Japan’s corporate cross-shareholdings are being unwound at an ever-increasing pace as the historical ties have come to feel more like handcuffs for modern management. But while in Germany – the other major economy where corporate groupings built in the aftermath of the Second World War are breaking up – the exchangeable bond has been used extremely effectively a number of times, it is yet to become a commonly used instrument in Japan. “We are extremely keen to get the orthodox, corporate listed exchangeable bond structure working in Japan,” says Michael Remington, a managing director in Credit Suisse First Boston’s investment banking division.
But there are obstacles that are making this and other sophisticated equity capital markets techniques difficult to establish.
Overwhelmingly the domestic banks are unwinding by simply selling down their shareholdings into the market using the block trade.
In western markets, the risk of block trades is that a sudden huge new supply of stock will depress the share price, punishing the seller if it retains any position. Although in Japan, bankers attempt to pre-place shares, rather than dump them on the open market, it’s still a crude approach. And a slump in the price of shares can still occur. The $1.5 billion fully syndicated offering of Toyota shares is an example. When the marketing for the deal began on January 9 of this year, Toyota’s price slumped 7%. Bruised and battered, the deal was quickly pulled.
One banker suggests that because of the Japanese tendency to follow a lead, potential issuers are all looking at each other, waiting for one to take the plunge and actually market an exchangeable.
UBS Warburg’s George Olcott, managing director, head of equity capital markets Japan, who can boast 25 years in the country, also tries his hand at the psychological reasoning. “There is a tendency to think that when you do an exchangeable into another company’s shares, somehow that will result in a disturbance in the other company.” Having a bond outstanding and especially one that can be exchanged seemingly causes ripples in the harmony that Japanese society strives to maintain.
Olcott continues: “The situation will change. They will come to realize that an exchangeable is actually better for the other company’s shares than just dumping them into the market. After all, issuing at a premium shows confidence in the performance of the other company.”
Nomura’s Hiromi Yamaji, managing director and head of global investment banking, says that the reason that this market hasn’t accepted the exchangeable is quite simple. “From the point of view of the seller, it’s not a real, true sale.”
It is also possible that Japanese banks and corporates may not be confident that the shares of companies they are offloading will perform well enough for exchange options to be exercised, leaving issuers to make large payments of principal to investors at maturity.
Stefan Kosciuszko, director of equity capital markets at Credit Suisse First Boston, adds: “One really has to look closely at the banking system to discover why there has not been such an active market for exchangeables.”
He explains that since the banks and the corporates are looking for ways to improve their return on assets and to boost the efficiency of their balance sheets, the exchangeable doesn’t really solve this issue.
Kosciuszko continues: “A key consideration with an EB of five or seven years is whether and when your stock gets sold.” He says that this is one of the key reasons why the block trade is increasingly being used instead. It provides more certainty.
David Hatt, Nikko Salomon Smith Barney’s managing director for equity capital markets, takes up the explanation and focuses on the accounting method employed by the Japanese. “Even though you have effectively hedged against movements in the underlying price, the mark-to-market accounting rules in Japan are such that P&L and balance sheet swings can still take place as the underlying share price moves.” Hatt explains that because the earnings are skewed it makes the corporates and the domestic banks reticent.
Japan’s tax laws provide another reason why exchangeables are not used. In Germany the government finally announced measures last year to free banks and corporations from capital gains tax on disposals of large equity positions which may have been acquired decades earlier and could not be unwound without incurring hefty tax liabilities.
Yet Japanese banks and companies continue to seek outright, immediate sales. Remington says: “As the process steams along, and given the immediacy of the situation, there is going to be a need for an increasing effort to find straightforward equity portfolio demand.” The growing urgency to find buyers would seem to suggest that the exchangeable market will soon take off. The value of the exchangeable is that it might expand the base of buyers by attracting bondholders keen to boost returns through equity options. But as always in Japan, it’s a case of waiting and wondering who will be brave enough to break from the herd and attempt something new.
