More than a year and a half after the publication of the Group of 26 proposals to reform the euro and sterling credit markets, the context of the discussion has been dramatically changed by the leveraged buyout (LBO) of Danish cleaning company ISS, which all too painfully demonstrated the impact of event risk on the price of bonds without adequate covenant protection. But while there is nothing like losing money to focus the mind, the parameters of the debate appear to be changing as impetus has drifted away from the G26.
The original proposals revealed in Credit (October 2003, pp. 34–37, see box) stimulated a heated debate among investors, issuers and bankers. Momentum seemed to be with the group as within months several extra names had been added to the original 26 signatories.
Yet the achievements thus far of the G26 are hard to gauge. The group rejected a buying strike but were hopeful that within six months some deals would incorporate some of their desired features. Notable successes included deals from Land Securities and Gecina, which featured some of the ideas suggested by the G26. The Gecina issue incorporated a change-of-control covenant and Land Securities' covenant package featured 'flippable' debt, a class of debt that switches from senior to subordinated debt when asset coverage dips.
But there have also been setbacks. Almost immediately after the proposals were unveiled many of the signatories provided ammunition for their critics by buying Danish brewer Heineken's unrated bond – despite their own proposals that unrated bonds were not acceptable.
And most telling of all, the group has not even met formally since the proposals were launched in October 2003, says Karl Bergqwist, head of institutional credit investment at Gartmore Investment Management, one of the original signatories.
Stephen Wilson-Smith, head of credit research at M&G Investments in London – another of the original group – says that the G26 stopped signing people up once it realised that a longer list of signatories would not hasten change.
One reason for the loss of momentum is the absence of a consensus between investors, according to Katherine McCormick, head of EMEA corporate research at JPMorgan. She says that some investors always felt that they were smart and could generate alpha (above-market returns) by knowing the risks better than others. "Then there were other guys that basically wanted high-yield covenants on high-grade issuance," she says.
Similarly, there is a difference of opinion regarding the relative importance of various types of covenant protection. All investors agree on the importance of the provision of rating downgrades for borrowers that have undergone a change of control. But Craig Abouchar, senior fund manager, high yield at Insight Investment in London, says that efforts would be better focused on the matter of negative pledges.
More generally, one of the reasons why many investors were reluctant to back the proposals – and why the proposals have had a less than hoped for impact on the market – is that the G26 were simply asking for too much, according to Abouchar. "Clearly they weren't going to get all [they wanted] and it would have been better to focus on what is achievable rather than things like downgrade triggers," he says.
Meanwhile, Continental investors seem to have taken a less militant stance that the G26. Peter Walburg, global head of fixed-income research at DWS/Deutsche Asset Management in Frankfurt, says there has never been a clamour among European investors for pushing the investor protection agenda to the exclusion of other parties in the credit market. "We are only interested in a dialogue with all three constituencies [investors, issuers and banks]," he says.
To that end, in addition to leading the working group of the German fund management body Bundesverband Investment und Asset Management (BVI), Walburg also leads a parallel group for the Association des Marchés de Taux en Euro (AMTE), the euro debt market association, which includes issuers, investors and banks. The conclusions of these groups could yet decide the future of European issuance (see box over).
A painful paradox
In 2002 there were tough market conditions which drew attention to how deals were structured and covenanted, recalls JPMorgan's McCormick. But by the time investors had considered how they wanted to approach this issue, market conditions had changed, and remained relatively positive – with the exception of May 2004 – until two months ago.
Julia Killmer, on the euro corporate syndicate desk at ABN Amro in London, notes that during the strong market conditions of recent years there was too little supply and too much demand, which meant investors had to buy deals regardless of documentation standards. But as a result of recent volatility, there has not been as much fast money around to fill gaps when real money decides not to participate in a deal.
That should mean that for investors eager to see change in the euro market, the circumstances appear better than ever. "The rule is that if the markets get dicey then bondholders have more power and that is what has happened," says JPMorgan's McCormick. ABN's Killmer agrees that investors have got "their best shot yet" at raising documentation standards.
McCormick cautions that while investors have an opportunity to get a better deal under relatively weak market conditions, it is not clear that we are entering a new bear market which would give them the upper hand for long enough to force through permanent structural change. Rick Deutsch, head of European credit research at BNP Paribas, summarises investors' power: "This is a temporary phenomenon – a blip."
