Corporate Hybrid Capital Roundtable 2007: Part 1
IFR: I would like to kick off the discussion by taking a look at corporate hybrid supply so far this year, or to be more accurate, the lack of it. The pick-up in M&A activity towards the end of last year had fuelled expectations that supply would exceed volumes we have seen in recent years. However, this has certainly not been the case with only three public deals this year so far. Why is that?
Geoff Tarrant, Deutsche Bank: This is a very good question. Firstly, consensus expectations were a little unrealistic about the growth of the market in 2007 for a product was still in the fledgling stages of establishing itself. Having said that, we would probably agree that volumes in the first half of the year have been disappointing, although we expect full-year volume to be at least the equivalent of the €6.5bn that they were in 2006. Therefore much of the supply will materialise in the second half of this year and still a fair amount of it will be driven by M&A activity. Overall, the market should continue to grow at a steady, rather than spectacular pace.
Peter Jurdjevic, Citigroup: What is also important is the fact that some of the acquisitions we have seen were undertaken by companies that were not under ratings pressure, either because they had a lot of capacity at the ratings band or were highly rated and were therefore able to take a downgrade rather than defend a rating through a hybrid. For example, we have seen companies such as Atlas Copco and Volvo debt-finance acquisitions without incurring ratings downgrades, while Enel was willing to let its ratings drop and therefore did not require hybrid financing for its acquisition of Endesa. However, when we begin to see acquisition activity put real pressure on companies with ratings in the Single A or Triple B spectrum, we may also see increased issuance of equity and equity-like instruments such as hybrids as companies take action to defend their ratings. Rexam is a recent example of a Triple B company that bolstered its ratings following an acquisition through the issuance of a hybrid.
Geoff Tarrant: The level of interest in the product from corporates is greater than it has ever been before. There is definitely a wider sphere of companies looking at the product and this should be reflected in the growth of issuance year-on-year as it gains greater acceptance.
Peter Jurdjevic: It’s also worth noting that about 20% of M&A activity has been done by private equity, which generally is not motivated by credit ratings. That’s not an insignificant portion of the M&A market.
IFR: We touched on M&A activity and subsequent ratings defence, but what other drivers are there likely to be behind the increase of hybrid issuance that is anticipated?
Shazia Azim, RBS: We have also seen situations whereby companies have used hybrid capital in order to reduce their pension deficits. We have observed over the last 18 months that corporate interest in the structure has increased exponentially compared to what we have seen in the past and while there may be no sizable batch of M&A and ratings preservation fuelled issuance imminent, corporates have begun, like financials, to view the product as an interesting tool of efficient capital management.
Khalid Krim, Barclays Capital: I believe the other thing which makes the product attractive to corporates is the benefits of hybrids like the non-dilutive nature of these financings, the ability to achieve equity accounting under IFRS or tax deductibility. These are important for clients, especially when you speak to private companies – family or state-owned – or small clients which do not have access to the equity market. They are often looking to achieve equity accounting under IFRS to strengthen their balance sheet, to reduce their weighted average cost of capital and remove some pressure on any covenants that they have with their banks.
Peter Jurdjevic: I think the common denominator for all of these, with the possible exception of the equity substitute balance sheet-supportive trade, is that there is some kind of ratings pressure. There is a need to defend the rating whether it results from an M&A event, from a share buyback or simply from excessive leverage. That is the common thread that connects all these different applications.
Malcolm Cruickshanks, JPMorgan: Going back to the question of why there has not been more issuance and a key issue is at what point the management are comfortable with the ratings. We have seen UK corporate ratings slide over the last five years, from an average rating of Single A minus to an average of Triple B. With the debt markets as they are, being Triple B minus may not be such a bad thing as perhaps it would have been five or ten years ago, so this is clearly one of the counterbalances against a version of hybrid issuance. As companies have now moved down the ratings spectrum, the opportunity to defend themselves against LBOs or acquisitions through the issuance of a hybrid has become an attractive proposition. If you look at the great theory behind hybrids, which I am sure we are all talking about with issuers, it does improve your weighted average cost across your capital, a scenario which companies should theoretically embrace. It is just about getting them to the point that they are comfortable with the structure.
Franck Robard, SG CIB: Absolutely. In the future more corporates should view the hybrid instrument as a relevant tool to optimise their financial structure, and not only as an instrument which can benefit acquisitions or defend a ratings situation. In this respect, the new requirements and replacement language from Standard & Poor’s could help with this situation.
Malcolm Cruickshanks: Another important point to note is that the equity markets have been extremely strong for the last 18 months and has subsequently provided an easy alternative market to access. When the equity markets become a little more difficult – which no doubt will happen at some point – hybrids should become more attractive because there will be fewer options available to management. We have seen a number of acquisitions whereby companies have gone straight to the equity markets, and even upsize deals simply because the demand has been so great.
