Banks get their fingers burnt by Tabacalera

Issuer: Tabacalera
Amount: Pta281 billion ($1.9 billion)
Type of deal: secondary equity offering
Launched: April 27

When the four global coordinators for the privatization of the remaining 52% of Spanish tobacco group Tabacalera left the company's Madrid office on April 20 they were pretty pleased with themselves. They had just negotiated the largest underwriting discount in Spanish privatization history, 13.02% for the two institutional tranches of the sell-off. The banks in the syndicate had agreed to underwrite the sale at Pta3,340 a share.

It had been a hard job to convince Seppa, the government agency handling the sale, that such a large discount was warranted. "All of us were aware that the market was a bit shaky," recalls a senior official at Seppa involved in the negotation. "The volatility was greater than in previous offerings and so they were asking for a bigger discount." He says that they didn't ask for much above the agreed 13%.

A week later, and the global coordinators - Argentaria, BBV, Central Hispano Bolsa and Merrill Lynch - were left ruing the fact that they hadn't been more aggressive. Since the underwriting agreement had been signed, shares in Tabacalera had plummeted by over 16%.

At the close of trading on Monday, April 27, Tabacalera shares were worth just Pta3,205. It had been the worst day of the year for European equity markets. It was the day chosen to price the sale.

For the first time since the UK government's disastrous sale of BP shares in 1987, underwriters of a major privatization were going to lose money. But unlike in the BP debacle, the shares were not redistributed among the syndicate according to their underwriting commitment. The lead managers simply went with the existing order book. Was the loss just bad luck? Or was it bad management by the global coordinators?

With just over 20 million shares included in the institutional tranches of the sale, the total loss on the deal was in the region of $18 million - Pta135 a share. The selling concession was set at just under Pta32, with another Pta20 included in the fees. At best, syndicate members could claw back just over Pta52 on each share, still leaving their total loss in the region of $11 million. One syndicate member estimates that individual losses range from $10,000 to $1 million. What is certain is that everyone lost money.

In the run-up to the sale, no-one was in any doubt that Tabacalera stock was highly valued, maybe dangerously so. Analysts at one syndicate bank warned that the stock was overpriced but the bank still decided to underwrite the deal because of its relationship with the Spanish government. During the marketing period Tabacalera's share price ran from Pta3,400 to Pta3,900. It was a company with strong fundamentals and during the roadshows it had unveiled a new restructuring strategy.

In the week after the underwriting discount was set the stock price fell steadily, from Pta3,840 on Monday to Pta3,365 at the close of trading on Friday, still comfortably above the underwritten price. The book-building process indicated that investors also saw Tabacalera as overpriced at Monday's levels, with the book only coming together strongly after the stock had fallen through Pta3,500.

By Friday the international tranche was covered over two and a half times, the Spanish institutional tranche nearly five times covered and the retail tranche more that 15 times subscribed. By any measure, the offering appeared a success.

But over the weekend markets were unnerved by rumours that the US Federal Reserve was about to abandon its neutral stance on interest rates. Unrest in Indonesia also contributed to fears over the situation in Asia.

When exchanges opened on Monday, markets across Europe nosedived. Tabacalera's share price performed even worse than the Ibex. With 90 million additional shares about to hit the market, there was inevitably a lack of buyers for the stock. People were selling Tabacalera shares into a vacuum.

Syndicate members watched the stock price fall. Agonizingly, it wasn't until the last hour of trading that it actually fell through the underwriting price of Pta3,340. Once through, it continued to slide, eventually closing at Pta3,205.

The global coordinators and Seppa convened for what should have been a straightforward meeting to agree the offer price. The highest price that can be set for a secondary offering is equal to the price for the last sale on the offer date. That price happened to be Pta135 below the underwritten price. Now the whole nature of the underwriting agreement was in question.

Was there any chance that the Spanish government would not exercise its right to sell the offering at Pta3,340? "There was no question," says a source at Seppa. "As a public entity we could not relinquish this economic right."

In that case, what was the best way to complete the sale? The shares could not be sold into the market at Pta3,340 when they were trading Pta135 lower. "During the conversation about what would be the best outcome for everyone, it was suggested that Seppa sell the shares at the fixed institutional price [of Pta3,205], but asked the syndicate to pay us the difference [of Pta135]," says the Seppa offical. That is what happened. And the syndicate members began to howl.

The global coordinators could have redistributed the shares among the syndicate members, as had happened with the BP deal in 1987. That caused the stock to trade appallingly for two years after the sale. The only realistic choice was to go with the book. One banker likens the situation to walking along a clifftop during a storm. It's a hazardous pathway, but your only options are to continue along it or turn and jump off.

"Apart from the price problem we had a wonderful book," says the senior Seppa official. "If the banks had taken the shares we would have had a very bad scenario. The share price would have dropped and the retail tranche would have suffered."