A New Low for Investor Protection in Euro High Yield

Primary deals launched in the European high yield market over the last two weeks have been diverse, and at times opportunistic. 

Douglas, a struggling German retailer, is looking to refinance outstanding debt with a deal set to be priced on Friday. That will follow a €300m BB- rated bond from Spanish homebuilder Via Celere, a €500m BB- rated bond from aluminium sheet producer Novelis and dual sterling and euro B- rated issue from Advanz Pharma, formerly known as Concordia. 

However, it was a deal from French real estate servicer Foncia priced last Friday – €400m of secured bonds, €250m of unsecured bonds and a €1.275bn Term Loan B – that really caught our attention, and a few aspects of the bond transaction are worth examining.

Foncia is a provider for every aspect surrounding the rental, management or sale of residential units. Since its acquisition by Partners Group back in 2016, Foncia has looked to be an improving story; the company has grown at a steady pace, generated cash and reduced its leverage, while its scale and brand has also enabled the acquisition of smaller rivals. Last week’s issuance facilitated a €475m dividend for Partners Group and refinanced existing debt. While investors are usually wary of dividend recap transactions, Foncia’s growing business in our view supports such a transaction. 

However, the troubling aspect of this transaction was the aggression of the covenants, with the initial documents appearing to leave a lot of leeway for the issuer at the expense of investors. For example, there were no caps or time limits for expected synergies and cost savings from acquisitions when computing the covenant debt ratio. The portability clause also looks generous based on a 6.4x consolidated net leverage ratio. There is also plenty of headroom for additional debt, allowing Foncia to add material leverage to the pro-forma leverage of 6.4x for this transaction. Most troubling of all was the inclusion of what many investors have come to call ‘J-Crew covenants’.

In 2017, J-Crew transferred intellectual property to an unrestricted subsidiary, removing collateral from secured creditors through a two-step, so-called ‘trap door’ mechanism. This transfer of value allowed J-Crew to issue more debt and refinance some subordinated debt, which caused an outcry at the time and investors have been very vigilant about the inclusion of such clauses since. The documentation for Foncia includes a clause allowing investments in unrestricted subsidiaries, which in effect could lead to value leakage. It is not a ‘trap door’ stipulation as it was in the J-Crew case, but in our view would have a similar impact, and its inclusion is somewhat surprising given Foncia’s arguably asset light nature and its ability to pay further dividends to the shareholder. 

We thought Foncia was one of the better credit stories to come to the European HY bond markets over the last two weeks, but it was also the deal that had the most aggressive covenants. Given its positive business trajectory, it is hard for us to see why Foncia would have pushed for this level of flexibility in its bond terms. Either way, in our view this has established a new low for investor protection in European high yield.

Foncia’s Term Loan B docs were ultimately amended and a cap on EBITDA adjustments introduced, which suggests the issuer did receive some push-back from loan investors. However, the bond docs were not amended. Given the secured bonds were priced at 3.375% (from initial guidance of 3.5% area) and the CCC+ unsecured bonds were priced at 5% (well through initial guidance of 5.25-5.5%), it seems there was enough demand for the issuer to resist any push-back it did receive from bond investors.

With conditions in European HY looking favourable for opportunistic issuance, investors will have to be vigilant for more of these clauses over the coming months.