The games that bankers play

EQUITY CAPITAL MARKETS are back on track – at least if the furious activity of the last week of June is anything to go by. In the US alone 23 deals came to market, according to Dealogic. Of these, 11 were convertible bonds. They included the second largest of the year to date, a $4 billion single-tranche offering from General Motors as part of a bumper pension plan refunding that also included a $13.5 billion multi-tranche, multi-region bond issue.

There were also 11 US-registered common stock secondary offerings, and even two US-registered IPOs. That week was the culmination of a marked increase in the number of equity deals since the start of May, once investors and issuers were no longer distracted by the invasion of Iraq. “It almost feels like bubble territory in terms of the number of deals being done,” says Doug Baird, head of US equity capital markets at Deutsche Bank in New York.

But don’t break out the champagne just yet. It’s much less easy to make money on secondary offerings and convertibles than it was even two years ago. The non-IPO equity capital markets business now demands more capital, more risk-taking, more deal-sharing and lower fees than ever before. It is, in short, becoming much more like the bond markets – though it’s not as profitable.

“Fixed-income divisions are bringing in roughly two times the earnings of equities right now, and the return on equity is higher as well,” says one senior executive. “But the headcount is probably roughly the same. So the answer is more rationalization. It’s what fixed income went through from about 1995 to 2000.”

The incredible IPO bull market of the late 1990s shielded equity departments from such downsizing. “Margin compression happened in fixed income 10 years ago,” says Mike Clark, global co-head of equities at CSFB. “But in equities, in the bull market, you could have overcapacity and get away with it.”

Clarke is trying to treat the recent downturn as a way to change his business fundamentally. “This is an amazing opportunity to reposition the franchise,” he says. “We need good people, and need excess returns to pay them, so we need to run an efficient franchise. We can be fifth, sixth or seventh in the league tables but in the top three in share of wallet. I’d rather hire four good idea generators than buy market share in low-bid secondaries.”

This is exactly the way bond market bankers started to talk in the late 1990s, especially after the crash of 1998. More equity bankers are questioning the value of the way so many of them used to prefer to be judged. “The league tables, in general, are less important than they were three years ago,” says Jeff Edwards, global co-head of equities at Merrill Lynch. “There used to be a very high correlation between the volume of new business you would do and revenues. That’s less the case now.”

This is especially true in convertibles, where desperation for league-table credit has eroded the market’s profitability. “A lot of convertibles issuance this year has been what I call manufactured deals,” says one equities banker. “Underwriters have been incentivizing companies to issue convertibles rather than bonds by creating structures that allow them to beat their Libor targets. These are bond deals, essentially, but are being manufactured to be equity deals so that the banks can get slightly better fees, assuming they price them right, but, more important, so they can get equity league table credit,” he continues. “It might work okay on the well-though-out deals, such as Wells Fargo and Sallie Mae. These are rated sufficiently highly to mean that you can be pretty sure that they won’t trade much below 98.5, so you even manage to keep some of your fee. But for other deals there are banks out there that seem willing to pay $5 million, maybe even $10 million, for $1 billion of league table credit. They’re buying a bond at the wrong price and getting league table credit for equity.”

And that’s not the only way to play the league tables game these days. Welcome to the fantastic new world of equity underwriting, where the best job is to be a bookrunner without books. It involves little or no work, yet you get to claim a portion of the bookrunner fees, an equal share of the pie in the league tables and the ability to tell your friends and clients that you ran that deal. “When there’s a pricing call for the deal, you might just be given the number so you can dial in and listen to what those actually running the deal are up to,” says one senior equities banker.

If you don’t believe such a dream job exists, just take a quick look at some figures from US equity and equity-linked capital raising in the US for the first half of the year. According to Dealogic, US investors had a choice of 222 secondary equity deals in the first half of the year, whether registered or 144a. Of these, 127 had a sole bookrunner; 43% of the deals had at least two bookrunners, compared with just 9% in 1999 and 19% in 2001. Multiple bookrunners, bankers point out, were unheard of 10 years ago.

