a bond market primer for new issuers

8/10/2019 A bond market primer for new issuers

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A bond market primer for new issuers

For corporates, especially those seeking

growth, two aspects stand out in

particular. The first is that bonds enjoy

bullet repayments although refinancing

risks are increased. The second is that

bonds have incurrence only covenants

as explained below. Together these

two characteristics offer significant

advantages, particularly the ability to

fund further growth and development

from internally generated resources. Lets

look briefly at these two aspects in turn.

Bonds are cheaper than loans to

service

Bullet repayments offer borrowers a

number of advantages. First, interest

only payments mean that debt service

is considerably lower than would be

the case for a comparable loan as banks

typically require a significant part, if

not all, of the loan to be repaid over the

loan life. Bullets thus allow borrowers

to accommodate higher leverage, greater

headroom and, significantly, a much

higher level of retained cash for growth,

which, in the case of a loan would

otherwise be required to amortise debt.

To illustrate this Table 2 compares the

debt service on Marcolins 200 million

six year bond (fixed at 8.5% over six

years) with a loan of comparable size and

maturity assuming a bullet of 70% for

the loan, which would be very borrower

friendly in the loan market. Marcolin wasrated B- and, at the time of issue, the all-

in cost of a bank loan would have been

c. 5% (margins for B- rated credits were

c. 450 bps whilst three month Libor was

c. 50 bps).

Bond financing, as discussed in Capital Thinking, is growing in importance as an alternative source of funding forcompanies in Europe. As the European bond markets evolve to accept smaller issues, mid-market companies are accessingthe market for the first time. For finance directors who have not previously considered bond financing as a viablealternative or supplement to bank financing, it can come as a pleasant surprise to discover the advantages bonds offer. Inthis special supplement we analyse the factors that should be taken into consideration before going down the bond route.

ISSUE 2 SUPPLEMENTJANUARY 2014

CapitalThinking

The analysis below (Table 1) illustrates

the additional cash required to service

the loans. Despite the fact that the bond

coupon is much higher than the interest

on the loan, even on the most optimistic

assumption of only 30% amortisation on

the loan, the bond consumes less cash for

debt service. The absence of amortisation

on bonds carries other additional

benefits: first, the cash retained can be

reinvested in the business, which is a

significant benefit to corporates lookingto reinvest their profits for growth.

Second, bullets provide borrowers with

much greater headroom than loans, even

with higher leverage. Issuers should

be mindful however of the increased

refinancing risk associated with bullet

repayments. Here, headroom refers to

the difference between EBITDA and a

breach of the loan or bond covenants,

which brings us to the matter of

incurrence covenants.

with less onerous incurrence only

covenants

Historically, high yield loans (ie those

rated BB- and below) include extensive

financial covenants, apart from certain

cov-lite syndicated loans, which

we have discussed previously. These

financial covenants require a borrower

to comply with various financial

ratios on an on-going basis, typically

quarterly on a trailing 12-month period.

The most common covenants are

leverage, cash flow cover and interest

cover. These financial covenants are

designed to trigger before the borrower

experiences a payment default, giving

the lenders time to take remedial

action. Failure to comply with these

financial ratios is an event of default,which is a breach of the terms of the

loan and, in extremis, entitles the lender

to accelerate and/or enforce their

collateral, potentially seizing control

of the group from the existing equity

owners. Loans often include a further

capex covenant, which is not a ratio, but

a restriction on the amount a borrower

can spend on capex in any year. Loans

typically include between two to four

of these covenants.These financial covenants are absent

in traditional high yield bonds, which

contain incurrence only covenants.

Incurrence covenants do not require

testing at regular intervals, but are event

driven. They are tested only if and

when the borrower takes affirmative

action, such as incurring additional debt

Table 1: Debt Service year one

Loan Bond Difference

EBITDA 37.5 37.5 -

Interest (10) (17) (7)

Principal (10) - 10

Debt Service (20) (17) 3

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(hence the term incurrence), acquiring

or selling assets or distributing cash to

shareholders. More significantly, with

regard to debt service, bonds simply

require that the borrower make the

scheduled payments, which, in the

case of a bond, is only the interest. The

absence of financial covenants in bonds

coupled with the lower debt service

from bullets amplifies the headroom

available and significantly reduces the

potential for this type of default. Toput this in context, Marcolin enjoys

headroom of over 2.2x on an interest

cover test, which implies that EBITDA

would have to fall by over 50% to

trigger a payment breach.

