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Treatment of Junior Corporate Debt in Europe April 2011 2 Corporates

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Treatment of Junior Corporate Debt in Europe April 2011 2 Corporates Corporates Corporates EMEA Treatment of Junior Corporate Special Report Debt in Europe European HoldCo PIK and Shareholder Loans Analysts Executive Summary Cecile Durand‐Agbo This report identifies characteristics which allow Fitch Ratings to exclude HoldCo +44 20 3530 1220 [email protected] PIK (payment‐in‐kind) loans or notes and Shareholder Loans when determining a group’s IDR. Fitch assesses if these types of debt instruments increase the Matthias Volkmer probability of the default of the wider corporate group, as reflected in the relevant +44 20 3530 1337 [email protected] IDR. Edward Eyerman Features which support exclusion of these debt instruments in the Restricted +44 20 3530 1359 Group’s IDR (see page 2 for definition) perimeter include: [email protected] • the loans are unsecured and contractually subordinated, or more frequently Related Research structurally subordinated when issued by an entity outside the Restricted • Definitions of Rating and Other Rating Group; Opinions (August 2010) • the loans are PIK‐for‐life (without cash‐pay obligations or options) during the • European Leveraged Credit Review ‐ Stabilisation in Performance as Refinancing life‐time of the transaction; Approaches (January 2011) • the loans’ effective final maturities are longer dated than any of the more • Rating Approach to PIK Loans in Restructurings (June 2009) senior ranking debt elements in the group’s capital structure, and lenders do • European Holdco PIK ‐ Evolution and not possess independent enforcement rights in respect of them. Formidable Growth (May 2007) • Coercive Debt Exchange Criteria Factors which would, in contrast, favour inclusion of these debt instruments in the (March 2009) Restricted Group’s IDR perimeter include the inverse of the features noted above, plus the following (mostly relevant for Shareholder Loans): This report replaces the previous Criteria Report “Rating European • marketability and transferability of the loan; Holdco PIK”, published on 11 July 2007 and further expands its scope to • large relative size of the loan in relation to the group’s overall capital include Shareholder Loans. structure. Shareholder Loans can be found in many corporates, notably in privately held companies. HoldCo PIKs are more common in so‐called leveraged buyout (LBO) capital structures. Where they co‐exist, they often share similar characteristics, though Shareholder Loans are typically further subordinated to Holdco PIKs. Figure 1 Defined Terms in This Report “HoldCo PIK Issuer” Refers to the entity which issues the Holdco PIK, outside the Restricted Group “Junior Debt Issuer” Refers to the entity which issues the high‐yield instrument within the Restricted Group “Senior Secured Refers to the entity which issues the senior secured Loans, within the Restricted Issuer” Group and generally owns the operating entities or is the debt issuer the closest to the operating entities “Restricted Group” Refers to an effectively ring‐fenced group of entities including the Senior Secured Issuer and the Junior Debt Issuer and all operating subsidiaries below them. It includes all the debt (and issuing entities) referenced in the intercreditor agreement. “Ring‐fencing” Refers to contractual and structural mechanisms that create a Restricted Group of borrowing entities, separate from other entities within the group. NB: Throughout this report, the agency uses the above defined terms to refer to the different issuing entities within a theoretical HoldCo PIK issuing group of borrowers. The below diagram is a graphic representation of these definitions. They are used for greater ease of reference in this report. The Junior Debt Issuer could be either a second lien issuer, a mezzanine issuer or a high‐yield issuer Source: Fitch www.fitchratings.com 8 April 2011 Corporates Figure 2 Theoretical HoldCo PIK and Shareholder Loan Issuing Group Shareholder Loan Shareholder Loan Issuer Parent HoldCo PIK Issuer HoldCo PIK Debt Junior Debt Issuer Junior Debt Senior Secured Issuer Senior Secured Debt Operating Subsidiaries “IDRs opine on an entity’s Restricted Group relative vulnerability to Source: Fitch default on financial obligations. The “threshold” default risk addressed by Restricted Group’s IDR Perimeter the IDR is generally that of The Issuer Default Rating (IDR1 ) assesses the likelihood of a payment default of an the financial obligations issuing legal entity on its debt obligations. For the purpose of the IDR, all secured, whose non‐payment would unsecured and subordinated debts that may trigger a default at the rated entity best reflect the uncured under the loan documentation are included in the ratings