Euroweek high yield report: structuring

Euroweek high yield report, July 2011

Any investor in an Asian high yield deal will pay close attention to the covenant packages around the bond. But they’re only half the story: just as big an issue is the question of being able to retrieve anything if things go wrong.

It’s a challenge, in different ways, in both the countries in which high yield issuance is most active. “The structuring part varies by jurisdiction,” says Matthew Sheridan, a partner at Sidley & Austin. “The two countries that have dominated high yield issuance are China and Indonesia, and there are very different issues in the two places.”

In China, the problem is one of offshore versus onshore rights. “In China, you’ve got an issue of structural subordination that arises,” says Sheridan. “As a practical matter, it’s impossible to get guarantees from companies onshore for the offshore debt. An offshore holding company issues the notes, and they don’t have guarantees from the subsidiaries that own the operating assets in China.”

Bankers agree. “The weakest structures are undoubtedly coming from China, due to the fact that you cannot get any collateral, onshore share pledges or onshore guarantees,” says Florian Schmidt, managing director, debt capital markets, Asia at ING. “You’re as far away from the cashflow as you can be when you’re holding offshore hold-co debt. Surprisingly, you will find a whole host of lawyers who will say: we can make it happen and take possession of the onshore company via offshore share pledges. I say: good luck to them.”

None of this seems to bother investors, who have been fervent buyers of Chinese paper – much of it unrated – despite the open secret that it things go wrong, they will be deeply subordinated compared to onshore creditors. “The market seems to have accepted that it can get comfortable with no security from these companies, particularly those which are listed,” says Joseph Tse, partner at Allen & Overy.

And, in fairness, it’s not as if investors are stupid: they make a choice based on their assessment of risk and reward. The idea that they might lose everything in a default is simply factored into the equation. “Investors are getting a huge premium in terms of the coupon on some of these issues,” says Sheridan. “There are some pretty savvy investors out there who think this is a great play.” And so long as there is appetite for new issuance, then nothing much is going to change, even when better options exist. This became clear after the financial crisis. “In 2008, when the market fell apart, we thought China high yield would have to come back in a different form, and we started looking at structures to improve the situation,” recalls Sheridan. “But there is no silver bullet. There are structures you can put in place, but they have drawbacks and we couldn’t find enough interest on the bank side to take any of them to market, and then investor demand came back so there was no need to do it.”

In Indonesia, the challenge is different. There, guarantees are not the problem; but pushing them through a court process should the need arise is a whole other matter. “Indonesia has its own issues,” says Sheridan. “While you can get guarantees onshore, and collateral, you have got enforcement issues. That’s been there for a long time and it hasn’t changed a whole lot.” There are also specific structural peculiarities around withholding tax and a rule by the market regulator, Bapepam, on material transactions, discussed at more length in the Indonesia chapter; but in essence, neither has helped issuance. “On withholding tax there has been a lot of uncertainty about what the right rate is over the last six years, and that has been a dampener on issuance,” Sheridan says. And the Bapepam rule, requiring issuers to get shareholder approval including pricing and a fairness opinion before launching a deal, “has put a number of deals on hold.”

Alongside these jurisdictional considerations are the covenant packages around the bonds. Opinion is somewhat divided on whether these packages are getting more or less onerous, and they certainly vary from market to market. “On a global 144a-type transaction, covenants are relatively tight; on a Regulation S or CNH deal, they tend to be looser,” says Paul Au, head of Asian debt syndication at UBS. “In the Philippines, if the deal is anchored by local investors who know the issuers, you don’t necessarily need covenants – or a rating – to get the deal done.”

Some say they see a greater intensity of investor attention towards covenants. “Investors and issuers now accept that if you are non-investment grade, you have to live with a high yield covenant package,” says Augusto King, co-head of debt capital markets for Asia at RBS. “Investors will look at it and literally work out how much more you can borrow. I’ve been in meetings where the investors will say to the issuer: ‘this package allows you to borrow another $150 million. Why do you need this cushion?’”

Others see a trend in the opposite direction. “Covenant packages have been getting lighter over the last few years, although it is cyclical,” says Eric Greenberg, managing director, financing group and head of leveraged finance in ex-Japan Asia at Goldman Sachs. “They will remain so as the market remains active, but when the market starts to cool they will get tighter again. Covenants always move in cycles related to the strength of the market.” Those who are doing the borrowing tend to see covenant packages getting easier, from their perspective: in the issuer roundtable in this guide, Parry Tse of Evergrande – one of the major Chinese real estate borrowers – talks about how covenants appear to be lightening for issuers like his.

