Bridging the gap

As heavily indebted companies look to refinance, senior secured bonds could provide the answer. By Brian Conway

During the previous credit cycle an unprecedented ­volume of bank debt was taken out by companies to fund acquisitions and ­leveraged recapitalisations, much of which is due to mature in the next five years.

Since the financial crisis traditional bank lenders have been constrained in their ­ability to lend due to internal competition for capital, funding issues, more selective lending criteria and changes in the ­regulatory environment.

Furthermore, much of the demand from collateralised loan obligations that ­provided so much of the original funding in the last credit cycle has ceased to exist and has not been replaced by other sources. It is not clear, therefore, how these heavily indebted companies will be able to repay or refinance this wall of maturing debt.

Banks and borrowers have been ­working on strategies that will enable the borrowers to bridge the funding gap by reducing their debt or extending the maturity profile of their debt. One solution has been to look to the capital markets as a source of ­funding.

Historically high-yield bonds in ­European leveraged financings have been relegated to a junior position in the capital structure, with the exception of certain ­floating rate note financings that replaced other term debt completely and for notes issued by some large crossover credits.

High-yield investors demanding greater protections have won some concessions over the years in the form of subordinated ­guarantees and limited security, but as a point of principle bank lenders in European leveraged transactions generally required that high-yield bonds be ­structurally ­subordinated to the bank debt.

Towards the end of 2009, following a trend that began in the US, a number of European companies refinanced a portion of their bank debts with senior secured bonds. Partial refinancings were required in the context of covenant resets, but were subsequently used to extend the maturity profile of the companies’ debts and ­diversify their sources of funding. For the issuers, senior secured bonds have the added ­benefit of being subject to incurrence covenants only.

Senior secured bonds have been used in a variety of transactions. At first they were used to refinance a portion of the existing senior debt only, where a significant amount of bank debt remained outstanding. Increasingly, though, there have been fixed-rate issuances of high-yield bonds that ­refinance the entire debt capital structure, where banks provide a working capital ­facility that ranks prior to the bonds on the receipt of proceeds of enforcement – so-called ’super-senior revolving credit ­facilities’.

Changing scene

The market has continued to evolve. The financing provided for the acquisition of Swiss telecoms company Sunrise ­Communications, completed this month, broke new ground for European leveraged acquisition financings, when the capital ­structure incorporated senior secured bonds alongside senior-term debt, the proceeds of which were used to fund an acquisition rather than repay existing debt. In light of the lack of liquidity for bank debt, this has established a precedent that is likely to be followed in future acquisition finance transactions.

The inclusion of senior secured bonds in the capital structure gives rise to ­intercreditor issues that do not arise where the high-yield bonds are structurally and contractually subordinated to the bank debt.

As senior creditors, bondholders expect to enjoy much the same rights as senior bank lenders, including the same guarantees and security as the bank debt; loss-sharing with the bank lenders; the right to accelerate their debt and enforce guarantees and ­security; no payment blockages or standstill periods; and the right to have a say on the release of security.

Intercreditor agreements have been ­negotiated on an ad hoc basis, depending on the particular circumstances in which the senior secured bonds are issued: whether the senior secured bonds are refinancing all or only a part of the existing bank debt, the size of the senior secured bonds relative to the retained bank debt and other deal-specific considerations.

Approaches vary from deal to deal and no clear consensus has yet been formed. It is likely that the intercreditor provisions for the super-senior working capital facilities will always be different from financings where there is a significant component of term bank debt.

Where the senior secured bonds have been used to refinance only part of the ­capital structure, bank lenders are willing to consent to amendments to their documentation to permit the issuance of such bonds because it will reduce their exposure and mitigate the refinancing risk.

Taking control

As the senior secured bonds on these deals represent a smaller portion of the debt ­capital structure, to date the voting ­mechanics have been structured to give bank lenders control over any enforcement of security.

On transactions where the amount of the senior secured bonds is significantly larger than the bank debt, the bondholders will generally expect to have a greater say on the enforcement of security.

Given the liquidity constraints among traditional bank lenders and the projected funding requirements over the next five years, there is a clear need for alternative sources of funding.
Senior secured bonds will not be suitable for all capital structures, but they will go some way towards bridging the funding gap and addressing refinancing risk where the capital structure can accommodate them.

Brian Conway is a partner at Latham & Watkins