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Growing pains

Facing its first wave of defaults, Europe's high-yield market wants a bigger voice in debt restructurings. Is anyone listening?

Facing its first wave of defaults, Europe's high-yield market wants a bigger voice in debt restructurings. Is anyone listening?

By Suzanne Miller
August 2001
Institutional Investor Magazine

On September 22 of last year, U.S. food additive maker CP Kelco successfully sold E255 million ($239 million) worth of ten-year 11.875 percent high-yield bonds to European investors eager to buy anything unrelated to the telecommunications business. Just two months later, on November 16, CP Kelco had some bad news for its new bondholders: The Wilmington, Delaware-based company would miss its third-quarter profit targets by a wide margin. The bonds plunged from E94 to E58.

Investors, outraged that the company would issue new securities a week before the end of the quarter without alerting them to a potential problem, organized a conference call four days later to complain to underwriter Lehman Brothers. "When am I getting my money back?" shouted one frustrated debtholder, according to a listener.

The CP Kelco investors should count themselves lucky. The B-plus-rated company wasn't in default, so they didn't have to contend with other, more senior lenders who could strip away what was left of the bondholders' investment to meet their own claims. What's more, Lehman's buyout fund owns 71 percent of CP Kelco, which was formed only last August when chemicals maker Hercules merged its food gums business, Copenhagen Pectin, with a Monsanto Co. division, Kelco Biopolymers. As a result, the investment bank, which could have been dragged into court over its due diligence efforts, had considerable incentive to work a deal. Ultimately, Lehman bought the bonds back in December for 92 percent of face value (an initial offer of 80 percent was rejected) to avert a major rift with investors.

A Lehman spokesman says that Monsanto, itself a unit of Pharmacia Corp., supplied inaccurate information that both CP Kelco and the investment bank used in their bondholder materials: "Because we saw the way this was evolving, we thought the right thing to do was to buy back bonds from those who invested initially." CP Kelco is now suing Pharmacia, charging its Monsanto group with providing faulty financial figures to complete the original sale to the Lehman buyout partnership.

Other European high-yield investors, choked with underperforming telecom bonds and facing the E45 billion market's first wave of defaults, would gladly settle for a 92 percent recovery. Eight companies defaulted on their obligations in the first half of this year, up from five in all of last year, while the European default rate leaped from just 1.47 percent in 2000 to 5.04 percent in 2001, according to Credit Suisse First Boston. In most cases, investors in these busted deals have few alternatives but to take deeply discounted equity in return for their bonds. Why? Because the bankruptcy rules in important European legal regimes like the U.K.'s grant sweeping rights to senior lenders - that is, bankers - who can pick and choose among assets to sell and essentially take control of a business to assure repayment. Elsewhere, legal systems give precedence to protecting corporate assets and workers' jobs. Either way, investors have little chance of a meaningful recovery.

Skirmishing between established bank lenders and junk bond investors has just begun. "Senior banks don't look beyond the end of their noses," one veteran high-yield investor says. "When this market explodes, it will be ugly, and a lot of capital will be withdrawn. Bondholders will say, 'Bloody hell, I'm holding equity.' Until things change, we're wary of what we buy."

European high-yield investors are trying to fight back. Last fall they formed a trade group, the European High Yield Association. Composed of more than 300 buy- and sell-side players, it aims to teach investors how to perform their own due diligence before buying into an issue.

On July 31, the EHYA won its first - albeit small - victory. As part of a broad Department of Trade and Industry review of British insolvency law, Chancellor of the Exchequer Gordon Brown issued a white paper that proposes to allow nonbank lenders like high-yield investors to participate in appointing administrative receivers in a bankruptcy. Previously, the selection and oversight of a receiver was left completely to banks. Though it stopped well short of many of EHYA's goals, Brown's proposal opened the door a bit for investors.

Senior lenders, of course, respond vigorously to these incursions. Reducing the banks' powers in a restructuring, says a spokesman for the British Bankers' Association, the country's trade group for lenders, means "less flexible finance - more expensive and less available."

Fumes a senior executive at one of the U.K.'s leading commercial banks: "We've been restructuring for hundreds of years, and suddenly the high-yield investors want to change the rules? If bondholders don't understand what they're getting involved with, they shouldn't buy junk bonds. They're getting paid for a reason - yields like that aren't had without a reason."

