European High Yield Bond Market - Spotlight on Italy

 

This article (i) discusses the Italian high yield bond market and its prospects; (ii) analyzes the structural features and terms of recent Italian high yield bond issuances and how they differ from the broader European high yield market; and (iii) outlines certain relevant Italian law considerations, including Italian case law on fronting structures, equitable subordination of shareholder loans, and enforceability of super senior structures.

A Decade and a Half of Italian High Yield

Italian issuers have been at the forefront of the European high yield market for the last few years, with active participation from notable issuers such as Wind Tre, Nexi, Gamenet, and GTECH/IGT. In 2017, Wind Tre made history by issuing the largest ever FRN tranche (EUR 2.25 billion) as part of a multi-tranche EUR 7.2 billion (equivalent) jumbo bond issuance.¹

Since Wind Tre's early high yield bond issuances in the mid-2000s, the Italian high yield market has matured significantly, becoming a large, predictable source of funding for Italian companies. The main notable feature of the Italian high yield market is its recent explosive growth, with an average of 12 high yield bond deals coming out of Italy each year since 2016.²   In 2018, the total volume of public high yield bond issuances in Italy stood at over EUR 11 billion, and the overall market remains robust.^3,4 Recent research by Société Générale shows that Italian bonds account for 18 per cent of the iBoxx high-yield index tracked by bond investors, far more than any other country. According to Refinitiv Eikon data, Italian corporate issuers have an estimated total of EUR 63 billion of high yield bonds currently outstanding.

We expect the Italian high yield market, and its percentage share of the European market, will continue to grow for the foreseeable future. Several legal and economic factors we have observed inform this view.

Firstly, from a legal perspective, there are limitations on the ability of foreign financial institutions to lend to Italian companies: Italy is one of the few European countries where lending is still seen as a "regulated business" that can only be carried out by select institutions which comply with local regulatory requirements . As a result, options for foreign investors to gain exposure to Italian credits are often limited to investing in public bond issuances in the capital markets (which are fully open to foreign investors) or through participating in "fronting structures", whereby a licensed lender based in Italy (the "Italian Bank Lender of Record" or "IBLOR") lends to an Italian borrower, with foreign lenders participating in the financing by way of back-to-back loans under separate agreements with the IBLOR. However, the legality of certain types of fronting structures has now been called into question as a result of a recent Italian supreme court decision issued in early 2019. See more on this under the heading "Italian Law Considerations / Relevant Recent Legal Developments – Fronting Structures" below. On that basis, we expect that an increasing number of leveraged financings in Italy could take other forms (such as high yield bonds).

Secondly, from an economic perspective, demand for bond issuances will continue to be driven by Italy's positive economic outlook, improving returns from corporate bonds relative to government securities and the continuing pursuit of yield by investors, as well as aggressive cost competition between Italian and international investment banks in search for deals.

Italian Bonds – Features and Terms

About a dozen high yield bonds were completed in the Italian market over the last 12 months. The following observations can be made about these transactions:

Parties

Issuer characteristics

• A balance between corporate and sponsor-backed issuers compared to the general European market: In recent months, approximately half of the Italian high yield deals completed were sponsor-backed (such as Italmatch (Bain), Recordati (CVC), Doc Generici (ICG), Cirsa (Blackstone) and Forgital (Carlyle)). Forty per cent of issuers were publicly listed companies, whereas a few Italian high yield issuers were family-owned (or otherwise closely held), such as Roma 1927.
• Wide range of deal sizes: Issuer size based on marketed EBITDA ranged from EUR 75 million (Italmatch) to as high as EUR 1.7 billion (IGT); with bond issue sizes varying from EUR 225 million (Gamenet) to over EUR 1.6 billion (Cirsa).
• Modest leverage: The lowest reported opening leverage was 1.1x (Roma 1927), and the highest was 5.4x (Italmatch). The majority of Italian issuers fall comfortably below the 6x leveraged lending guidance benchmark.
• Sectors/industries: By far the most active sectors by deal volume in the last 12 months were gaming/leisure (Gamenet and IGT) and manufacturing (Guala Closures, Forgital and Recordati).

Investor characteristics

International banks that are well-recognized in the high yield sector (Deutsche Bank, BNP Paribas, Credit Suisse and Goldman Sachs) continue to lead the majority of high yield transactions in Italy. Despite that, Italian national banks such as UniCredit (which acted as lead-left on Gamenet and played an active underwriting role in over half of the recent Italian deals), Mediobanca, Banca IMI and UBI Banca have generally been playing a more active role in the Italian high yield market compared to other national banks in their jurisdictions. This is due to the historically strong relationships between Italian banks and corporates, and consolidation of the Italian banking sector during the downturn, with the remaining local banks emerging stronger and more versatile.

