Back in business

HERE’S A QUIZ question. The following equity capital markets deals were all done in the same month of the same year: the first convertible for a dot com in Europe; the largest ever sole-managed block trade; an accelerated book build for a technology company equivalent to 50 days’ trading volume priced at a premium to the close. When was this? The answer, which may come as a surprise to many, is last month. Lastminute.com’s e103 million convertible, Dutch telecom KPN’s e2 billion block trade, and the French state’s sale of 16% of software company Dassault Systèmes for e600 million, were all successfully executed in September.

Global equity capital markets volume in the first nine months of 2003 was down 5% on the same period in 2002, making for the worst first three quarters since 1997 according to Dealogic. But there were strong levels of issuance in the second and third quarters. This suggests that the primary equity market is back in business.

It’s only following the trend in the secondary market. Fears about the war in Iraq and mixed economic data kept issuance low in the first quarter but the strong rally in the stock markets since March has given issuers the courage to raise equity again. The last time the Dow Jones saw an equivalent rise was between October 1998 and April 1999. It’s intriguing that global ECM activity over the past two quarters is even higher than it was then.

And along with issuers, investors have begun to brave the equity markets again. Inflows into US mutual funds turned positive in April for nearly the first time in 10 months and the trend has continued since.

In September vendors took advantage of this with several significant transactions that have raised the spirits of ECM bankers who are now hopeful that issuance will remain buoyant. Already the slimmed-down equity markets divisions of several houses are rumoured to be straining under the pressure of higher deal volumes. As a result there has even been a moderate pick-up in hiring in equities, a real sign of confidence, with several big firms adding to their sales and sales trading teams. And there has been intensive activity among new boutique houses.

The newly revived equity markets are not returning to the IPO fever that prevailed until the bear market began in 1999. Different classes of deals are now being done.

Convertibles have risen to prominence this year, accounting for 50% of global ECM volume in the first nine months, up from 32% in the same period in 2002.

The first stage of this boom was driven by low interest rates and high volatility, raising the value that issuers can extract from selling options. Even as underlying equity market volatility has come down, the rising strength of the market has made convertibles attractive to a newer set of issuers.

“The convertibles market has often been a herald of activity in the equity market,” says John St John, global head of equity capital markets at Dresdner Kleinwort Wasserstein (DrKW). “We’ve also started to see use of the product filter down from blue chips to smaller issuers. Issuers are coming to the market opportunistically, not out of desperation, because the market looks attractive. It’s a reflection of a return to health of the market,” he says.

UK property firm Liberty International, which issued a £240 million ($385 million) convertible in September, managed by Morgan Stanley and UBS, is a good example of an atypical convertible bond issuer that suddenly found the product attractive because of the strength of the market. Liberty has stayed away from public financing sources for five years, with the exception of a secondary share offering in November 2002, financing itself instead through securitizations. Despite low volatility in the firm’s stock, Liberty was able to tap the convertibles market to issue shares at an implied premium to its net asset value, a particular goal for property companies. The deal, the largest from a European property company for five years, has an indicative coupon of between 3.65% and 3.95% and a conversion premium of between 19.7% and 23.4%.

All-time high “So far this year it has mainly been low interest rates and high volatility that has made the convertibles market attractive,” says James Eves, head of European equity linked at UBS. “But for Liberty it was the very strong performance of its share price, which hit an all-time high a couple of weeks ago and more than offset its decreasing volatility.”

Because the equity story, not volatility, was the key driver, the deal attracted mainly outright investors and not hedge funds, the largest pool of investors in the convertibles market. This meant that the deal was not priced aggressively, but less distribution to hedge funds is something that many issuers prefer.

While the volume of global convertibles issuance in the first three quarters of 2003 increased by 50% to $121.7 billion on the same period in 2002, the third quarter of 2003 was the first this year in which stock issuance outpaced convertibles.

