trends in canadian high yield debt: covenant packages

Dentons Presents: Trends in Canadian High Yield Debt

Dentons Canada LLP

Bill JenkinsGlobal Vice-ChairCalgary

Elana Hahn Partner Toronto

Sylvain DhenninPartnerLondon

Bill GillilandPartner Calgary

Dan Shea AssociateCalgary

CalgaryLondonToronto

Canadian High Yield Debt: Covenant Packages

June 25, 2014

By: Bill Jenkins, Partner & Global Vice-ChairBill Gilliland, PartnerElana Hahn, Partner Dan Shea, Associate

Dentons Canada LLP

Purpose of high yield debt covenant packages

Dentons Canada LLP 3

• Prevent issuer from incurring excessive debt and protect bondholder position in the capital structure by limiting structural/lien subordination

• Provide appropriate constraints on issuer’s balance sheet while preserving flexibility for execution of strategy, payment of dividends and operation of the business

• Increase prospect of capital gains by requiring issuer to manage leverage, limit dividends (generally 50 per cent of earnings must be reinvested) and limit acquisitions, encouraging improved credit

• Incurrence-based (not maintenance-based)

Comparison to investment grade covenant packages


Investment Grade

• Limitation on liens (i.e. negative pledge)

• Change of control and ratings event

• Amalgamations, consolidations, mergers, sale of assets, etc.

• Limitation on incurrence of indebtedness (sometimes, but more permissive)

High Yield

• Limitation on restricted payments (includeslimitation on dividends)

• Limitation on incurrence of indebtedness and issuance of disqualified stock

• Limitation on liens (i.e. negative pledge)

• Limitation on dividends and other payment restrictions affecting restricted subsidiaries

• Transactions with affiliates

• Asset sales

• Change of control

• Amalgamations, consolidations, mergers, sale of assets, etc.

• Restrictions on subsidiary guarantees

• Covenant suspension

Restricted subsidiaries, unrestricted subsidiaries and the “system”


Restricted Subsidiaries• Governed by the indenture and within the “system”, and generally able to freely transact with the issuer

and other restricted subsidiaries

• Income produced by restricted subsidiaries is counted towards covenant compliance (subject to certain limited exceptions)

• Usually all subsidiaries are designated as restricted subsidiaries at the issue date

Unrestricted Subsidiaries• Not governed by the indenture, but unable to freely transact with the issuer and restricted subsidiaries

(transactions between unrestricted subsidiaries and the issuer/restricted subsidiaries must be tested against the indenture covenants)

• Income produced by unrestricted subsidiaries is only counted towards covenant compliance to the extent actually received by the issuer/restricted subsidiaries (e.g., through dividends)

• Decisions to designate a subsidiary as unrestricted require careful consideration and must satisfy the designation covenants

Restricted subsidiaries, unrestricted subsidiaries and the “system” (continued)


Issuer

Restricted Subsidiary



Unrestricted Subsidiary

Part of the “system” and subject to indenture covenants

• Issuer may be required to provide certain carve-out financial information in continuous disclosure filings that excludes unrestricted subsidiaries

Limitation on restricted payments (includes limitation on dividends)


• Limits “restricted payments” in order to control movement of cash and assets from within the system to shareholders, subordinated creditors and investments outside the system (i.e. to ensure cash and assets remain available to satisfy bondholder claims)

• Restricted payments include:• Dividends and other distributions• Repurchases or redemptions of equity• Repurchases or redemptions of subordinated debt• Investments (defined broadly)

• Issuer and restricted subsidiaries are prohibited from making restricted payments unless certain conditions are satisfied:• Issuer has availability in its “restricted payment basket”;• Restricted payment is a “permitted restricted payment”; or• Restricted payment is a “permitted investment”

Limitation on restricted payments (includes limitation on dividends) (continued)


Restricted Payment Basket• Issuer can make restricted payments if it has availability in its restricted payment basket,

is able to incur at least $1 of debt under the coverage ratio after giving pro forma effect to the restricted payment and is not in default

• The restricted payment basket is increased/depleted from the issue date based on various factors including:• A percentage (often 50%) of consolidated net income is added to the basket with 100% of losses

subtracted (sometimes based on 100% of consolidated EBITDA less a multiple (usually 1.4x) of fixed charges)

• 100% of proceeds from certain equity issuances are added to the basket• Conversions of certain debt/disqualified stock to equity may increase the basket• Net reductions in certain investments made after the issue date increase the basket• FMV of investments in unrestricted subsidiaries increase the basket upon designation as restricted

subsidiaries

• Definition of consolidated net income is critical to the restricted payment basket calculation



Permitted Restricted Payments• Issuer is permitted to make certain “permitted restricted payments” at any time and

regardless of its financial condition• Permitted restricted payments can be classified into two main categories:

