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Headline: Eurobond syndicate practises - Transparency or skulduggery?
Source: Euromoney
Date: February 2000
Author: Marcus Walker
Some investment banks in the euro bond market are pushing for underwriting syndicates to disclose their order books. On the surface, it's a technical debate about how to organize bond deals. Underneath, it's a fierce clash about different banks' competence. The argument polarizes US and European firms. Marcus Walker hears the claims and counterclaims, and how the internet might lead to an unexpected solution
Charlie Berman
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The dreaded pot system is becoming a familiar sight in international bond deals. It involves co-managers on a syndicate revealing their sales orders to the lead-managers, who then decide how to allocate securities among the investors in the collective pot. The method arose for emerging-market and US high-yield deals, spread to US corporate and agency deals, and is beginning to be used in Europe. But in the latter case, it is encountering heated opposition from many of the region's indigenous banks.
Proponents say the pot creates transparency for the syndicate managers and ensures a better quality of distribution for the borrower. The traditional method of allocating a quantity of non-earmarked bonds to syndicate members, whose sales to the market can't be verified, allows them to mis-state their placement success. But detractors say the lead-managers abuse the disclosure of orders within a pot to poach investors from rival banks.
The dispute takes place in the context of a fast-growing euro-denominated market for corporate bonds, in which the pecking order among investment banks is still fluid. Places in the clique of between five and 10 dominant arrangers
are up for grabs. When the euro credit market began in 1999, it was expected to develop like the US market, and US-based firms such as Morgan Stanley and Salomon Smith Barney were expected to triumph. Instead Deutsche Bank, Paribas, Dresdner Kleinwort Benson, ABN Amro and Warburg Dillon Read all had a busy year in 1999. Whichever way you spin the euro league tables, even if you take out Pfandbriefe or look at corporate bonds only, European investment banks performed strongly.
David Ovenden
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Bankers at European firms explain that familiarity to local borrowers helps clinch business. "There's no doubt that the European banks have shown the Americans a clean pair of heels so far," says James Witter, co-head of European corporate bond origination at Dresdner Kleinwort Benson. "Cracking corporate relationships is a harder act than the US investment banks envisaged." John Winter, head of European debt capital markets at Deutsche Bank, agrees: "A few European houses like Deutsche have made a good start. It's not overly surprising that one tends to do more business with those banks one has had relationships with for years."
But many bankers at US-based global houses smell a rat. They say their European rivals played a combination of relationship and nationalist cards. These tactics were especially pronounced as the battle began in early 1999, says Charlie Berman, head of European debt capital markets at Salomon Smith Barney: "In general, European banks tried to characterize this as a European bond market for European underwriters and investors. In the early stages, many European banks told issuers that there was no need for US investment banks, and to exclude them from syndicates."
In Berman's view, local lead managers sometimes disguised a lack of pan-European distribution outside their particular national market. "The second half of 1999 highlighted the transactions which were truly well placed, and those which suffered from old practices like keeping bonds on books and selling them to the retail market over several months, or allocating oversized blocks to a narrow investor base, so that when the
market turned they were dumped and spreads rose."
Proprietary investors
Roy Boecker
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At European houses, capital-markets executives agree that some bond deals were poorly distributed last year, but point the finger straight back at the American banks. Roy Boecker, global co-head of origination at ABN Amro, argues: "The distribution of European and US houses is fundamentally different. Where issuers have used European firms, they have achieved a much wider distribution, with smaller tickets but larger numbers of accounts all over Europe. The European banks are less reliant on the top 30 to 40 accounts."
The message is echoed at other local-based players. Richard Johnson, head of the syndicate desk at Warburg Dillon Read, says: "The European banks have shown last year that they have a deeper distribution to second- and third-tier accounts than the US banks."
So Euromoney conveys the suggestion to Charlie Berman that the Wall Street firms don't know Europe's buy-side beyond the top tier of investors, whereas firms like ABN Amro may have a more intricate network of clients. When Berman has finished laughing, he challenges his European rivals to prove it: "European firms are the most resistant to transparent bookbuilding and syndication. They say they have proprietary investors, and they want to keep their distribution inside a black box." Inside the box, there may be nothing but their own balance sheet.
"We advocate a lot more transparency, particularly between joint bookrunners," says Berman. "Get your cards out on the table, when you are supposedly working together
on a deal."
Showing your cards is what the pot system is all about. It guarantees that lead-managers know what joint leads and co-managers are doing with their bonds. Kevin Brolley, head of corporate bond sales in Europe at Chase Manhattan, says: "The pot system improves the efficiency of the process. A transparent book makes for a better deal. The investor knows that the syndicate members are working together. It's more difficult for syndicate members to dump bonds they can't sell through brokers, exploiting the lead-manager's support bid."
