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Introduction

High yield debt is an integral part of the capitalstructure of many private equity sponsored port-folio companies. Its principal benefit to the

sponsor is to provide long-term debt financing to theportfolio company without the financial covenants andmany of the other restrictions typically found in tradi-tional credit facilities. Its principal benefit to investors,as the name would imply, is a high interest rate, as wellas the possibility of capital appreciation as the creditquality of the portfolio company improves over time.Because of the mutual benefits to sponsors and in-vestors, high yield notes have become an important fix-ture in the array of financing vehicles available to theprivate equity sponsor when financing the acquisition orrecapitalization of a portfolio company. Largely fueledby the private equity sponsor market, the total value ofhigh yield debt offerings in 2004 was a record $163 bil-lion (Thomson Financial Securities Data).

The importance of high yield debt to the private eq-uity sponsor highlights the importance of a deeper

understanding of the instrument itself.On the surface, high yield covenants look much like therestrictions you might find in any credit agreement.They are not. Credit agreements generally contain a mix-ture of “maintenance” covenants and “incurrence”covenants. A “maintenance” covenant requires thecredit party to maintain or achieve a certain level of fi-nancial performance to avoid default. Thus, a typicalcredit agreement might require the debtor to maintain acertain level of revenue or a certain ratio of earnings tofixed charges. “Incurrence” covenants, on the otherhand, are only measured when the debtor proposes toundertake some action, like incurring additional debt ormaking a restricted payment.

The other critical distinction between a credit agreementand a high yield indenture is the time horizon of the in-strument and flexibility to amend it once issued. Thecredit agreement usually carries a term of five years orless; the indenture is usually seven to ten years in dura-tion. The credit agreement can be, and often is,amended with some regularity; the indenture may onlybe amended by consent solicitation, which is costly andtime consuming. It is this aspect of the high yield in-denture that demands the private equity sponsor’s at-tention. There is but one chance to get it done, and getit done right. It is truly “the gift that keeps on giving.”

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Gerald T. Nowak is a partner at Kirkland & Ellis LLP where hespecializes in corporate finance and securities law, mergers andacquisitions and corporate governance. The author would liketo thank Todd W. Haigh and Michael E. Sullivan, also ofKirkland & Ellis LLP, for their invaluable efforts in completingthis publication.

BY GERALD T. NOWAK

The Gift that Keeps on Giving:Negotiating the High Yield Indenture

PhilosophyWhen negotiating the high yield indenture, it is helpfulto understand the overall “philosophy” of a high yieldcovenant package. The fundamental goal is to protectthe bondholders by prohibiting actions by the issuer andits restricted subsidiaries that could be detrimental totheir ability to repay the bonds and service the interestthereon. To put it in plain English, and subject to nu-merous exceptions and qualifications, through the typi-cal high yield indenture covenant package, the bond-holders are in effect saying:

do not further leverage the business; we are in-vesting in these bonds based on your current andplanned borrowings;

do not distribute or invest your assets outside ofyour own business; we would rather have you usethese “extra assets” to repay us;

do not sell assets unless you use the proceeds toreinvest in the business, reduce indebtedness or re-pay us;

do not incur any more liens, including throughsale-leaseback transactions; your assets are muchmore valuable to us if they remain unencumbered;

do not cut sweetheart deals with your affiliates;these just transfer value away from the businessand we get nothing in return;

do not allow your subsidiaries who have not guar-anteed our bonds to guarantee your other debt; wecannot let you subordinate us to such debt by giv-ing it a direct claim on the assets of these sub-sidiaries;

do not allow restrictions to be placed on your re-stricted subsidiaries that make it harder to getmoney upstream to repay us and service our inter-est payments; and

do not sell stock in your restricted subsidiaries; wewant to have the only equity claims against thesecompanies through our position as your creditors.

The reason it takes many pages to make these simplestatements is that businesses operate in a complex world

and you need many carefully crafted exceptions to thesegeneral rules to allow for this reality. The other factor isthat, as lawyers are fond of pointing out, the languagematters. Given the amount of money generally at stakeunder a bond indenture, litigation over language is notuncommon. Careful consideration and drafting at thefront end can eliminate or at least minimize the risk ofcostly and unpredictable litigation down the road.