assessment. Where the failure of that entity. As rated entity is part of a group of borrowing entities with cross‐guarantees and/or such, IDRs also address cross‐default mechanisms in place, the perimeter of debt obligations relevant to relative vulnerability to the rated entity’s IDR would be widened accordingly — thus the IDR may be the bankruptcy, administrative relative default probability of a specified group that will include the rated entity. receivership or similar concepts . , Throughout this report, we use “Restricted Group IDR” to represent the specified group’s IDR, even though the IDR is applied to one entity. “Definitions of Rating and Other Forms of Opinions” In groups with heavily engineered capital structures, such as LBOs or high‐yield issuers, this specified group may be deliberately “restricted” contractually or structurally to stratify collateral availability. “. non‐payment on an Corporate analysis sets a perimeter of operating assets, cash flow and debts which instrument that contains a form the basis for estimating vulnerability to default. Fitch’s principles on this are deferral feature or grace that the perimeter is normally set at conservatively broad levels for debts, and period will generally not be conservatively narrow levels for assets and cash flow. HoldCo PIKs and Shareholder considered a default until Loans represent two of the few situations where debt instruments will on occasion after the expiration of the be treated as excluded from this perimeter. deferral or grace period, If a loan agreement explicitly provides that non‐payment of the loan is not an event unless a default is otherwise of default, Fitch may not treat a non‐payment as a default for its rating purposes. It driven by bankruptcy or is likely, however, that non‐payment would be reflected in the accompanying other similar circumstance, distressed financial profile of the rated entity, and hence in lower IDR and senior or by a coercive debt debt instrument ratings. The treatment of the non‐payment as a default will exchange.” depend on Fitch’s view whether it is a Coercive Debt Exchange or not (see Fitch’s “Definitions of Rating and Other Coercive Debt Exchange Criteria, dated 3 March 2009). Forms of Opinions” 1 For additional information please refer to Fitch’s rating definitions on http://www.fitchratings.com/creditdesk/public/ratings_defintions/index.cfm Treatment of Junior Corporate Debt in Europe April 2011 2 Corporates PART 1: Rating Approach to HoldCo PIK – the Effect on an Issuer’s IDR The individual loan ratings reflect the ranking and/or security of a particular loan within the relevant group’s capital structure, and hence its expected recoveries in a default scenario. The ultimate purpose of determining whether a Holdco PIK meets Fitch’s criteria is to evaluate whether a new Holdco PIK could have any adverse impact on the IDR of the rated entity (ie, increase the probability of default on the Restricted Group). In this regard, Fitch considers the terms of the Holdco PIK itself to consider whether such terms could make a default of the Restricted Group debt more likely. In particular Fitch will consider: 1. how a default on the Holdco PIK could affect the Restricted Group itself and its existing debt; and 2. if such a default could impact the Restricted Group, whether the Holdco PIK itself is more likely to default than the existing Restricted Group debt, thus lower the IDR of the Restricted Group, and the more senior debt instrument ratings. Step 1: Ring­Fencing Structural Subordination: Issued by a HoldCo Outside the Restricted Group This is key to analysing the impact that a HoldCo PIK default may have on the • If the HoldCo PIK is Restricted Group. In theory, if the issuer is outside the Restricted Group, then structurally subordinated effective structural subordination and ring‐fencing can exist (ie, the Restricted and has explicit language Group and its assets can be legally separated from other related companies in the preventing cross‐default, group and grant enforceable security over their assets in respect of the holders of the note can be excluded the senior debt and the junior debt). Also, if there is no cross‐default to the from the Restricted Restricted Group, a default at the HoldCo PIK Issuer level should not affect the Group’s IDR perimeter Restricted Group debt, so the IDR of the Restricted Group entities should not be affected. In addition, if effective ring‐fencing exists, then the non‐Restricted Group debt is not legally an obligation of the Restricted Group and does not increase the probability of default of the Restricted Group. Only an Equity Claim Structural subordination of the HoldCo PIK is reinforced if the only assets of the HoldCo PIK Issuer are shares in the Restricted Group (rather than an intercompany loan) and HoldCo PIK proceeds are paid out directly
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