"The pot system is not perfect, but there is a need for borrowers to know who their bonds are being sold to," says Rob Rooney, head of Eurobond syndicate at Morgan Stanley Dean Witter. He argues that investors benefit too when borrowers insist on transparent syndicate practices, and he names two good models: "Ford and GMAC care and know where their bonds are going. The dealer community is under pressure from Ford and GMAC to place their bonds in good hands. As a result, investors have confidence in the bonds. Is there a European single-A corporate that can raise money in the same volumes and for the same price? Ultimately, transparency is in the interests of everyone."
Rooney's colleague, Anthony Barklam of Morgan Stanley's syndicate desk, believes transparent order books would lead to a more meritocratic league table of arrangers: "The pot has the supreme ability of separating the men from the boys. The US investment banks are confident that they have the broadest and highest-quality investor base."
Ulterior motive
Rob Rooney
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At some European banks, opponents of the campaign for pots see a hidden agenda. Foremost among the critics is David Ovenden, global head of syndicate at Paribas: "To be quite frank, most of this is coming from US banks: they've got nothing to lose. The ulterior motive is for them to work out where European bond deals are going. They can get the names of European investors from the phone book, but they don't know what makes the investors tick.
"Ten years ago most foreign banks in Europe built a combination government bond, derivatives and dollar Eurobond business, but not a local-currency distribution of European names. There are still a large number of accounts that people either don't know, or think only buy 20-year Italian treasury bonds."
He continues: "Two years ago, most firms outside two or three of us didn't have the confidence to sell Ecu and later euro issues. The US firms especially were scratching their heads and saying 'where the hell are they selling this stuff?' The investor base is much more fragmented than in the US. What US banks are keen on is a pot deal with a European bank where they want to know more about their distribution."
As well as the long-term, espionage value of order-book disclosure, pots can get abused by lead managers within the confines of individual deals. Investors whose orders go into the pot are asked to designate which syndicate member took the order; that bank earns the corresponding commission when the final allocation is determined. But since the lead-manager controls the allocation, it can bully investors into designating it as the originator of the sale. Several European banks report incidents where lead-managers cajoled syndicate partners' investors to reassign their orders. This abuse of the pot destroys the incentive for junior syndicate members to collect orders.
Ovenden says: "Investors know that if they give an order to a co-lead which goes into a pot, they will bring down the wrath of the bookrunner, and they probably won't get any bonds. What a pot deal ends up being is a one- or two-handed distribution by the bookrunners. This is definitely suboptimal for the transaction, and can even lead to inferior prices and borrowing costs for the issuer. We think that the pot system is not appropriate in Europe at this stage."
At Warburg Dillon Read, Richard Johnson agrees: "The pot deters investors from giving orders to a co-lead, and prevents co-leads from having any real role." He goes further, arguing that pots don't even stop banks from inflating their investor base: "Within a pot we've come across orders that don't really exist, from banks who want to show they've got distribution in a certain region. These orders then disappear towards the end of the deal."
Paribas rejects the argument that European investment banks are resisting disclosure to hide their lack of placement power. Ovenden says: "It's simply not true that the European banks have bad distribution: they've placed too many bonds well to say that." He attributes this criticism of European houses to a professional snobbery among the Wall Street firms. That sense of superiority is, he thinks, the driving force behind the whole pot debate: common US practices are assumed to be best for Europe too, ignoring differences such as a highly diffuse buy-side and a cultural preference by the region's investors for remaining anonymous.
Ovenden adds: "For the past 10 years, the intellectual high ground in the Eurobond market has been with the US banks. The European banks have been slow, inward looking, and wanted to preserve their triple-A ratings more than they wanted to achieve a return on equity. US banks have been able to strut around and talk down their noses about how the business should be run. But guess what: the Europeans got their skates on [when the euro came in]."
Who's telling the truth?
Bankers at US houses reject the arguments against the pot. Paul Hearn, head of European debt capital markets at JP Morgan, says: "Among big-name accounts there are not many proprietary investors. I accept that there are smaller names in European banks' home countries that the US banks and other European banks will not have access to. It's very flattering of the Europeans to suggest that once we find out an investor's name, they will suddenly start trading with us. It's not practical for us: investors below a certain size don't pay for the coverage."
Hearn argues that pots promote accurate judgements: "Lack of transparency leads to a more defensive approach to pricing. It means there's not much knowledge in the hands of the lead-managers, who ultimately have to advise the borrower on pricing."