Bank lenders adopt a conservative

approach

The bullet structure of bonds provides

powerful reasons for growth companies

to favour bonds over loans (albeit itcarries a greater refinancing risk). Bonds

offer other significant advantages for

borrowers, stemming from the differing

approaches of banks and bond investors

to lending. Bank lenders are inherently

more conservative than bond investors,

particularly if they retain all or even

part of the loan on their book. Banks

assess a credit on the basis of base

case financial projections provided by

the borrower and the loan includes a

number of financial covenants designedto ensure that any material deviation

from that base case will trigger one or

more of those covenants and with it an

event of default.

In addition, bank lenders also limit

their exposure by prohibiting the

borrower from pursuing a wide range

of corporate actions. These can include

incurring additional debt, providing

security, M&A, investment in capex (in

excess of the capex covenant) and asset

sales, unless they fall within one of the

permitted baskets or carve-outs in the

loan, which tend to be more restrictive

in smaller loans. If the proposed

corporate action exceeds the relevantpermitted threshold then the borrower

needs to obtain and, often pay for, a

waiver from the lenders.

whilst bonds offer exibility

For historical reasons bonds can offer a

higher degree of operational flexibility.

The incurrence covenant package

allows borrowers a much wider range

of corporate actions, such as incurring

additional debt, paying dividends, M&A,and making capital investments, but

only if the borrower can demonstrate

improved financial performance at the

time of the proposed action or event. For

example bonds typically allow additional

debt incurrence if the borrowers

financial performance (and debt capacity)

has improved since issuance.

Although the structure of bond

covenants is extremely complicated the

good news is that all bond covenants

follow the same structure. First, a

general prohibition; second, a proviso

to the general prohibition; and third, a

series of baskets or carve-outs, which

operate independently of the prohibition

or proviso. These baskets may have

an absolute (hard) cap or a soft cap

determined by EBITDA, Total

Assets etc.

So, whilst there is a general

prohibition on debt incurrence, theproviso is regulated by what is referred

to as the Ratio Debt Basket (RDB).

This is generally based on an interest

cover test, usually the Fixed Charge

Coverage Ratio (FCCR) or a leverage

ratio. To illustrate, assume an issuer has

100 million of bonds and the RDB

requires a leverage ratio of 4:1 or better

for Debt: EBITDA. If EBITDA rises

from 25 million at issuance to 30

million the following year, the borrowerwill be able to incur an additional 20

million of debt (4 x the additional 5

million EBITDA). If EBITDA declines

to a new low of 15 million the year after,

the borrower will not be in default, but

will be precluded from incurring more

debt under the RDB until its EBITDA

exceeds the previous high water mark

of 25 million. Counter-intuitively, even

when EBITDA has fallen issuers may

still be able to borrow more debt under

general and other baskets assuming they

have spare capacity. A similar approach

is used to allow bond issuers to complete

other event driven corporate actions such

as M&A, asset sales and investments. It

is this operational flexibility, which is

particularly useful to borrowers seeking

to grow their business.

Size matters

As mentioned above, access to the

capital markets is constrained by issuesize and the borrowers debt capacity.

There are a number of established

financial ratios used for measuring debt

capacity in the capital markets with

the principal ratios being the leverage

ratio and the FCCR (effectively interest

cover on loans).

Leverage ratios for recent European

bond issues ranges from around 2.9x

EBITDA for Sappi, a cyclical paper

company, to 6.3x for Convatec, a

medical supplier, with around 4x being

the mode. Table 3 above, provides

a matrix summarising the EBITDA

and leverage multiples for a variety of

tranche sizes.

