A SUPPLEMENT TO EUROMONEY – MARKETS 1997The head of equity capital markets at a large European bank hesitates, just for a moment, before making a surprising confession. The bonus his firm paid to him in early 1996 still sits in cash at his bank. He has not invested the substantial windfall in the equities markets. Nor does he feel any inclination to invest the bonus he is about to be paid for 1996 which, given the scale of new issue activity last year, will be an even more handsome sum. The reason is simple. He feels that world share markets are at or close to their tops. Instinct tells him that stocks are unlikely to move up substantially from their present values and may well fall back. But the same banker is rubbing his hands in glee at the prospect of another year of hectic activity in international equity primary markets, during which he will be urging buyers to exchange their cash for shares. “If just a fraction of the deals we have in the pipe-line are done this year, we will have a very strong 1997,” he chortles. Apparently, he has no qualms about briefing his firm’s equity sales force and through it end investors of the tremendous buying opportunities to be had in subscribing to new share issues. He does not blush when admitting that his own cautious investment approach, while seeming prudent, has not, so far, proved wise. “Investors who have held on to cash have been penalized. They are not boasting about it.” The story is the same at every major equity capital markets desk. Bankers have scarcely had time to reflect on an extraordinary year just past new issue volume of international equity and equity-linked debt in 1996 was $113 billion compared with $73.4 billion in 1995, $96.2 billion in 1994, $84.9 billion in 1993 and $48.8 billion in 1992 before preparing themselves for more of the same to come. “New issue volume will be comparable to last year. There are a lot of fairly price insensitive vendors out there namely governments which will continue to sell stocks,” says Alex Graham, director of equity capital markets at Salomon Brothers in London. Meanwhile institutions and retail buyers have plenty of cash available to invest. So for the moment, the conditions are right for the new issue boom to continue. But in the back of everyone’s mind is the worry about a possible secondary market crash that might abruptly close the new issue business down. European privatizations are the most obvious and imposing source of new supply scheduled for this year. With Italy and Spain leading the way, governments intend to raise some $53 billion in 1997, compared with $43 billion last year, according to research compiled by jp Morgan. Europe feels like the very centre of the international equity business. In the electric utility sector for example, Salomon Brothers expects up to $2 billion worth of new issues this year in America. That pales beside the $10-billion worth of Endesa stock which the Spanish government still owns, most of which it would like to sell. While bankers expect a reasonably quiet start to the year the first quarter is traditionally slow for equity fund raising as companies collate and publish their prior year financial reports even in January they were already working on a number of sizeable transactions including the sale of shares in the Spanish telephone company, Telefonica. That may well set the tone for the year. Telecom stocks comprise a substantial part of the enormous forecast supply. The first sale of shares in Telefonica in September 1995 was not a conspicuous success the share price fell 6% within the first month of trading and the market will watch closely how the Spanish Treasury and its lead banks handle this follow up. “It was a difficult deal at a difficult time,” recalls one banker. “Now we are in a much more favourable market for global equity and Spanish stocks in particular.” The second quarter will be extremely busy, with huge deals scheduled including the flotation of the uk’s Halifax Building Society which plans to convert to a bank and the privatization of France Telecom, potentially the deal of the year. “April, May and June will be quite exceptional,” predicts Amir Eilon, head of capital markets at bzw, “with it all building to a crescendo in June itself. Half of the six month calendar is due to come to market in June. And in some ways you could say the second quarter is the year.” The schedule for the second half of the year is somewhat harder to discern, although highlights in the fourth quarter should include privatization of the Italian telephone company, Stet, and possibly other large Italian transactions. Can it all be done and on schedule? Yes, says Jerker Johannson managing director at Morgan Stanley International, “as long as the present high level of liquidity prevails, we believe that the market can absorb this kind of volume. And the degree of visibility helps. The market prices new supply into already listed stocks.” As to the question of timing, he continues: “There has been too much fuss over whether it is possible to complete deals within a certain number of weeks. In the us domestic market, lead managers often execute several deals a day. As the European markets mature, investors and sales forces will become used to handling and analyzing several deals at once.” But Morgan Stanley’s own esteemed market strategists are not so reassuring. Barton Biggs is quite negative on prospects for the us equity market, forecasting a 10% price fall sometime this year. A poor performance there might have a damaging affect on other major markets. Richard Davidson, the firm’s European strategist, is not quite so pessimistic as Biggs, but cautiously forecasts a moderate 10% performance across Europe for this year. The truth is that most bankers working in equity capital markets are simply crossing their fingers and hoping that markets will stay kind. Graham, at Salomon Brothers, is strongly reminded of January 1994. “We are pretty much back where we were then. Nobody is ready openly to admit that there is any risk of markets collapsing, but then it only took a 50bp hike in interest rates to blast the equity market in 1994. Today, people are saying that the market is well prepared, or that it simply won’t happen. But that’s just how they were thinking in early 1994.” Eilon, while pleased that bzw has as many transactions pending as it has ever had, is cautious about the huge calendar in the second quarter. “I’m sure it can’t all be done. Some deals will be deferred; some may be accelerated.” What worries him is not simply levels of liquidity he agrees that there is plenty of cash