Corporate Hybrid Capital Roundtable 2007: Part 3
Franck Robard: It will take time for issuers to become familiar with the new concepts and requirements. They will need to become comfortable with how it works and what are the exact legal consequences for them of having such governance in the documentation. If we go back to the very beginning of this market in December 2005, some European corporates were not comfortable even with the statement of intention of the replacement language required by rating agencies to optimise the benefits of hybrid structures. Nevertheless, most of them have finally accepted this provision which is included in the documentation of almost all of the hybrids issued. The same process is likely to happen with the RCC. Currently it could be a deal breaker for some issuers but we believe that they will become more and more comfortable and familiar with this provision.
Shazia Azim: What is interesting about the S&P position on RCCs is that in some ways it is less strict than Moody’s, while very clearly being an outlier amongst the rating agencies in its necessity to achieve intermediate equity credit. What they have put out is actually relatively easy to achieve because they offer so many carve-outs that you are not necessarily in a situation where you are stuck with a product that you cannot use or do not need to use. However, I think the key point comes back to whether issuers are going to be comfortable with it and the whether such cumbersome features are necessary to achieve intermediate equity credit for hybrids. That is the crux of the matter and it will become a question of that versus the number of basis points that they have to pay for an instrument that does not require an RCC, if the market does not develop in the way we hope it would.
IFR: Do you think they will be comfortable with it, you seem to be saying that you need a few to set the pace and then others will follow?
Khalid Krim: I think on the issuer side when you discuss with CFOs and treasurers they are sensitive to these replacement provisions. The carve-outs and the ability that S&P can give you in terms of non-replacement in specific circumstances is a flexibility that is appreciated and balances the stronger undertaking of the company. As I said earlier, I strongly believe it’s a matter of time to see the first European corporate hybrid featuring an RCC as when we describe to our clients the carve-out and how you can structure them, they very often confirm that in that case they can make themselves comfortable and feel comfortable internally explaining this covenant.
Malcolm Cruickshanks: I think this is clearly going to present a stumbling block in terms of growth in the hybrid market, although we probably all agree that the market will see roughly the same amount of issuance this year as last year. It will be supplied towards the end of this year and perhaps that level will continue going forward, but not at the pace that we would have hoped for previously.
IFR: Was that always the target volume or is that the modified one. Did you start off with some €20bn or work your way down?
Malcolm Cruickshanks: It is difficult to predict what the volume is going to be given the unique set of circumstances that are required before issuers get beyond the consideration stage and put together a plan of action, which may well be dependent upon M&A activity. While we always expected a roughly similar amount of issuance to what we have seen in previous years, I think there was a consensus expectation for a lot more because the market takes the view that this is attractive from a weighted average cost of capital point of view, so everyone should be doing it. Perhaps the issuers disagree.
Geoff Tarrant: I think €20bn would not have been unrealistic with regards to what many market participants were anticipating. From our point of view, we expected to see year-on-year growth and everyone has probably been a little surprised by volumes in the first half and expect that to be materially higher in the second half.
IFR: Malcolm and I were talking earlier about the various regional markets competing against each other. Is that the missing piece in the jigsaw at the moment?
Malcolm Cruickshanks: With regard to currency, I do not think there is a lack of sterling demand, I just think it is more obvious for issuers to go to euros or even go to dollars than to go into sterling, unless of course they are UK issuers. If we see some more UK issuers coming to the fore, then we should see a growth in sterling.
Geoff Tarrant: I think there is definitely appetite there in sterling but the choice of denomination is more a function of issuer preference. Everyone is active in euros which is the most established and deepest market, reflected by the level of outstanding issuance. The common theme of European corporates is to look towards euros because their home currency for the majority of issuers.
Peter Jurdjevic: I agree with Geoff’s point. Rexam was indifferent to the denomination of its hybrid because it needed US dollar funding for its acquisition of OI Plastics, but US market execution was less attractive than European execution at the time. So, Rexam executed in euros and swapped the hybrid. But generally we can expect GBP-functional currency corporates to look first to the sterling market for hybrid funding.
IFR: Someone recently described the corporate hybrid market as 27 different conferences and three issues. While both these numbers are probably wrong, how over-hyped is this market and is it fair to say that we are never going to see a flood of supply.