In Italy, high yield bond investors are typically investment banks, pension funds, hedge funds, mutual funds, insurance companies, and private wealth management accounts while loan financing is still almost exclusively provided by the traditional banking sector. Direct lending by other players, such as credit funds, is still in the early stages of development. However, it has been growing consistently over the last few years, with GSO's EUR 625 million unitranche funding of the tie-up between US chemicals group Reichhold and Italian polymers maker Polynt in 2016 being one of the largest direct lending transactions in Italy (and Europe) to date.

Structure

Floating Rate Notes (FRNs)

Over the last 12 months, FRNs constituted about 60% of all high yield deals in Italy, which is noticeably higher than in the broader European market, where they remain a minority at roughly 20% of deals in the first half of 2019 - itself a significant increase on the historical average, as high yield bonds have previously been marketed as fixed income instruments.

The tendency to use FRNs in Italy relates to the fact that many comparable deals that would have been structured as loans in other jurisdictions, are executed as bonds in Italy due to Italian lending restrictions on foreign lenders as described above. See more on this below ("Italian Law Considerations / Relevant Recent Legal Developments – Fronting Structures").

Over the last 12 months, six tranches of FRNs were issued in Italy: (1) (Gamenet EUR 225 million Floating Rate (EURIBOR +5.125%) Senior Secured Notes due 2023 (September 2018); (2) Italmatch EUR 410 million Floating Rate (EURIBOR +4.750%) Senior Secured Notes due 2024 (September 2018); (3) Guala Closures EUR 455 million Floating Rate (EURIBOR +3.500%) Senior Secured Notes due 2024 (October 2018); (4) Recordati EUR 650 million Floating Rate (EURIBOR +6.250%) Senior Secured Notes due 2025 (October 2018); (5) DOC Generici EUR 470 million Floating Rate (EURIBOR +3.875%) Senior Secured Notes due 2026 (June 2019); (6) Cirsa EUR 490 million Floating Rate (EURIBOR +3.625%) Senior Secured Notes due 2025 (August 2019).

Optional Redemptions (10% at 103; Equity Claws)

Although these features are becoming increasingly common in the broader European sponsor-led high yield market, only a small percentage of recent Italian deals have partial redemption features whereby the issuer can redeem, during the "make-whole" period, up to 10% of the bonds at 103% each year, and/or up to 40% of bonds at coupon rate with the proceeds of equity issuances. The reason for the low incidence of these partial redemption features in Italy is the relatively high percentage of the FRNs. Unlike fixed rate notes, which typically have a "make-whole" period set at half or slightly less than half of the tenor of the notes, FRNs typically have a much shorter "make-whole" period of one year, with a redemption price stepdown to 101% in the second year, and par thereafter.

A couple of recent unusual FRN non-call formulations coming out of Italy are worth noting. FRNs issued this summer by DOC Generici contain a bespoke partial redemption feature allowing the company to redeem 10% at par during the "make-whole" period. The most recent Cirsa FRN iteration issued in August 2019 has a stepdown directly to par (rather than 101%) at the end of its first year "make-whole" period.

Amendments / Lower voting threshold

Another notable characteristic of Italian high yield bonds is the application of the Italian Civil Code, which raises the question as to whether voting thresholds higher than a simple majority (such as the 90-100% supermajority requirement for key money terms in high yield bond indentures⁵) would be upheld by Italian courts. As a result, high yield bonds involving an Italian issuer have evolved to require a 75% supermajority voting threshold, and the disclosure includes a risk factor stating that this contractual threshold may be further reduced to a simple majority under Italian law.

Covenant terms

As a general observation, though not universally so, we find that Italian issuers have been able to negotiate documentary terms that are somewhat more favorable to the issuer when compared to other European credits, such as shorter non-call periods (due in part to the high percentage of the FRNs), leverage-based portability, RPs made with excluded contributions, RPs made with excess proceeds of asset sales, leverage-based RP basket, and EBITDA-based basket growers. This may be due to a few high-profile sponsor-backed Italian deals, for example Recordati and Nexi, which tested the boundaries of the market, in addition to a number of very solid and very large repeat corporate issuers (such as Wind Tre), which may be able to command more issuer-favorable terms compared to other issuers.

Below is an overview of the prevalence of certain select covenant terms in Italian high yield bonds issued over the last 12 months.

