Have Ashursts and Latham helped give birth to the ultimate high-yield vehicle? By Catrin Griffiths

When is a high-yield bond not a high-yield bond? When it’s a mezzanine note.

The mezz note – courtesy of the Royal Bank of Scotland (RBS), ING, Ashurst Morris Crisp and Latham & Watkins – is the latest ingenious contribution to the abiding debate on subordination in the high-yield market.

The new debt instrument pioneered on the recent Focus Wickes deal has provoked a whole lot of interest. “I’m definitely looking at this mezz notes structure for something I’m working on,” confides one City finance partner.

High-yield has never really recovered its glory days of the late 1990s, when no telecoms financing was complete without a junk bond issue. Since then, the volume of high-yield investment has fallen through the floor. Corporate downturn aside, high-yield’s sudden unpopularity was also because investors have a loathing of structural subordination, whereby bondholders come at the bottom of the creditor pile. And as high-yield issuance has fallen off, the popularity of mezz financing has grown.

“There’s increasing convergence of investor bases,” argues Nick Coates, head of European high-yield at RBS. “We view the mezz note as a hybrid product, as an alternative to a bond or mezz.”

But isn’t the concept of selling a mezz instrument to high-yield investors fraught with contradictions? And how on earth do you reconcile the intercreditor issues? Well, Ashursts and Latham think they’ve hit on a workable solution.

Although one market source claims that some rival institutions – perhaps miffed that a bank with a senior debt pedigree has come up with this – are conducting a whispering campaign against RBS’s concept, there is no doubt that the mezz note goes some way to satisfying the demands of high-yield investors. The bond was certainly adjudged a success in the market. Rated B3/B+, and in two tranches of sterling (£190m) and euros (e140m (£96.5m)), the take-up was heavy.

But to get the deal away, there have had to be a lot of compromises inherent in the structure. Ashursts’ Nigel Ward (who stepped in to lead the deal after Stephen Short left for Simpson Thacher & Bartlett) and Latham’s Bryant Edwards had to wrestle with the problem for several months before formulating an answer. The trade-offs they have come up with have kept all parties – senior, high-yield and sponsor – happy.

It is not overfanciful to imagine that Ashursts and Latham turned to their advantage their joint experience on Legrand, where Ashursts acted for Lehman, RBS and Credit Suisse First Boston (CSFB) on the senior and Latham for CSFB on the mezz and high-yield. Crucially, the senior lenders – traditionally hostile to giving much ground to the bondholders, as Legrand demonstrated – have got a good deal on this one.

The senior lenders have certainly won out on the voting threshold. Normally set between 25 and 50 per cent, the threshold for noteholders to declare default is now set at 66.66 per cent.

“The rights of mezz noteholders are weaker than those of traditional mezz lenders,” acknowledges Latham’s Edwards. “But you have to remember they’re stronger than those of the high-yield lender.”

What the noteholders got was upstream credit support with access to the operating companies instead of just the holding company – putting them ahead of trade creditors. This enhanced security is the Holy Grail for high-yield investors.

But in return for getting through that crucial contractual subordination, the mezz noteholders have given up their rights to call protection. The bonds can be called after a year on an exit, either through initial public offering or trade sale. This concept must have made some fixed income desks hesitate, but it’s darn good news for sponsors. As one private equity lawyer says: “It’s seen as potentially groundbreaking. The private equity market has been wanting more flexibility from high-yield investors for some time.”

Although this product is going to be of interest on a number of refinancings, RBS is cautious as to whether it can be replicated wholesale on other deals, particularly in certain European jurisdictions. “The security structure with second liens over the assets and cashflows does generally work better in the UK,” admits RBS’s Coates.

Meanwhile, the Focus Wickes deal tops off a great run of success from Ashursts, Latham and RBS. Much to the chagrin of Clifford Chance and Allen & Overy, Ashursts nabbed the two biggest leveraged buyout financings in Europe in the past year: Seat PG (for Barclays, BNP Paribas, CSFB and RBS) and Legrand (for Lehman, RBS and CSFB).

In the meantime, RBS’s star is certainly on the rise – and Latham with it.

RBS has only had a high-yield team in place for a year, when it hired Coates from ING. In the space of 12 months, RBS has been involved to varying degrees on Legrand, Vivendi, Heidelberg Cement and now Focus Wickes – the last three as bookrunner. And as RBS’s preferred outside counsel on high-yield, Latham is set for a rather nice flow of instructions.