Negotiating the IndentureNegotiating a high yield indenture is unlike any othernegotiation in a variety of ways. For starters, thepractice is not to negotiate the indenture itself; ratherit is to negotiate the section of the offering memoran-dum entitled “Description of Notes.” That section willset forth, verbatim, the relevant covenants of the in-denture, with the remainder of the indenture consist-ing of so-called “boilerplate.” The exact terms of thenotes as set forth in the indenture are too precise andimportant to risk summarizing or paraphrasing them inthe disclosure document.

The more substantive difference in these negotiations isthat the roles and incentives of the various parties areless than clear cut. The sponsor and the portfolio com-pany, for example, clearly want maximum flexibility, butat the same time want the notes to be marketable, andmarketability will suffer if the note terms differ materi-ally from investor expectations. The investment banks’primary interest seems to be in keeping the indenturewithin the range of marketability, but at the same timethey are also acting as financial advisors and should belooking out for the sponsor’s financial interests. Addingto the complexity is the investment banks’ interest in“franchise issues,” i.e., maintaining their credibility withbuy-side players. Finally, in a situation where the highyield notes are being issued in connection with the ac-quisition of a portfolio company, the sponsor and thecompany are essentially on the same side of the tablewhen negotiating the indenture while they are simulta-neously negotiating against each other in the acquisi-tion transaction.

That all said, the negotiation itself resembles a typicalcredit negotiation in which investment banks’ counsel

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will present a document that contains some, but not all,of the typical carveouts that a sponsor can expect to re-ceive. Issuer’s counsel will then work with the sponsorand the portfolio company to prepare a mark-up that ad-dresses the company’s needs and brings the descriptionof notes up to what, in issuer’s counsel’s experience, isa “market” deal. The parties will then negotiate from aposture that basically has the company and its counselasking for additional flexibility and the investmentbanks’ and their counsel resisting those requests. Onlyat the very end of the negotiation will each party recog-nize the subtext of their respective interests, i.e., mar-ketability on the part of the sponsor and the company,and their role as financial advisor on the part of the in-vestment bankers; once that epiphany takes place, theparties tend to resolve their differences quickly andwithout unnecessary drama.

Involvement of the private equity professionalsand theportfolio company’s CFO and financial and accountingstaff in this process is essential. Rarely will issuer’scounsel be able to anticipate all of the specific flexibil-ity the company needs. Even the so-called boilerplateprovisions can be important in this regard and it is agood practice to spend time thinking about all of thereasonably foreseeable transactions and activities inwhich the company may engage and testing these underthe proposed note terms to see whether they are per-missible. A few of the areas worth exploring in this re-gard are:

future acquisition, joint venture and investmentplans;

future financing plans including equipment financ-ing, sale-leaseback transactions and other secureddebt arrangements;

debt or debt-like arrangements incurred in the or-dinary course of business;

future operations outside the United States;

need for letters of credit and other credit enhance-ments;

anticipated funds flow between and among affili-ated companies;

potential new lines of business; and

potential related party transactions.

It is also important to harmonize the note terms withthe covenants and other provisions applicable to exist-ing company debt instruments such as secured credit fa-cilities, recognizing of course that they will differ some-what due to the inherent difference in the instruments.Having flexibility in your credit agreement will do youlittle good if the same transaction requires consent un-der your indenture. Indeed, given the difficulty ofgetting waivers under indentures, failing to get thelanguage right in an indenture can dictate corporateactions for years to come.

The Credit PartiesBefore entering into a detailed discussion of the impor-tant covenants contained in a high yield indenture, it isimportant to understand the structure of the high yieldcredit and how various categories of credit parties relateto the indenture and the credit.

In order to understand the high yield structure one mustgrasp the concept of the “system,” i.e., the issuer andthe guarantors (and, for some purposes, non-guarantorrestricted subsidiaries), but excluding any unrestrictedsubsidiaries (each of these parties will be discussed indetail below). The high yield indenture generally regu-lates the flow of money outside of the system (includingthe ability to repay certain debt to parties outside of thesystem) and allows the free flow of money among partiesinside the system. Many professionals liken the highyield indenture to a plumbing system, which, while animperfect analogy, helps in understanding the conceptof free circulation within the system and the preventionof leaks.

