Senior, junior or in the middle: the battle goes on

It all used to be so beautifully binary. In the 1990s, workout ­battles were usually between the company and its banks. But that was before the complex financing arrangements associated with the leveraged market became the norm.

“In the good old days, the arrangers of the senior were the arrangers of the junior,” says one magic circle lawyer. “They would agree all the docs and they would do very little negotiation with the junior creditors.”

“The intercreditor agreement was a very formalistic document and the product of 15 years of negotiation and refinement,” says Kirkland & Ellis partner Stephen Gillespie.

“From 1993 onwards the terms of the intercreditor didn’t change very much. Those terms were pretty favourable to the ­senior lenders: it gave the junior lenders the right to pull the trigger but it gave them no control over the process or little protection in terms of valuation.”

All change

But the entrance of players such as Intermediate ­Capital Group and MezzVest into the market changed everything for lawyers. Not only did it become clear that separate representation was required for senior and junior investors, but the intercreditor agreement itself became the key battleground for lenders, not least because the junior lenders were looking at the bond market and eyeing their protection with some envy. While valuation had remained the core discussion point in restructurings, all of a sudden debt release mechanisms became a huge issue.

Over the past four years, ­there have been several major deals and cases, along with a revision to the Loan Market Association (LMA) standard agreement. But despite two high-profile court cases where the senior lenders got the results they wanted, ­market practice is shifting towards accommodating the junior lenders.

Talking about the Car Wash

“The mezz have spent the past few years lobbing rocks,” says one finance partner who habitually acts for senior lenders. One of those rocks turned out to be a case that went all the way to the High Court in August 2009 - in the matter of Bluebrook Ltd & Ors. Following the 2006 leveraged buyout (LBO) of IMO Car Wash Group by ­Carlyle Group, the holding company Bluebrook had senior and mezzanine credit agreements, where the later was subordinated to the senior.

The restructuring proposal was backed by an HBOS-led consortium of senior lenders, advised by Lovells (now Hogan Lovells) ­partner Paul McLoughlin and Debbie Gregory, while the ­company was advised by Latham & Watkins insolvency partner John Houghton. The restructuring involved a pre-pack administration, with the transfer effected free of the security and guarantees of the mezzanine lenders following the value breaking in the senior debt.

The mezzanine creditors, led by Partners Group and advised by Gide Loyrette Nouel partner Michael Doran and consultant Claire Pointing, most assuredly did not like the proposal, challenging it on fairness grounds. Despite the company commissioning three valuations of the senior from PwC, Rothschild and King Sturge, which all arrived at the same ­conclusion that the value broke in the senior, the junior lenders published an independent valuation from LEK Consulting stating the contrary, using what was dubbed a ’Monte Carlo’ simulation.

“After the crunch there were a lot of question marks about where the value broke in restructurings,” says a City lawyer. “In the mezz, IMO Car Wash answered the question in quite a disastrous way. And as for that Monte Carlo approach, well, it’s like, on a fine day, with a following wind, if the stars are aligned, it would be worth more.”

However, while many senior lender lawyers clearly feel that the mezzanine side was taking a punt with a weak case - and certainly, Mr Justice Mann found squarely for the restructuring proposal - the genie was out of the bottle. IMO Car Wash had weakened the hand of the mezzanine debt, but it had crystallised the concerns around valuation and given a voice to junior creditors.

In an enforcement situation, the senior agent can sell assets free of the claims of the subordinated lenders. Lawyers note that this can give rise to a ­situation where a group of companies is sold free of mezzanine debt, but with the senior debt in place, for a notional value to a special purpose vehicle (SPV) that is owned by the sponsors and senior lenders. They can then invest in the SPV and de-lever the capital structure, which has been controversial in the mezzanine community, to say the least.

Junior lenders began to agitate for more rights. As Ropes & Gray partner Tania Bedi notes: “There’s now a trend to see clear criteria and requirements that the senior creditors need to meet in relation to a security enforcement involving a sale to an SPV with the effect of stripping away the junior debt, such as a requirement to get a fair market value opinion, an auction process and so on.”

Directories approach

After IMO Car Wash, the scene was set: when and for how much could the senior sell, and what ­protection did the junior creditors have? Only a year after the case, lenders were litigating again in HHY Luxembourg SARL & Anor v Barclays Bank & Ors (2010), ­better known as the European Directories case.

European Directories was formed in July 2005 when Yellow Brick Road was bought for e1.8bn (£1.59bn) by a consortium led by Macquarie, which was advised by Clifford Chance. The company ran into financial trouble not long after and turned to Kirkland & Ellis partners Kon Asimacopoulos and Partha Kar for the restructuring plan.

Security trustee Barclays Bank, advised by Allen & Overy (A&O) partner Ian Field, and senior lenders including Lloyds, RBS and Allied Irish Bank, represented by Linklaters partners Rebecca Jarvis and Yen Sum, worked with European Directoriess on the restructuring proposal. But in the intercreditor agreement, ­drafted by Clifford Chance, there was a key release provision that cut the junior lenders out of the picture, resulting in an enormous and eventually costly stumbling block.

The junior lenders, led by AMP Capital Investors and Hastings Funds Management and advised by Quinn Emanuel Urquhart & Sullivan partner Richard East and Ropes & Gray partner Maurice Allen, litigated.

