The most macho game in town
In the first quarter of 1991, as European stock markets roared ahead by an average of 20%, the most profitable – and potentially the riskiest – game for equity brokers was the bought deal. Houses make up to £8 million ($13.5 million) a deal selling large chunks of equity held by one company in another. Some brokers even suggest that a new mechanism for distributing shares has come of age.
When Brierley Investments, the New Zealand-based conglomerate which grew aggressively during the 1980s through debt-financed acquisitions, was forced in February to reduce its 100% gearing ratio, it came up with a slightly unusual method.
Brierley was unlikely to be able to raise new equity, particularly since its share price had fallen from NZ$1.40 in September 1990 to NZ$0.80 at the beginning of this year. So rather than have a financial and operational restructuring forced on it, the company chose to raise money by launching a programme of disposals – selling the stakes it owned in a range of companies – via bought deals. Brierley sold its holdings in, inter alia, British food retailer WM Low, Australian Advance Bank and British automotive and defence group Vickers. Those three deals alone raised over £160 million.
Bought deals (also known as block trades), such as those arranged for Brierley, are suddenly the hottest area in the equity market. Companies sell large lines of single stocks to one or two brokers, which then rush to distribute the shares.
The brokers buy the shares at a discount to the market price, then sell them on at a slightly smaller discount. The size of the initial discount varies according to the prevailing mood in the market, the size of the block, the liquidity of the stock, and the market’s perception of the company and its fundamentals. Another factor is the degree of secrecy surrounding the deal. If everyone knows a block is up for sale the discount may be narrower than when a deal unexpectedly hits the market. "We always try to keep a transaction confidential, but some of our competitors prime the market to expect them," says one broker. "If the market price discounts new supply, a broker can bid tighter to that price." That priming process can lower the share price. The discount to market price at which bought deals are offered can be as high as 10% and as low as 1% or less.
Apart from Elsevier’s holdings in Pearson and Wolters Kluwer, recent large bought deals also include Pearson’s stake in Elsevier; ICI’s stake in Enterprise Oil; Sunningdale’s stake in RHM; and a 16.7% stake in Cadbury Schweppes sold by General Cinema.
The size and transparency of the London market dictate that large UK bought deals are quite visible. Large transactions worth over £2.5 billion have been executed in recent months. In addition there has been a host of smaller UK deals and a growing volume of bought deals in continental European stocks.
Bought deals have been executed with increasing frequency since the beginning of the year, when UK and continental stock markets rallied. Declining interest rates are prompting institutions which had been heavily invested in cash to divert their liquidity into stocks. For vendors, the bought deal offers a quick and simple means of converting unwanted shares into cash.
The disadvantage of the bought deal for vendors is that they have to sell their shareholdings at a discount. But they do not have to pay underwriting fees, as on a syndicated placement. And they avoid the risk of the stock market deteriorating during the time it would take to structure a syndicated offering.
There is a reason for the sudden popularity in bought deals. In the late 1980s, many major European companies responded to the distant challenge of the single market by buying large blocks of each others’ shares. The logic was that these equity stakes would cement strategic alliances.
For many, these grand dreams of alliance have proved illusory. And, as a consequence, companies are becoming keen to free the capital which they have locked up unproductively in large blocks of equity. Some companies just want the cash, others are looking for new strategic investments. Other, highly-leveraged companies are using block trades to restructure.
For brokers, the block trade is about as macho as their business gets. These deals involve massive principal risk, pure and simple. There are no underwriting fees, no hedging strategies and precious little chance of pre-selling. If a broking firm is approached by a vendor keen to off-load a position, the broker may have a day or two to test the market appetite for a stock in order to gauge the correct price. If the broker approaches the vendor, it will have to come up with a price and stick to it.
Brokers bridle at any suggestion that bought deals are pre-placed. “You may sometimes elicit an element of comfort from key investors," says one. "But if you walk it around the market, then you are getting nearer to an agency deal. We conduct bought deals on a net basis." Most brokers protest this point a little too vigorously. According to one market-maker at a US firm: “If you look at how large some of these deals are and how small some of the firms executing them are, you have to think that either the firms have access to much more capital than they let on, or they are pre-placing." It would be naive to accept that brokers sounding out the market always stop short of rounding up verbal orders.