A host of elements appear in high yield covenants; Tse at Allen & Overy says they typically include restricted payment, debt incurrence, negative pledge, asset sales, transactions with affiliates, and change of control; sometimes they extend to restrictions on mergers and consolidation, dividend payment, issuance of capital stock by restricted subsidiaries and others. “The covenant package will reflect the quality of the issuer,” he says.

Within this, some areas are more closely monitored than others, and issuers need to be aware what they’re taking on. “Covenants around total indebtedness, leverage ratios and cash flows are the three main areas the issuer needs to look at very carefully,” says Henrik Raber, global head of debt capital markets at Standard Chartered. “It can restrict them from potential future growth plans or corporate restructuring.”

Again, what’s possible varies from place to place. “In Indonesia you can look for protection by going as high as senior secured,” says Schmidt. “In some instances there have been maintenance covenants which, of course, cannot protect you in a default scenario, but at least you know when the alarm bells start ringing.” Some Indonesian issues use cash waterfall structures, domiciled offshore and pledged to noteholders to give them something of a hold on cashflows. “Overall in Indonesia, you find that there are much better structures that get you as close as possible to the cashflows.”

While it’s natural for investors to seek protection in a market in which they are structurally subordinated anyway, banks do counsel against being too restrictive. “Covenant packages are important from the perspective of giving investors comfort that the business is going to be operated in a prudent fashion, but they should not tie the issuer in knots,” says Rod Sykes at HSBC. “It’s very important the covenant packages are structured in a way that allows issuers to operate their business in an effective way with the necessary degree of flexibility.”

Schmidt feels that market discussion about the strength of covenants somewhat misses the mark. “There’s always been this discussion post-crisis about covenant-light versus covenant-heavy. I’m not sure whether that discussion is appropriate in the Asian high yield context,” he says. The term originates in European LBO issues, he says, where maintenance tests were replaced by incurrence covenants prior to sub-prime. Under the criteria commonly used there, all Asian high yield issues are covenant-light by definition, making a nonsense of the idea of Asian bonds becoming more covenant-light. “When you look at structures in Asia versus the US, you may be surprised to find Asian structures being much tighter, in terms of carveouts, the number of covenants and the numericals within them. But that tightness is clearly a function of uncertainties around the legal systems and recovery scenarios.”

An exception is the Philippines, where transactions often feature very few covenants and are frequently unrated. These sell mainly onshore to Philippine accounts. “Some of these companies are extremely well run and managed, but the overall packages are not that attractive,” says Schmidt. “We recently had an RFP from a Philippine issuer who said: if you want to put a covenant package in, don’t bother to bid. But if Philippine onshore investors are comfortable with the risk, that’s fine; offshore investors typically are not.”

Besides, given the external considerations, the covenants are perhaps not the point anyway. “In the US you have Chapter 11 to compute recovery values, and European investors can almost do the same, but Asian investors essentially rely on the legal systems mainly in China and Indonesia,” says Schmidt. “Inevitably they come to the conclusion: they may have bankruptcy procedures in place, but will the jurisdictions be friendly to me or lean towards the debtors? That is something a structure cannot capture.”

When it comes to questions like tenor, there is a fairly established format. The typical maturities are five year non-call three – the sweet spot for first times issuers; seven year non-call four, popular with repeat issuers; and in a few cases 10-year non-call five. “In a lower interest rate environment tenor has been pushing out towards seven years. That’s been a very popular maturity, seven year non-call four or five, and that’s going to continue,” says Raber. “Some companies might have a preference for the non-call period to be as short as possible, given their growth rates.” These is usually a non-call period, followed by a call at par plus half the coupon, which then declines to par on a ratable basis, Sykes adds.

The launch and phenomenal early success of the offshore RMB bond market brings with it its own questions of security, structure, subordination and covenants. And if anything, things are more tricky here than anywhere else. “Exactly the same issues in relation to taking of security arise whether the bond is denominated in RMB or not,” says Tse. “But with RMB bond issuance there is an extra layer of regulatory issues separate from the security issues, and the biggest of them is the repatriation of proceeds.”

As always, questions of investor protection and covenants vary with the state of the market. In a boom market, investors demand less protection, because if they step back from a deal somebody else will just take their place. But if, as bankers suggest in other sections of this guide, we are on the cusp of a change in the supply-demand balance in Chinese high yield, perhaps we are also ready for a change in the balance of investor protection and covenant requirements. Issuers may need to make bigger promises in future in order to get their deals away.