Portability

Portability – the ability to consummate a change of control transaction without triggering a change of control put right at 101% if certain conditions are met – is making a comeback throughout Europe, appearing in 48% of deals in 2018. In contrast, in Italy it is only found in some recent deals. In each case the portability feature takes the form of a consolidated net leverage-based test rather than a ratings-based test.

In at least one instance, namely Cirsa (June 2018), portability was removed during the marketing process (though in a testament to changing market conditions, it was included in the more recent Cirsa transactions that closed in May and August 2019). Another recent deal containing leverage-based portability was the latest Gamenet bond (September 2018). In both Cirsa and Gamenet, the leverage level for a "portable" change of control transaction was set at the opening leverage. In that regard, portability was available to the company immediately from the closing date without any prior deleveraging required.

The main reason this feature is not seen in Italian deals as often as in the broader European market is the relative prevalence of issuances by corporates or family-owned issuers compared to sponsor-backed issuances. Portability is more commonly seen in European high-yield issuances for private equity transactions, because portability is more important for private equity sponsors focused on exit scenarios, than for non-sponsor-backed issuers.

Restricted payments

The restricted payments covenant in recent Italian deals tended to be fairly permissive. Some of the more distinctive features of this covenant in Italian transactions are outlined below:

• Builder basket. The market convention is that the issuer is allowed to make restricted payments (RPs) (i.e. dividends, payments on subordinated debt, and investments) utilizing the "builder basket" primarily consisting of 50% of the issuer's Consolidated Net Income (CNI) calculated on a rolling basis. An RP starter basket (i.e. a pre-set basket as an additional component of the 50% of CNI builder basket, and in addition to the general RP basket) is a relatively new feature seen in recent high yield deals. This feature is found in half of recent Italian high yield deals (Cirsa, Italmatch, DOC Generici and Forgital).
• Leverage-based RP basket. An RP basket that allows for restricted payments, on the condition that a pre-determined pro forma leverage ratio is met, is a relatively new feature, but which has now become almost standard in European high yield transactions. While all recent Italian deals that we reviewed have this feature, the leverage test is typically set conservatively, and below the issuer's opening leverage, thus requiring some de-leveraging (half a turn to a turn) before the basket can be utilized. Investors have recently been scrutinizing this provision during the marketing process, as evidenced by the fact that in at least one recent deal the leverage level for the basket was reduced during the marketing period (i.e. in Cirsa (June 2018) and that lower level was further maintained in subsequent Cirsa bonds).
• RPs made with excess proceeds of asset sales. Typically the asset sales covenant in a high yield bond requires the proceeds of asset sales in excess of a specified threshold ("excess proceeds") to be applied to repay bonds and other debt (subject to reinvestment rights). Recently, a formulation began appearing in certain sponsor deals that subjects this repayment requirement to an additional leverage test: if the leverage is below a specified amount, then only 50% of the asset sale proceeds shall be deemed to constitute excess proceeds. Moreover, the remaining 50% that do not constitute excess proceeds are permitted to be taken out as a restricted payment with no conditions attached. In Italy, all three of the recent Cirsa deals and the Forgital bonds contain this formulation.

Debt covenant

The debt covenant in recent Italian deals is generally consistent with broader trends in the European high yield market.

• Basket size: The credit facilities basket in Italian deals tend to be fairly small. In most cases it is set between 50% and 100% of the issuer's EBITDA. The other major debt baskets such as capital leases and the general debt basket are also modestly sized (when calculated as a percentage of the issuer's EBITDA).
• Growers: Grower baskets are baskets set at the greater of a pre-set monetary threshold and a percentage of the issuer's EBITDA or total assets at the time of calculation (thus they "grow" as the issuer's business grows, but never fall below the minimum monetary threshold). All recent Italian deals contain grower baskets based on a percentage of EBITDA (which is generally considered a more issuer-friendly metric than the percentage of total assets due to the potential availability of various EBITDA add-backs).
• Contribution debt: The ability to incur "contribution debt" (which is the ability to incur EUR 1 of debt for every EUR 1 of equity contributed to the group after the bonds have been issued) is found in all recent Italian deals that we reviewed. This feature has become prevalent in the broader European high yield market.
• Acquisition debt: Acquisition debt (i.e. debt incurred to finance acquisitions) is permitted (typically subject to the availability of at least EUR 1 of capacity under the ratio debt basket and pro forma FCCR being no worse than prior to the incurrence) in all of the recent Italian deals we reviewed, which is consistent with the broader European high yield market trend.
• Non-Guarantor sublimit: Conservatively, every Italian deal we reviewed contained a sublimit for incurrence of structurally senior ratio debt at non-guarantor subsidiaries.