At first instance, Mrs Justice Proudman held that the release of liabilities to the mezzanine lenders could refer only to the company whose shares were being directly sold, not indirectly held subsidiaries, but in October 2010 the Court of Appeal overturned the decision. Senior lenders, spooked by such a literal approach at first instance, could breathe easier, but it did not end the debate.

At the same time, the LMA was trying to get to grips with the debate. But the senior lenders’ dominance of the body has left it open to criticism from mezzanine players and their advisers.

Over the course of 2009, the LMA revised its standard document. The document now allows claims to be released on enforcement where the security agent has taken “reasonable care to obtain a fair market price in the prevailing market conditions” for the assets or shares, but with no obligation to change the timing of that sale to get a higher price.

However, Linklaters partner Nick Syson points out: “The LMA intercreditor [agreement] doesn’t cater for the current senior/mezzanine position, but there is a working party that’s looking at what changes need to be made.”

Stephen Mostyn-Williams of SMW Law, who specialises in advising mezzanine lenders, agrees that the current LMA intercreditor agreement has some way to go. “It’s a menu, and a menu that can’t necessarily steer you in the way you want to,” he says.

Sifting through the debris

Restructuring lawyers, however, are still wrestling with the issues thrown up by European Directories. “Deficiencies in the drafting of release provisions in 2006 and 2007 vintage documents have proved problematic in the current round of restructurings,” says Ropes & Gray’s Bedi, “although the courts have upheld the pro-senior view in relation to release provisions even when the ­drafting has been unclear, as in European Directories.”

Quinn Emanuel partner Richard East, who acted for the junior lenders on European Directories, has been heavily involved in unpicking the deals drafted at the height of the LBO boom.

“There are a whole raft of restructuring deals out there, all with the pre-2009 language,” he says.

A WorldPay of difference

And yet despite the high-profile court cases and the attempt by the LMA to tweak its standard agreement, these have not been the only events to shape intercreditor dynamics in recent deals. The current driver is economic reality.

Given the fluctuating fortunes of the bond market according to whichever Southern European country is at risk at any given moment, private equity houses need to call on sources of finance other than the senior, and woo them because they can fill the gaps in the capital structure.

“The mezz are looking at the high-yield and saying ’they have protections in there that are better than the mezz’,” points out one lender lawyer.

Nowhere was this better illustrated than on Bain Capital and Advent International’s acquisition of RBS’s payment processing unit WorldPay for $3.2bn (£1.99bn), where Bain turned to Kirkland & Ellis’s Gillespie for financing advice and the senior lenders used Ashurst partners Nigel Ward and Jane Fissenden.

On WorldPay, many features of protection for bondholders appeared for the subordinated lenders, who were represented by Philip Bowden at A&O, which is normally seen as a senior lender firm.

WorldPay has become the flagship deal for the junior creditors; Mostyn-Williams describes it as “seminal”, while Syson notes that WorldPay “has established the principle that mezzanine lenders are entitled to contractual value protection”.

“Actually, it’s unforgivable of A&O - it’s messed the market up. It’s not big and it’s not clever,” adds a senior lender lawyer, not ­entirely joking.

A&O’s involvement on the ­mezzanine side may have raised eyebrows among its core senior lender constituency, but the firm was actually gifted the deal by Gillespie, since Ashurst was already involved for the senior. It was Gillespie who, mindful of the need to get mezzanine investors on board, put together the papers and who, while being non-deal specific, sounded out various terms to a series of potential lenders.

The decision to accommodate the subordinated lenders on WorldPay may have been entirely pragmatic, but it certainly led the thinking on additional release conditions for junior creditors, which has aped certain features seen in the high-yield market.

That said, Gillespie disagrees with many lawyers’ analysis that the intercreditor on the deal relied on trends within the high-yield market.

“I’m not sure that WorldPay really borrowed anything from that market,” he says. “The idea of consultation and putting conditions around forced releases has been out there in the senior/mezzanine context for years, the main difference being that before 2007 the seniors could swat most of the mezzanine issues away whereas now, when they need the mezz to get the deal done, they can’t.”

Features now being agitated for by mezzanine lenders also include process-related conditions, such as a stipulation that any sale should be enacted via a public ­auction or any other competitive sale process (although the definition of ’public auction’ has sparked some debate). If a public sale process does not happen, some intercreditor agreements provide that release should be dependent on a fairness opinion, which ­confirms that the sale price of shares of assets is fair according to market conditions. Of course, there is more debate here over who should provide such an opinion: should it be an investment bank or one of the big four accountants? And how should conflicts be resolved?

However you calibrate it, WorldPay has moved the market on. As Syson notes: “The ­senior/mezzanine position had been pretty settled for the past 25 years, so the recentmarket changes have created  an additional workstream for senior lenders.”

“It does seem to be regarded by the market as a good starting point for senior/mezz intercreditor ­discussions,” says Gillespie. “But in this very competitive market, there are fewer deals being done and those deals that are being done are pretty bespoke, so there’s no hard and fast template or ­’market standard’ position that parties are sticking to. But WorldPay gives the junior lenders good negotiating ammunition.”

Mostyn-Williams goes further. “This has definitely become the basic starting point,” he declares. “People recognise the fact that if you produce an intercreditor agreement from 07, the mezz will say no. It’s definitely shifted.”

With the high-yield market ­currently fragile, sponsors will be looking increasingly to mezzanine financing over the coming year, and the junior lenders will not be giving up their newly won ­position any time soon.