In these acquisitive times, a bank needs to find a cost-efficient means of funding its ambitions. In the recent takeover squabble for Belgium's Générale de Banque, ABN Amro suggested that it would issue $1 billion worth of preferred stock in order to help fund its, ultimately unsuccessful, bid.
For European banks, issuing preferred or capital securities promises to be an increasingly popular strategy, not only to fund acquisitions but also to shore up regulatory capital. Because in the right light regulators see preferred securities as tier-one capital, and accountants see the dividends payable on the securities as tax-deductible. It's a classic hybrid: it can be dressed up as equity or as debt, and the borrower can change the costume to suit the occasion. As one US banker puts it: "It is cheap, non-dilutive, no-voting equity, that doesn't cost significantly more than debt."
Issuance of this type of security is spreading beyond its traditional home in the US. This year capital-starved Japanese banks have jumped on the bandwagon, with deals from Sumitomo, IBJ and Fuji.
The latest jurisdiction to approve preferred securities as tier-one capital is Italy, and with the wave of consolidation in the country's banking sector it could prove to be an active market.
Racing to launch the first deal from the country were Merrill Lynch and Goldman Sachs, the two leading players in capital securities. Goldman Sachs claims to have beaten its arch rival to the market by a couple of days with an Ecu/euro deal for Intessa worth $250 million to $300 million. But Merrill can claim to have made the bigger splash, with a proposed $1 billion capital raising for Banca Commerciale Italiana (BCI).
"What is different is that we're accessing every single market place," says Harish Raghavan, managing director of global product development at Merrill Lynch in New York. The deal has three tranches, in dollars, sterling and Ecu/euro. "It is the first deal of its type: a multi-tranche, multi-currency capital raising, that shows how the next generation of capital securities will evolve," predicts Raghavan.
Usually, the biggest hurdle in issuing capital securities is satisfying the regulators. And because regulators in each jurisdiction are free to offer their own, often idiosyncratic, interpretation of the Basle guidelines on regulatory capital, there is no international blueprint for the structure.
"The deals that you will see around Europe are all amalgams of different techniques," says Vincent Oratore, managing director of global product development at Merrill Lynch in London. "They involve case-by-case agreements with regulators on what constitutes non-dilutive tier-one capital. You're not going to get identical repeat structures."
What most of these deals do have in common is the use of a US-domiciled vehicle or subsidiary that can take advantage of the preferential tax treatment afforded to preferred stock when issued out of a limited liability company (LLC) which qualifies as a partnership for US tax purposes.
The BCI deal has a three-tier structure. The bank sets up a 100%-owned LLC in Delaware. The LLC then issues perpetual preference shares and lends the proceeds back on a perpetual subordinated basis through notes issued by BCI's New York branch. The LLC securities are purchased in whole by a trust which then issues trust preferred securities to investors.
At this level, the BCI deal looks very similar to the $1.8 billion transaction led by Goldman Sachs for Sumitomo Bank earlier this year. However, that deal, and the new Intessa transaction, involves the LLC purchasing a credit-linked note issued by the bank (see diagram). "It's encouraging that you can take the same concept beyond one Basle signatory [country accepting Basle capital standards] to another," says Chris Hogg, head of new products at Goldman Sachs in New York.
But the BCI structure accomplishes different goals. "Firstly, the structure provides full loss absorption at the BCI level and secondly, for regulatory reasons, it may be important that the limited liability company is used as a real subsidiary," says Oratore. The Basle committee may deem that the on-loan structure is too passive, making the LLC akin to a special-purpose vehicle and the capital securities ineligible as tier one. In that case, the committee would approve a portfolio structure, where the LLC receives and manages a portfolio of the parent bank's assets. The BCI deal includes a provision allowing it to switch from one type of structure to the other if need be. It also includes a fairly unusual feature in tier-one transactions, a white-knight provision. In the case of the parent bank effectively going bust, provided a white knight comes in to rescue it, the preferred holders lose their dividend right but maintain their liquidation preference.
The BCI issue promises to be just the first in a succession of similar deals. Three deals are due from French banks during July, with Goldman Sachs having just launched a $275 million, 144A issue for Natexis, following in the wake of similar deals for Société Générale and BNP.
But does Europe have a deep enough investor base to absorb the flow? Raghavan believes that if it isn't already there, it will be soon. "As Europe gets a credit curve for lower-grade credits, so it will develop a credit curve for higher-grade subordinated product that will allow those credits to raise preferred share capital," he says. That should mean opportunities for corporates as well as banks.
As more national regulators interpret the Basle accord in a manner that allows their banks to raise tier-one capital through preferred securities, the Basle committee may be forced to revise its guidelines.
"It is a very opaque discussion, and at root is a competition issue," suggests Scott Ulm, managing director at Credit Suisse First Boston in New York. "As far as European banks are concerned, their competitors in the US are enjoying a cheap source of capital that they are not, and there will have to be some sort of levelling of the playing field." With the next meeting of the Basle committee scheduled for the beginning of July there is a widespread belief that new recommendations will soon be published, most likely in October. Many, however, remain sceptical. "I've heard it all before," says one banker. "You have to take these things with a pinch of salt." Another suggests that the conservative Basle committee remain wary of what they see as "the snake-oil salesmen of Wall Street". James Rutter