2 CAPITAL THINKING ISSUE 2 SUPPLEMENT JANUARY 2014

Table 2: Bonds vs Loans

Bonds Loans

Bullet repayment profile Amortisation (and bullet) repayment profile

Floating and Fixed rate Floating rate only

Quarterly reporting Monthly reporting covenants

Potentially longer tenors Shorter tenors

Public disclosures Private information

Incurrence covenants Maintenance covenants

Repeat issues can be completed swiftly andon attractive terms and conditions

For subsequent loans, the credit processis standard, even if terms, conditions andpricing remain unchanged

Passive investor base Active lender base

Investment of managerial resources tocomplete the initial prospectus, navigatethe ratings process and organise and attendroadshows

Shorter time frame to arrange bank finance

More capricious capital markets can close inresponse to market and political shocks

Bank lending remains open in all but the mostextreme market conditions


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For bonds at the upper end of

the range (c. 200 million), an issuer

would need EBITDA of at least 40

million on leverage of 5x. This is high,

but not unduly so for a strong credit,

whilst EBITDA of 35 million would

imply very rich leverage of just under6x. For a smaller bond of say 150

million, leverage of 5x would be enough

to access the markets. Obviously,

attractive credits would be able to

accommodate higher leverage, which

would open the market to smaller

issuers such as Soho House, which had

senior secured leverage of 5.2x, whilst

cyclical credits would need lower

leverage and a correspondingly

higher EBITDA.

From a bank lenders perspective

leverage of 5x seems extremely rich

for a small company, but the figures

are not as dramatic as they first

appear, since bonds can accommodate

greater leverage than loans in view

of their bullet amortisation nature.

In comparison, a loan amortising

fully over six years may struggle to

accommodate leverage of 3x or greater.

but so does qualityObviously the size of the business,

or its EBITDA, is not the only

consideration and much will depend on

other factors affecting the investment

decision. These include whether the

business is defensive in nature or offers

potential growth; whether it occupies

a specialist niche with high barriers to

entry; whether it has strong market

position (number one or two) in an

attractive sector; whether it has a trackrecord of stable, if not increasing, cash

flows; and perhaps most importantly,

whether it has a proven management

team who can deliver the proposed

strategy. In some cases an asset base

will provide an additional measure of

credit support although, in general, it

is the cash flow, which is the critical

factor. Interestingly, Soho House,

despite reporting a financial loss of

17.4 million for the LTM period inthe Offering Memorandum, met many

of these criteria and thus, despite the

additional handicap of being unusually

small in terms of EBITDA, was able to

complete a bond. This deal highlights

that non-financial factors, such as

a strong management team with a

credible strategy, can trump the more

negative aspects of a deal.

Bond terms are highly standardised

Debt service is not the only factor

confronting potential candidates

seeking alternative funding and issuers

will want to familiarise themselves

with the other key terms of bonds

and how they compare with loans.

Fortunately, the capital markets

have been established for a long time

and the high-yield bond market is

well regulated with standardised

documentation. This means that there is

a high degree of standardisation in the

key terms applicable to bonds. These

are summarised below:

High yield bonds are extremelyflexible and have been issued across the

capital spectrum from senior secured

(eg NH Hoteles), through second lien

(eg Tank & Rast) and senior unsecured

(eg Tullow Oil Senior) and as PIK

notes (Xella PIK Toggle). In addition

they can be used for a wide range of

funding requirements including general

corporate purposes, growth, refinancing

bank debt, dividend recaps and

acquisitions although the preparationfor a bond will require a bridge to

provide certainty of funding.

European bond markets are eclectic

with issuers drawn from a wide range

of countries including Spain (NH

Hoteles), Italy (Rhiag, Cogetec),

Germany, Greece (Emma Delta),

Poland (TVN), Netherlands (Nuance)

and also some less familiar jurisdictions

such as Serbia (SBB Telemach),

Romania (RCS), and the Czech

Republic (EP Energy).

Table 3: Debt Capacity based on Total Leverage

Leverage (debt: EBITDA)

EBITDA 4.0x 5.0x 6.0x

20.0 million 80 million 100 million 120 million


30.0 million 120 million 150 million 180 million 35.0 million 140 million 175 million 210 million


Table 4: Key high yield bond termsCurrency: $ most liquid but increasingly and

Maturity: Five to ten year (bullet). Much longer and shorter maturities available

Payment: Fixed rate (payable semi-annual) or Floating rate (payable quarterly or semi-annual)

Coupon: Ranges from 5% for senior secured to 9-12% for PIK but occasionally lower for

established and attractive issuers eg Fresenius 2.875% (January 2013)

Ranking: Senior Secured (incl. Second Lien), Senior Unsecured, Senior Subordinated or PIK

Credit Rating: Typically both S&P and Moodys

Reporting: Quarterly and annual

Offering: Europe and/or US European offerings do not require SEC Registration

Listing venue: Luxembourg, London, or Dublin

Investor base: Pension funds, insurance companies, asset managers (dedicated long-term high

yield/credit funds), very high net worth retail individualsPreparation: 12 weeks for new issuers (six weeks for established issuers)

Application: General corporate purposes (eg growth), renancing, dividend recaps, M&A

To see how European bond marketsare accepting smaller issues frommid-market companies, refer to the2nd issue of Capital Thinking.