Malcolm Cruickshanks: There has clearly been a lot of interest in the market simply because it is a new development, but there has not been this rush of issuers because it is a product that needs to be put in place at the right point in time. It is an education process that has been gone through and now we will see that beginning to bear fruit. In the next few years perhaps we will see three conferences and 27 issues. The interesting thing that has happened in the US is that you have a number of utilities all on the same benchmark index, all competing against each other for equity investors. As soon as one emerged, we have seen seven issued within the space of six months. So that perhaps it is more natural: where everyone is listed on the same market and is directly competing for funds. So you can really use those cross capital arguments. But perhaps "flood" is not accurate for Europe.
IFR: Are the large majority of traditional corporate bond and high-yield investors now embracing the structure or is education still key to getting them on board?
Franck Robard: This is an ongoing process but now the vast majority of investors are comfortable with the instruments. It has been a relatively quick learning process as most of them where already familiar with deeply subordinated bonds with various types of interest payment mechanisms as they are buyers of Tier 1 issues from financials institutions. . For them the additional steps in order to jump in the specificities of corporate hybrids has not been difficult. As a consequence, we have seen an important portion of fixed-income investors coming into corporate hybrid issues. This process has been very fast compared to what has happened in the past at the emergence of the Tier 1 market for banks.
Shazia Azim: As you see the market evolving so the products will evolve. Clearly investor education for corporate hybrid issuance will have to continue and as we have seen in the financial space, there is a time at which they will eventually become familiar with the product and comfortable in investing. The classic example of such evolution and investor education is the development of the institutional non-step market, a product with which institutional clients are now familiar after the initial period of education.
Peter Jurdjevic: I think Franck made the point earlier that it largely depends on whether you are in a bull market or a bear market. If you are in a bear market, there is much more scrutiny on the structural features and more interest amongst investors to understand the differences across structures.
Khalid Krim: On the investor side one key concern was the valuation of this instrument when looking back two years ago when the corporate market started to take off. At that time there were very limited comparables and benchmarks to use to assess what the right spread should be. Every investor had their own thoughts and valuation model and it was taking more time for investors to make up their mind on the expected pricing. Today, investors are more sophisticated and there are enough corporate hybrids outstanding which are providing investors with comparables. The fact that we have also seen a good performance of the existing hybrids and tightening of spreads across this sector is also helping us to bring issuers into the market.
IFR: So who is really responsible for all the talk surrounding hybrids? Is it the investment banks because it's what they want the situation to be, even though sometimes it's a triumph of hope over experience, or is it genuinely warranted on occasion?
Peter Jurdjevic: The investment banks are reacting to the requirements of the rating agencies and the desires of issuers to create hybrid financings at the lowest possible price. It is the responsibility of the investment banks to make sure that all products are available for their clients, but we are to a large degree reactive to the financing environment that issuers and investors find themselves in. I would not say the investment banks are particularly hyping up the product but everybody is just reacting to a new development.
Khalid Krim: Since the beginning of the market and with the increased number of transactions it is fair to say that hybrid was “flavour of the month” and that a number of investment banks were heavily marketing and pushing the product to their clients without clearly thinking about the client's needs and objectives. Today it is less the case and I would say that the education process with corporate issuer has been done. Our senior bankers and origination team tend to spend more time with our corporate clients in helping them first to identify the situations that may require a hybrid – rating pressure, acquisition financing, pension deficit – and secondly in preparing the story for investors. I think that is something that issuers are sensitive to and keen to evaluate prior to deciding to embark on such a financing. Hybrids are a product that we are hopeful to see as one of the financing tools available to corporates and that every client, like on the bank side, will be issuing the product regularly.
Franck Robard: The good thing is that now hybrids are in the tool box of each and every CFO and group treasurer. Therefore, when a specific situation will occur and if a hybrid issue fits with this specific situation they will just use it.
Geoff Tarrant: If you look at the FIG market as an example, in the late 1990s when this started there was a compelling reason for banks to immediately go 15% hybrid capital, given the cost of capital benefit, but it did take a couple of years to start to build up and we have seen almost year-on-year growth all through the last six or seven years. It did not come in the rush that people expected then, and I think the corporate hybrid market is going to be somewhat similar. It is going to take a couple of years to develop and then it will – it should grow at a steady pace year on year.
IFR: Because potential issuers are a more disparate bunch, every deal is on a case-by-case basis and every one has their own peculiarities. Is that right?
Malcolm Cruickshanks: That, as well as the actual underlying investors of the stock. For example, UK investors buying equity have different demands to those investing in French equities. So just because two companies compete head against head in terms of the products they are selling, that does not necessarily mean they have to have the same capital structure.
IFR: If we take market conditions out of it, regardless of what spreads may do, are we going to see greater growth going forward?
