A bond market primer for new issuers

For corporates, especially those seeking

growth, two aspects stand out in
particular. The rst is that bonds enjoy
bullet repayments although renancing
risks are increased. The second is that
bonds have incurrence only covenants
as explained below. Together these
two characteristics offer signicant
advantages, particularly the ability to
fund further growth and development
from internally generated resources. Lets
look briey 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 signicant 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, signicantly, 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 (xed 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 was
rated 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 nancing, as discussed in Capital Thinking, is growing in importance as an alternative source of funding for
companies in Europe. As the European bond markets evolve to accept smaller issues, mid-market companies are accessing
the market for the rst time. For nance directors who have not previously considered bond nancing as a viable
alternative or supplement to bank nancing, it can come as a pleasant surprise to discover the advantages bonds offer. In
this special supplement we analyse the factors that should be taken into consideration before going down the bond route.
ISSUE 2 SUPPLEMENT JANUARY 2014
Capital Thinking
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
benets: rst, the cash retained can be
reinvested in the business, which is a
signicant benet to corporates looking
to reinvest their prots for growth.
Second, bullets provide borrowers with
much greater headroom than loans, even
with higher leverage. Issuers should
be mindful however of the increased
renancing 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
nancial covenants, apart from certain
cov-lite syndicated loans, which
we have discussed previously. These
nancial covenants require a borrower
to comply with various nancial
ratios on an on-going basis, typically
quarterly on a trailing 12-month period.
The most common covenants are
leverage, cash ow cover and interest
cover. These nancial 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
nancial 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 nancial 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 afrmative
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
CAPITAL THINKING ISSUE 2 SUPPLEMENT JANUARY 2014 1
(hence the term incurrence), acquiring
or selling assets or distributing cash to
shareholders. More signicantly, 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 nancial covenants in bonds
coupled with the lower debt service
from bullets amplies the headroom
available and signicantly reduces the
potential for this type of default. To
put 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 it
carries a greater renancing risk). Bonds
offer other signicant 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 nancial projections provided by
the borrower and the loan includes a
number of nancial covenants designed
to 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 relevant
permitted threshold then the borrower
needs to obtain and, often pay for, a
waiver from the lenders.
whilst bonds offer fexibility
For historical reasons bonds can offer a
higher degree of operational exibility.
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 nancial performance at the
time of the proposed action or event. For
example bonds typically allow additional
debt incurrence if the borrowers
nancial 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, the
proviso 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 borrower
will 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 exibility, which is
particularly useful to borrowers seeking
to grow their business.
Size matters
As mentioned above, access to the
capital markets is constrained by issue
size and the borrowers debt capacity.
There are a number of established
nancial 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 and
on attractive terms and conditions
For subsequent loans, the credit process
is standard, even if terms, conditions and
pricing remain unchanged
Passive investor base Active lender base
Investment of managerial resources to
complete the initial prospectus, navigate
the ratings process and organise and attend
roadshows
Shorter time frame to arrange bank finance
More capricious capital markets can close in
response to market and political shocks
Bank lending remains open in all but the most
extreme market conditions
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 under
6x. 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 gures
are not as dramatic as they rst
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 quality
Obviously 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 track
record of stable, if not increasing, cash
ows; 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 ow, which is the critical
factor. Interestingly, Soho House,
despite reporting a nancial loss of
17.4 million for the LTM period in
the 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-nancial 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 extremely
exible 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, renancing
bank debt, dividend recaps and
acquisitions although the preparation
for 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
25.0 million 100 million 125 million 150 million
30.0 million 120 million 150 million 180 million
35.0 million 140 million 175 million 210 million
40.0 million 160 million 200 million 240 million
Table 4: Key high yield bond terms
Currency: $ 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 individuals
Preparation: 12 weeks for new issuers (six weeks for established issuers)
Application: General corporate purposes (eg growth), refnancing, dividend recaps, M&A
To see how European bond markets
are accepting smaller issues from
mid-market companies, refer to the
2nd issue of Capital Thinking.
Please click here to access.
CAPITAL THINKING ISSUE 2 SUPPLEMENT JANUARY 2014 3
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Debt Advisory contacts
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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 to
describe the margin, spread or fee in a loan
Bridge (fnance) In the context of an acquisition, a short-term loan used by bidders to
provide certainty of funding pending the arrangement of longer-term
funding, typically a bond
Bullet When the entire principal of a bond or loan is due and payable on
the fnal maturity date ie, there is no amortisation prior to fnal
maturity date
Coupon The (fxed) 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 fnance
the payment of a cash dividend
FCCR The Fixed Charge Coverage Ratio. A fnancial ratio or covenant,
which takes various forms. In the high yield bond market it measures
EBITDA to fxed charges (usually net interest). Similar to interest
cover 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 fnancial covenant which measures
Debt-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 rate
debt
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 a
long-term loan, which may include an amortising tranche (TLA) and a
bullet tranche (TLB). Invariably the RCF enjoys super-priority vis-a-vis
the TLA, TLB and the bond.
PIK Pay-in-Kind. Note or loan where the interest remains unpaid, accrues
and is capitalised until fnal maturity when it is paid together with the
principal due
PIK Toggle (or PIYW) Feature often found in PIK loans or notes, which gives the borrower
the right to elect whether or not to pay part or even all the interest
due for any period. Also known as Pay-if-You-Want (PIYW)
RCF A loan facility with a bullet maturity, which allows a borrower to draw
and repay and redraw amounts over the life of the facility. Typically
used to fund fuctuations in working capital
Recapitalisation A change in the capital structure of a borrower in which additional
debt is raised so that leverage is increased. The new debt is used
to refnance the existing debt, but the incremental (recapitalised)
amount is used to fnance a cash payment to the owners
Refnancing A transaction in which a borrower replaces existing debt with new
debt such that there is no change in the level of gearing. Currently
may involve the refnancing of existing long-term bank loans with
bond fnancing, whilst the existing RCF remains in place, but may be
promoted to super-priority vis--vis the bond
Road Show A presentation by an issuer of bonds to potential investors prior
to an offering. It involves the senior management, usually the
issuers managing director and fnance director, making a series of
presentations to analysts, fund managers and potential investors
about the impending issue. Depending on the size of the issue the
road 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, the
USA and Asia
Second Lien A secured loan or note which ranks after frst lien loans or notes
Tenor Term of loan or bond