA, which metric is still in evidence but less prolific. Investors seem to be favouring hard or tangible assets as security, rather than pushing for unrestricted growth. This seems one positive point among a report that is largely bad news for the AFME investors.

‘Grower baskets’ are so-called because they promote the growth of assets – or prevent their being sold off – with an ‘either or’ clause; the basket may be the greater of €10million, and a set percentage of total assets (with the percentage set at the equivalent of €10million on the issue date).

  • So-called ‘equity claw’ provisions have become less restrictive; in the majority of covenants now allowing the issuer to redeem up to 40% of the high yield bond using the proceeds of certain equity offerings. Previously the market norm had been a limit of 35%.

Within the first three years after the high-yield bond is issued, the issuer can redeem up to 35% or 40% using the income from certain equity offerings- dependent on the covenant provisions. The redemption price is the principal amount, plus accrued interest, plus a premium equal to one year’s interest payment.

Appendix A

Alliance Bernstein LP
BNP Paribas Investment Partners
ECM Asset Management Limited
Fidelity Worldwide Investments
First International Advisors LLC
GLG Partners LP
Henderson Global Investors
Investment Management
Invesco Perpetual
Legal & General Investment Managers
Mirabaud Asset Management Limited
Muzinich & Co.
Berman LLC
Northlight Group
Pictet Asset Management S.A.
Pioneer Investments
Robeco Group
Rogge Global Partners Plc
Ireland Limited
T Rowe Price
Threadneedle Investment

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