around but investors’ propensity to buy. If investors begin to believe that stock markets cannot go on performing so strongly, they will begin to build up cash. Indeed some market veterans rather wish a stock market correction would come sooner rather than later. “Many would welcome a short, sharp fall of around 10%,” says Paul ffolkes Davis, managing director at NatWest Markets. “Until something like that happens, investors will be nervously expecting it.” That nervousness about how equity investors might anticipate a market downturn is exacerbated by a second worry for lead underwriters. Increasingly, they feel squeezed between the demands for good investments of increasingly sophisticated investors with a wide number of stocks to chose from and of experienced vendors who are keen to extract the highest possible valuations from the market at the least expense. The French Tresor, never an issuer to make life easy for investment banks, provides an example of how a regular seller of stock can become aggressive with bankers. Most French privatization secondary sales of stock are now conducted as block trades or bought deals. Instead of indulging in lengthy marketing campaigns and building a book of orders, the French treasury asks banks to bid at very short notice for large blocks of stock and expects winning banks to bear the risk of a share price collapse while placing the stock. “When they first appeared, you had three or four days notice, during which time you pre-marketed stock, so that by the time you came to bid officially, you already had the deal sold. And discounts were 3% or 4%,” recalls Davis. “Now, they tend to be done as blind auctions. Visable discounts are coming down to 1.5% to 2%, often on less attractive, less liquid stocks. And those firms which aren’t keen to bid, can find that their prospects for future business are damaged. It’s an exciting development from the market’s point of view but there is always the danger that one day, one of these is going to go wrong.” In truth, the French have been canny. Many of the market’s leading firms have joined together in consortia to work on privatization sales. So when the French government asks for competitive bids on the stocks of these companies, no firm wants to appear weak and bid lower than its peers. Unfortunately for nervous bankers, it’s not just the French government which is hooked on block trades. Increasingly, corporate shareholders are keen on using the mechanism to dispose of unwanted investment. Most bankers agree that the financial rewards for executing large block trades do not adequately compensate the risk. Nor does executing such nerve-jangling deals necessarily forge a strong relationship with the vendor. The winning firm has no opportunity to impress the stock seller with the acumen of its research analysts, its clout with key investor accounts or the hard-driving quality of its sales force. All it reveals is its appetite for risk. “From a commercial viewpoint, doing these deals is nutty.,” says one banker. “We are all playing with fire and one day soon one of these deals is going to come badly unstuck.” Banks should turn down block trades this year. But they probably won’t. Banks feel compelled to compete for every scrap of business, even in a hectic new issue market. The reason, explains Eilon at bzw, is that banks have seen fees for privatization business decline from 4% three years ago, to 2.5% to 3% on certain high-profile European secondary sales. Banks want to make up in volume what they are losing in fees and they may be tempted to push the market too far, to try and sell stock at the wrong price at the wrong time. Combine such pressure on intermediaries with fragile investor confidence and it’s easy to understand why Eilon says: “This year, accidents are out there waiting to happen.” A badly handled new issue, one in which the share price falls quickly after launch and primary market investors lose lots of money, could hurt other new issues. What may see the equity new issue business through any such downturn is a trend within Europe towards greater equity investing. Johansson at Morgan Stanley explains: “In continental Europe to date, the percentage of insurance company and pension fund assets invested in equities is quite low. What we are beginning to see is a strategic move out of fixed income and cash into equities.” Johansson is reminded of the big shift of us institutional money into overseas equity two or three years ago. “From 1987 to 1992 we all talked about that a great deal without much happening. But when the flows really started in 1992-1993, they were immense. You had single us pension funds putting $5 billion into international equities in a short space of time. We are about to see something similar in Europe.” Though new issues have been slow to appear in January, secondary market volumes have been heavy. In the first three weeks of the year, us stocks, which some investors thought had become overvalued, rose by 6% on daily volumes of 500 million shares, 20% greater than last year. European markets have touched all time highs. Demand is strong. Partly that reflects a favourable economic outlook, with moderate growth, subdued inflation and steady bond yields. More importantly it reflects this shift of money into equities. Lucinda Riches, executive director at sbc Warburg, points out: “In Germany until recently institutions were 90% invested in bonds. That will change. The Deutsche Telecom issue shows the spread of an equity culture. In Portugal, domestic institutions were less prominent buyers of privatizations two or three years ago. Now there are more Portuguese institutions submitting larger orders with every deal. And many European companies are growing uncomfortable with their unfunded pension liabilities. As they move to being more fully-funded that will push more money into equities.” Retail investors in certain countries also are being presented with cash to invest. In the uk, the de-mutualization of the old building societies and insurance companies is usually accompanied by payments of hundreds or thousands of pounds to account holders. Some of that will flow into personal equity plans. An added twist to this will be that more of this investing will be cross-border, as European economies and capital markets converge and the single currency is introduced. For the moment uk-based fund managers have large international holdings, many of their continental counterparts do not. “When you market a French stock, you don’t really bother going to Milan to sell,” says Graham. “But that will begin to change as