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Why corporate hybrids are not all they’re dressed up to be

by Peter Lee

Every market participant has had something to gain from corporate hybrid securities. Bond fund managers have delighted in high yields; issuers have enjoyed cheap equity. Ratings agencies have been paid for their trouble, investment banks have pocketed juicy fees and traders have revelled in the volatility. But what seems a perfect fit might well fall apart at the seams in an unfolding credit downturn. This will either expose the defects in the market and destroy it or validate hybrids as an asset class.

History of corporate hybrids: How did we get here? | Future of corporate hybrids: Where are we going?

THE LUNCHTIME CONVERSATION has ranged widely over the advantages for corporate issuers of the new breed of hybrid securities, which investment banks have been championing since the summer of 2005 as the next great thing in capital raising.

Ratings agencies regard these subordinated, perpetual or very long dated bond deals as comprising between 50% and 75% permanent equity capital on the balance sheet. Accountants agree. Maturities can extend and coupon payments be deferred, so providing a loss-absorbing cushion to senior creditors. Yet tax authorities treat the high coupon payments as debt-like interest costs to be paid from pre-tax earnings. And hybrids don’t dilute existing shareholders.

It’s a dream combination.

Over his aperitif, the banker has enthused about hybrids’ potential for financing goodwill on acquisitions, helping bidders stretch their offer prices and funding corporate pension liabilities – all while shoring up credit ratings. Over the main course, he has talked earnestly about lowering companies’ weighted average cost of capital and boosting shareholder returns. It’s only a wonder that more companies haven’t already sold them.

For investors, though, the high yields on these subordinate instruments have to compensate for a lot of risk and uncertainty. And now, as the waiter hovers with the bill, the talk finally turns to negative convexity and asymmetric payoffs. In a bull credit market, with low absolute rates and historically tight credit spreads, hybrids offer much-sought-after extra yield. But in a bear credit market, they might perform far worse than any other debt instrument in an issuer’s capital structure and, in certain circumstances, worse even than the equity.

To the investment banker, this is self-evident. “Oh, these are among the most toxic instruments we’ve ever created,” he says. “And they’re absolutely a bull market instrument. In a bear market, it’s not a question of maybe losing just a percentage point. You can lose 10 points in a heartbeat,” he warns.

So why have investors been buying hybrids? The banker’s look seems to ask how many more times he must explain the blindingly obvious. “Because they’re irrational,” he says. “But you probably shouldn’t quote me saying that,” he adds as an afterthought.

No, probably not. He has, after all, just proudly proclaimed that his firm has several hundred investment bankers around the world busily talking up these instruments to potential issuers. “There are guys pitching this for me who normally don’t want anything to do with debt, because it isn’t cool,” he says.

It’s cool now. Ask any investment banker and they’ll tell you the same thing: today, along with M&A, hybrid capital raising is item number one or two on the agenda that coverage officers want to raise with corporate customers. It’s not hard to see why. The case for issuing is pretty compelling. And investment bankers have their own incentive to argue it strenuously. Fees on corporate hybrids often go undisclosed. Some investors that have bought them aren’t aware of the fees arrangers are taking. The standard is 1% for institutional deals in Europe. That is many times more than for a conventional bond. And these are big deals. Of the nine corporate perpetuals launched in Europe from the start of 2005 to mid-March 2006, five have been for €1 billion or more.

For retail-targeted deals sold to private banks in Europe and to retail buyers in Asia, fees range from 2% to 3%. In the US, standard fees come in at 3.15%.

So there’s plenty in it for the arrangers, although the CEOs and CFOs of investment banks might care to reflect that they are playing a close to zero sum game. Hybrids are essentially one high-fee product competing with another – straight equity and convertible bonds. The arranging bank might not come out very far ahead if an issuer were simply to choose a hybrid over an equity raising – although it might benefit by getting paid twice if companies were to issue hybrids and buy back other capital instruments, equity or debt.

Lower down the ranks, it’s a fair bet that friendships between bankers in debt capital markets and those in equity capital markets are being strained as never before. One originator pulls a face as he chats to Euromoney about the product. An email has appeared in his inbox from an ECM colleague about a joint call the two are due to make on a client. The ECM banker wants to talk about a convertible. The debt originator, of course, has something else in mind.

Issuers pile into the arbitrage

There’s plenty in it for the issuers too. They’ve realized that hybrids are not expensive debt; they are cheap equity. That’s why French construction company Vinci was willing to persist with its €500 million deal through nerve-wracking primary market conditions this February, to lock in flexibility in its funding for the acquisition of toll road operator ASF (Autoroutes du Sud de la France).

It would have been an easy deal to pull. French media company Thomson had sold a similarly structured hybrid a few months earlier that had been poorly received. Then, as the roadshow for Vinci kicked off, Thomson issued a profits warning and the trading price of its hybrid fell by another six or seven points. Amid a bout of anxiety on a possible turn in the credit market, at least one investment-grade bond issue had to be postponed. Vinci and its lead banks toughed it out and completed their much riskier trade. They chose to talk only to those investors that had provided early expressions of interest during the roadshow for a credit that stands to benefit, following the acquisition, from stable cashflows on long-term road concessions comprising up to 65% of its ebitda. They kept the order book open for just three hours and reduced time to settlement to discourage shorting.
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