These issues wouldn't seem so pressing right now except for the enfeebled state of the fledgling European high-yield market. More than half the outstanding issues, sold largely by telecom and media companies, are trading at distressed-debt levels of more than 1,000 basis points over standard government bond benchmarks. Just 9 percent traded at such levels in January of 2000, according to Merrill Lynch & Co., and that proportion is expected to grow as the U.S. and European economies struggle to stay out of recession.

Certainly the rising woes in the junk market aren't restricted to Europe; the more mature U.S. market is struggling, too. Last month American Express Co. took a stunning $826 million write-down on the value of its junk bond portfolio owing in part to rising defaults. The difference is that in the U.S., investors like American Express have gradually built protective covenants into their indentures to give them greater legal clout in their wrangling with bankers when companies face bankruptcy. Although amounts vary, U.S. investors generally get about a 40 percent recovery on their claims during the settlement process.

"This is where it gets interesting. We're in the fourth year of the European high-yield market, and defaults are starting to occur apace," says Myra Tabor, head of special investments at Royal Bank of Scotland in London (see story). "We will soon know if the theoretical doomsday scenario pans out - bonds are both structurally and contractually subordinate, and hence senior bank creditors will get 100 percent before any bond recovery."

Even if Tabor's worst-case scenario doesn't materialize, high-yield bond investors still face an uphill battle to get a seat at the table in the restructuring process. Despite the encouraging news in the DTI review, it's going to take awhile to overcome some of the more serious challenges.

"If we can't get over the issues today, Europe's market is going to struggle to grow. Regulators have to start listening," says Martin Reeves, director of European credit research at Alliance Capital Management, who serves as co-chair of the EHYA's advocacy group. Reeves and James Roome, a high-yield restructuring specialist in the London office of law firm Bingham Dana, authored a letter in February to the DTI outlining industry concerns.

Even before the DTI proposal arrived, investors had started to take action to protect themselves. Bondholders of cash-strapped U.K. printing company Polestar Corp., for example, recently hired law firm Cadwalader, Wickersham & Taft to press their rights in any upcoming restructuring. Although the company, rated B by Standard & Poor's, has not defaulted, it has been under intense price pressure in its business and is trying to find new sources of cash and aggressively cut costs. Investors, worried because Polestar has £264 million ($377 million) in debt senior to their own £140 million, want to become a part of the negotiations if the company is forced to restructure. Because Polestar remains solvent, the company and its bankers haven't had to address the subordinated lenders' request as yet.

To date, however, only an occasional stroke of luck has intervened to help bondholders. In April senior banks appointed a receiver for Cammell Laird Holdings, a U.K. ship repair company that defaulted on £125 million of high-yield bonds and £50 million in bank debt after an Italian shipping operator, Costa Crociere, canceled an important contract. Initially, it seemed the bonds would be deemed worthless because they're subordinate. However, Cammel Laird is suing Costa Crociere for damages, and some of the proceeds may be earmarked for junior lenders. Any recoveries on the bonds will depend on the success of the arbitration between Cammell Laird and Crociere. Even if Cammell Laird wins its case, recovery for investors is hardly a sure thing. Although some analysts believe the bondholders could get as much as £50 million back, others think the senior lenders will end up with much of the cash. The market clearly isn't expecting much: Cammell Laird paper was recently quoted at a bid-spread of 5 to 8 pence.

How did the European marketplace find itself in such a perilous predicament? Blame Europe's bankruptcy laws. In the U.K. senior bank lenders are the undisputed kings of corporate restructuring. Under U.K. insolvency law dating back to the 19th century, senior banks have what's known as a floating charge that gives them the right to seize almost any asset to get repayment. As the name suggests, the floating charge overhangs the entire corporate entity, giving the banks wide latitude to pick and choose what assets to sell. Granting such wide-ranging powers to banks in a restructuring was supposed to encourage them to lend, because they had substantial guarantees if something went awry.

Although investor advocates like Reeves and Roome pushed the government to abolish the floating charge as part of its DTI review, Chancellor Brown, as expected, left it intact.