Do brokers hedge these massive positions? "That can be very difficult,” says Michael Sargent, deputy chairman of SG Warburg Securities, "because you have to decide what you are going to hedge against and what you are going to hedge with. Are you really worried about the general market level or interest rates which might affect stock markets or about the currency the stock is denominated in? I am not sure there is always the liquidity in futures and options to hedge." Having made a judgement on buying a stock, brokers do not see the logic of betting against themselves. Having taken on the shares, and that can imply a position of several hundred million pounds or more, brokers have no time to compile ingenious hedging strategies. There is only one thing to do: sell the stock and sell it fast.
According to Anthony Abrahams, head of market making at Smith New Court, a typical bought deal takes between 45 minutes and one hour to place. “Within 20 minutes, you know whether you are going to be successful, or not." That’s how long it takes for the firm to contact its prime institutional clients. "Sometimes you can tell in ten minutes," ventures one broker.
Bought deals tend not to be placed with single strategic buyers, or small groups of institutions. In the effort to unload positions brokers will offer the stock to as wide a range of institutions as possible. But the reaction of their largest accounts dictates success or failure. “If you are turned down by the top 20,” says one broker, “you are in for a struggle.”
Large trades in the UK market have to be reported after 90 minutes. If the market knows how much of a stock has become available and if, for whatever reason, only a relatively small portion has been placed after 90 minutes, the market will assume that something is wrong. Then, the phenomenon of self-fulfilling prophecy ensues and the deal really does go wrong.
"You cross your fingers every time you do one of these," says one broker, "because probably the reward is not adequate to the risk you take." But such is the hunger for volume in the equity markets that brokers are only too keen to take on bought deals.
"I wish," says the same broker, "that we could do one every day.”
Despite the enormous publicity that surrounded Kleinwort Benson’s Premier Consolidated transaction (see box), there have been no other disasters of a similar scale among recent bought deals. "Of course one or two have struggled to get away," says one broker. For example, market makers report large blocks of Wolters Kluwer shares going through the market weeks after that bought deal was announced. It is impossible to say if this was evidence that Goldman Sachs had been forced to book a large number of shares, or simply a sign of blocks which Goldman had sold changing hands.
"We have not heard of any major losses,” says one broker. This can be explained in part by the strength of the firms which transact most bought deals: SG Warburg, Smith New Court, Cazenove, Goldman Sachs and BZW.
The availability of large amounts of capital is not in itself enough to guarantee success in transacting bought deals. Capital is necessary, as is the organisational structure to deploy it quickly. "Vendors offering a bought deal do not have much time for firms who say ‘let us get back to you in a couple of days’,” according to one broker. Even more important are high-quality market-making and sales skills. Hence the presence of a partnership broker, Cazenove, and an independent jobbing-oriented firm, Smith New Court, among the better-capitalised full service institutions which regularly undertake bought deals.
Clearly there is money to be made in bought deals. Although some brokers are reluctant to reveal the price at which they have purchased shares, others have fewer qualms about disclosing the turn they are making. Cazenove, Smith New Court and Swiss Bank Corp split £1.92 million after buying Pearson shares from Elsevier at 754p and selling them to institutions for 762p. Morgan Stanley and SG Warburg earned £2.06 million after buying 59 million Sedgwick shares from Transamerica for £128.9 million, or 218.5p per share, and selling them at 222p. SG Warburg and Cazenove netted £7.93 million on the sale of Enterprise Oil shares. Clearly turns of 1% and over are expected. "Assuming no client relationship, I would not be interested in transacting bought deals for below 1%," says Simon de Zoete, deputy chairman of BZW’s equity division. Some large continental deals are said to have netted the brokers turns of 2.5% to 3%.
Brokers insist that it is a competitive business. Vendors do not ask one broker to better another’s bid on a block of shares. But they do let it be known that more than one broker is interested. The five leading firms are not alone in conducting bought deals. Most large British brokers have done them. Of the American firms, Morgan Stanley has undertaken at least one of the major transactions – Sedgwick – and Lehman Brothers is another name which has cropped up. "It’s a type of risk which British and US houses are predisposed to take for cultural reasons," says one British broker, "but the continental firms are interested and learning fast."
“There has been some pressure on margins," says Charles Stonehill, executive director, equity capital markets, at Morgan Stanley International. But it does not seem to be a cut-throat business yet. "Sometimes we are told by the vendor that we are in a competitive situation when I am not at all sure that we really are," says one broker. One recent development in the pricing of bought deals is for vendors and brokers to agree a base price at which the broker will buy a block of shares. If the broker then successfully distributes the shares among institutions at a substantially higher price, the vendor can take a slice of those profits. Is this compensation to vendors for brokers making a killing on bought deals?
