Legal Spotlight

As the credit cycle turns and the market prepares for a rise in the speculative-grade default rate, Stephen Phillips, partner at White & Case, fears that high-yield bondholders across Europe may be marginalised in the next wave of restructurings

Sliding down the capital structure

I am writing a day after the Bank of England lowered interest rates. Counterintuitively, shortly after the announcement the interbank rates increased, the pound strengthened and share prices fell. These are not the easiest times to make solid predictions and trading decisions and it is my observation that many of those operating in the bond and loan markets have struggled to make sense of the recent conditions. It seems that many of us are having to cope with the unexpected. One prediction that appears to be increasingly likely to come true is that bond default rates are to move closer to their long-run average. If you accept this premise, and it is one that rating agencies support, questions arise as to when this pattern will emerge and how bondholders will fare when it happens.

Before this summer's events the conditions prevailing in the European credit market over the past few years had been benign by any historical standard. In fact, notwithstanding the gloomy headlines of recent months, the global speculative-grade bond rate still remains very low, with Standard & Poor's reporting a 1.42% European 12-month trailing speculative-grade default rate in October. Before the liquidity crunch, companies with relatively low credit quality found it easy to obtain finance at very reasonable rates of interest and, when the time came to repay the debt, they found it easy to refinance so that the time for actual repayment stretched out into the future. The times of easy credit have now gone, and it is likely that the inability to get a refinancing away will be one of the biggest contributors to the default rate over the next year.

We have been here before. Almost as soon as the high-yield bond market had become established in Europe in the late 1990s, participants encountered challenging conditions, to put it mildly. A staggering 89% of European cable- and telecoms-related high-yield bonds were in default according to Fitch. It was boom time for distressed debt investors who would often agree to write off all or part of their debts in return for a majority equity stake in the distressed company; the restructurings of Telewest, NTL and Jazztel are just a few examples of this trend.

Distressed debt specialists drew their experiences from the US but the market there differs from Europe in a number of important ways. For example, unless shareholders put their hands in their pockets and organise a rights issue, little or no value is usually retained by US shareholders in a Chapter 11 proceeding as the US Bankruptcy Code allows a judge to approve a bankruptcy plan even though it is opposed by shareholders. In Europe, value often tends to flow to shareholders in restructurings because insolvency laws in Europe do not deal effectively with the 'ransom' extracted by shareholders for their consent to a restructuring. The rash of European insolvency legislation in recent years has not really changed the position. In the Eurotunnel restructuring, for example, creditors wrote off $3 billion of the debt and yet the shareholders retained a minimum of 13% of the equity. Looking across the Channel to the UK, it appears the institutional shareholders and hedge fund owners of Northern Rock are determined to have their say and obtain maximum value in the restructuring process. One can imagine that we will see more of this kind of assertive behaviour with shareholders engaging in a game of brinkmanship, selling their consent for a consensual restructuring at a high price.

European high-yield debt has made a spectacular come back from the nadir of 2002/3, with approximately $40 billion of high-yield issuance in 2006 according to Moody's. The revival of the market has been aided by changes in the European high-yield model, which has led to the inclusion of upstream guarantees from operating companies - a feature found in the US model but which was missing from the early European high-yield structures.

Given the increased complexity of capital structures compared with the early 2000s and the consequent increase in the number of stakeholders whose consent will be required for a financial restructuring, there is a serious prospect that stakeholders will, on occasions, fail to reach agreement on a restructuring plan. If the senior lenders decide a consensual deal is not on the cards they will be able, in a typical structure, to instruct the security agent to release the bond guarantee claims and sell the business as part of an overall security enforcement action. If a business is sold in a distressed state it is likely to be purchased for a depressed price, often at a value that may barely cover the full amount of the senior debt. Accordingly, value flowing to the more junior parts of the debt structure in these circumstances is likely to be fairly minimal.

The fight for value in the last wave of restructurings often occurred between the high-yield bondholders and the debtor (fighting on behalf of the equity), with the senior lenders standing mainly on the sidelines jealously guarding their position and perhaps seeking a consent fee. The complex, highly leveraged deals of the past few years mean that in the next cycle, the value break may well occur in the additional tiers of debt, sitting above the bondholders in the capital structure. This paves the way for a new breed of senior debt held by distressed debt investors with the incentive and pluck to press the trigger on a security enforcement.

Accordingly, the senior lenders have the 'security enforcement trigger' and the shareholders have the 'consent card' but for high-yield bondholders it is questionable what leverage they have to defend their position in a restructuring. One view which follows from this analysis is that specialist distressed debt investors are likely to buy at the extreme ends of the capital structure.

It is, however, often easier to threaten a security enforcement process than to execute one: documentation has often been put together at breakneck speed; intercreditor agreements may not be quite as clear on the rights of the senior lenders as they should be; and the laws of the various jurisdictions where enforcement must take place may not be conducive to a smooth process. In addition, any security enforcement process carries the risk of destabilising the business.

These factors may encourage consensus amongst the stakeholders, but whether high-yield bonds will fare as well in the next cycle of restructurings as they did in the last one remains a major doubt.

- Stephen Phillips is a partner in the financial restructuring and insolvency team within the London banking and capital markets group at White & Case.