This article is primarily focussed on the inter-creditor relationship of senior and mezzanine debt, but the principles are the same for any form of subordinated debt and apply equally to high yield and PIK preferred, D notes, second lien or whatever title is applied to the relevant debt instrument as encountered.
RULES OF THE LONDON CLUB
As a quick reminder for readers, here's a summary of how mezzanine has evolved in the UK. It essentially grew from the desire of borrowers, or more correctly the equity sponsors, to put more leverage into their deals, while lenders wanted to obtain a better risk/return ratio for providing that leverage. The idea was that the lender would get an equity kicker plus a higher rate of interest. Not all of that higher rate could be paid in cash, so a portion – generally half – was “rolled up” (Payment in Kind or PIK) and added to principal. The equity kicker was dealt with by an option (warrants) in favour of the bank(s) to subscribe for shares.
A borrower and lender agreed in advance the price for, and quantity of, shares to which the warrants related from an agreed financial model: if the deal did better than the model projections, there would be a windfall profit for the lender; if not, then at least the mezzanine lenders had received a higher rate of interest. The early mezzanine lenders, it's worth remembering, were generally banks and therefore in the practice of taking security for their loans.
Mezzanine became a fully secured debt instrument and was generally borrowed by the same company as had borrowed the senior debt (leading to the need for a contractual subordination). It had the benefit of the same security package (and guarantees) as the senior, hence ranking ahead of trade and other unsecured creditors (at least in the UK). Also, since the providers of senior and mezzanine were often the same institutions, mezzanine was supplied on similar documentary terms: identical credit agreement as representations, covenants, events of default. The main differences were that there was no amortisation of mezzanine – it was a bullet repayment – and the financial covenants were set some ten to fifteen per cent higher than the senior covenants. This model proved highly durable and successful. Standardised intercreditor terms were also developed.
All parties to the inter-creditor arrangements had a “seat at the table.” It was the absence of this seat at the table that, among other things, so irritated high yield bondholders in structurally subordinated structures where high yield was issued, without the benefit of any upstream guarantees, by an immediate holding company. When both senior and mezzanine had a broadly common group of debt holders, the value of this seat was not addressed. Even after the advent of a number of independent mezzanine providers, a “club” attitude still prevailed. And because the mezzanine had both a secured debt interest and an equity interest through the warrants, interests with the private equity providers were aligned – at least in theory. Restructurings tended to be done on a consensual basis: the “London Rules” applied.
TOUGHER TIMES: TOUGHER NEGOTIATIONS
But today the plethora of mezzanine providers, many of which have no “equity”, i.e. warrant interest in the deal, have different priorities. While high yield providers are finally achieving the seat at that elusive negotiating table, some of the mezzanine debt holders already sat there are asking if they can eat and drink or merely observe? Indeed some are asking whether they might not be better protected if they had a right to remove other diners and take their seats? And maybe, suggest some, a structurally subordinated position might be the best place from which to do this?
At the heart of the debate of whether “contractual subordination” is good or bad is a fundamental misunderstanding. Having as a primary borrower a holding company with no assets other than the shares in its subsidiary and (possibly) the benefit of a downstream loan is not the problem with structural subordination. It is the absence (at a minimum) of a secured upstream guarantee from that subsidiary. Such a guarantee replicates in its entirety the contractual subordination by making the guarantor a primary debtor as if it were the actual borrower. But neither type of subordination in themselves are “good” or “bad” – it's the terms of the deal that counts. And that's why some mezzanine providers are now questioning how well the traditional contractual inter-creditor deal works in today's markets.
One of the first issues to be addressed by those questioning the historic approach is interest payments due to the mezzanine providers. Mezzanine has moved towards high yield in becoming focused on its ability to receive its interest. Why? Because many mezzanine providers today are leveraged, and an inability to pay interest on their borrowings can have serious consequences. The traditional “sticking plaster” approach to a credit in difficulty, whereby the mezzanine would roll up its previous cash pay interest, is not available. It's in this scenario that the question arises as to when a senior lender can “stop” interest payments to the mezzanine providers being made – and what, if anything, the senior lender should give up in return. This is one of the hottest issues being debated amongst this group today.
Another issue is control of security enforcement. Unlike Chapter 11 in the United States, the seat at the table gives little in this regard. While the provisions of the recent UK Enterprise Act may lead to change, historically senior lenders in this jurisdiction have had absolute control over when security is enforced and the consideration for which it is sold, without having to have any regard as to whether it is the best time in the cycle to maximise value for all creditors.
The new administration procedures may alter this, but for now the majority of deals in work out are under the old law – and in some cases mezzanine lenders are seeing the consequences: and have little if any leverage. Most countries in Europe have alternative systems, many including court-enforced auctions. At least rights such as no enforcement sales without an independent valuation and a right for the mezzanine to buy out the senior debt prior to enforcement are becoming market standard. But are they going far enough?
MORE QUESTIONS THAN ANSWERS?
In addition to looking at their relationship with senior debt in a number of stressed situations, mezzanine providers are looking at equitisation as a possible solution. Conversion of mezzanine to equity with consequent de-leveraging can transform the picture.
But there are questions. Should the mezzanine have up front buy out rights vis-à-vis the equity? And if so, should senior debt not agree to stay in the deal and take advantage of any defaults which have previously occurred to enforce for a pre-determined period? And if such buyout rights are not considered acceptable, could a charge over the shares of an intermediate holding company – perhaps the mezzanine borrower – achieve the objective of assuming the “equity” and other subordinated creditors? Such a charge would support a downstream guarantee to the mezzanine debt providers of the liabilities of their – structurally subordinated – borrower. Some readers will no doubt be aware that the ability to achieve an effective de-leveraging can be a powerful tool in negotiations with senior debt providers.
Mezzanine providers are also resisting the previously broad ambit of “drag-along” provisions, whereby senior amendments also automatically flow through the mezzanine agreement without consent being needed. The concept and scope of “entrenched provisions” is rightly being extended.
Besides this source of tension with senior lenders, mezzanine providers are also considering whether the blanket release following senior enforcement of second ranking in favour of the mezzanine is in fact appropriate. This is particularly relevant in cross-border deals. Agreeing to rank second is one thing, but agreeing in advance to give up security and guarantees on a senior enforcement sale – when the sale may be carried out on a fire sale basis or indeed for the purposes of a “pre-pack” sale to the senior lenders or their nominee is something else altogether.
The tradability of senior debt is also giving rise to new concerns. Should mezzanine have a right of first refusal if all, or substantially all, of the senior debt is to be sold to the same purchaser who is effectively seeking to acquire control, and possibly ownership, of the debtor for the price of the senior debt only?
As will be seen from the foregoing, the terms of inter-creditor arrangements between senior and mezzanine are under what might (somewhat euphemistically) be described as “dynamic review”. In addition, PIK preferred lenders are calling for rights to take control of the board, and are demanding a controlled sale under certain circumstances. No doubt the high yield bondholders, having forced themselves to the table, will have more to add to the debate. We'll keep you posted.