Meanwhile, investors have clearly been sensitised to the issues of covenant protection that were raised by the G26. "For Continental investors, ISS and the LBO mania that followed is the first time that they have felt pain from the type of event risk the standards initiative was concerned with," says Gartmore's Bergqwist. "It acted as a catalyst."
The sterling market was always more aware of event risk largely because it has been through similar problems in the past: UK investors know what LBOs can do to their returns. "Euroland has now been woken up by ISS, whose bonds fell by 25% overnight," says Bergqwist. "If ISS was 1% of your fund and your target is 75bp a year, then you would have lost a third of your performance instantly."
Mikael Anttila, fund manager at SEB Investment Management in Stockholm, speaks for many when he says: "Bondholders have been badly treated. We've always been astonished at some of the documentation in the market and ISS has confirmed that something needs to be done." He adds: "A banker at a US investment bank once told me that European investors don't pay attention to the documentation of bonds. We need now to pay attention."
But curiously no one now seems interested in tapping into this increased awareness of event risk or leveraging investors' position of relative power in order to force change. DWS/DeAM's Walburg says that the investors he has spoken to have no intention of "abusing the stronger position" that they find themselves in. Given his commitment to working with issuers and banks to find consensus solutions, this perhaps comes as no surprise.
But many of the G26 investors also now feel that any change in the market must develop in a more organic way. "There is currently no coordinated effort regarding the proposals but everyone is pushing for the same things separately," says M&G's Wilson-Smith. "If all investors talk about change of control at one-to-one meetings then issuers will have to take notice."
Forward, not back
So if the G26 is not going to push an overt agenda of investor rights, how is the market going to change? One way to use investors' current position of power is to get protection on a bond-by-bond basis and hope the trend sticks, says Wilson-Smith.
In the aftermath of ISS, brick company Wienerberger, car rental firm Sixt and drug company Syngenta were all forced to include a change-of-control covenant in order to complete their deal – or at least complete it at acceptable terms. Auto and defence technology group Rheinmetall was not able to print its deal despite a roadshow and initially positive feedback. It belatedly included one but had lost momentum and was forced to abandon its deal.
Killmer at ABN Amro, a bookrunner on Wienerberger's €300 million deal, says that the company had prepared its transaction documentation before ISS. But with investors spooked by capital losses and lack of bondholder protection in ISS's documentation, the concept of change of control suddenly became important.
The market assumption was that companies with steady cashflow and market capitalisations of less than €15 billion could be potential LBO targets. "Wienerberger suddenly found – having met both criteria – that questions during the roadshow focused on change-of-control provisions," says Killmer. While the company had not considered itself at risk of an LBO due to its well-spread shareholding, Wienerberger nevertheless took investor concerns seriously.
The intention of the deal was to lengthen Wienerberger's maturity profile and broaden its investor base and therefore the concerns of real-money accounts in the UK, Germany and France had to be addressed – even though the transaction was strongly subscribed by Austrian domestic demand. "What really changed the company's mind was hearing an investor in the UK say, 'I view change-of-control provisions as an insurance policy and will potentially give up 3bp–5bp for it'," recalls Killmer. "In the assessment of Wienerberger, change-of-control provisions would not impact its financing abilities going forward and therefore it decided to give them."
Gartmore's Bergqwist says that an appeal to issuers' bottom line is central to gaining acceptance. "If I were a finance director, why – unless I thought an LBO was likely – would I want to have volatile instruments in the market which just increase my funding costs and might hamper my access to the market?" he asks.
But as JPMorgan's McCormick notes, issuers continue to dislike the restrictions that covenants place on their ability to operate; one of the reasons they choose to issue bonds is that they are more flexible than bank debt. "Every issuer has to offset capital efficiency with flexibility and if you're high grade then you can benefit from flexibility," she says. "There may be cost benefits to having improved covenants but it has to be weighed against the flexibility lost."
Refresher: The G26 proposals
1. Minimum covenants for corporate investment-grade issuers: change-of-control provision linked to a rating downgrade, normally to below investment grade; negative pledge ensuring the preservation of the instrument's structural integrity and a restriction on the disposal of assets, limiting the scope for asset stripping and financial engineering.
2. Issuer call options: replacing the spens call provision with a swap-based level. Less onerous on the issuer and still fair to investors.
3. Documentation standards: a draft prospectus, available prior to a roadshow.
4. Disclosure: information in a standardised format and on an ongoing basis.
5. Credit ratings: issuers should obtain at least two ratings.
6. Better provision of secondary market liquidity
7. Bondholders are stakeholders: better direct communication between investors and companies will promote market liquidity and best market practice.