“It’s got absolutely nothing to do with making a killing," answers an angry Abrahams at Smith New Court. "Bought deals involve a massive risk and firms very rarely make massive profits." According to a broker at another firm: "If anything, the use of a base price is a device to protect the principal player, not the vendor." The mechanism first cropped up at the beginning of the year, when the direction of stock markets was still uncertain. A low base price protects the broker from taking a disastrous loss, while still allowing the vendor to benefit if the market’s appetite turns out to be stronger than anticipated.
“It is not a device that we like to build into our thinking," says Sargent at SG Warburg. "It does not betray much confidence in the price you are bidding at.” Another broker adds: "Remember these are informal, verbal agreements. They could become messy."
Some firms will advise the vendor at what price they intend to place shares on the market. That provides some comfort to the vendor that it is not being asked to sell at an overly generous discount. And it may help the vendor to choose between a bought deal and an underwritten offering.
"But if you are in a competitive situation I do not think that you have that obligation," says Morgan Stanley’s Stonehill.
What is the future for bought deals? So common have they become that it is tempting to argue that the standard means of distributing equity has changed. "Bought deals have at times offered both certainty and a better price than syndicated offers during the last three months," says one broker. Total costs and commissions of an underwritten deal can amount to 3% or 4%. Any bought deal where the vendor sells at a discount lower than that might be considered cost-effective. The key question now is whether companies will go beyond selling unwanted blocks of other companies’ shares and raise new equity themselves through bought deals. "It has already happened, look at Hanson," says BZW’s de Zoete. This April, the multinational launched a £500 million Euro-convertible through a bought deal with five firms led by CSFB. "You could describe that as a deferred equity offering," argues de Zoete. BZW bid to take the whole transaction.
Bought deals are unlikely to replace underwritten, syndicated offerings as the standard means for companies to issue new equity, for two reasons. First, the whole process of lead managers and issuers embarking on roadshows and making presentations to analysts and market makers can boost a company’s share price, despite the fact of forthcoming new supply. Second, negotiated deals allow companies some considerable say as to who will end up owning their shares. Bought deals allow for no such control.
That is not to say that they work to the detriment of the companies whose shares are being sold: it is often quite the reverse. Companies who may be wary of the threat of takeover, if large blocks become available, tend to derive comfort from seeing those shares widely distributed among institutions. Brokers like to make a virtue out of this necessity: "It’s healthy for the companies [whose shares are being sold]. They all want good, long share registers," says one.
That was certainly the reaction of Chips (JCL) Keswick, chairman and chief executive of Hambros Bank, to the news on April 12 that Baltica had disposed of its 14% stake in the bank. "I am pleased to see that Baltica made a profit and I welcome our new shareholders," he says. The Danish insurance company did not disclose the price at which it sold its 22.9 million ordinary shares and 13.3 million convertible bonds to Smith New Court. But it did say that it made a Dkr100 million ($14.8 million) profit on the price of Hambros shares at the end of 1990. "I think this will improve our share register,” Keswick told Euromoney.
When Transamerica decided to reduce its stake in Sedgwick from 39% to 25% through a bought deal with Morgan Stanley, Sedgwick’s broker – SG Warburg – was brought into the transaction. It was a sign that the two companies intended to maintain cordial relations. Cazenove has appeared in some transactions because it is broker to the company whose shares are being sold, not because it has a massive appetite for principal risk. But it is not a widespread practice.
The boards of those companies whose stock is being placed are generally unlikely to be consulted about the forthcoming activity in their own shares. This would amount to a breach of confidentiality between broker and vendor. Companies will simply be informed by the vendor, typically on the day of the transaction, that their shares have been sold to a broker. By the time the company finds out, its shares are being distributed. Speed and secrecy are essential.
There is plenty of supply for more bought deals. To date, continental European transactions have been large in size but few in number. They could become increasingly common. There are plenty of redundant cross-shareholdings to unravel. Large international securities houses, which have not shone in UK domestic bought deals, are pushing the concept.
As to whether the bought deal will become a standard means for companies to issue new equity, one British broker says: "What it needs is a real stamp of approval. It needs, for example, the government to legitimise the bought deal by using it for a privatisation." In fact, the UK government has already completed one bought deal.
On July 17 last year, NM Rothschild, on behalf of the Treasury, invited representatives of four leading market makers to bid for 54 million shares of British Gas that were still owned by the government On the following morning, at 7:45, an auction was conducted. Fifteen minutes later SG Warburg bought the shares at 219.75p. By 8:22am it had sold them to 60 financial institutions at 220.5p. The shares closed that day down 1p at 222p. The Treasury stated that it felt the tender auction had secured it a competitive price.