Italian Law Considerations / Relevant Recent Legal Developments

Fronting structures

Due to a recent Italian Supreme Court' decision (decision n. 12777 (22 March 2019)), market players have been discussing the legality of full pass through fronting structures and the implications on Italian lending structures. In that decision, the court held that full pass through fronting arrangements breach Italian regulatory requirements because they de facto permit unlicensed lending entities to offer and make loans to Italian companies in breach of the Italian Banking Act. The decision has effectively rendered illegal the use of IBLOR fronting structures to support Italian lending transactions in the leveraged finance sector and more broadly in the Italian credit market. In light of the decision, market players are now actively considering alternative options for deals previously framed under fronting structures (usually in the range of EUR 150-300 million), such as bonds, securitization, private placement and unitranche lending (including a mix of bank loans/bonds underwritten by an alternative lender).

Equitable Subordination

Another recent Italian Supreme Court's decision n. 12994 (15 May 2019) will make equitable subordination of shareholder loans more likely going forward, which will make parties more reluctant to use shareholder loans in holdco/opco lending structures. In this decision, the court held that the re-characterization of shareholder loans as equity (usually driven by the thin capitalization of the Italian borrower) applies even before the borrower is subject to insolvency proceedings or its creditors commence enforcement/attachment actions. If a shareholder loan is re-characterized as equity, the directors of the borrower cannot repay that loan if – at the time of the proposed repayment – the thin capitalization issue has not been remedied. The court also stated that the judge may raise the equitable subordination point by law, hence putting pressure on directors of Italian companies in respect of which a shareholder loan repayment notice has been served. This recent judgement has increased the structural and legal issues associated with holdco/opco lending structures involving Italian companies; in addition, directors of Italian companies will now have to manage payments in respect of shareholder loans (especially where the company's debt/equity ratio was on the funding date, and still is, particularly high) with increased diligence.

Ranking/ Super senior status questioned

Under a recent Decree of the Tribunal of Milan issued on 15 November 2018, super seniority of a bank loan versus a junior bond issued by the same Italian entity, will be recognized – under Italian law – only if certain conditions are met. More specifically, the court held that contractual subordination arrangements (in this case relating to a super senior RCF being provided by a French bank to an Italian company that was also the issuer of HY/junior notes) would be recognized in the context of pre-insolvency proceedings involving the Italian debtor only if the junior creditors have expressly accepted the subordination/junior ranking arrangements set out in the intercreditor agreement (and have become a party to it). This means that when the initial junior creditors transfer the debt to new parties, the transferees may not be bound by the subordination provisions. This decision, despite being issued by a lower court, has stimulated an interesting debate in the Italian market on how super seniority arrangements, especially where the finance documents are governed by English law and/or the laws of the State of New York (as would be the case in most larger financing transactions), may survive and be recognized on the insolvency or pre-insolvency of an Italian obligor. This issue is particularly difficult to address when the junior bonds are listed, while it is probably easier to draft or amend contracts when the notes are issued to direct lenders in the context of a private placement/unitranche deal.

Governing law of documentation

The Italian high yield market is dominated by bonds governed by New York law and issued under Rule 144A/Regulation S exemptions from registration with the SEC.
In addition to high yield bonds, larger issuers also tend to have bank debt in their capital structure, typically represented by a senior facilities agreement (which may include an RCF and a term loan tranche) or, in the case of corporates, bilateral working capital facilities and/or guarantee lines. The senior facilities agreement, as well as the intercreditor agreement (for secured deals), tend to follow the Loan Market Association template, which is governed by English law. Smaller bilateral facilities sometimes are governed by Italian law.

If the issuer is an Italian-incorporated company (rather than an SPV incorporated in an alternative jurisdiction such as Luxembourg), in addition to the New York law bond documents, the transaction documents typically include also the resolution to be adopted by the issuer in respect of the proposed note issuance under Italian law (which will be in notarial form) .