Faced with contradictory claims about distribution abilities, and mutual accusations of ulterior motives in promoting or resisting the pot system, it is hard to judge who is being most honest. The argument about the existence or otherwise of proprietary investor bases would be settled if European banks published their books - but such information, of course, is what European banks say US rivals are eager to exploit.
The allegations about the abuse of pots are easier to settle. One US investment banker questioned on a no-name basis says he has seen such tactics used against him by US firms who are relative newcomers to Europe. These banks hassle investors whose names are given up, trying to win their custom for the present deal and future transactions. "So we see that there is some truth to the Europeans' complaint. But it isn't exclusive to US banks doing it to European banks."
Rather, it's endemic to all sales teams who are under pressure: "If Deutsche Bank is lead-manager and they see an account from Germany give an order to a US bank, that salesperson is going to get creamed. So he rings up the account and says 'what the hell are you doing? You are going to lose me my job.'" In this banker's view, every major investment bank in Europe has relationships with and proprietary intelligence on different investors.
Hearn is sceptical about whether banks make many unwelcome, cajoling calls to investors. "Investors won't put up with that. They are tending to deal with fewer and
fewer counterparties, and if you try that tack you'll find it comes back and bites you.
So if US banks are doing that, it's pretty stupid."
Salomon's Berman argues that name disclosure in itself doesn't win or lose you clients: "In the US, everyone knows who the top investors are, but newcomers still find it hard to enter the market, because transparency means that orders are given on the basis of quality of service, including research and secondary liquidity. Let's compete on quality of service."
This argument seems a valid response to fear of a hidden agenda by US banks chasing market share: if European firms' services are good enough, they have nothing to fear from transparent order books.
However, it doesn't refute Paribas' argument that pot structures marginalize all but the lead-manager, which is not in the borrower's interests. And the fact remains that European investors instinctively dislike publicizing their purchases. They prefer to determine for themselves which investment banks they deal with.
The third way
Warburg's Johnson believes there is a third way between the drawbacks of the pot system and the opaque methods of traditional Eurobond syndicates. With the help of the internet, the benefit of transparency can be achieved without triggering Machiavellian manoeuvres between syndicate members. Johnson says: "Transparency with the issuer is of paramount importance and is something issuers find very valuable. This can reduce the importance of transparency between lead-managers."
The trail has been blazed by Freddie Mac, which launched a $6 billion global bond on
January 5. Lead managers Warburg and Merrill each gave Freddie access to special websites to monitor the deal. Jerome Lienhard, head of borrowing at Freddie Mac, says: "We could actually see Warburg's book build up in real time. It was nothing revolutionary, except that all the information was right there and unfiltered. The clarity of the book allowed me to view this from a syndicate manager's perspective for the first time."
He continues: "For a bookbuilding and transparency process it was fabulous. We will encourage firms that have internet capability - I guess that will be all of them in future - to allow us to see their book. That could be a requirement, at least for lead managers."
Incorporating the co-managers' books on-line would make things complex; in Freddie Mac's deal they received an allocation in the old-fashioned way. Lienhard says: "Looking at multiple websites is inefficient. The challenge is to create one integrated platform. We're going to have to play a role in some sort of industry-wide system." He says Freddie Mac's next step will be to talk to peers, including GMAC, Ford Credit and TMCC.
Lienhard is aware of the sometimes bitter arguments between investment banks over the pot. He says: "The argument for the pot system is that it provides transparency for the bookrunner and more control, but the problem is that it creates a lack of an incentive for anyone but the bookrunner to sell bonds. I still tend to be a pretty strong subscriber to the view that if you're going to have a syndicate, you want everyone in it to sell bonds for you. If we can develop this internet-based primary distribution system, there's potential that the co-managers can play a more significant role. The playing field is levelled."
Hearn doesn't think the third way goes far enough. "I agree that [transparency for the borrower but not between the banks] is better than nothing. It may work well with a sophisticated borrower, but if you're talking about a first-time corporate issuer, he has no idea what's a good account and what isn't. Even with a really good borrower, as lead-manager you get a little more cautious when it comes to pricing if you don't have an institutional pot." For Hearn, online pots are the ideal.
The alternative is that an all-seeing borrower takes an increasingly direct role in the calibration and distribution of a bond deal. Leinhard can envisage this: "I think [the online book] has the potential to dramatically alter the distribution process in ways people hadn't thought of."
Freddie Mac's funding head concludes: "Ultimately we have much more incentive to provide a distribution based on the merits of the order book than the bookrunners do. But I may be getting into controversial territory here." That much is indisputable.
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