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Structuring opens up new possibilities

09 Apr 2006

Asian high yield issuers have used sophisticated cashflow structures and equity enhancements to meet investors' needs and raise cash where plain vanilla structures might not have worked. Adam Harper asks how this has been done and assesses the importance of structuring in high yield deals.

So your company has been through a restructuring and your credit rating is double-B at best. And you need a sizeable chunk of long term money quickly because there is an urgent refinancing requirement, or you need to build a new plant. Alternatively, you might be a new company without assets raising funds for an equity investment.

The high yield market might just be prepared to consider you as a credit, but you are going to have to offer something more than just a high coupon — which could be impossible in itself. So is all hope lost?

Absolutely not. During 2005, the Asian high yield market showed that innovative structures, equity participation and watertight security packages could all help persuade investors to put up their money in cases where they would not have done for a plain vanilla deal.

But while the boundaries of what is possible in the public markets were pushed back last year, investors also made it clear that some credits simply could not be placed, regardless of the structural comforts and other blandishments they were prepared to offer.

It goes without saying that some of the heavily structured deals that failed, such as that for China-based Sateri International, may have succeeded in more benign markets, and that some of the deals that offered investors less protection but succeeded, such as the unsecured bond for Indonesian property company Lippo Karawaci, may have struggled in more difficult conditions.

But as Max Blandon, head of leveraged finance and high yield for Asia at Morgan Stanley in Hong Kong, points out, there is no such thing as a structure for all occasions.

"We have seen poorly structured transactions get done in strong markets," he says. "But what bookrunners should be focused on is executing deals that seek to protect bondholders, while giving issuers the maximum flexibility to execute their business plans."

How, then, can deal structures protect investors without stifling the borrower? Indonesian coal miner Adaro sold a $400m five year bond in December last year that featured a 'cashflow waterfall', intended to ensure that Adaro's cash revenue — held offshore in Singapore — was used to reduce gearing before it was returned to shareholders. Goldman Sachs and JP Morgan led the deal.

The Ba3/B+ bond, which was secured on export receivables, helped to refinance a bridge loan put in place to fund the acquisition of the company by Indonesian businessmen Edwin Soeryadjaya and Theodore Rachmat along with a consortium of international investors including the Government of Singapore Investment Corp and the private equity divisions of Citigroup and Goldman Sachs.

Attractive structure

Under the terms of the 'waterfall', cashflow is first used to amortise a $200m loan and pay bond interest. Then cashflow is subject to a fixed charge test to ensure that Adaro's Ebitda is more than twice its interest expense. If this is the case, cash can be used to pay interest on an existing piece of mezzanine debt.

If there is still more free cash, another fixed charge test is applied and, if this is passed, half the available money is used to prepay the loan and the other pays more mezzanine interest. Theoretically, if Adaro was throwing off still more cash, it could be used to build up collateral to tender for the notes once the loan had been fully prepaid, or start to prepay the mezzanine.

While bankers at the leads say investors were primarily attracted to Adaro as a credit in the context of steadily rising coal prices, they add that this structure offered investors complete transparency in terms of the use of proceeds and the way in which the company's debt would be serviced and repaid.

Adaro's deal was a runaway success, attracting orders worth $1.7bn from 111 investors and enabling the company to increase the amount from $300m to $400m. This despite the fact that the ownership of Adaro was about to be disputed in a Singapore court, although counsel to the deal stated that, in their view, the lawsuit was not material to the ownership or operations of Adaro.

"Simply having a good credit is not enough if bondholders are concerned that they will never see their money again," says Fergus Edwards, head of syndicate for Asia at JP Morgan in Hong Kong. "Equally, you can have all the structure in the world, but, if investors don't like the credit, they won't buy it. The structure has to be moulded around the credit, meeting investors' concerns. It is about the right covenants for that company at that stage in its life cycle."

Similarly, structural enhancements can help put investors at ease about the risk they are taking in one respect but they cannot persuade them to take that risk unless the price is right. And there are situations in which would-be high yield issuers have to look beyond what they can offer through debt alone.

"If the cashflow is strong but all the assets are otherwise secured, or just if it is a tough deal, a company can shorten the tenor, reduce the size of the offer or increase the yield," says Andrew Cooper, head of Pacific Rim equity-linked origination at Merrill Lynch in Hong Kong. "But not every issuer can or wants to pay a big yield, or sacrifice size or term. Equity optionality doesn't cost cash, so companies can attract investors with a story rather than blunt cash yield."

This was a technique that Merrill employed when it brought $151m of debt with warrants for Indonesian specialty chemicals maker Sulfindo Adiusaha in December last year. The product was dubbed 'Powers' — standing for Pre-initial Public Offering With Equity Rights Securities — because it gave bondholders the right to buy Sulfindo shares at 85% of the institutional offer price as and when the company went ahead with a planned initial public offering.

The deal enabled Sulfindo to subsidise the cost of debt that it needed to repay bank debt and invest in a new power plant while ensuring that the controlling shareholders' stake in the company was not diluted ahead of the IPO. The 10% coupon was certainly towards the top end of yields, but it was less than what the restructured Sulfindo would have been paying if it had been accessing the plain vanilla bond market.