A small proportion of deals this year – nine at last count – even had three or more banks listed as bookrunners. And these are not large deals. Chubb’s $803 million deal last month was the largest, with Willis Group’s $734 million deal at the end of April the next largest. All the others were for $410 million or less. One, for Allied Waste at the end of March, needed the combined underwriting and syndication prowess of UBS, CSFB and Citigroup to get a $100 million deal done. Any of these nine deals could easily have been handled by one investment bank.

Bevies of bookrunners It’s a similar situation in the convertible bond market. “The Xerox deal was replete with bookrunners,” says one banker, referring to the $800 million deal in mid-June, which had four banks listed as bookrunners: Citigroup, Goldman Sachs, JPMorgan and Merrill Lynch. These same four banks were also appointed bookrunners for the firm’s $410 million common equity offering. The two-tranche $4.5 billion deal for Tyco, had six banks listed as bookrunner. In June, General Motors appointed seven banks as bookrunners both on its straight bond deals and on its $4 billion convertible bond.

Seven bookrunners for a $4 billion convertible is beyond even the absurd state of affairs ruling the market for the first six months of the year. By June 27 there had been 147 convertible bonds issued in the US, according to convertbond.com. Roughly 40% of them had more than one bookrunner, and almost 20% had three or more banks touting their position at the top of the syndicate. Deals as small as $100 million, such as the one for LIN TV at the start of May, had three banks listed as bookrunner.

Few banks seem to have too much of a problem sharing the bookrunner role with just one other competitor. Nevertheless, as one investment banker puts it: “We do try for sole mandates, but it’s so hard if there’s a lending relationship bank that wants to get in on the deal.” Generally, though, two bookrunners can easily share the responsibilities. More than that, and it becomes tough for issuers and investors to understand banks’ true credentials.

There are ways to work out who does what or, more important, who doesn’t do anything, on a deal. The first stop is the front page of the prospectus. As more banks are asked onto deals as bookrunners, or force their way in, the more frequently the lead bookrunners will demand left-hand positioning on the cover – once again something borrowed from the bond markets. If more than one bank occupies the left-hand spot, the giveaway is if the list of bookrunners is out of alphabetical order.

But it’s not always straightforward. In the Xerox convertible, for instance, Citigroup, Merrill Lynch and then Goldman Sachs appear on the left. JPMorgan occupies the right-hand column. The order is slightly different for the common stock offering: Goldman Sachs now takes the lead position, followed by Citi and then JPMorgan. Merrill Lynch is now on the right.

But they all receive full league table credit. What’s more, they all, officially, receive the same number of securities to distribute, which also happens to be the same number as the two lead managers, Deutsche Bank and UBS. To complicate matters further, JPMorgan is listed in both deals as the global coordinator.

The positioning on the prospectus for the General Motors convertible is almost turning the practice into an art form. Merrill Lynch, Morgan Stanley and Citi clearly occupy the left-hand column, in that order. The first two banks clearly have the bragging rights. Then, in the middle of the page, in alphabetical order, come BoA, Goldman Sachs and JPMorgan. UBS occupies a place all to itself over on the right.

Sometimes, all the banks do play a role. The top two bookrunners on each of Tyco, Wells Fargo and General Motors played full roles. On the first and last of those two deals, which had six and seven bookrunners respectively, bankers describe the third bookrunner as playing “a near-full role”. On the Sallie Mae $3 billion deal in April, on the other hand, all three banks played a full role. As an example of how this could change the league tables, Euromoney has taken the first three deals and removed league table credit for the lower-ranking bookrunners, and shared it equally among the top three (see table 2).

Banks share responsibilities on certain deals. One bank will draft the documents, another will be responsible for the roadshow, should there be one, and building the book will fall to a third.

To some bankers the reason for the rise in multiple bookrunners is simple: “It’s just a way of paying the bank lending group, pure and simple,” says a senior equities banker. “It’s much easier for the issuer just to make all of them bookrunners. But real deals don’t pick multiple bookrunners. Everybody knows it’s not the way to run a deal.”

