As if the high-yield bond market hasn't treated private equity firms well enough already, some financial sponsors are now pushing for more flexibility in the covenants - or the restrictions around a company's capital structure - that govern their high-yield borrowings.

Attorneys approached with implementing such changes said that less restrictive covenants are aimed at helping portfolio companies raise cheaper capital to finance expansion. Such changes could also make it easier for sponsors to exit their companies more easily.

"What I see is that [private equity firms] are more interested in being aggressive, to push the envelope on making the covenant structure more friendly to their exit," said Edmond Gabbay, a partner in the corporate and finance practice at law firm Kaye Scholer. "There's been a drive for the private equity shops to repatriate and reinvest some of their money," he said, "and it's dovetailed very well with the interests of banks, underwriters and M&A advisers who are interested in seeing more transaction volume."

Private equity shops would like to see covenant restrictions eased in part out of a desire to securitize pieces of the companies they have purchased. More recently, private equity firms have expressed interest in securitizing future revenue streams, a financing that would tend to work best for companies that have highly predictable earnings, such as music or movie companies or fast-food franchises.

"Increasingly, people are trying to craft their covenants to permit securitization cutouts of the nonreceivable type," said Ira Schacter, a partner at law firm Cadwalader, Wickersham & Taft. The problem, he noted, is that high-yield covenants in general preclude securitizing those types of assets.

Such deals have always worried high-yield bondholders because of the possibility that the cash received upfront in a securitization would wind up in the hands of the financial sponsor, not the company responsible for generating those future assets, remove the asset from the company's balance sheet, possibly weakening its financial position and increasing the possibility of bondholder losses. This type of financing could also leverage the company beyond the ratio initially agreed to by high-yield lenders.

Not surprisingly, then, high-yield covenants often require that if a restricted subsidiary is securitized, via increased debt, then some or all of the company's original high-yield debt be paid off immediately.

There are some ways to get around these covenants, and that's what private equity shops are pushing to exploit. In some currently employed methods, for example, covenants can allow for a company's restricted subsidiary to be moved to an unrestricted subsidiary, assuming certain tests were passed. Such hurdles include receiving a fair market for the transfer or sale of the asset, including perhaps 75% to 80% of the sale price received in cash. That cash would then be used to pay down senior debt or to make capital investments. If those sorts of tests were met, the securitization would not trigger a need to prematurely pay off the high-yield debt. Altering high-yield covenants could require less vexing restrictions on what can be securitized.

Such alterations would take the form of more relaxed restrictions on what can be securitized, though the same basic test - whether the money will go to the private equity firm as a payoff or back into the company for investment - would likely have to be met.

The point of securitizing future revenue streams is to achieve cheaper financing than a company might otherwise receive by taking out traditional senior bank debt. That cheaper financing would ultimately aid high-yield bondholders by bolstering the company's cash flows, or so the thinking goes.

"I spent last summer in one transaction talking to both high-yield and securitization underwriters to find a middle ground, to explain to them that even though there's a little bit of degradation in the covenants, they're benefiting from the securitization," said Cadwalader's Schacter.

Schacter said his clients are showing increased interest in restructuring covenants after deals have closed. "It's becoming more frequent where you'll have closed the deal and people are still coming to us to look at the covenant package to see if there's a way to get a transaction done under the existing covenant." That sort of thirteenth-hour workaround is impetus enough for many firms to seek a more flexible arrangement with lenders prior to inking a deal.

Kaye Scholer's Gabbay agreed. After a deal is closed, he said, "I certainly see the guys who underwrote the first issue going back to the company [looking for] another M&A assignment or a high-yield assignment to help the [sponsor] realize a return. And at that point we try to figure out how to fit that transaction in."

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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