This was helped by large transactions such as the e2 billion KPN privatization block trade on September 19. Sole bookrunner Citigroup placed 300 million shares for the Dutch state at e6.78, a 0.4% premium to the previous day’s close: an impressive achievement given that the stake was equivalent to 26 days-worth of trading volume. “We launched the deal at 7am and sold it in under two hours,” says Darrell Uden, European head of syndicate at Citigroup. “The deal’s removal of an overhang that was holding back the share price performance, combined with KPN’s strong value story, made us confident that we could place the block close to the market.”

As well as being the largest ever sole-led risk trade the deal is second in size only to the £3.2 billion Vodafone block managed by Deutsche and Goldman in 2000.

Hard underwriting and bought deals have been a notable feature of equity capital markets since the downturn. The decision of Deutsche Bank and DrKW to lead UK multi-utility United Utilities’ rights issue without underwriting is therefore another sign of revived confidence spilling over from the secondary market into new issues. It would have been unthinkable just a few months ago.

“Its not the first time a rights issue has not been underwritten,” says David Hutchison, head of UK equity advisory at DrKW, referring to BT’s hefty £5.3 billion issue in 2001. “The company’s reasons for seeking equity are well appreciated by investors and with its relatively low-risk profile we felt that underwriting would be an unnecessary expense.”

The heavily geared utility wanted to raise equity to fund a £6 billion infrastructure upgrade plan running until 2006. Because of the time scale of the capital expenditure plan the deal’s managers decided to structure the deal in two tranches. The first stage of the rights issue raised £510 million, with the rest of the proceeds from the five-for-nine issue to be received in 2005. In total the rights issue will raise £1 billion. This approach enabled the company to cut the cost of equity raising while being up front with shareholders about its future needs.

ECM bankers are constantly fantasizing about European privatizations. A number of attractively sized assets have already passed through their hands this year, including KfW’s $5.7 billion Deutsche Telekom exchangeable in August, the largest convertible ever, as well as the e1.3 billion sale of 27 million Renault shares by the French state in July. More are on the horizon. Further sales in Deutsche Telekom, Deutsche Post, Deutsche Bahn, KPN, Electricité de France and Gaz de France, are all thought to be coming to the market over the next few years.

“This time it is the need to raise cash for national treasuries struggling to stay within the eurozone’s budget deficits rules rather than Thatcherite ideology that is driving the process,” says DrKW’s St John. “There are a number of elephants in the pipeline but the limiting factor at the moment is that retail investors are still off the radar screen. A lot of e2 billion to e5 billion sales could be easily handled by institution-only accelerated book builds but until retail demand comes back the e10 billion to e15 billion-plus deals will probably stay off the menu. The big difference between this next wave of privatizations and the last will be that governments will increasingly use exchangeables to dispose of their stakes, just as in the private sector,” says St John.

On September 18, JPMorgan completed what it claims is the first combined equity and equity-linked secondary offer from any government, when it led an exchangeable and secondary offering of a 34.7% stake in steelmaker Voestalpine for Austrian state holding company Österreichische Industrieholding (ÖIAG). Some 25% of the company’s shares were sold through the fully marketed equity offering, which priced at e32.50, flat to the previous close. The rest was disposed of through the e245 million exchangeable, which carried a 1.5% coupon and 27% premium.

The bookrunners imbedded an innovative soft mandatory element into the deal’s structure. This enables the government to repay the principal in the form of shares plus cash, so even if the exchangeable is out of the money and fails to convert ÖIAG will be able to fully dispose of its shareholdings and participate in some upside.

“What this and other recent deals show is the diversity of products that sovereigns are now prepared to use,” says Viswas Raghavan, co-head of equity capital and derivative markets at JPMorgan. “We used to only see fully marketed deals or accelerated transactions but now the full spectrum of products have been embraced.”

A couple of quarters of more normal activity in the markets may not sound like a lot to get excited about. But considering that this follows three years of shrinking new-issue volumes and large-scale ECM lay-offs, and more recently three consecutive quarters of truly pathetic issuance, the market is buzzing. Bankers are asking if the new-issue revival be sustained and which firms are best positioned to profit if it can.

