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.”
The shadow of the retail investor looms large over the deal. Seventy per cent of the offering was destined for retail accounts. It was going to the people who pay taxes and who vote governments into power. Seppa couldn’t risk anything going wrong with the retail tranche.
As in other Spanish privatizations, when the global coordinators agreed the underwriting discount for the institutional tranches they also agreed a maximum price for the retail tranche: Pta3840. The week-long, hard underwriting period was effectively there to protect the retail offering. Yet underwriters of the retail tranche agreed only to sell shares at 3% under the closing price on Monday, 27 April. For that generous agreement they received an extra 100 basis points in fees.
“It’s paradoxical and somewhat unfair that although 70% of the transaction was in the retail tranche, those banks did not have to pay out anything,” says a member of the international syndicate. “It’s a double standard.” Nevertheless, it was one that all the banks accepted before the transaction.
In truth, the banks involved accepted a lot before the transaction. And why not? In more than a decade not a single underwriting agreement had been enforced, what reason was there to expect that this would be the exception? Why bother scrutinizing the details? Signing an underwriting agreement appeared to be money for nothing.
None of the banks involved would have expected to wheedle its way out of the agreement to pay the Spanish government Pta3,340 for each share. But what many of the banks did expect was more control over the decisions that were made once the market closed on Monday afternoon. Instead they found that they were herded into a corner by the global coordinators.
“For them to act on behalf of the syndicate without any consultation is wholly inappropriate,” says a syndicate member. “It’s a matter of principle.” When bankers start invoking moral principles in their favour, something must be amiss.
The global coordinators’ argument is simple. Although it would have been nice to call up each syndicate member to apprise it of the situation, their time was better used negotiating with institutional investors to make sure the book held together.
“In the middle of the battlefield you don’t stop to take a vote,” says a banker at one of the coordinating firms. “You get to the top of the hill, count who’s alive, tend to the wounded, and go on.” It was at this point that syndicate members started to provide creative interpretations of the underwriting agreement.
The global coordinators did not get formal confirmation that the underwriting commitment would be enforced until 11pm on Monday. One syndicate member called up to find out what was going on. He immediately started to argue that the shares should be redistributed among the syndicate and not distributed according to the order book. At that point the global coordinators decided to cease communication with the syndicate.
Effectively frozen out of the decision-making process, syndicate members began to scrutinize their underwriting agreements to see whether the global coordinators could legitimately exercise such control. “Nothing gets people reading contracts quicker than losing money,” observes one banker. The syndicate members found that the global coordinators had broad powers, limited only to the extent that their actions could not be to the detriment of the syndicate.
The global coordinators deny that more communication with syndicate members would have enabled them to cover their economic risk more effectively. The underwriting contract prevented the banks from shorting stock or taking out hedge positions on the Ibex, but they could have set up an imperfect hedge by writing contracts on correlating markets. The ideal time to have done that would have been before the underwriting period began on April 20. According to the global coordinators, by Monday evening it was too late to do anything.
Tabacalera has been a wake-up call for banks to examine the underwriting process in general. One of the junior syndicate members on the Tabacalera deal points out that, unlike bond underwriting, in the equity market your underwriting commitment and the allocation of shares you receive is often not the same.
In the case of Tabacalera this was important because the Pta32 selling concession was a small balm to the Pta135 loss on each share. But although one syndicate member claims his book was four times covered, he received only 60% of his underwriting commitment and yet had to pay 100% of the loss. “You should be given your full fees even if you don’t get the paper,” he argues. “I don’t have a problem with the fact that the leads control where the paper goes, but I do when they control the allocation and then keep the selling fees as well. If you’re not a lead-manager you get the long end of the stick, and then when the shit hits the fan, you get the stick where it hurts as well.”
The solution is for the lead-manager to simply write a cheque to the co-leads, whether or not they give them their full allocation. The lead managers’ argue that in this instance they only escaped with such small losses because of the work that some members of the syndicate put into building a large, and high quality, order book. In their allocation they wanted to reward those managers that had performed well by giving them a larger dose of the selling concession balm. They also say that only one manager had his book four times covered, and he received double his underwriting commitment.
With the Tabacalera deal in mind, the underwriting agreement on the forthcoming offering of $8.5 billion of shares in power company Endesa has already been rewritten. Gone is the week-long hard underwriting period, with an overnight agreement taking its place. “That [week-long] arrangement has always been a matter of holding your breath,” suggests one banker. He recalls the first Endesa offering, when the shares traded through the underwriting price for much of the day before finally closing at Pta2,684, just Pta25 above the underwriting price.
The performance of Tabacalera shares following the sale seems to vindicate the coordinators’ actions. Only 10% of the offering was traded on the first day. And when the Spanish market fell again on the Wednesday after the sale, Tabacalera’s share price actually rose to Pta3,270.
“It seems that a few banks say that they would have been better off receiving the shares, but who knows? It was a bad-luck situation, an unforeseeable event. It was not a case where Seppa and the global coordinators didn’t agree the right underwriting price,” argues the Seppa official.
During the course of its privatization programme, the Spanish government has progressively cut fees at the same time as taking increasing control over each sale. By the time of the Tabacelara sale, shrewd negotiation had left Seppa very much in charge. “We are not passive agents,” agrees a senior offical at Seppa. “The major decisions are taken by us. It’s right that the owners of the stock have the greatest say [in the privatization].”
That leaves banks with less influence over how an offering is managed, and less fees for the work involved. Inevitably that means that some syndicate members do as little work as possible. “I think that the execution was poor, and the syndicate wasn’t focused enough,” says one syndicate member. “But if you don’t pay people, they don’t do the work. And the fees are just too low in Spain.” The irony is that it was the banks, and not the Spanish government, which suffered.