Opening up the investor base

Although an equity upside like this could rule out dogmatically fixed income-only funds from investing in the bonds, Cooper at Merrill argues that it also broadens the spectrum of potential investors.

"Adding an equity enhancement to a high yield offering opens up the transaction to a greater sphere of potential hedge fund investors," says Cooper. "A standard high yield deal has a particular, mostly traditional, investor base, since the best thing that can happen is just getting your money back. An equity component means you can double your money, so we can sell to a wider investor group. That means bigger deals and tighter pricing, and sometimes it actually makes a hard high yield deal possible."

Increasing the investor audience was also an important consideration when Chinese property developer Shui On Land used an equity sweetener to complete a $375m three year private placement via JP Morgan in October last year. The bond paid an 8.5% coupon but also carried warrants for the purchase of 3.1% of the company's outstanding ordinary shares.

However, Edwards at JP Morgan says the warrants were more of a bolt-on feature than a central reason for investors to buy the paper. "It is less optionality in itself than an added kicker which makes it attractive to accounts that might not focus on the deal if it were plain vanilla," he says. "Yes, it was equity, but it could equally have been a higher coupon or payment-in-kind."

However, the kind of enhancement offered by Sulfindo's Powers will be of little comfort to investors if the company runs into trouble or fails to complete its IPO since it offers upside participation rather downside protection.

If Sulfindo or any other company in this situation were to fail to float its shares and underperform financially, its debt would become worth less — as, in turn, would the nominal value of its equity.

"Equity enhancements are a one-way bet, giving another dimension to the upside," says Cooper. "These are sometimes mistakenly regarded as additional downside protection: in most situations, where the equity risk can't be hedged, that's not the case — the enhancements add extra promise on the upside to compensate for the debt risk being taken."

"Equity component or not, investors are still pretty focused on the credit story. In emerging markets, debt and equity values tend to be pretty highly correlated so if a company defaults, the equity is not going to be worth much."

Some would-be Asian high yield issuers have used pledged equity, in addition to security over assets, to help investors get comfortable with credit risk. In November, the Ba3/B+ rated China-based fibre and pulp manufacturer Sateri International attempted to sell a $300m five to seven year bond that eventually offered bondholders the pledge of 51% of Gold Silk, the company through which Indonesian businessmen Sukanto Tanoto controlled Sateri.

At the time, some bankers said the prospect of losing control of Sateri meant that it would be very much in the interests of the ownership and management to protect bondholders' interests and ensure timely servicing and repayment of the debt.

When combined with pledges of stock in Brazilian plantations owned by Sateri, security over the present and future assets of its Brazilian Bahia Pulp operation, a package of other exacting covenants and an indicative yield of 11.5%-12.5%, it seemed like there was little else that Sateri could offer investors.

But it was not enough. Amid fragile market conditions, bookrunners Credit Suisse and Merrill Lynch could not muster the necessary interest from the market before Sateri ran up against the end of a 135 day 'comfort period' since its last annual report.

Investors' credit fears, which centred on Sukanto Tanoto's ownership of the company, could not be overcome by one of the most exacting covenant packages presented in the Asian high yield market in recent memory.

Bankers say the deal could well have succeeded if it had returned in better conditions during January and February, but the fact remains that high yield issuers have to be as flexible as possible about timing and cannot rely on an attractive covenant package and yield by themselves.

Listening issuers

One notable feature of Asian high yield transactions in the lower reaches of the public market is their tendency to be evolutionary processes. This was evident with Sateri, which changed the maturity, covenants and indicative pricing of its deal in response to investor feedback.

But it is not unusual and has certainly never been more apparent than in the case of China's Mandra Forestry, a high yield deal that evolved rapidly as bookrunner Morgan Stanley tried to balance the conflicting considerations of maintaining the B1/B rating, raising the money Mandra needed and offering a sufficient return to investors.

As a start-up, Mandra presented the Asian market with a very rare proposition, something that was like a private equity financing. The proposed $235m 10 year deal was intended to enable Mandra and its backers to acquire 270,000 hectares of forest in Anhui province, China.

Morgan Stanley was faced with the difficult task of approaching specialist high yield investors during a tough period for the market, but was ultimately able to bring this innovative deal to completion. However, it had become a very different animal by the time it was priced.

The amount was reduced to $195m and the maturity to eight years. Mandra was also obliged to pay a hefty 12% coupon. On top of this, it was forced to concede some very advantageous terms to investors.

After three years, Mandra is obliged to return to investors any cash it has above $50m by buying back the bonds at 102.00. The bonds also became callable at five years at 106.00 and at par in each subsequent year of their lives. Investors were also granted warrants for 20% of Mandra's equity.

Many bankers said Mandra ought to have raised money in the equity market instead; but by going down the debt route, the shareholders were able to obtain the money they needed without suffering too much dilution.

"We have moved from where a straightforward offering was considered a big leap, to today, where complex transactions which provide investors with equity participation are getting done on both a public and private basis," says Blandon at Morgan Stanley. "This has occurred in a matter of 18 months."

Although transactions like Mandra are more typical in the private placement market, it demonstrates — like Sulfindo and Adaro — that tight structures and different enhancements can be used to achieve what might otherwise be impossible in the Asian high yield market. 

09 Apr 2006