IFR: The issuance of a hybrid has often been a time-consuming exercise that can also be more expensive for issuers. Is this still a potential problem that you encounter?
Peter Jurdjevic: It could possibly be a mild deterrent in some jurisdictions where we have not yet seen a corporate hybrid issued to date. But I think we would all agree that any structuring issues can be addressed. It’s more of a case of issuers not wanting to be the first to execute a new transaction. But overall, when an issuer is in a situation where it needs to undertake certain measures in order to defend a rating, it is not a question of the issuer not issuing hybrids simply because there is some work to be done on the structuring. It is just a matter of putting the time aside to do it
Khalid Krim: It is not only the fact that it is complex. People normally understand the product and the features that you need to put into the structure to achieve a certain degree of equity credit with a rating agency. I think it is more the fact that, compared to a straight senior bond, the people at the finance division of the issuer need to involve other divisions internally, either accounting, legal or tax people, who are usually not involved in regular capital markets financings. This implies some internal work to do in order to get all the sign-offs and may take more time for the CFO or the treasurer. The need to get these internal sign offs combined with the external confirmation required from auditors, tax and legal advisers is making the process longer. Although not legally required, very often clients are formally presenting the structure and terms of the hybrid to the board level to explain what that means for the company and also how in the future the company will be bound by certain provisions of the hybrids that it plans to issue – for example,. replacement provisions. When you step into the CFO or treasurer’s shoes, these are the kind of topics that they have to address when presenting the product internally.
Peter Jurdjevic: The transaction by Rexam that we recently structured is the first new generation hybrid from a UK corporate. Prior to the transaction, some of our UK clients expressed reservations or concerns about the tax treatment, given the agencies’ equity credit requirements. I think everybody at this table would have been highly confident that the deal could be structured in such a way that it is debt for tax purposes. However, it is one thing for us to express this confidence, but it is quite another thing for an issuer to actually go through the steps and put its reputation on the line by doing a transaction. But once the transaction is done, in this case the Rexam issue, what we would expect to see is more companies following suit, as we have witnessed in other jurisdictions.
Franck Robard: From an issuer’s perspective the complexity of the instrument is not an issue and any constraints can be tackled from the structuring aspect. However, there are a number of different structures outstanding, with their own specificities such as payment mechanisms, early redemption options and ACSM wording. At the moment the market does not really differentiate all these different types of structure, a scenario which is normal in the bull market that we have seen for the past two years. Nevertheless, the situation can be very different in a stress scenario, where market participants are likely to look closely at the risks associated with every hybrid outstanding.
Geoff Tarrant: I have never seen an issuer say it is not looking at hybrid capital because the structure is too complex, although I think this point could be more relevant for an investor. A lot of the structures have their own nuances and there has not been a great deal of standardisation in how transactions have been done, even more so when you consider that some issues in the US market are done differently as well. Therefore it has been a bit more challenging for investors to understand the differences and nuances in the structure, although as we go forward and the market continues to develop, there will probably become a greater degree of standardisation. Nonetheless, you will always see differences in the structure because issuers have different preferences and objectives and, as structurers, it is a core requirement that we adhere to their individual needs.
Malcolm Cruickshanks: There is also another potential spanner in the works and that is the rating agencies. The regular changes in hybrid rating requirements make it very difficult to benchmark structures that have been issued to date in Europe, against those that are going to be issued in the future. This has not really posed such a problem in the US market given the degree of standardisation and perhaps that is something that will become more prevalent in Europe. But of course there are jurisdictional issues and the subsequent ability to get equity accounting credit versus debt accounting, which is always going to retain a certain degree of differentiation. That said, issuers need to spend time to really understand what they are looking for and to use these elements appropriately.
Geoff Tarrant: The US hybrid market is getting very much driven by the tax side, as issuers attempt to secure the most robust tax structure. There have been developments over time in this respect and some of these improvements have been utilised in subsequent transactions. This is a lot more difficult in Europe where you are dealing with multiple jurisdictions and a much more flexible tax landscape than is available in the US.
IFR: Peter touched on the potential of new jurisdictions opening, noting that the Rexam issue should pave the way for other UK issuers to follow. What other jurisdictions could play a notable role in market growth?
Shazia Azim: The UK was the last bastion of not having a corporate hybrid market and should therefore clearly play a key role in issuance volumes in the future. Most other Western European jurisdictions have already seen a reasonable amount of issuance with the exception of Spain.
Khalid Krim: Spain and Portugal is definitely an area where we see potential for growth.
