Benefits of diversity
Equity-linked bankers have seen extraordinary changes in 2009. Companies that once hated convertibles have been forced to return. The dominant investor base – and its method of valuing bonds – has become a price taker, as hedge fund money is outweighed by the outright investors’ dollar. Demand has peeled off and bonds traded down. Yet the market is more robust. Owen Wild reports.
For six weeks in 2008 the European convertible bond market appeared to thrive. A series of deals saw volume hit a five-year high in May 2008. Sentiment among bankers was equally high.
“Equity-linked is a cyclical market that relies on the conditions being just right in credit, equity and debt markets and just now we are in the sweet spot,” said one banker at the time.
Yet that comment preceded a four-week freeze, and only a handful of deals followed in the rest of the year. The conditions were right, but negative attitudes towards the product persisted.
To some extent, that remains the case. One 2009 issuer in Europe, advertising agency WPP, had issued its previous convertible in March 2002. The seven-year absence from the market was not accidental: the firm found alternative financing avenues more attractive.
But for many companies, by the Q12009 there were no other avenues. The straight corporate debt market was booming – but only for the best credits and at high cost. Bank lending was elusive and equity markets were only there if a company was willing to pay everyone to buy its heavily-discounted stock. It was less stars being aligned to drive issuance than the market benefiting from considering all comers.
While the market since March has felt more vibrant than for several years, volumes are still unremarkable. Companies have been modest in the size of bonds, with deals tending to represent up to 10% of share capital – with most deals coming in at around €250m–€750m. The modest size has helped most get done: at the end of June, six companies completed convertible issues in one week, all priced on original terms and fully distributed.
Challenges remain, especially for the bankers. The equity-linked market moves in cycles of activity and complete stasis, partly a snowball effect where the momentum of dealflow is matched by a desire from banks to price as tight as possible for clients. This is commendable but often leads to excessively tight pricing – and ultimately failure. A new investor base may help to counteract that.
“If issuers want to achieve attractive terms today, the pricing typically needs to be adequate for both outrights and arbitrage accounts: both breakeven and theoretical values need to be looked at," said Antoine de Guillenchmidt, head of EMEA equity-linked origination at Morgan Stanley. "Even if terms are attractive enough to arbitrage investors, they want to see that the deal will be supported by outrights.”
This requirement for balance has helped ensure steady pricing and maintained interest for those investors attracted to converts by the huge yields available in the secondary market in late 2008 and early 2009. A book 10 times covered was the norm in February. Allocations on some deals ran on into the evening, despite a book closing in the morning. That level of coverage has fallen a little - though J Sainsbury's £190m deal was over 20 times covered - but the base of support if pricing meets both investor groups' needs is more substantial than before.
"The money chasing this paper is amazing for a market that was dead on its knees at year-end," said one London-based banker. "So long as you are not stupid, the liquidity chasing CBs is insane. Now you even have shareholders coming in. They are not interested in vol, they are buying equity with a guaranteed yield."
On some deals the participation from outright investors and shareholders has been such that final pricing has actually squeezed arbitrage accounts out of the deal – a complete inversion of the situation for the previous five years. SGL Carbon's €190m convertible in late June was allocated 90% to outrights.
Most agree corporates must ensure diversified sources of funding and the equity-linked market is often the last to close to them, as Eurocastle Investment showed with its rescue convertible.
Some more recent deals have struggled as investors become twitchy about current share prices and the speed with which they have recovered, despite little improvement in financial performance. With that in mind some European bankers point to the US experience and are encouraging the use of concurrent equity issues and convertible placings.
“The combination of equity and equity-linked issues makes sense as it provides confidence to convertible buyers of the reference price level," said de Guillenchmidt. "Those investors know that the level of premium is justified as the reference price equates to the equity clearing price: a level at which long-term outright equity accounts are buying; this gives convertible accounts confidence to buy into the security at 30%, 35% or 40% up.”