Three's company

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Issuer: Canal+
Amount: Ffr2 billion, exchangeable into shares of Mediaset
Launched: February 12
Lead manager: Lehman Brothers, UBS

Last September, giant French pay-TV company Canal+ announced its acquisition from Richemont SA and MIH Ltd of the European television operations of Nethold. That deal is due to close in April. Even before completion it led last month to a smart piece of corporate finance: a Ffr2 billion issue by Canal+ of five-year bonds exchangeable into shares of the leading Italian commercial television and media company Mediaset.

Bonds exchangeable into an issuer's own shares or its parent's are common: bonds exchangeable into an already purchased block of shares of a third party company are much rarer. This deal takes the concept to a new and previously unheard of level: a convertible into shares which the issuer doesn't even own yet. It was an opportunistic, almost cheeky transaction, but one that may point the way for other European companies to be much more dynamic in financing and hedging their cross-shareholdings in each other.

Nethold, which has growing television interests in Belgium, the Netherlands, Nordic countries and Italy, had acquired 6.5% of Mediaset in 1995, when Fininvest, the company of Silvio Berlusconi which at that time owned 100% of Mediaset, sold down 18.5% of the company to three strategic investors.

Between that time and the announced purchase of Nethold by Canal+ nearly 18 months later, Mediaset had been the subject of a large and fairly successful public share sale in July 1996; several directors of Fininvest and Mediaset had come under criminal investigation by Italian magistrates; and Mediaset's position as a dominant force in Italian television and advertising had prompted hostile regulatory and judicial review.

Canal+ was attracted by Nethold's 45% holding in Italian pay-TV company Telepiù. It was not so sure it wanted to hold onto the Mediaset stake as a long-term investment, particularly if that meant funding the position at high lira interest rates. It asked its financial advisers to find a way out. "From the outset, Canal+ seized the initiative," says Ludovico del Balzo, managing director at Lehman Brothers in London. "By contrast there are many noyaux durs in France ­ which perhaps will be reshuffled ­ that have not yet taken full advantage of innovative market structures for monetization."

Through October and November last year, Laurent Perpère, chief financial officer of Canal+, reviewed options principally with UBS, its adviser on the Nethold acquisition and with Lehman Brothers, adviser to the Nethold and Richemont side. The key challenge, it quickly became apparent, was timing. The acquisition is still subject to certain regulatory approvals and will not be complete before April. Canal+ could not ask Nethold to sell the Mediaset shares outright, either through a block trade or a marketed secondary offer, before the acquisition goes through. And the 270-day lock-up agreement signed by Mediaset's core shareholders ­ including Nethold ­ at the time of its IPO, expires in March. That means those shareholders, including Fininvest itself, still with 51.7% of Mediaset, will become free to sell their shares into a thinly traded market, potentially hurting the price and eroding the value of Nethold's stake.

One obvious approach for Canal+ would have been to sell call options or buy put options on Mediaset shares. But the 6.5% stake is worth roughly $360 million, while daily turnover in Mediaset stock is only $8 million. Any derivatives position that would later require dynamic delta hedging through buying or selling more shares could prove troublesome.

By December, Canal+ had decided on an exchangeable bond offer to refinance the position. It briefly considered dollar- and lira-denominated deals before opting for a French franc bond. The Eurolira market is narrow for such a complex deal and in any case most of Canal+ revenue flows are in French francs. The exchangeable bond includes a mandatory six-month call option, if the acquisition doesn't go ahead, at 102.036% for the par issued bonds. That would reward investors with 50 basis points over French five-year OATs or 160bp over short-term BTANs.

There is a limit on what detailed financial data Canal+ can release about how the company will look after the Nethold acquisition. The pieces of Nethold it is acquiring have not previously existed as stand-alone divisions. But most analysts guess the company will be a BBB+/A­ type credit. Banks are eager to lend to Canal+ and an exchangeable bond is a way of using the company's strong balance sheet to cut the cost of financing the Mediaset position.

Had Nethold sold a convertible in February, it might have been accused of breaking the Mediaset shareholders' lock-up agreement. This precludes not just the sale of shares but of any covered derivatives or notes convertible into shares. But Canal+ was the issuer in this case, and it did not yet own the shares, nor had it signed any lock-up agreement. That might look like a false distinction to other Mediaset investors, who could think that Canal+ is stealing a march on them and breaking the spirit, if not the letter, of the lock-up.

Exchangeable bonds, with their senior debt element, often attract arbitrageurs to sell the underlying stock and buy the bond. Following the deal, Mediaset's share price fell by almost 5%. This may be explained by a general correction in Italian stocks and concern over regulatory reviews which, at worst, might eventually force Mediaset to sell one of its three commercial television stations. Many equity analysts are cautious on the stock. But the launch of the exchangeable bond may also have been unhelpful. It focused investors on the imminent expiry of the lock-up and the large overhang of stock potentially for sale.

Paradoxically, the exchangeable bond was also designed to pacify Mediaset investors. "We wanted to strengthen our ties with Berlusconi as a leading figure in Italian media and not just get rid of the stock," says Perpère. "The free float is so tight, selling 6.5% might have endangered the market. Before launch we discussed the deal with Fininvest and Mediaset and they thought it was a much better idea than a block sale." A French franc convertible bond is a less perfect arbitrage vehicle ­ and so potentially less damaging to Mediaset's share price ­ than a lira bond would have been.

Exchangeable bond holders tend to delay conversion into underlying shares for as long as possible, so as to extract the maximum value from their conversion option. So the structure effectively locks up the 6.5% block for at least four years, before bonds become callable. "I don't think any other shareholder except for Berlusconi is so committed," says Perpère. The structure includes a flexible cash option. Canal+, if it decides it wants to retain a core holding in Mediaset, can offer cash instead of shares to converting bondholders at an amount reflecting the price of the underlying shares on the day of notification of conversion.

To preserve confidentiality, Lehman and UBS handled the deal alone with no syndicate. Pre-marketing consisted of calls to six leading equity-linked buyers on the evening before launch. The deal was launched, marketed, three times oversubscribed, priced and allocated ­ all on February 12. It was quick but not easy. Lack of detailed financial information precluded any sales to the US, home of the world's largest convertible bond funds. And there were restrictions on the amounts that could be sold into France and Italy, the other natural home markets. Convertible bond funds in London and Switzerland, plus some fixed-income investors took it up. UBS itself was a big buyer.

A final complication was the currency risk of a French franc bond exchangeable into lira stock. Unfavourable exchange rate movements hit the deal. The lead banks initially oversold, creating a short position, but had to buy back large numbers of bonds during stabilization. commencing two days after launch.