European investing will go from being 20% sector-based, 80% regional, to the reverse of that.” If markets do stay strong, investment banks have more than just privatization business to look forward to. Dante Roscini, managing director at Goldman Sachs, points out that in 1992 there were just three international equity market issues worth more than $1 billion. Last year, there were 16 and of these, nine were corporate deals. It is these huge transactions on which the business thrives. The very large deals have come to account for between 55% and 80% of total annual volume and that trend towards more and larger corporate issues should continue in 1997. The exact pipeline is less easy to predict than for privatizations, which are generally publicized long in advance of coming to market. Corporate deals can spring up more suddenly. “Corporate deals are becoming a staple of the market and we will see more of them this year,” predicts Roscini. He adds: “More and more the very large corporate deals are what you might call event-driven, involving subsidiary spin-offs, placements of no-longer strategic holdings, as part of corporate restructurings, rather than simple fund raising.” Because many European companies are cash rich and there are few plain vanilla equity fund raisings, there is often an interesting story behind each corporate deal and that often helps to generate enthusiasm for stocks. Bankers are preparing for the spin off of hmr from Hoechst in German and of Ciba Specialty Chemicals from Novartis of Switzerland. Johannson at Morgan Stanley adds that; “There is also an ageing class of entrepreneurs and private company owners in continental Europe which is providing fertile ground for ipos.” The embrace of shareholder value in Europe is a trend which may outlast any market downturn and continue to provide new business for equity firms throughout the year. It was evident in the spate of uk share buy-backs in 1996 and may lead to more subsidiary spin-offs in 1997. Bankers certainly hope so. Fees are generally richer on corporate deals than on privatizations, often ranging on initial public offerings from 5% to 7%, depending on the size of the company, the popularity of the sector and the obscurity of the company. Moreover, firms outside the global bulge bracket are now finding that the roles of regional co-lead managers they may take in privatizations are simply not worth the trouble. That certainly was the lesson banks learned again during the Deutsche Telekom deal, the undoubted highlight of 1996. One banker says: “We originally expected to earn $5 million from that deal and ended up earning $1 million. We were sand-bagged by the lead managers. We had protracted fights with them, with the company and our own sales force which was at times on the point of mutiny. We can make more money on a corporate deal of one fifth the size of a major privatization, control the process better, endure less hassle and not tie up our resources unproductively.” One sector where there may be much corporate, as well as privatization business is telecoms. The forthcoming government sales Spain’s Telefonica, France’s France Telecom, Italy’s Stet are well known. Bankers wonder what other small deals might be lurking among the second gsm licence holders and alternative network providers. Some phone companies may wish to fund the building of infrastructure in foreign markets with partial equity sales in these projects. Such telecom deals may be smaller than the privatizations and even fewer, but for the lead banks they may be more rewarding, with fees of up to 7%. Sceptics question how many more telecom stocks international investors are willing to buy following years of heavy issuance. But in most developed countries, where more and more data and services are being transmitted through telephone lines, the telecoms sector is a huge and still growing proportion of national gdp. In America, a general equity portfolio may have as much as 10% of its investments in telecoms and Europe may be heading that way. In the emerging markets, the capital needs of telecom companies are huge. Other sectors which may be in vogue this year are financial institutions insurance companies are on the point of a substantial consolidation, mutual companies such as British building societies are converting into stock companies. In Italy, the foundations which own many banks have to diversify and sell off part of their bank holdings in the process. Auto companies, auto components makers and engineering may be active, likewise transport and related infrastructure. Just one sub-set of transport and infrastucture is European airports. There are just three public stocks, the uk’s baa, Copenhagen airport and Vienna airport. baa has a market capitalization of £5.3 billion. Using that as a rough guide, the market value of Germany’s international airports could be up to $15 billion and at least one should make it to the public market this year. The public equity markets will face strong competition, particularly in spin-offs of companies’ subsidiaries, from trade buyers. Sometimes preparations for anipo can flush out an industry buyer and what was planned as an equity deal becomes a private mergers and acquisitions transaction. Sometimes private buyers will pay higher multiples. Equally, there may be only a few industry buyers capable of bidding for a large subsidiary. And if recent strong ipo markets continue, many sellers will choose to use the equity route. Increasingly, vendors are likely to appoint advisers capable of the so-called dual-track approach. They will give their business to banks strong both in m&a and in equity capital markets and prepare to sell divisions without ruling out either method until the last possible moment. That should enhance the dominant position of the leading international investment banks. Another trend most banks predict will continue is for smaller, stronger syndicates. Riches says: “There will be fewer passengers in the junior roles and more teaming up between global co-ordinators.” For emerging markets, 1997 could be the year in which deals from Russia, the former cis, eastern and central European countries finally come to fruition. Many transactions have been worked on and talked about for two years and more and the potential back-log is now enormous. One of the more exotic and challenging might be the Serbian or as the Serbs themselves prefer to call it, Yugoslavian telephone utility. After that, Turkey Telecom, which has been in the works for more years than most bankers care to remember, should be perfectly simple and straightforward. |
