IN FEBRUARY, DEUTSCHE Bank launched a e1.06 billion mandatory exchangeable into USA Interactive, a subsidiary of Vivendi Universal. That doesn’t seem a big deal: financial institutions are often able to access markets closed to other issuers. But beneath the surface this was not a straightforward transaction.
Though Deutsche provided the market with few details about the transaction, bankers at rival institutions deduced from comparing the terms and maturities of the warrants and the bonds that the seller was Vivendi itself. It had owned 60 million warrants in USAI since 2001, when it acquired some assets of USA Entertainment. On the back of a strong set of results from USAI, Vivendi was keen to raise some much-needed cash via a disposal. But it hardly took genius to work out that another exchangeable from the beleaguered French media firm would not go down well.
So instead of coming to market with a block trade in USAI or an exchangeable bond, Vivendi entered into a series of hedging arrangements with Deutsche Bank, the upshot of which was that it effectively disposed of some of the warrants – 21 million with an exercise price of $27.50 and 7 million with an exercise price of $32.50 – and raised $240 million in the process. Deutsche Bank was then able to structure and launch a nine-year floating-rate exchangeable deal in two tranches – one for $777 million issued at 134.5% of par and with a conversion price of $27.50 and another $285 million tranche issued at 125.2% of par with a conversion price of $32.50.
Deutsche Bank effectively created a security that enabled investors to rely on its own creditworthiness and not that of Vivendi. At worst, those who bought the convertible will end up holding a Deutsche Bank bond. At best, they get to play the USAI recovery story. This deal was particularly complex, given that Vivendi owns warrants rather than shares in USAI, but it’s a timely example of a growing trend in the equity capital markets.
While old-style equity capital markets business has slowed to a trickle, if not an intermittent drip, it’s a different story for equity derivatives. Bankers say the corporate market is seeing bucket-loads of business at the moment and the private market in particular is booming. In a bid to capture more of this business, many banks have reorganized. “Traditionally the desks were separate but as the derivatives products become more mainstream, banks are merging corporate derivatives and equity capital markets,” says John Porter, head of European equity syndicate at Morgan Stanley.
Deleveraging in an imperfect world
That strategy seems to be paying off. Significant numbers of corporates are focused on deleveraging and those that aren’t probably should be. In a perfect world, they would issue their own equity to raise capital. Enough said. The next best alternative is to sell any holdings in another company, particularly when such stakes are considered non-core by the market. But many CFOs are reluctant to sell shares at depressed prices in fragile markets, where the mere hint of a block of shares for sale might drive the price down. The desire to achieve higher valuations is currently driving a new wave of structured equity capital markets transactions.
“There are corporates that have to sell, regardless of where the market is,” says Salvatore di Stasi, head of structured equity products at JPMorgan. “The common perception is that the market is going up so almost everyone is buying derivatives today rather than doing straight sales.”
Serge Marquie, who heads Deutsche Bank’s strategic equity transaction group, agrees that the types of deals being seen today are a function of market conditions. “Why would you do something complicated during a bull market?” he asks. “When every equity issue is going up, you don’t need to worry about efficiency as much. Today we don’t see any corporate that isn’t looking at all the possibilities.”
Those transactions that do see the light of day may involve a credit wrap, as in the Vivendi case, or often a hedging solution. “Recently transactions have become more and more tailored as issuers become more and more demanding,” says Toby Smith, head of European corporate equity derivatives at Citigroup. Many corporates are also turning to private issuance as an alternative to the unappealing prospect of exposing themselves to the wilds of the public markets.
One option for these types of companies is to enter into a straightforward hedge with a relationship bank. This involves buying an out-of-the-money put from the bank at, say, 90% of the current share price. To reduce the premium a company has to pay, its CFO could then choose to sell another out-of the-money put option at say 70%, giving protection at between 70% and 90% of today’s price. The advantage of this structure is that he is able to capitalize on any upside that might result from a rising share price. The disadvantage is that downside protection is limited to 30% below the current share price.
An expensive strategy
Another solution is to sell stock forward at a premium valuation. Just as three years ago forward purchases were all the rage to try to mitigate rapidly rising share prices, now the opposite is true. Forward selling involves the corporate agreeing a price in the future with the bank, which then borrows the shares and sells them to hedge the downside. A put option can be used to do this but then the company runs the risk of non-conversion if the share price is above the put strike price at maturity.
As selling stock forward using a put can be an expensive strategy, firms often sell a call option back to the bank to subsidize the premium it has to pay. This is a classic equity derivative collar. Given the recent fall in interest rates, however, bankers say it’s difficult today to structure such deals in a way that makes them cost-effective. Because interest rates are so low, it is difficult to get sufficient spread between the put and the call to provide the client with a zero-cost hedge. “Traditional collar economics have gone away because of the low interest rate environment in Europe,” says Graham Clark, a managing director in equity capital markets at Merrill Lynch.
