Latham hatches radical plan to shake up high yield market
21 November 2005
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Is high yield dead in Europe? That's what the champions of mezzanine and second-lien debt would like you to think. High yield has certainly struggled in the past year or so.
While in 2004 there were plenty of corporates recapitalising by replacing bank debt with high yield bonds, in 2005 the number of deals has seriously fallen off, say gloomy high yield lawyers. The two headline European issues of 2005 - Wind at €12bn (£8.14bn) and Tim Hellas, the first all-bond financed leveraged buyout in Europe - are enormous, but even they don't mask the slack.
The high yield desks of investment banks have got the jitters, and it's not hard to see why. The banks might want to push high yield because of the big deals and the league table standings, but at the same time they have to offer an attractive financing structure that will help win the whole mandate.
In fact, high yield professionals are getting so rattled, certain influential figures within the market have decided to do something about it. So here's the big news: European High Yield Association (EHYA) chair and Latham & Watkins finance partner Bryant Edwards is set to launch a campaign in January to persuade the high yield market that it should dilute call protection, and fast.
Dilute call protection? This is radical stuff. Traditional high yield investors are not going to be too happy. For them, a no-call provision for five years on a 10-year bond (or four-year no-call on a seven-year bond) means certainty within the investment portfolio.
Call protection means that companies wanting to refinance their capital structure can't just pay back high yield investors whenever they fancy without a serious redemption premium or 'make whole' payment. This has made high yield terribly attractive to pension funds, for example, which want a fixed-rate product where they can accurately match liabilities to assets over a long period.
So Edwards' move is hardly likely to be immediately popular with everybody. However, he argues that with the right level of compensation, high yield investors simply have to start being more flexible. "The high yield market has got to be willing to accept lower call protection," he says.
Edwards has a track record on this. Last year he helped pioneer the hybrid product of the mezzanine note on the Focus Wickes deal. That addressed the vexed issue of subordination and got noteholders the crucial contractual subordination they wanted. Traditional high yield investors dislike the European approach of structural subordination, whereby bondholders come at the bottom of the creditor pile. And in return for getting contractual subordination, those noteholders had to accept a mere one-year call.
Edwards accepts that dilution of call protection for a fixed rate instrument might be a bit radical for some of his constituency in the EHYA. "Yes, it's controversial with some buyers, but [the lack of flexibility] means they're losing out on a lot of credit," he argues. "That's why I'm pushing to have a programme in January to tackle the issue head-on with the buy side. They're going to have to rethink long no-call periods."
Edwards' case looks compelling. The European high yield market has certainly been losing popularity over the past couple of years. High yield has even seen problems in the US, exacerbated by the high-profile downgrade of General Motors to junk status. That essentially put a stop on the high yield market for several months, as investors struggled to rebalance their portfolios.
But in Europe there is even more competition for credit. For example, when Debenhams refinanced earlier this year it preferred to incur a substantial make whole payment on the high yield and go for an entirely senior debt package. There is so much liquidity in the senior debt market at the moment that sponsors can get very nice deals indeed from the banks.
"The US has never had a mezz market which approaches what Europe has," says Edwards. "We see deal after deal after deal not using high yield, but high yield is a better product - it trades better and is more transparent than mezz."
The prime movers here are, as always, the European private equity sponsors, which have exerted the biggest pressure on call protection. "Up until recently they had to go for high yield issues because the mezz and other subordinated debt were simply not deep enough to support target bid prices," says Ed Eyerman of Fitch Ratings.
Indeed, call protection has already started to fray around the edges. In more recent times there has been a series of floating rate high yield issues, which were designed to replicate bank debt. Given that bank debt is prepayable at any time, it's fair to assume that flexibility dominated the discussions on the financial package. This culminated in Cablecom in March this year, which had a six-month call - the shortest yet. Latham advised the company and Simpson Thacher's Walt Looney advised Goldman Sachs, Credit Suisse and Deutsche.
But even this faint movement is not enough for Latham's Edwards. The floating rate high yield market has inevitably burgeoned this year because of the assumption among investors that interest rates will rise. The real argument to be won is on the fixed-rate notes.
As far as he is concerned, the high yield market is missing a trick because powerful sponsors want a refinancing instrument that helps them to exit even faster. Research from Fitch underlines this. In a recent paper on leveraged buyouts (LBOs), it notes that prepayment times are getting shorter, in the retail sector especially. New Look was recapped a mere 11 months after the LBO closed, Debenhams 13 months and Vivarte 18 months. This compares to an average of 22 months in the wider market. And even that 22 months has come down from the average several years ago.
There may be some initial resistance among the high yield community to dilution of call protection, but it's the rush towards LBO exits driven by the private equity houses that may sway the argument in the end.
Nick Coates, head of European high yield at RBS, gives Bryant Edwards' move a cautious welcome. "If you have a multiplicity of products, which are subtly different, I can quite see the rationale for establishing some product uniformity," he says. "If there is a dilution of call protection, investors should reasonably expect to be compensated for it.
"And if the compensation is right, then the product should clear the market."