Please click here to access.

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Debt Advisory contacts

Shaun OCallaghanPartner, Head of Debt AdvisoryT +44 (0)20 7865 2887M +44 (0)7545 301 [email protected]

David AscottPartnerT +44 (0)20 7728 2315M +44 (0)7966 165 [email protected]

Michael DanceSenior ConsultantT +44 (0)20 7383 5100M +44 (0)7525 352 [email protected]

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Christopher McLeanManagerT +44 (0)20 7865 2133M +44 (0)7825 865 [email protected]

Jonathan MitraManagerT +44 (0)20 7865 2407M +44 (0)7815 144 [email protected]

Glossary of relevant terms

Bonds Debt securities, which are listed, traded and usually rated

bps (basis points) 1/100 of one percent (0.01%). The unit of measurement used todescribe the margin, spread or fee in a loan

Bridge (nance) In the context of an acquisition, a short-term loan used by bidders toprovide certainty of funding pending the arrangement of longer-termfunding, typically a bond

Bullet When the entire principal of a bond or loan is due and payable onthe nal maturity date ie, there is no amortisation prior to nal

maturity dateCoupon The (xed) rate of interest paid on a bond. Usually calculated on the

face or par value of the bond

Dividend recap A recapitalisation where the additional debt raised is used to nancethe payment of a cash dividend

FCCR The Fixed Charge Coverage Ratio. A nancial ratio or covenant,which takes various forms. In the high yield bond market it measuresEBITDA to xed charges (usually net interest). Similar to interestcover in a loan.

High yield In debt markets, bonds or loans with credit rating BB- (S&P) Ba(Moodys) and below

Investment grade In debt markets, bonds or loans with credit rating BBB- (S&P) Ba(Moodys) and above

Leverage ratio Financial ratio often included as a nancial covenant which measuresDebt-to-EBITDA

Margin The percentage that is added to a particular interest or base rate(e.g. Libor) to determine the interest rate payable on variable ratedebt

Notes Another name for bonds

Pari Loan/Bonds A capital structure in which a borrower has both bonds and loans,typically an RCF, but occasionally accompanied by both an RCF and along-term loan, which may include an amortising tranche (TLA) and abullet tranche (TLB). Invariably the RCF enjoys super-priority vis-a-visthe TLA, TLB and the bond.

PIK Pay-in-Kind. Note or loan where the interest remains unpaid, accruesand is capitalised until nal maturity when it is paid together with theprincipal due

PIK Toggle (or PIYW) Feature often found in PIK loans or notes, which gives the borrowerthe right to elect whether or not to pay part or even all the interestdue for any period. Also known as Pay-if-You-Want (PIYW)

RCF A loan facility with a bullet maturity, which allows a borrower to drawand repay and redraw amounts over the life of the facility. Typicallyused to fund uctuations in working capital

Recapitalisation A change in the capital structure of a borrower in which additionaldebt is raised so that leverage is increased. The new debt is usedto renance the existing debt, but the incremental (recapitalised)amount is used to nance a cash payment to the owners

Renancing A transaction in which a borrower replaces existing debt with newdebt such that there is no change in the level of gearing. Currentlymay involve the renancing of existing long-term bank loans withbond nancing, whilst the existing RCF remains in place, but may bepromoted to super-priority vis--vis the bond

Road Show A presentation by an issuer of bonds to potential investors priorto an offering. It involves the senior management, usually theissuers managing director and nance director, making a series ofpresentations to analysts, fund managers and potential investorsabout the impending issue. Depending on the size of the issue theroad show may be made over a few days if it is on a regional (e.g.pan-European) basis, or over a week or more if it covers Europe, theUSA and Asia

Second Lien A secured loan or note which ranks after rst lien loans or notes

Tenor Term of loan or bond