For luxury goods company Richemont, whose brands include watchmakers Jaeger-LeCoultre and Baume&Mercier, raising money was not a priority. It did, though, have a delicate timing problem. It owned 27.7% of British American Tobacco. But it also held just over 120 million convertible preference shares into BAT due to mature in June 2004 with a redemption price of 675p. If, at maturity, the shares were trading below 675p, Richemont would redeem the bonds and receive £820 million in cash. However, if the share price rose and the bonds converted, Richemont would go above the upper holding limit under the UK takeover code and be obliged either to launch a full bid – which it did not want to do – or become a forced seller.
Several analysts had already flagged Richemont’s position, so it seemed likely that the market would react to the share overhang and the price would probably converge until the situation was resolved. This meant that Richemont would miss out on any upside above 675p per share and this effectively reduced the value of its stake.
One possibility was for Richemont to sell a call option on the 5% and earn a premium on that. However, if it did this with a single counterparty it would simply transfer the problem elsewhere. The bank that bought the call would have to short BAT shares to hedge its exposure and, at maturity, the market would know that there was still a forced seller out there. So instead Richemont went to the convertible market. This seems counter-intuitive as it wasn’t looking to raise money. However, says Gautam Wadhwani head of equity-linked solutions at Lehman Brothers, the decision made perfect sense. “No-one looks to the convertible market as a way to hedge exposures,” he says “But we felt Richemont could achieve a much higher valuation in this market because of dearth of supply and the lack of equity sensitivity in existing convertible bonds.”
Raising debt was not an objective, however. The solution was to remove the debt part of the convertible, selling warrants instead. The outcome was the same as if an OTC call option had been sold. “Issuing a warrant allows companies to do everything a convertible bond does but without the debt piece,” says Wadhwani.
Lehman was aware that investors would have to short BAT shares to hedge their position, so it ran a bookbuild for the warrants and £200 million of stock simultaneously. Investors could only buy warrants if they also bought stock, enabling Lehman to keep tabs on the degree to which the stock was being shorted. In all, 121 million warrants and 32 million shares were sold to convertible buyers.
Richemont raised 36p per warrant – an implied volatility of 25%. It would have got around 18% in the OTC equity derivative market, Wadhwani says. The bookbuild took less than three hours and demand was such that BAT’s shares recovered 3.4% the next day.
If, at maturity, BAT’s share price is above 675p, the warrant investors will pay £816 million ($1.32 billion) to Richemont to exercise those warrants and acquire the shares. If the price is below 675p, Richemont will receive the redemption amount of £816 million. Either way, its BAT stake stays at 27.7%.
Wadhwani says this technique is easily adaptable to issuers with capital requirements. He is talking to 20 or so issuers about similar transactions, of which two-thirds are connected to fund raising.