• Restricted payments that should be permitted at all times such as payment of dividends that were permitted to be paid when declared, repurchases/redemptions of equity or subordinated debt with the net proceeds from a concurrent sale of the issuer’s stock, cashless exercises of options and redemptions of rights under poison pills

• A series of specific baskets (some of which will be customized to the issuer) that provide flexibility to make restricted payments within certain parameters, such as a hell-or-high-water basket (which is often based on the greater of a specified threshold and a percentage of consolidated net tangible assets)

• Although permitted restricted payments can be made regardless of financial condition, certain permitted restricted payments reduce the restricted payment basket



Permitted Investments• Issuer is also permitted to make certain “permitted investments” at any time regardless of

its financial condition• There are several types of permitted investments:

• Permitted investments that should be permitted at all times such as investments in restricted subsidiaries, investments in government securities and investments received in comprise of counterparty obligations

• Specific permitted investments that are tailored to the issuer (for e.g., common to include carve-outs for certain joint ventures for E&P issuers)

• Hell-or-high-water basket (which is often based on the greater of a specified threshold and a percentage of consolidated net tangible assets)

Limitation on incurrence of indebtedness and issuance of disqualified stock


• Limits incurrence of debt and issuance of debt-like equity based on issuer’s ability to service overall debt including any proposed additional debt• Indebtedness defined broadly (may include production payment obligations for E&P issuers)

• Issuer and restricted subsidiaries are prohibited from incurring debt and issuing debt-like equity unless certain conditions are satisfied:• Issuer satisfies the applicable financial ratio (generally a coverage ratio, but leverage ratios common

for certain industries); or• The additional debt is “permitted debt”

Limitation on incurrence of indebtedness and issuance of disqualified stock (continued)


Ratio Debt

• Issuer can incur debt if it can satisfy the applicable financial ratio • Typically based on a coverage ratio that compares adjusted EBIDTA to fixed charges• Occasionally based on a leverage ratio that compares consolidated debt to adjusted EBITDA

• Coverage ratio calculated on trailing 12-month and pro forma basis including giving effect to issuances/repayments of debt and certain acquisitions/dispositions since the beginning of the 12-month reference period

• Coverage ratio permits incurrence of increased debt as credit improves

• Definition of adjusted EBITDA and related definitions are critical to ensure appropriate inputs into the coverage ratio

Limitation on incurrence of indebtedness and issuance of disqualified stock (continued)


Permitted Debt

• Issuer can also incur “permitted debt” at any time and regardless of financial condition

• Common “permitted debt” items include:• Bank debt (limited based on specified thresholds, for e.g., greater of a specified amount and the

issuer’s borrowing base and/or a specified percentage of consolidated net tangible assets (for E&P issuers, this can include future net revenues from proved and (in some cases) probable reserves))

• Certain capital lease obligations and purchase money obligations• Intercompany debt within the system• Certain refinancing debt• Hell-or-high-water basket (often based on the greater of a specified threshold and a percentage of

consolidated net tangible assets)• Ordinary course items that technically are debt• Certain issuer-specific and negotiated exceptions

• Issuer is not required to identify a single basket that will permit the entire amount of new debt and has flexibility to reallocate among baskets in the future

• Permitted debt exceptions should be sufficient to fund fixed charges for a reasonable period of time

Limitation on liens


• Restricts issuer and its restricted subsidiaries from granting liens (which includes security interests, mortgages and other encumbrances) and acts as an anti-layering protection, maintaining bondholder priority in the capital structure

• Issuer is permitted to grant certain specified “permitted liens”, which include customary items such as liens securing debt under credit facilities, purchase money liens, liens on refinanced secured debt, liens existing on the issue date and liens arising by operation of law (e.g. rights of way, liens for taxes not yet due, etc.)

• Permitted liens also include exceptions tailored to the issuer and typically include a hell-or-high-water basket

• Issuer may also be permitted to grant liens if the issuer is willing to simultaneously grant a ratable lien for the bondholders (or, in the case of liens granted on subordinated debt, a senior lien)

• Important to issuer that permitted lien concept align (and be at least as broad as) the definition of permitted liens in the issuer’s credit facility

Dividends and other payment restrictions affecting restricted subsidiaries


• Ensures issuer has appropriate access to cash and assets of restricted subsidiaries by prohibiting limitations on the ability of its restricted subsidiaries to declare and pay dividends, make/repay intercompany loans and/or transfer assets within the system

• Covenant is subject to customary exceptions for items such as:• Limitations existing on issue date• Limitations under applicable law• Customary non-assignment provisions in contracts and interim period covenants in purchase and sale

agreements• Limitations relating to permitted liens• Limitations in place at the time a company becomes a restricted subsidiary

Transactions with affiliates


• Requires transactions between the issuer/restricted subsidiaries and affiliates to be arm’s length (i.e. terms no less favourable than what could be attained from a third party)

• Does not apply to transactions below a specified threshold, and also excludes various normal course transactions, transactions within the system, transactions that are permitted by the restricted payments covenant and issuer-specific exceptions