Even though they acknowledge that the floating charge is a much more formidable barrier to recovery, the high-yield advocates are eager for any hint of progress. The ability to participate in the appointment of a receiver that will operate under court supervision, rather than at the behest of the banks, will have to suffice for now.

"I think this would greatly improve the bondholders' position in default, because it will allow more say from creditors most affected by the value fetched for assets sold, rather than leave it all in the sole control of the banks," Roome said just before the release of the white paper. In the U.S., he notes, "if banks are going to be paid in full, they essentially have to do what they're told because those affected - the bondholders - are more at risk. Here the bank-appointed administrative receivers have had unqualified power."

Britain's laws aren't the only cause for bondholder concern. In 1999 the German government changed its bankruptcy laws to more closely resemble the U.S.'s Chapter 11. However, German law still provides no guidelines for U.S.-style debtor-in-possession financing that assures a company of funds while it restructures its operations and negotiates with lenders. As one lawyer says of the shifts: "It's more transparent now, but we're all still nervous. It has not been used on any big companies yet." Under French law, subordinated creditors have virtually no legally defensible rights for recovery.

Bondholders, of course, have themselves to blame for much of their trouble. Investors have gone along with an indenture clause, known as structural subordination, under which, in the U.K. at least, bondholders have no real rights. Structural subordination, in its most basic terms, means that bondholders are lending to a holding company and not to the operating company, where the assets reside. As a result, the investors have no direct claim on cash or other assets - only the equity of the holding company. If the company is insolvent, that equity can be worthless.

The recent uncertainties about investors' role in the recovery process may further limit volume at a time when the market needs a boost. European corporations haven't leaped at the chance to issue high-yield debt: New-issuance volume fell back to E12.2 billion last year from E15.5 billion in 1999, and, given the weakening economy, it may slip to E8.5 billion in 2001. As a result, investors find it hard not to participate in deals.

"It has taken some convincing to get issuers to do high- yield as a debt capital source in Europe," says Anton Simon, co-founder and CIO of London-based New Flag Asset Management. The borrowing technique still has a slight stigma, Simon notes.

With so few deals to choose from, buyers are torn between putting their money to work and pushing for extensive disclosure. Some observers believe investors have clearly opted for the former: "The difference between Europe and the U.S. is that the investor base in Europe are sheep," says one investment banker. "They don't have enough expertise assessing the risk-reward. So if gossip goes around that a deal is hot, everybody buys. Nobody has the courage of their convictions."

The buyers' quandary was evident again in May when German gas company Messer Griesheim sold E550 million worth of high-yield debt through Goldman, Sachs & Co. to refinance the biggest buyout in German history. (Goldman's private equity arm, together with Allianz Capital Partners, had purchased a majority stake in Messer Griesheim, the industrial gas unit of the Franco-German company Aventis.) The ten-year 10.375 percent issue (priced 563 basis points over comparable government securities), the largest European junk offering to date, was a smash, trading up from par to 105 before it was even allocated. When orders totaling E1 billion came in, Goldman and Messer increased the size of the transaction from E400 million to E550 million. Starved for deals - especially industrial credits that have tangible assets and cash flow - investors drove the bonds as high as 108 (a spread of 420 basis points) in the aftermarket.

Although investors were clearly clamoring for a new, nontelecom deal, they still grumbled about the lack of disclosure: The prospectus contained no information about Messer's bank loan covenants. "Lots of investors had problems with the amount of information being given out but found themselves in a position where they needed something like Messer in their portfolio," one European investor recalls.

The covenants weren't included, says a Goldman spokeswoman, because the company is rapidly deleveraging, and its bank loan agreements detail its plan to reduce its debt levels. Messer's lawyers were worried that including this information would be tantamount to providing projections, so the firm decided to omit the information. Goldman also didn't want to provide information that could be considered an endorsement of Messer's internal projections; if the company didn't reach its targets, the investment bank might be held responsible. In Europe companies and their bankers don't have to offer this data.

Ultimately, investors' willingness to participate in deals where they find disclosure inadequate will determine how seriously their concerns are taken. Mitchell Harwood, senior vice president of P. Schoenfeld Asset Management, a New York high-yield money manager with European holdings, puts it bluntly, "The only thing that allows European bondholders to put any teeth into anything is not to buy."