Marrying venture capital and high yield

"To understand the legal aspects, you have to understand how these deals are done," says Mark Campbell, a partner at Clifford Chance, a law firm that has been more active in European venture-capital transactions than most.

Often a deal is the result of a European conglomerate selling off a division. The bidders may include a trade buyer, a venture-capital company and a financial buyer (such as Nomura, which has a portfolio of industrial businesses). "The seller is looking for amount, certainty and speed," says Campbell. The trade buyer will have corporate banking lines, so can produce the cash. But the trade buyer risks being held back by competition issues - the anti-trust authorities may investigate. The venture-capital firm has few competition hurdles to jump but needs to raise cash quickly, especially if the trade buyer is offering a high price.

"If the venture-capital company is proposing to use high-yield debt, it will normally need bridging finance in the meantime," says Campbell. A major factor is whether the issue is to be marketed in the US. In Europe the capability to analyze high-yield issues and their covenants still resides in the credit function of banks, whereas in the US institutional investors, being more used to high-yield issues, have developed this capability in-house. Selling high-yield issues in the US, like any securities issue, carries with it disclosure requirements that can take time to satisfy, hence the need for the bridge. "If you're going to market the issue in the US, you need full access to the management to deal with the detailed disclosure required in the US and to take them on the roadshow, which they won't be able to do while they're in the thick of the transaction," says Campbell.

Not surprisingly, documentation tends to follow New York models. "Broadly viewed, it isn't that complex," says Rick Ely, a Clifford Chance partner. The indenture - which sets out the noteholders' rights and has to comply with the US Trust Indenture Act - contains a well-established range of covenants, customized to the nature of the issuer and its credit characteristics. "Whereas in a loan the commercial bank retains the risk, here the primary goal of the investment bank is to achieve a package of covenants that falls within market norms, while the issuer wants as few restrictions as possible. It leads to interesting peculiarities of negotiation that you don't get in a commercial-banking context."

In most cases, there is also a registration rights agreement, which sets out the issuer's obligation to register the securities with the SEC. This effectively converts what would otherwise be privately placed securities into ones that can be publicly traded. Institutional investors like registration rights because they may be subject to regulatory or policy limits on the amount of restricted (that is, non-registered) securities in which they can invest. Registration takes these securities out of the private-placement basket and into the publicly registered basket. There will also be an offering circular of the same quality as an SEC-registered document.

The covenants in a high-yield issue will generally be looser than in a bank debt financing because of the investor audience. Seeking a waiver or amendment of terms from the holders of a widely held security raises too many practical difficulties, so issuers try to limit the situations where that may be required. There will be no financial maintenance covenants (such as coverage ratios) but simply incurrence tests that prohibit additional debt, unless debt coverage is above a specified level, and that restrict dividends to 50% or less of cumulative net income.

"Provided the issuer doesn't need additional financing, engage in significant acquisitions or disposals, or seek to pay dividends, the high-yield terms should have relatively little impact," says Ely.

Since the high-yield issue is only one aspect of the debt financing, the senior lenders will be concerned to retain their priority by taking security over assets or, where high-yield debt is subordinated, by way of inter-creditor arrangements where the borrowing entity is the same. New York law has liberal third-party beneficiary rules making it easier to create debt securities that are subordinated to the rights of senior debt holders while ensuring that they retain priority. Most European jurisdictions lack this flexibility.

Alternatively, they will lend into an entity interposed between the high-yield issuer and the operating assets. This structural subordination means that, if there's insolvency, holders of subordinated high-yield debt are the equivalent of ordinary shareholders in the operating subsidiary, and rank behind the senior debt.

Providers of bridge finance want to be sure the high-yield issue will be launched rapidly to take the bridge out. "If you're [providing the] bridging, you've got to make sure you can get out of the bridge and into the high yield, where someone else owns the paper," says Campbell.

This can be achieved by an escalating interest rate on the bridge loan so it becomes increasingly uneconomic or by attaching warrants that convert into equity, effectively turning it into mezzanine finance. This is a deterrent for the venture capitalist since it is having to forgo some margin by surrendering equity.

"Both sides have to take an informed decision that the high yield will work otherwise the bridge goes nowhere - to the lenders' dismay - and costs the venture capitalist equity," says Campbell. Venture capitalists prefer high yield because, unlike mezzanine finance, there is no equity kicker to give away. Mezzanine providers also typically demand much higher returns.

Two other aspects of European venture-capital deals have technical wrinkles. The first is that the use of a securities issue alongside bank debt throws up competing concerns since they exhibit different characteristics under corporate, tax and securities law. The second is the interplay of international financial law (English or New York) and local law. "The high-yield market expects documentation based on the US model but you need a hybrid," says Ely. "So you may have a 120-page agreement spelling everything out in typical English or New York fashion but it must also work in conjunction with, say, the German civil code, where the tradition is for much shorter documents and where Anglo-American legal concepts on which the US model is based simply don't apply."