Certain banks are selling the benefits of multiple bookrunners to issuers as hard as they can. Banks with co-manager or even lead-manager status will tell the issuer that investors only ever call back the bookrunners. Without increasing the fee pool, they argue, the issuer could make them a bookrunner in name so that investors will be more inclined to call them back. The issuer then gets more potential distribution for the same price.

For some banks it would appear to be a strategic imperative to make sure that they attain or retain a high standing in the league tables. Goldman Sachs, for example, say competitors, needs to rank high to justify its continued existence as an independent investment bank.

JPMorgan, on the other hand, say its rivals, needs to prove its mettle, in the convertible market at least, after David Coulter, CEO of the investment bank, made a very public commitment to that business.

At the time JPMorgan was fourth in the league tables. Convertbond.com shows that JPMorgan now stands at the top of the table for all US deals, just ahead of Goldman Sachs and Citigroup.

For jointly led deals, though, the league tables assign each joint bookrunner an equal portion of the deal, with no regard to the role actually played in the transaction. Some argue that a fairer representation of the strength of a firm’s franchise can be determined by ranking firms based on deals on which they act as sole bookrunner.

The drawback to this approach is that it doesn’t take into account how many overnight deals a bank does: it’s on these deals that the bookrunner might be decided on price alone. Using sole bookrunner mandates makes for very different positions in the league table. It looks, in fact, much more like a straight equity league table, where the independent investment banks take the top spots. It would appear that, where there are no lending relationships to consider in doling out mandates, the investment banks are still the underwriters of choice.

Splicing the sole bookrunner league tables as percentages of total deals done and as a percentage of each bookrunner’s total ascribed volume makes for slightly different results. The commercial banks still figure much lower down in the table, but the top half of the table is easily skewed by banks that have only done a handful of deals, such as Lehman Brothers. One could argue that Lehman has simply been more judicious in choosing overnight mandates to bid for. Morgan Stanley might feel aggrieved by the percentage league tables: it’s been involved in 35 convertible bonds, more deals than any other bank this year, has sole lead managed more than any other bank except Merrill Lynch, and acted as a chief bookrunner on each of the four largest deals of the year.

Chasing league table position on convertibles can be costly. Mention the name Grey Wolf to a banker and the reaction is instant. Either a laugh, a sharp intake of breath, an “Oh God, that one”. It’s what most call the worst convertible deal of the year so far, a $150 million overnight deal by Deutsche Bank at the start of May. Some reckon that Deutsche only managed to reoffer the deal at 93.5% of par and that it could have lost Deutsche $8 million or more.

Not so, says Deutsche. “It amuses me to hear competitors speculate on where the bonds were offered or how much we may have lost,” says Brooks Harris, the bank’s head of US convertible origination. “The facts are that we never bid the bonds below 98% and we didn’t lose money on the deal. It’s a testament to our placement capabilities that we could structure a deal this aggressively and see it trade like this.”

That below-par feeling Bankers should be wary of crowing too loudly about their rivals’ mistakes because almost all of them have had at least one blow-up. By the end of June, according to data Euromoney has collected, 18 convertible bond deals, all of them overnight deals, were reoffered to the market below par. “We’ve been seeing deals that in theory people should be fired for,” says one banker. “There have been numerous deals priced at par and reoffered immediately way below that, at 96 cents or even lower. And these are bond-heavy converts. You could never get away pricing a deal that poorly in the straight bond market.”

All the banks in the official top 10 convertible bond league table (see table 1) have at least one sole lead managed deal fitting that description. Citigroup, CSFB, Goldman Sachs and Merrill Lynch each have two such deals.