The IssuerThe threshold question in establishing the high yieldcredit party structure is determining who should issuethe notes. For existing public companies, the issuer willtypically be the public company itself. For non-publiccompanies, the matter is less clear. If the parent com-pany in the corporate chain is also a fully functioning

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operating company, the parent company is still likely tobe the issuer. If the parent company is a pure holdingcompany, the question becomes more complex. A typi-cal outcome is that the issuer will be a second-tier op-erating/holding company, with all domestic subsidiaries,and possibly the parent, guaranteeing the debt, al-though the parent guarantee creates some complicationsunder the Sarbanes-Oxley Act as discussed below. Theprincipal driver behind this structure will be the desireon the part of the company’s senior lenders to be lowerin the capital structure, and therefore closer to the op-erating assets, and the noteholders’ desire to be at thesame level as the senior debt.

The GuarantorsHigh yield notes are often guaranteed by most, if not all,of the company’s domestic subsidiaries, and sometimesby the issuer’s parent holding company. The purpose ofthe guarantee is to create a direct obligation on the partof the guarantors.

The question of whether to issue a parent guarantee isboth a credit decision and a financial reporting decision.The credit enhancement of a parent guarantee when theparent is a pure holding company is less than com-pelling, nonetheless some investment banks may recom-mend it to enhance their marketing of the notes. Thequestion of whether to provide a parent guarantee is alsoinfluenced by the senior secured banks’ desire to get apledge of the operating company’s common stock, whichis thought to require some obligation on the pledgor’spart to be effective. If the parent does not guaranteethe securities, the issuer must provide financial reportsthat are not consolidated with the parent company butare consolidated with all subsidiary guarantors. If theparent does guarantee the notes, the issuer may reportconsolidated financial statements at the parent companylevel, simplifying its reporting requirements.

Issuers are also influenced by the requirements of theSarbanes-Oxley Act of 2002, which are only applicableto the parent if there is a guarantee. Of course, thisassumes that the parent is not itself a public reportingcompany subject to Sarbanes-Oxley because of its ownpublicly traded equity or other public debt. In particu-lar, Sarbanes-Oxley prohibits loans to executive officers,

which can adversely impact the company’s ability to pro-vide tax-efficient management equity to its executives.For this and other reasons, parent guarantees are be-coming less common when the parent is not a public re-porting company.

The enforceability of the guarantees may be limited byapplicable “fraudulent conveyance” laws. The purpose ofthese laws is to protect the other creditors of the guar-antor. These laws generally provide that if a guarantordid not receive adequate value for its guarantee, theguarantee may not be enforceable. Legal practitionersgenerally believe that the guarantee of indebtedness in-curred to finance the consolidated group is supported bythe parent’s implicit promise to provide intercompany fi-nancing when needed, but none believe it so strongly asto write a formal legal opinion on the subject. Fraudu-lent conveyance risk is a risk that the market has learnedto accept as inherent in the guarantee structure.

Non-Guarantor Foreign SubsidiariesFederal tax rules effectively prohibit the guarantee of adomestic company’s indebtedness by a foreign sub-sidiary. This is because, to the extent such indebtednessis so guaranteed, the earnings of that subsidiary,whether or not dividended to the parent company, willbe treated as a “deemed dividend,” increasing the com-pany’s federal income tax obligations. This result is wellunderstood by high yield professionals, and the inabilityof foreign subsidiaries to issue guarantees is not (or atleast should not be) controversial.

Restricted SubsidiariesThe term “restricted subsidiary” is a bit misleading. Re-stricted subsidiaries are “restricted” in the sense thatthey are governed by the terms of the indenture; they arenot “restricted” in the sense that they are freely able totransact with other restricted subsidiaries. Think ofthem as being “in the system,” rather than being “re-stricted.” Generally, all subsidiaries of the issuer will berestricted subsidiaries unless designated as unrestrictedsubsidiaries, including both guarantors and non-guaran-tors. This means that all income produced by these sub-sidiaries is counted for purposes of compliance with thevarious covenants described below, and these sub-

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sidiaries are all limited in their ability to take the vari-ous actions that are limited by those covenants. Thedistinction between guarantors and non-guarantor re-stricted subsidiaries is more subtle. Some actions, suchas making restricted payments, are, to the extent per-missible at all, permitted by any restricted subsidiary.Other actions, principally the incurrence of indebted-ness, are limited to guarantors when permitted at all.This is to avoid allowing the notes to become struc-turally subordinated to other indebtedness.