Franck Robard: There has been nothing out of Spain despite the fact that Spanish companies have in the past issued preference shares that were sold domestically in the retail markets. So in terms of cultural education, Spanish issuers are familiar with the hybrid product and we can thus expect some issuance from Spain. This is likely even if the legal framework in the country is perhaps not the easiest to combine with other requirements, such as those of the rating agencies or the accountants.
Malcolm Cruickshanks: It is also important to identify why companies are issuing hybrids, which as we broadly agreed earlier has largely been to defend their ratings. There are clearly many more companies rated in the UK, France and Germany than there are in the other parts of Europe. So this is probably why we have seen only one issue out of Italy, one issue out of Sweden and one from Denmark. This could also act as a constraint for the growth of the Spanish market in the future.
Geoff Tarrant: I am sure in time we will see issuance out of Spain, although, as Malcolm pointed out, there is probably a more limited number of potential issuers in the jurisdiction. For a start, there are fewer rated companies because attractive bank funding is less available, while there are also some structural challenges in that would probably make it the most difficult jurisdiction in Europe in which to make the hybrid work. Still, I do not see these issues being insurmountable.
Peter Jurdjevic: It is also important to note that UK corporates have not been as acquisitive as corporates in other jurisdictions recently and therefore have not had as great a need for hybrid capital.
Khalid Krim: It is also fair to say that some clients didn't want to be the first one to access the market and go through all the tax and rating aspects of hybrids in the context of a UK company. This is something that Rexam was prepared to do to fund a strategic acquisition and successfully issued the first UK corporate hybrid in June this year. Since that transaction we have been in contact with a number of clients in the UK willing to understand the structure, the particular features needed for a UK Plc and investor perception of such structure. We expect to see more UK corporates accessing this market including in sterling which is a currency where UK corporates are still absent.
Peter Jurdjevic: I know that Rexam did receive numerous calls after that trade from other UK issuers. I think many companies are looking at and interested in the structure.
Khalid Krim: It also depends how you define Europe. We have tested the level of interest in most countries and have identified companies outside the countries that have issued hybrid securities so far that are interested in the product. This includes those in Eastern Europe, Russia and the Middle East, where banks may have issued hybrids the past but corporates have been absent.
IFR: Russia was highlighted there which is consistent with feedback that we have received suggesting that the country could play a significant role in hybrid issuance in the future. Gazprom, for example has well established curves in euros and dollars, so how far away are we from Russian corporates bringing a hybrid?
Franck Robard: If we consider that European corporates started to issue senior debt instruments in the capital market in 1997/1998 and have recognised the benefits of hybrid capital in 2005, we can imagine that there will be a number of years before Russian or Eastern Europe corporates issue this type of instrument. Nevertheless, the situation is different as the market exists, there are references outstanding and the learning process for all parties involved has been done. Therefore, this timing will be shortened , and corporate hybrid issues out of Russia or Eastern Europe will happen, probably not in the coming months, but in the coming years.
Geoff Tarrant: It is probably going to be at least two years before we see any material emerging market supply. There may be one or two transactions from well known companies but I do not anticipate it becoming active until 2009.
IFR: Assuming these markets do eventually embrace the structure, is this really just a bull market instrument as far as investors are concerned and do we need an upbeat market backdrop for these deals to work.
Khalid Krim: The potential problem with these jurisdictions for investors is that the issuer may not be very well known in the capital market and may not have issued a senior bond before. This increases the amount of due diligence and credit analysis that a potential investor would have to undertake. However, if there is a rationale for issuing a hybrid that can be clearly outlined then this is definitely a product that could be useful and utilised by companies in these regions.
Malcolm Cruickshanks: I think you also have to draw the distinction between the emerging markets countries, which are rated in level B territory which compares to the Middle Eastern countries that perhaps you are referring to which often have ratings of Single A. These would consequently be less of a problem for investors.
Geoff Tarrant: There is no doubt that sub-investment grade and unrated issues are going to be more challenging to get done in a difficult market. But I think in the market as a whole, issuers with investment grade senior ratings or well known unrated issuers are going to have the capacity to do transactions in all types of markets.
IFR: We touched there on potential markets that could pose a problem for some investors. More broadly, to what extent has the investor community for hybrids grown over the past couple of years and how has it become more sophisticated as to its understanding of these structures?
Malcolm Cruickshanks: Investors have put in a great deal of time and effort familiarising themselves with the structure. This is a very encouraging development amid the limited supply we have seen so far this year and one that bodes extremely well for future issuance. Another impressive benchmark is the level of liquidity that these issues carry in the secondary market. I know that at JP Morgan we have seen huge volumes going through all the benchmark hybrids that have been issued which demonstrates that people are willing to take a view and thereby invest in future issues.
Click here for Part two of the Roundtable.