Geoff Tarrant: I think we will see the market continue to grow. It will grow in size over time but it is going to be a steady pace rather than a spectacular expansion. There is no question there was a level of over-hype and some unrealistic expectations about how quickly it was going to grow and how much issuance there was. I feel, talking to clients generally, there is a greater acceptance now than there was a year or two ago of the benefits of the product. I do think we will see growth going forward over the next six or 18 months.
Peter Jurdjevic: There may be a pause as the market reacts to S&P’s revised position on step-ups and replacement language, but once that gets sorted out, I would agree with Geoff that we would continue to see increasing supply. The product has many applications and you just need the circumstances to arise to precipitate issuance.
Khalid Krim: I also expect to see some variations of straight and standard corporate hybrid. For example issuance of hybrid securities by unrated issuers. We should see more unrated hybrid issues in Europe specifically for companies looking to issue non-dilutive instrument accounted for as equity under IFRS – the securities can be subordinated perpetual securities like the IVG transaction or senior perpetual bond like the Cemex transaction. The other product that we do expect to see more going forward are hybrid convertible. For issuers that are comfortable with potential dilution attached to convertibles, the hybrid convertible is a nice way for issuers to reduce the cost of their hybrid financings and diversify their investor base by tapping the convertible bond funds. I would not rule out going forward that the unrated and the convertible hybrid markets will constitute sub-segments of the corporate hybrid market.
IFR: The reason some people became involved in hybrids in the first place was that that was the only place they could get the returns they were after because spreads had tightened in so much. So if the market is not in a bull phase, has one of the major reasons for getting involved effectively been removed? How important is what is happening in the the underlying market to attracting participants?
Peter Jurdjevic: I am personally sceptical of that. There is generally a price at which the deal will get done. I would say in a bear market maybe that price may impede issuers in certain circumstances, but I would be surprised to see issuers stop completely simply because there is a bear market. It becomes more challenging and more expensive for the issuer, but if there is a need to issue, I think deals still get done and the market still exists.
Franck Robard: Yes the underlying market has been supportive in the past two to three years is important. Nevertheless, even in a bear market, hybrids remain an available option and deals will get placed at an appropriate spread. Such spread levels could appear expensive compared to the market conditions prevailing currently, but we do not forget that in a bear market it is likely that the equity market premium will rise and therefore the cost differential between equity and equity-like instruments will remains in favour of hybrids.
Peter Jurdjevic: In the institutional markets in Europe and the US, hybrids have become an established and accepted asset class. Retail markets come and go but for certain names they are sometimes available and they are generally less sensitive to volatility in the broader markets. There really is not such a need to expand the universe on the investor side. It is already there. I think it is the supply side that is lagging.
Malcolm Cruickshanks: In a bear market issuers will find themselves in a circumstance of weakening equity markets as well. So in comparison to equity, it may make sense to pay what would seem today a lot for a hybrid but it may make capital sense in order to help them to underpin their credit quality.
Geoff Tarrant: I agree. It is not necessarily a bad thing if conditions get tough. Yes, spreads on hybrids will be wider but, as Malcolm said, equity prices are likely to be lower. So the impact of dilution is more significant, and also in an environment ratings may be under a little bit more pressure than they would otherwise be. In order to protect those ratings, yes, hybrids will come at a higher cost but it might be the lesser of two evils.
IFR: Coming back to the Rexam transaction. Given the ongoing demand from UK real money accounts for long-dated sterling-denominated assets, why did Rexam choose to raise euros with its inaugural hybrid issue.
Peter Jurdjevic: The reason was that the euro market was the deepest and most liquid hybrid market available and that Rexam did not need to raise sterling capital. If Rexam had needed to raise more than €750m, it would have issued a second tranche into the sterling market. But as it turned out there was no need because the company was able to raise the necessary size in the European market alone.
Khalid Krim: Given the amount that Rexam needed to raise in the hybrid market, a sterling tranche would have been small and there could have been some liquidity concern from investors if the issue was too small. In terms of issuer profile, rationale and structure, I think this is a deal that could have been sold easily to sterling investors at the same price. It should be noted that even if it was denominated in euros, UK investors did constitute the majority of the buyers. This is a confirmation of the leading role that that the UK investors are playing in the European hybrid market.
Malcolm Cruickshanks: I think also you have to draw the distinction between the long-dated bond transactions that we have seen earlier this year versus hybrid paper. Whilst hybrid is theoretically long-dated in the capital structure, investors are buying it as a 10-year instrument. So, whilst the sterling market is very developed in the long end the hybrid structures we have seen have short call dates.