Some of the deals were only so bad that they lost the banks involved some of their fee. Banks usually received between 2% and 2.25%, for convertible deals, and may well receive less for overnight transactions. Of these 18 deals six were reoffered at 98.5% of par or better, a level where the banks definitely still see some of the fee. Another seven were reoffered between 98% and 98.25%. Five were below. In terms of dollar loss, CSFB’s Yahoo! deal, JPMorgan’s deal for Delta and Citigroup’s deal for Nabors seem to top bankers’ lists. Nabors reoffered at 97%, but that was exacerbated by its being for a $700 million security. Delta’s $350 million convertible reoffered at 94.5% of par, while the Yahoo! deal, the first of the disastrous deals back in April, reoffered at 96%. The company has since registered the deal with the SEC, in which it declared that CSFB had kept a large portion of the bonds. Luckily for the bank, the convertible price improved dramatically in the weeks after launch, and has probably stemmed some of the losses.

Following these dramas, bankers reacted with cautious optimism to the latest primary market uptick. “Issuance started to broaden out in the last six weeks on the back of a rising equity market,” says Larry Wieseneck, global head of equity capital markets and co-head of global finance at Lehman Brothers. “We’re getting to see some real deals at last from companies who are happy seeing their stock price go up.”

It’s one of his deals, – the $621 million follow-on common stock deal Lehman Brothers executed for Dominion Resources on May 21 – that several competitors point to , as one of them puts it, as “the deal we will all look back on in a couple of years’ time and be able to say that this marked the start of a bull market in issuance”.

Dominion opted for an overnight deal, choosing its bookrunner solely on the basis of price. The stock market had already closed for the day when Dominion invited bankers to bid for the deal in which it was looking to issue 10 million shares. “It was a very sterile process, as with most of these overnight deals,” says one banker. “They told us they wanted to issue stock and gave us 10 minutes to submit our bids.”

Nine banks bid, by email, before the 5pm deadline. The winner was Lehman Brothers and its bid stunned competitors. “You’ve got to wonder whether they decided that they would be prepared to own the stock themselves,” says a senior equity banker at a rival firm. “Because the terms they offered were incredible. Or maybe they just had their eye on what it would do for their league table status.”

According to rivals, Lehman was charging a gross spread of just 14 basis points to execute the deal. That’s cheaper even than banks have bid to do secondary offerings for corporates in the emerging markets. Dominion’s stock had closed that day at $62.70; Lehman offered to buy the block of 10 million shares for $62.11, and would then reoffer them to investors for $62.20. “It sounded crazy at the time,” says one banker. “They were charging less than $900,000 to take on $620 million of risk. We were scratching our heads trying to work out what angle they had. We even wondered whether they’d simply made a typo in the email.”

The following day, news of the share sale caused Dominion’s price to fall, and it closed at $61.59. Lehman was already facing a loss of $5.2 million based on that day’s share price close. There were only two trading days left before the long weekend.

But the price picked up before the end of the week, closing at $62.29 on Thursday 22 and $63.99 on Friday. It reached as high as $64.65 the following Tuesday before slipping off somewhat. Lehman had pulled it off, and made a decent profit in the secondary market to add to its seemingly paltry fee. Did it just get lucky?

Lehman’s Wieseneck says: “We know and like Dominion’s stock. And that’s a crucial part of the decision-making process for us when we decide to bid for this kind of business.” Having a view based on good research and trading ought to be a prerequisite for banks wanting to bid on block trades. Lehman, it seems, is one of few that actually practices that.

“We like the broader issues about the utilities sector as a whole and we like Dominion,” says Wieseneck. “We were also confident that the tax bill would be signed.” It was, a day later, containing legislation reducing double taxation of dividends. That ought to make dividend-paying stocks such as Dominion more attractive. “We thought that for all these factors it would be a good stock to own,” says Wieseneck. “And if we thought that, investors were bound to think that as well.”

In this instance, they did. In the five weeks since companies have issued more secondary offerings and converts: 53 deals from 51 companies came to market in June, making it the biggest month ever for convertible issuance. Whether that translates into a good second half of the year is another matter. Without an increase in IPO issuance, however, the league table games look set to continue.