Unrestricted SubsidiariesUnrestricted subsidiaries are the mirror image of re-stricted subsidiaries. These subsidiaries are treated as“outside of the system,” and therefore are not restrictedin what they can do, but at the same time they are notpermitted the freedom to freely interact with the creditparties inside the system as are restricted subsidiaries.Thus, the income from unrestricted subsidiaries does notsupport the consolidated group’s compliance with thehigh yield covenants, and all transactions with the unre-stricted subsidiary must be permitted by the transactionswith affiliates covenant, any capital contributions orloans to, or guarantees of the indebtedness of, the un-restricted subsidiary are restricted as investments in theunrestricted subsidiary. Many issuers will look to thecreation of an unrestricted subsidiary to solve a per-ceived problem under the indenture only to find that theformation of an unrestricted subsidiary causes moreproblems than it solves.

The Covenant Package

The Indebtedness CovenantThe indebtedness covenant and the restricted paymentscovenant are the two most important covenants in thehigh yield indenture. The indebtedness covenant is im-portant because additional indebtedness dilutes thebondholders’ claims against the assets and cash flow ofthe issuer and guarantors. In addition, increased debtservice requirements can weaken the credit to thedetriment of the value of these bonds. Indebtednessgenerally includes all borrowed money, capital leases andmost other types of obligations to pay money. It doesnot, however, typically include ordinary course trade

payables or other debts routinely incurred and retired inthe ordinary course of business.

The indebtedness covenant generally restricts the issuerand any restricted subsidiary from incurring additionaldebt except in two circumstances: first, if the issuermeets the “coverage ratio exception,” the issuer and anyguarantor will be permitted to incur “ratio debt”; andsecond, the issuer and other credit parties may typicallyissue “permitted debt” at any time.

The coverage ratio exception allows the issuer and anyguarantor to incur unlimited additional indebtedness solong as, after giving pro forma effect to the additionalindebtedness, it meets the defined ratio of EBITDA tofixed charges (the “coverage ratio”). The defined cover-age ratio is most commonly 2.0 to 1.0, but sometimes itis higher or “steps up” over time to higher ratios in sub-sequent years. Issuers typically are not eligible for thecoverage ratio exception at the time they issue the notesand thus must look for another exception to incur debtin the immediate post-issuance period. The reason forthis is that the investors in the bonds do not want ad-ditional debt issued unless and until the issuer’s abilityto take on and service more debt is meaningfully en-hanced through growth in profitability and cash flow.

The typical indenture also allows various types of “per-mitted debt.” This is debt that the issuer may incur re-gardless of its recent performance or financial condition.Permitted debt generally falls into two categories: tech-nical debt that is not otherwise intended by the inden-ture to be prohibited; and limited debt baskets that arepermitted in pre-defined dollar amounts.

There are a number of items that are technically indebt-edness, but that no one believes should be prohibited bythe indenture. These include transactions such as the in-advertent writing of a bad check (technically creatingdebt to the bank that cashes it). There are also a num-ber of types of indebtedness that everyone agrees aredebt, but that the company should be able to incur, suchas guarantees of indebtedness otherwise permitted bythe indenture to be incurred. The initial draft of the de-scription of notes will contain a few such exceptions;experienced company counsel will negotiate for manymore. Note that some indentures categorize some of

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these carveouts as “permitted indebtedness,” while oth-ers carve the item out of the definition of indebtednessaltogether. The high yield indenture requires a carefuland informed reading to fully understand its nuances onthis point.

Permitted debt will also include a number of specifieddollar “baskets,” including (perhaps) a basket for localcurrency debt issued by foreign subsidiaries (for work-ing capital purposes) and, most importantly, a basketfor debt issued under the company’s senior credit facil-ities. Indentures will also contain a “hell or high water”basket, which permits a limited dollar amount of debt tobe incurred for any reason or no reason at all. Issuersshould guard this basket carefully, as hell and high wa-ter both occur more often than we’d all like.

One noteworthy issue is whether the various baskets arerefillable or one-time only. Obviously, the issuer wouldprefer to be able to refill the baskets as indebtedness in-curred under the basket is repaid. In years past, one-time only baskets were the norm. In recent years, we’veseen a movement toward more refillable baskets.

