Not so long ago, a large stake in Deutsche Telekom would have been a nice asset for any company to have on the balance sheet. When telecom companies were all the rage, such holdings could be sold for a healthy profit. By last year, however, such a block of shares was far more of a millstone than a jewel.
When Chicago-based Telephone and Data Systems (TDS) found itself needing to dispose of assets to improve its own situation – including more than 130 million shares in Deutsche Telekom – the options looked limited. Of course, it could sell the stake into the open market, but it was painful to think about the money it could have raised had it done that sooner. What’s more, the company felt sure that share prices wouldn’t stay at such low levels for ever. On top of that, TDS wasn’t keen on a large tax bill.
The solution was to use a structure that got TDS its capital up front but meant that if Deutsche Telekom’s share price recovered, the seller wouldn’t miss out entirely on the economic upside.
Three-bank split
TDS entered into three transactions with different banks during the second half of 2002 that enabled it to monetize its entire holding in Deutsche Telekom. On each occasion, TDS bought a put option from its bank at the current share price and sold it a call option with a strike price 30% above the present value. The average strike prices were e11.66 for the put options and e14.45 for the calls. Each bundle of options is European-style and has the same maturity of between five years and five-and-a-half years.
After establishing this collar, TDS then monetized the stake by borrowing the current value of the shares from its bank, which did not have to syndicate the loan because the company pledged its stake against the put option. As Toby Smith, head of European corporate equity derivatives at Citigroup, which handled one of the sales, explains: “When a company is buying a put and selling a call, it is possible for one counterparty to do this type of transaction in considerable size. That’s because the net vega [change in the price on an option that results from a 1% change in volatility] is one-fifteenth of the size it would be with a normal exchangeable.”
The transaction left Citigroup long Deutsche Telekom. To cover itself, it shorted 90% of the underlying shares in the market outright and also ran a delta hedge for the remaining 10%, which is adjusted on a daily basis. This means that the banks make money on the downside, should they have to pay out at maturity.
When the contracts mature, if Deutsche Telekom’s stock price is below the put strike then TDS can exercise the put option to force the banks to buy the shares at e11.66 each. However, if its valuation has risen above e14.45, the banks will trigger the call option and TDS will be obliged to surrender any gain above that level to the institutions. “The company has no downside risk and a small upside participation. We take all of the downside exposure below $11.37 and all of the upside above $13.64,” says Smith. How the bank hedges these exposures within its overall equities and equity derivatives book is its own business.
To keep the tax man happy, there has to be a small window of share prices – between the put and the call strikes – that would result in TDS retaining the shares. If the share price is between the put and the call option at maturity then TDS must repay the bank loan. “The likelihood of non-conversion is often small but there has to be a certain degree of probability that this will not happen,” says Smith. “The precedent seems to be around 20% between the call and put strikes but we have seen 15% in some cases.”
From a fee perspective, this deal was not as costly as might be expected. TDS received $1.4 billion up front in return for its Deutsche Telekom shares. Because TDS also receives a premium from the bank in return for the call option, this finances part of cost of the put option it has bought. The icing on the cake is that TDS has no tax to pay on this gain for five years as, technically, it still owns the stake.