Some corporates have also written calls – allowing bank counterparties to buy stock from them in future at a price agreed today – without buying a corresponding put. “High premia are available for those willing to sell calls because the markets are so volatile,” says Nick Hanbury-Williams, global head of block trades at UBS Warburg. Others have lent stock. Suez is said to have lent a stake in Fortis to Deutsche Bank. The only real benefit in such strategies, however, is the premium payment received from the bank. Simple call writing means giving up any right to appreciation above the strike price – unless the strike price is set high, so allowing the vendor to benefit from the first move up in the share price but reducing the premium received for an out-of-the-money option.
An alternative is to sell assets to a bank or a consortium of banks and do an asset swap. Recent examples of this include Mediobanca’s sale of a stake in Fondiaria, and Fiat’s December sale of a 6% stake in General Motors to Merrill Lynch, keeping the upside via an equity swap. One of the best-known instances was BSkyB’s monetization of a stake in Vivendi in 2001. This was not entirely related to the seller’s need for funds, as there were also regulatory issues that restricted BSkyB’s ability to sell. A lot of the transactions being seen today, however, are being done purely for the sake of raising financing.
The advantages of this type of deal is that the company gets immediate liquidity, as it would if it sold the stake, but unlike in a straightforward sale it also gets to keep part of the potential upside, depending on how the deal is structured. (see box) “What’s very interesting is how quickly this product has become a commodity,” says Marquie at Deutsche Bank. “What was the exception is now more and more common.”
Keeping it discreet
Another factor motivating the increased use of derivatives – besides the need to raise higher levels of financing than might be available in the open market – is the need for discretion. That’s particularly true when the company might be considered an insider in the firm whose shares they hold. In this case, selling openly risks sending a damaging message to the market and pushing down share prices further still. That was the case for Santander Central Hispano when it needed to dispose of a stake in Royal Bank of Scotland at the end of 2002. SCH entered into derivatives contracts with a number of banks which then gradually sold RBS shares to unwind those contracts over several months. This approach also gave some flexibility to SCH on how much of its stake in RBS it had to sell to achieve its tier 1 capital target while it also pursued other disposals.
This type of transaction, where the bank acts confidentially as an agent for the client, is increasingly common. “We did quite a lot of these deals in the third and fourth quarter of last year,” says one banker. The advantage is the client is able to get a better price for shares if they are dribbled bit by bit into the market rather than being sold all in one go. However, banks aren’t overly keen to do this business as, being confidential, it gets them no league table credit and is time-consuming because they can’t use their salesforce.
For many companies – perhaps too many – sitting tight has been the answer to today’s lowly equity valuations. Financial institutions such as HVB and Commerzbank as well as such companies as Vivendi, Suez and Philips have businesses on their balance sheets that they could sell but haven’t yet. “All these companies are doing is punting on the market going up again. They’re doing no favours to themselves or to the companies they hold,” says a banker keen to do some aggressive marketing.
Granted, it’s in his interests to say that: but proceeds from selling or monetizing a stake could be used to pay down expensive debt. Surely it makes more sense to do this than to gamble that the assets will appreciate enough to yield more than the interest payments on the debt cost?
With the variety of options now on the table, some of which have tax benefits as well as funding advantages, there is no excuse for inaction other than a considered view on a forthcoming upturn in share prices. “The menu of options has certainly expanded,” says James Eves, head of equity-linked at UBS Warburg. “There are now seven or eight products I would think about when a company says they want to do something that isn’t debt or equity. Two years ago there were probably three or four.”
Some firms are still reluctant to use derivatives in place of straightforward equity transactions, either because they themselves feel uncomfortable with anything that smacks of financial engineering or because their boards do. A finance director at one institution ended up resigning after a dispute with his board over call options he had sold. The options had a strike price 14% above the current price. When the shares rose 15% in three months, he was reprimanded for having cost the company money.
But that attitude seems to be dying. “The percentage of situations where clients are considering derivatives to dispose of assets is between 70% and 75%. In the past it was probably 30% or 35%,” says di Stasi at JPMorgan.
Most bankers feel that, while the derivative-based and equity-linked transactions dominating the equity markets today reflect current conditions, they also indicate a growing awareness among corporates of the technicalities of equity markets and an acceptance that equity sales can be dealt with in the same way as liability management by sophisticated treasury teams. “I’m convinced that when the equity markets come back, there’ll be a lot of public transactions again but I think the change in the level of sophistication is permanent,” says Deutsche’s Marquie.