• Issuer may be required to provide the indenture trustee with evidence of independent board approval if value of the affiliate transaction exceeds certain thresholds

• Most relevant for private companies with an equity sponsor

• In U.S. deals, common to require a fairness opinion if the value of the affiliate transaction exceeds certain thresholds (less common in Canadian transactions)

Assets sales


• Protects income-producing assets by predetermining the type and use of proceeds from asset sales (but does not prohibit asset sales)

• Assets sales must be made at fair market value and large portion of proceeds must generally be in cash or cash equivalents (70-80%) • Exceptions for designated non-cash consideration up to a certain threshold• Exceptions for assets used/useful in the issuer’s business

• Issuer typically has one year to use the cash/cash equivalent proceeds to either repay senior or pari passu debt, acquire assets in the same business or make capital expenditures. Remaining proceeds after the specified period (subject to a minimum threshold) must be used to make an offer to repurchase the notes at par, providing bondholders the opportunity to re-evaluate their investment in light of the asset sale• Any proceeds remaining after an asset sale offer can be used for any purpose (subject to compliance

with the other indenture covenants)

• Does not apply to every asset sale (numerous customary carve-outs including for ordinary course asset sales, transactions within the system and asset sales below a specified dollar threshold (for E&P issuers, may also exclude sales of properties with no 2P reserves))

Change of control


• Permits bondholder to reevaluate investment upon occurrence of a change of control

• Bondholder can put notes to issuer for 101% of par plus accrued and unpaid interest (but no make whole)

• Some deals include double triggers where change of control must result in, for e.g., a ratings downgrade, inability to incur additional debt under the coverage ratio or a decrease in the coverage ratio

• Trend towards capturing fundamental board changes within the definition of change of control

• Change of control may also be triggered by certain key shareholders dropping below a specified shareholding threshold

Amalgamations, consolidations, mergers, sale of assets etc.


• Prohibits certain fundamental transactions (including amalgamations, consolidations, mergers and sales of all/substantially all the issuer’s assets) unless certain conditions are satisfied:• Issuer/surviving entity is organized under laws of a specified jurisdiction and assumes obligations

under the indenture• Issuer/surviving entity would be able to incur $1 of debt under the coverage ratio after completing the

transaction or the coverage ratio would be at least equal to the ratio prior to the transaction• No default is occurring or will occur as a result of the transaction• Sometimes consolidated net worth must be at least equal to consolidated net worth of the issuer prior

to the transaction

• Does not preempt change of control put right

Restrictions on subsidiary guarantees


• Protects against structural subordination by prohibiting non-guarantor restricted subsidiaries from guaranteeing debt unless they provide a guarantee for the notes

• Covenant is generally subject to a threshold below which guarantees are permitted (however, it is usually triggered in all cases where the subsidiary becomes a guarantor under a credit agreement)

• Restricted subsidiaries may also be required to provide a guarantee if they incur debt above a specified threshold

Covenant suspension


• Certain covenants may cease to apply if issuer obtains two investment grade ratings• Some indentures permit covenants to permanently fall away, but more common formulation is

suspension during the period where issuer has at least two investment grade ratings and reinstatement if the issuer no longer has two investment grade ratings

• Covenants that cease to apply are those that are unique to high yield indentures, including:• Limitation on restricted payments• Limitation on incurrence of debt and issuance of disqualified stock• Limitation on dividends and other payment restrictions affecting restricted subsidiaries• Limitation on asset sales• Coverage ratio requirement relating to the restriction on amalgamations, asset sales, etc.• Transactions with affiliates

• Upon a reinstatement, the issuer has to account for debt incurred and restricted payments made during the suspension period by tapping into its available baskets (but will not be in default to the extent it does not have appropriate availability in its baskets)

About Dentons high yield practiceDentons has been advising issuers, investment banks and private equity sponsors in connection with high yield bond transactions for many years. Our involvement in numerous significant and innovative high yield bond transactions across North America and around the globe has enabled us to gain the trust of leading market participants. Our experience is not limited to the bond issuance process, but includes advising issuers on ongoing covenant compliance matters, consent solicitations, optional redemptions and negotiations with and for creditor committees in distress situations. This breadth of experience informs our ability to provide comprehensive and practical advice on the complex covenant patterns specific to high yield bonds.

We invite you to contact any of the following:


William (Bill) K. JenkinsGlobal Vice ChairCalgaryT +1 403 268 [email protected]

Dan SheaAssociateCalgaryT +1 403 268 [email protected]

Bill (William) G. GillilandPartnerCalgaryT +1 403 268 [email protected]

Elana M. HahnPartnerTorontoT +1 416 863 [email protected]

The preceding presentation contains examples of the kinds of issues companies dealing with the subject matter could face. If you are faced with one of these issues, please retain professional assistance as each situation is unique.

trends in canadian high yield debt: covenant packages

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