Security

A vast majority of Italian high yield issuances are secured. A typical security package consists of pledges over the shares of the issuer, the parent company and certain of their subsidiaries, as well as over material bank accounts, receivables and insurance policies. Other security, such as non-possessory pledges over movable assets, pledge over intellectual property rights, and real estate mortgages, is less common, mainly because of the complexity which may arise from a tax or regulatory perspective. Italian law does not provide for a "universal unlimited guarantee" over all the debtor's assets; nor does it provide for the creation of a floating or adjustable lien or encumbrance (other than privilegio speciale). In many deals, issuers are permitted to incur privilegio speciale liens under Italian law, which relate to movable assets (including stock and machinery) of the chargor and are loosely analogous to a floating charge under English law; these liens do not affect the power of the chargor to dispose of the charged assets in the ordinary course of business prior to the occurrence of an event of default.

Financial Assistance Rules

If the proceeds of high yield bonds are used to finance or refinance the acquisition of an issuer's shares or the shares of one of its parent, such obligations cannot be secured or guaranteed by an Italian member of the issuer's group as it would breach the financial assistance prohibition. Therefore, such limitations would restrict the ability of Italian guarantors to grant guarantees or provide security for financing used for such acquisition.

Financial assistance is prohibited pursuant to Articles 2474 and 2358 of the Italian Civil Code. The former provision applies to companies incorporated or existing as "S.r.l." (società a responsabilità limitata), in English "limited liability companies"; the latter applies to companies incorporated or existing as "S.p.A." (società per azioni), in English "joint stock companies".

The prohibition entails any direct or indirect financial support given by the relevant Italian company in connection with (a) the acquisition or subscription of its own shares (or "quotas" in the case of limited liability companies), as well as (b) the creation of security – in favor of the relevant Italian company – over the same company's shares (or quotas).

"Financial support" includes:

1. any loan or other lending transaction, including any loan whose proceeds are used to repay acquisition facilities that were used to finance the acquisition or subscription of shares (or quotas) of the relevant Italian company; and
2. any guarantee or security interest given in respect of any acquisition facility supporting the acquisition or subscription of shares (or quotas) of the relevant Italian company (or any refinancing loan falling under (1) above).

The prohibition on financial assistance applies also to a series of transactions that, taken together, may be regarded as being in breach of the applicable laws (scholars and courts take a "substance over form" approach). In case of a breach of Italian laws on financial assistance, the relevant transactions would be null and void and the directors of the relevant Italian company would face civil and criminal liabilities.

In relation to joint stock companies, a special whitewash procedure may be completed in accordance with Article 2358 of the Italian Civil Code. This is rarely used in practice because it is subject to a number of onerous requirements (e.g. any loan to be provided by the target company cannot be higher than the amount of distributable profits/reserves shown in the latest financial statements approved by the same company).

It should be noted that all Italian leveraged buy-outs contemplate a merger between the purchasing vehicle and the target company under Article 2501-bis of the Italian Civil Code. This type of merger – usually called "push down merger" – is the easiest way (and the instrument most frequently used in practice) to allow the lenders of the acquisition debt to obtain security over the target company's assets without violating the prohibition on financial assistance.

Corporate Benefit

In relation to corporate benefit, Italian law is quite strict because it does not recognize the concept of "group interest". As a general rule, in order for an Italian company to be able to provide upstream and cross-stream guarantees and/or security, that company must receive real and adequate economic benefit in exchange for its guarantees and/or security interests. Failure to comply with this requirement would render the guarantees and/or security interests ultra vires (and therefore ineffective/unenforceable) and could result in civil and criminal liabilities for the directors of the relevant company if it can be established that they did not act in the best interests of the company.

The concept of "real and adequate economic benefit" is not defined by the law, and therefore must be determined on a case-by-case basis. Up-stream guarantees are usually set at 130% (or 150% or 200%) of the principal amount of any intercompany or shareholder loan advanced to the guarantor by using the proceeds of the facilities or notes in relation to which the guarantee is given. In relation to cross-stream guarantees, a key element is reciprocity. Similar principles apply, mutatis mutandis, to up-stream/cross-stream security interests given by Italian entities. The established rule is that the risk assumed by the Italian company must not be disproportionate to the direct economic benefit received by the same company in connection with the overall transaction.

1. It is worth mentioning that all of Wind Tre's outstanding debt was recently refinanced at the parent level (CK Hutchison Telecom). It remains to be seen when or whether it will once again turn to the Italian high yield bond market for its financing needs.
2. That number has seen a small dip in 2019 with only 6 issuances to date.
3. Including the jumbo three-tranche Nexi deal (May 2018), which alone amounted to almost EUR 4 billion.
4. This reflects only public high yield debt offerings; the volume would be significantly higher if private placements (which are common in Italy) were also included.
5. The supermajority voting threshold typically applies to key money terms but not to general covenant amendments (which are subject to a simple majority threshold).