How popular the device becomes will largely depend on the future strength of stock markets. In the UK, rights issues, further privatisations and gilts issues will continue to compete for institutional liquidity.
"For this business thrive, it needs confidence in a sustained bull market," says one broker. "We have a bull market, but I am not sure that there is great confidence that it will be sustained." It is a good bet that one firm making a heavy loss on a bought deal that the market felt was correctly priced would be sufficient cause for a rethink at many firms.
When oil stocks hit the skids...
ICI was dissuaded from syndicating the deal by market uncertainty. It had considered another option: disposal of the stake to an industry buyer which might want to take it up. ICI probably felt that a premium should attach to a large block of shares which might be the basis for an industry buyer to build a controlling stake. However, finding industry buyers can take time and there is no guarantee of success. "Strategic buyers have become a lot more choosy. They are not as willing as they were two years ago to buy non-controlling minority interests," says Charles Stonehill, executive director, equity capital markets, at Morgan Stanley International.
The obvious potential buyer of ICI’s stake was Elf Aquitaine, which itself owned a similar-sized block of Enterprise Oil. But the British government quietly made known its displeasure at the prospect of a foreign state-controlled company acquiring Enterprise Oil, which was privatised in 1984. Any other potential acquirers – Atlantic Richfield was mentioned – would have been put off by the Elf Aquitaine blocking stake. ICI plumped for a bought deal. SG Warburg and Cazenove bought 113.3 million Enterprise Oil shares from ICI at 600p and placed them with institutions at 607p. On the day before the placing Enterprise Oil had closed at 673p. On the day of the placement it fell to 625p before closing at 629p. By the end of the week the shares had rallied further to 640p. ICI realised £680 million. The brokers’ reward was just under £8 million and a few more grey hairs. Watching the market price sink to 625p was not, apparently, an enjoyable experience. "It was a big transaction relative to the size of the company and a big stake; and because of that it took some time to do,” recalls Michael Sargent, deputy chairman of SG Warburg. “You do get nervous when the market price approaches the discount price.”
No doubt nerves were all the strained at SG Warburg and Cazenove during the Enterprise Oil placement, as more details emerged of the disastrous bought deal which Kleinwort Benson had executed. Early last August, Kleinwort bought 139.9 million shares of Premier Consolidated Oilfields from Burmah Castrol for £138 million, or 99p a share. It tried to place the shares with institutions at 103p but could find no buyers and eventually had to call in Cazenove and cut its losses at 78p a share.
"Institutions, particularly in the UK, hate to see brokers make a killing on any deal," says one broker. "They [institutional investors] should simply decide whether they want to own a particular stock and what price they will pay for it. But they also want to know what price you, the broker, paid. Kleinwort caused a buyers’ strike because it was trying take 4%." Kleinwort took a £34 million hit on the deal which led to the resignation of Charles Hue Williams, joint managing director of the bank’s securities arm.
An oil company stock seemed like a good bet when oil prices rose sharply in August. But institutions were unwilling to pay the small premium at which, in a departure from accepted practice, this bought deal was priced. Competing market makers, aware that Kleinwort was carrying the block, were disinclined to mark up that particular oil stock.
Hangover cure with a twist
The disposal through a bought deal last year by Dutch publisher Elsevier of its 33% stake in its domestic rival Wolters Kluwer added a continental dimension to what had previously been something of a UK phenomenon. Overseas institutional investors are becoming increasingly keen to buy shares from brokers during the execution of bought deals. "You have to have strong distribution outside the UK to do these deals," says Michael Sargent, deputy chairman of SG Warburg Securities.
Elsevier’s stake in Wolters Kluwer was a hangover from a failed takeover bid which Elsevier launched in 1987. Elsevier then amassed a 49% stake in Kluwer, before its target announced a defensive merger with Wolters Samson, which diluted Elsevier’s stake to 33%.
By mid-1990, Elsevier, which has long harboured ambitions to expand in the US, was keen to unload its stake and began planning a syndicated offer. The confusion in world stock markets which followed Iraq’s invasion of Kuwait rendered this impractical. But in November Elsevier received two unsolicited offers for its Wolters Kluwer shares. First an unnamed institution took a 5% stake off Elsevier’s hands. Shortly after this, Goldman Sachs bought the remaining 28% stake.
The transaction became a major talking point among equity houses. What had Goldman paid Elsevier for the shares? How and where had it placed them? Goldman sold the 14.4 million certificates for ordinary shares at F48 a share, a 0.8% discount to the market price, raising F690 million, the equivalent of $415 million at the time.