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France Telecom: led the mandatory |
Mandatory convertibles in Europe are finally trying to catch up with their American cousins. The few banks that tried to introduce them in Europe found it a thankless task, despite their being an established part of the US equity-linked market since 1989. In 2002, though, there were unexpected signs of life.
Depending on definitions, there were at least four European mandatory issues over the year. Before 2002 there had been just three in total. The takeoff has given some comfort to European equity-linked bankers, who have had few deals to celebrate in 2002 after the glut of issuance the previous year. Not everyone thinks these deals are going to keep coming much beyond 2003, though.
France Telecom led the trend with a e442.22 million exchangeable into ST Microelectronics, enabling it to sell its stake in the chipmaker more attractively than it could have done in the equity market. Swiss Life followed in early December with a three-year Sfr250 million ($173 million) mandatory linked to its rights issue.
Credit Suisse came to market soon after with a Sfr1.25 billion mandatory. All these issues were led by CSFB. Vivendi Universal came to market with a e1 billion mandatory and Alcatel followed with a e630 million issue. Both deals were led by Deutsche Bank and let the issuers get round French rules on the discounted sale of stock. And at press time, Banco Comercial Português was planning a mandatory deal worth at least e700 million, the first use of the instrument by a Portuguese bank.
As the name suggests, mandatory convertibles automatically convert to stock at a set date. So they pass on the stock’s potential downside to investors in return for a higher than normal yield. The instrument enables issuers to get equity credit from rating agencies and – an important feature for financial issuers looking for more capital – from regulators. It is popular in the US with companies that want to secure a rating or to clear the way to issue more debt without getting downgraded – a profile shared by the companies issuing in Europe. The alternative would be a rights issue but this is sometimes seen as indicative of desperation.
For investors, the appeal lies in a high yield combined with limited exposure to the potential falls in the equity price. For example, for the Credit Suisse deal, if shares fall by 25%, investors will only suffer from around a fifth of that loss. But if they rise by 25%, they will get four-fifths of that gain. This asymmetric risk/reward profile is characteristic of most convertible bonds.
Olivier Sachs, head of European equity-linked origination at CSFB, says: “These deals are groundbreaking for Europe, letting the issuers get equity credit from rating agencies and regulators together with a lower cost of funding than would have been available in the equity market, in case the stock performs during the life of the transaction.”
Many market observers doubt whether a natural investor base outside hedge funds exists in Europe for mandatories. In the US, the arbitrage community typically takes up between 60% and 75% of a deal, with much of the rest being bought by income-oriented equity funds – an investor type that is rare in Europe.
Bankers involved with the deals say the European market is developing along US lines, though, and that they were able to get more equity fund participation than some had predicted. For the Swiss Life deal, this was around 40% of final allocations. Both Swiss deals found good demand – Swiss Life’s was more than four times oversubscribed and Credit Suisse’s more than two and a half times.
John McAvoy, co-head of European equity capital markets at CSFB, says the market’s development in the past year has been remarkable. He says: “The mandatory market is very well developed in the US – it’s been going since 1989 and has made up an average of 15% to 20% of the whole convertible market, and this year that’s been closer to 30%. So far this year, European mandatories have accounted for about 17% of convertible issuance.”
Sachs is bullish about the instrument’s future in Europe. “We’re confident mandatories will be much more widely used in 2003, and will become firmly established as a vanilla product,” he says. “Already we’re in discussion with a number of European issuers – corporates as well as financials – about the instrument’s possibilities. It’s a great way of shoring up your rating and balance sheet if you’re moderately bullish on your equity.”
He expects more convertible issuance, though the market will increasingly be split between plain-vanilla products and more structured areas such as mandatories, which need to be customized to meet local regulatory and tax environments. “If markets stay where they are, I’m convinced mandatories will form a bigger part of the European convertible universe,” he says. “If equities were to rally massively this might not happen so quickly, though, as more issuers would probably issue standard convertibles.”
Others in the market aren’t so sure. Martin Haycock, head of international convertibles research at UBS Warburg, says companies are still heavily indebted and need to repair balance sheets. “This inevitably leads to an interest in sources of finance that create equity-like capital. I’m sure we’ll see more mandatories in 2003 but eventually companies will have deleveraged and we will enter the next cyclical upswing. When this happens mandatories in Europe will become less prevalent and traditional convertible bonds will dominate once again.”
If and when equity markets recover, high-coupon mandatory issuance could look like an expensive way of raising funds. Then straight equity sales, or more standard convertibles, are likely to bounce back.