Indebtedness at subsidiaries is often called out for evenmore restrictive treatment. The reason for this is thatdebt at a lower-tier company becomes structurally sen-ior to the high yield debt incurred by the higher-tieredissuer. In other words, the high yield debt becomes“structurally subordinated” to the debt at this subsidiarylevel. The only claim the high yield debt issuer has tothe assets of one of its subsidiaries is a claim as the eq-uity holder of the subsidiary. This equity claim is subor-dinated to the debt claim of the holders of indebtednessissued by the subsidiary, but can be improved by requir-ing any financial support from the parent to be made inthe form of intercompany loans, rather than equity con-tribution. Of course, this can also affect the company’stax position and should be analyzed carefully. Thisstructural subordination is the reason for, and its effectsare intended to be reduced by, the subsidiary guarantees.

The Restricted Payments Covenant

The restricted payments covenant is the other keycovenant in the high yield indenture. This covenantrestricts the flow of money “outside of the system,”

thereby preserving the company’s ability to repay its in-debtedness. Payments restricted by this covenant in-clude dividends to stockholders, investments made inthird parties, loans made to third parties and guaranteesof indebtedness of third parties. It is also important tonote what is not limited by this covenant—acquisitionsof companies that become restricted subsidiaries, capi-tal expenditures and intercompany loans and guarantees.

Like the indebtedness covenant, the restricted paymentscovenant permits two types of restricted payments:first, payments made pursuant to a growing net income“basket” for restricted payments; and second, identifiedcategories of “permitted restricted payments.”

The net income basket generally permits restricted pay-ments to be made in an aggregate amount up to 50% ofthe company’s consolidated net income (less 100% ofany loss) in the period (taken as one accounting period)from the time of issuance until the time of the restrictedpayment. There are a number of nuances to how thisamount is calculated, not the least of which is that theconsolidated net income will exclude the profit or loss ofany unrestricted subsidiary. Thus, if an issuer is inter-ested in being able to make restricted payments — andwho isn’t? — the designation of a profitable subsidiaryas unrestricted is not to be taken lightly.

“Permitted restricted payments” again fall into two cat-egories: restricted payments that should be permitted atany time, like the acquisition of an entity that becomesa restricted subsidiary or the payment of a dividend thatwas permitted to be paid when declared by the board;and a series of predefined baskets. For an issuer that iseither owned by a non-guarantor holding company orhas an obligation to make management fee payments toits private equity sponsor, a carveout must be negotiatedfor money to be dividended up to the parent to pay itsexpenses, e.g., franchise taxes and other expenses, or topay the management fee.

The baskets will be bifurcated into two sets: permittedrestricted payments per se and permitted investments.There are often separate “hell or high water” type bas-kets for each of these. It is important to remember thatinvestments are restricted payments, and thus the issuercan aggregate the two baskets when attempting to make

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an investment that is too large to be permitted underone or the other.

Two notes about joint ventures: first, most high yield in-dentures allow limited flexibility for joint ventures, andsecond, forming and operating a joint venture tends to cre-ate difficult interpretive questions under the indenture.The reason is that bondholders do not want cash removedfrom the issuer’s balance sheet and invested in an entitythat is not controlled by the issuer and subject to thecovenants of the indenture. Issuers for whom joint ven-tures are a serious option will need to provide for neces-sary flexibility in the drafting the high yield covenantsand, after the fact, parse the indenture carefully when at-tempting to form a joint venture.

The Dividend Stoppers Covenant

The dividend stoppers covenant is among the more ab-struse of the covenants in a typical high yield indenture.It is designed to ensure that the cash generated by re-stricted subsidiaries can flow up to the issuer for pay-ment of the notes, unencumbered by limitations otherthan those imposed by law or other routine limitations.Because a parent company’s claim on its subsidiaries’ as-sets and cash flow is typically only that of an equityholder, the only way for a subsidiary to get cash up-stream to its parent is by paying a dividend. Thus, thedividend stoppers covenant attempts to ensure thatthere are no limits on a subsidiary’s ability to declareand pay dividends. This is not usually a practical prob-lem for an issuer, save one important exception—thejoint venture. It is typical of a joint venture arrange-ment for the joint venture partner (even a minority part-ner) to have some measure of control over the joint ven-ture’s ability to pay dividends. This would not be per-mitted by most dividend stopper covenants, and hasitself been the “final straw” breaking the back of manyproposed joint ventures. The typical structural responseto this issue is to form a joint venture as 50% or lessowned by the parent, thereby making it a non-subsidiaryand therefore not subject to this covenant. Of course,that also has the effect of causing any investment inthat subsidiary to be a restricted payment under the in-denture, thereby once again proving that you can’t have

your cake and eat it too (no matter how good yourlawyers are!).

