The junk bonds are coming
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10 February 2014
The high yield bond market, traditionally the preserve of US lawyers, is coming to Europe.
Cahill Gordon & Reindel is New York's most notoriously thrifty law firm. It may have reported profits per partner of $1.6m (£1m), say sources, but it is reluctant to change its carpets.
So when news was leaked that the firm - which opened its only office outside Manhattan in Paris in 1935 - is opening in London in the new year, eyebrows were raised.
Cahill's parsimony is only part of the reason for its massive profitability. More important, it is the US investment banks' top choice for high yield bond work in leveraged finance deals.
Sources say that the firm has been under pressure from its banking clients for at least a year to set up in London. Deutsche Bank in particular is said to have pressed Cahill to establish a London presence to meet the growing demands of the European leveraged finance market.
High yield, or "junk", bonds are a means of raising finance for companies that are below investor grade according to the two main credit rating agencies, Moodys and Standard & Poor's. The bonds are a key part of the funding for leveraged buyouts (LBOs) and leveraged takeovers, which are mainly funded by debt with a relatively small equity component.
Kevin Adeson, executive director and head of the European senior debt practice at Morgan Stanley, says: "We've seen in the last two years a major development in the [European] high yield market, and that is in connection with the growth of the media and telecoms sector, leveraged buyouts, and big corporates reshaping their businesses and focusing on shareholder value.
"Private equity firms, both here and based in Europe and the US, are entering the market. High yield investor demand has changed with the unification of the currency, and the old arbitrage where these funds used to invest in high yielding government securities has gone away. This is tremendously fertile ground to grow a high yield business."
Sources say the main threat to Cahill's client base is Shearman & Sterling. Other strong players are Cleary Gottlieb Steen & Hamilton, Simpson Thacher & Bartlett and Latham & Watkins.
John Wilson, a corporate finance partner in Shearmans' London office, says: "We initially got into European high yield because I came to Paris and then to London in 1993. There wasn't any European high yield then. It started with the cable companies like Telewest."
Telecoms companies and LBOs continue to dominate the European high yield market because the banks are reluctant to provide the capital required for start-ups and buyouts.
In Europe mainstream companies continue to rely on bank loans, whereas in the US they are also tapping into the high-yield market.
US law firms dominate the European high yield market because the US market for junk bonds is so far ahead of its Continental cousin, and most buyers of European high yield bonds are based on the other side of the Atlantic.
Mark Stegemoeller, partner at Latham & Watkins' London office, says: "Europe is a growing market for high yield vehicles, but most deals require substantial sales into the US and most US investors require US disclosure and US law.
"One of the reasons US firms are here is to service the growing market for those deals being sold in the US."
Walter Looney, managing partner of US firm Simpson Thacher & Bartlett's London office, says: "The bank lending market has been an English law market and the English firms dominate that. The high yield market has so far been done under US law and the US firms have predominated in that area. In both cases there are exceptions but that's how it has spun out."
But, according to a source at a US firm, UK firms are "desperate" to break the US stranglehold on the high yield work in leveraged finance deals.
Looney explains the attraction: "It's a very law-intensive, non-commodity-like practice. It requires a lot of legal structuring and a lot of legal input, and it is quite interesting.
"It brings together a number of legal disciplines - tax, bankruptcy, banking, securities and M&A."
Leveraged deals are made up of different layers of debt graded according to their risk. These are senior debt, made up of a loan from an investment bank, and various other forms of debt including high yield, and equity.
The senior debt for UK and many European deals is issued under English law, and City firms retain a tight grip on this side of the deal.
Stephen Gillespie, a partner in Allen & Overy's banking department specialising in leveraged finance, says to gain US Securities and Exchange Commission (SEC) approval for a high yield issue US securities lawyers are needed.
But he adds: "You don't necessarily have to be an American law firm. We have got a team of 15 US securities lawyers, doing work for both the underwriter and the issuer doing leveraged finance work."
He admits UK firms have woken up late to the fact that the European high yield market will be a major source of work for finance lawyers and are now having to play catch-up with the US firms.
"The English firms have to make sure they protect their existing franchise. Not getting high yield work puts at risk your ability to get senior debt work, which we have built up in the last 10 years in terms of cross-border deals. The immediate strategy is a defensive one."
Stuart Popham, global head of finance at Clifford Chance, is less concerned about having to match the US firms. He says: "If you are a UK pension fund and if you were to ring up Goldman Sachs they would say they are going out of their way to create a European high yield market.
"[A high yield bond] is only a variation on a Eurobond. More has been sold into the States until now, but the real game will be in the euro zone.
"It is only one part of the deal and we are doing the lion's share of the syndicated loans that are put together to do the deal in the first place and we are advising on tax, environmental issues, property and all the other elements of the deal."
But he says the firm will build up its capacity on the US high yield side following the merger with Rogers & Wells on 1 January.
Gillespie believes A&O will continue to build up its high yield capacity through lateral hires. "People talk about mergers all the time, but one doesn't see much concrete evidence of serious transatlantic merger happening," he says.
"The white shoe US firms [equivalent to the UK's magic circle] are not interested in a merger at the moment, so you would be looking at a non-premier league US firm. One doesn't hear about merger as a way of solving high yield capacity."
But he adds: "The difficulty for an English firm is getting a top US securities lawyer to move. Our hands are tied with the lockstep system, and you would have to be able to have them outside the lockstep system."
This is exactly what Clifford Chance has done with Rogers & Wells' high-earning partners, and the US firm is offering a package of up to $2m (£1.25m) to bring a big-hitting M&A partner on board. On whether the firm would take this approach in building its high yield practice, Popham says: "This market is exactly one of the reasons why Clifford Chance and Rogers & Wells are merging and it is one we are determined we will cover."
Wilson says: "I welcome [UK firms] and I think they will be able to do it. It's a complicated product, just as complicated as an asset securitisation, but I have great respect for the English law firms and I don't see a particular barrier."
The US LBO houses, such as Candover and Hicks Muse Tate & Furst, are reported to have built up a $30bn (£19bn) war chest for European LBOs. Assuming a debt to equity ratio of four this raises the prospect of $120bn (£75bn) worth of LBO deals.
But Stegemoeller says: "For the market to really take off beyond telecoms and buyouts, companies in Europe will need to consider using capital debt to replace traditional bank borrowings."
For a firm as thrifty and conservative as Cahill to invest in a London office, the lure of the European high yield bond market has become irresistible. The battle lines are being drawn with magic circle firms scrambling for the rich pickings as they attempt to catch up with the US.