Whispers There are whispers that some investment banks – Merrill Lynch is mentioned most often – are already being stretched by the current level of activity. Merrill says it is now “right-sized”. But if equity markets continue their revival and global ECM activity, closely correlated with valuations, continues to increase accordingly, then it may not be long before many ECM desks find themselves unable to cope, having cut staff so brutally in the past few years.

Time will tell who has best used the downturn to rebuild their businesses for the years to come. In Europe many top investment banks cut back heavily on coverage of small and mid-cap stocks. “The rally over the last three months began in the micro-cap stocks and then moved to the small, the mid, and finally the large,” says Giles Fitzpatrick, head of European equities at ABN Amro. “Those houses that cut back on their smaller-cap coverage would have been embarrassed by that.”

There are already tentative signs that banks’ equities divisions are starting to hire again. SG, DrKW, and ABN recently announced a number of new hires for their equity divisions. SG intends to recruit 20 staff for its client-facing sales and programme trading teams on top of the 150 total hires it intends to make for its fixed-income and equity-derivatives teams.

DrKW has made a string of new hires over the past few months, including a four-man prop trading team last month and a new head of corporate block trading. This follows earlier hires in, among other areas, portfolio trading, FIG origination, equity derivatives, and securities lending.

ABN Amro also made five new hires in equity research in September.

Deutsche Bank too announced new appointments involving a reorganization of the senior management of its US ECM business. Rich Byrne was appointed to lead Deutsche’s US ECM business and will oversee the work of Douglas Baird, who will continue to run the business. Deutsche Bank also announced its intention to hire as many as 10 more bankers for its US ECM and corporate finance teams.

“There have been tentative signs of a pick-up since the summer,” says David Grant, a headhunter with Allemby Hunt in London. “There has been buoyant activity in sales and sales trading especially among the new boutiques that have set up, as well as some reshuffling between the sell and buy sides, although the increase in in-house research at the buy side has been less than forecast.”

Bridgewell, Seymour Pierce, and Teather & Greenwood, three London brokers, are among the most visible boutiques to make new appointments. Seymour Pierce hired three salesmen from ING, BNP Paribas, and Investec as well as several equity analysts. Teather & Greenwood hired three new analysts, and Bridgewell one.

The litmus test for the health of the equity capital market has traditionally been IPOs. Nothing shows investor confidence more than their willingness to invest in new companies without a coverage record. Dealogic numbers again show that, taken as a whole, the first nine months of the year have been dismal, with only 354 IPOs so far, raising just $23.4 billion, accounting for just 10% of ECM volume by value. This compares with 646 IPOs over the same period in 2002 that raised $47.3 billion and accounted for 31% of ECM deals.

Again, third-quarter figures give renewed hope. At the start of August there were only 25 deals registered with the SEC expecting to raise $3.3 billion. But 71 issuers filed with the SEC in August, the highest number since June 2002. August also saw filings for 24 IPOs, the most since October 2000. The last week of September saw four US IPOs, including one for a semiconductor manufacturer, AMIS Holdings, and one for an online gift retailer, Red Envelope. This, according to IPO research firm Renaissance Capital, is the first online business in the US to go public since May 2002. All four IPOs traded up from their initial offer price.

Before banks get carried away with optimism and start hiring indiscriminately, some sobering data should be considered. Although there has been ample investor demand recently, State Street’s quantitative investor confidence index, which models investor behaviour based on observed changes in risk appetite, showed a marginal fall in September. The index fell to 103.4 from 103.6 in August, but is still well above the 96.4 average in the first half of the year.

“I think that levels are likely to accelerate but there is a strong element of fragility to the recovery and it would take relatively little to make it start to crack,” says Dante Roscini, global co-head of ECM at Merrill Lynch. “Disappointing earnings, an economic shock, or another massive terrorist act would probably be enough to throw a spanner in the works.”