The Limitation On Liens Covenant

The limitation on liens covenant is almost identical,both in form and intent, to the similar covenant con-tained in all credit agreements. The covenant will gen-erally restrict the company’s ability to grant liens (otherthan permitted liens) on its assets unless the companygrants an equal and ratable lien to the holders of notes.The challenge in the high yield context is to cause thedefinition of permitted liens to match up as exactly aspossible to the same definition in the company’s creditagreement. Depending on the views of the investmentbanks’ counsel on this subject, this can be as easy as in-corporating that definition by reference or cutting andpasting that definition verbatim, or as hard as negotiat-ing each line item word for word. In either event, thebusiness deal should be that there can be no lien thatwould be permitted by the credit agreement that wouldnot be permitted by the indenture, and that there maybe some permitted by the indenture that would not bepermitted by the credit agreement.

The Asset Sales Covenant

The name of the “limitations on asset sales covenant” isactually quite misleading. While styled as a prohibitionon the consummation of asset sales, in practice thecovenant for the most part serves merely to define theacceptable use of the proceeds from asset sales. Gen-erally, the proceeds must be used to permanently repaydebt (not necessarily the debt issued under the inden-ture) or to purchase “replacement assets.” The term“replacement assets” is almost equally misleading, as itis not limited to assets replacing those sold, rather, itgenerally includes any assets that will be used in thecompany’s business.

These covenants also typically provide that assets maybe sold only for consideration consisting primarily (75%to 85%) of cash. Asset swaps, however, can be specifi-cally negotiated for as an acceptable alternative to acash sale if there is a realistic possibility that thesetransactions may occur. In any event, this covenant willrequire that assets be sold for their fair market value.

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To the extent the proceeds of asset sales are not used inaccordance with the covenant, the issuer must use theproceeds to make a tender offer to purchase the out-standing notes at a price equal to their face value plusany accrued interest. It is common to negotiate forsome basket amount of proceeds that does not have tobe reinvested but this is usually a relatively smallamount. Because the company can usually find a use ofthe cash permitted by the covenant that will be moreproductive than offering to repurchase the notes, suchan offer is rarely made in practice.

The Transactions with Affiliates Covenant

The transactions with affiliates covenant, like the assetsales covenant, does not actually prohibit transactionswith affiliates; rather, it imposes conditions on the con-summation of such transactions. The conditions to com-pleting a transaction with an affiliate of the companyare typically as follows: (a) the transaction must be onan arms’-length basis, and (b) receipt of the followingapprovals: (i) below a certain dollar threshold (usually$5 to $15 million), none; (ii) above a certain dollarthreshold (usually $25 to $50 million), board approvaland a fairness opinion from a financial advisor; and (iii)between those two figures, board approval. Board ap-proval in these instances will often be defined to meanthe approval of a majority of the directors who do nothave an interest in the transaction.

Other Covenants

The indenture will also contain a number of othercovenants, from the mundane (maintenance of existence,delivery of compliance certificates, etc.) to the substantive(equity clawback, no call periods and optional redemp-tions, limitations on sale-leasebacks, etc.). While thesecovenants are important and will be the subject of somenegotiation, they do not typically occupy the same amountof attention as the foregoing covenants.

ConclusionThe high yield indenture is a complex and sometimescounterintuitive instrument. By its nature, it will bepart of the portfolio company’s capital structure for along time, often for as long as the private equity spon-

sor remains in the investment. If for no other reason

than that, it merits the full force of the private equity

sponsors attention, for it truly is the “gift that keeps

on giving” for years to come. Whether it will be giving

the sponsor relief, or headaches, over that period de-

pends on how successfully the indenture is negotiated

in the first instance.

National Venture Capital Association