Sunday, 22 July 2018

Solace in structured solutions

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Japan’s equity capital markets have seen a remarkable transformation over the last 12 months with the primary market metamorphosed into a ghost town. The slumping issuance figures paint a bleak picture for Japanese bankers, but for some the year has been saved by the emergence of highly tailored and highly profitable structured trades. Govinda Finn reports.

What a difference a year makes. After a frenzied 2006, Japan equity issuance is down almost 60% in 2007, global convertible issuance is down 60% and moving strike convertible bond (MSCB) issuance is down a staggering 95%. A sea change in conditions has battered public market issuance but has also resulted in a bonanza for private structured deals.

One after another, banks have announced complicated and highly tailored deals including Resona Holdings’ ¥350bn (US$2.93bn) preference offering, Liberty Global’s ¥86.4bn block trade, Goodwill Group’s ¥15bn warrant offering and Fujitsu’s ¥200bn of convertible bonds.

The string of high profile deals have generated headlines and, more importantly, large profits for the banks involved, making them the must-have deals of 2007.

“These types of deals certainly have become a more important part of the business in Japan,” said Alex Large, head of Japan ECM for JPMorgan, “In a quiet year for traditional issuance, they have been especially significant”

The deals have also dominated the league tables with Morgan Stanley representing the only one of the five overseas firms in the top ten that has not delivered a structured trade.

Recent interest in structured solutions has emerged as a result of a deeper currents within the Japanese equity markets. Perhaps the most important trend has been the development of shareholder activism in Japan.

A number of overseas investors led by Steel Partners, Perry Capital and the Children’s Investment Fund, as well as powerful domestic institutions such as the Japan Pension Fund Association, have increasingly pushed for greater influence over the corporate agenda.

Their aggressive dividend demands and return on equity requirements concentrated minds across Japan’s corporate landscape on the importance of shareholder voting rights, dilution and the danger of takeovers.

Nearly 10% of Japan’s listed companies, or 378 firms, announced measures to fend off unfriendly buyout bids by June this year. Against that backdrop, corporate managers have started looking for financing structures that target well-defined financing aims and provide greater control.

“Japan’s corporates like certainty and investor control, and priate deals are ideal for meeting these aims,” noted Alex Woodthorpe, head of Asia Pacific ECM at Merrill Lynch.

Merrill was able to provide Resona with that certainty by buying all of the ¥350bn preference shares that the bank issued to help pay back government funds. Merrill also took responsibility for dealing with the investors, something that Japanese corporates still prefer to avoid.

Another factor that is clearly subduing equity issuance is the exceptional health of Japanese corporate balance sheets following successive years of record profits. With capex financing tailing off and M&A needs still muted, Japanese corporates have been content to focus on their more prosaic financing requirements.

The ¥200bn convertible bond refinancing from Fujitsu in August may have come earlier than expected but it seems to reinforce the argument that the agenda is no longer being pushed by market impetus.

One final trend that may be driving the structured boom is the complete disintegration of the MSCB market, which has fallen 95% this year. Worries about the share price impact of such deals forced the government to introduce new MSCB regulations in July, but for many issuers the structure was tainted long before the government took action.

The correlation between the fall in MSCB issuance and the growth in structured deals is striking but may not be directly linked as there seems to be a clear migration in the quality of issuer considering structured products.

“MSCBs were primarily for distressed companies, the story of the last 12 months is the move of highly structured products to investment grade, blue chip firms,” Large noted.

Minimising dilution

Despite the interest surrounding these structured deals, some bankers are quick to warn that the distinctiveness of each trade means it too early to determine any specific financing trends.

“When the tide is out, the deals that are less market sensitive are exposed” a banker at a bulge bracket bank noted. “The bread and butter of ECM business is not under threat,” he added.

The structured deals are certainly a diverse bunch with issuers demanding tailored solutions to the very specific nature of the firm’s financing needs. However, similarities do exist and a number of central themes have emerged.

Perhaps the most unifying structural factor of is the issuer’s desire to minimise the impact of share dilution and avoid antagonising existing shareholders. The emphasis on dilution may appear intuitive to most corporate managers but in Japan it is a relatively new concern.

“Historically Japan has been relaxed about dilution but things are changing,” said Doug Howland, head of Japan ECM for Deutsche Bank.

Resona employed a soft call, cash settlement structure to limit dilution and bankers close to the deal noted that the know-how to limit dilution had been an important factor in winning the business.

Fujitsu made dilution its number one priority when refinancing ¥250bn of outstanding convertible bonds and the new ¥200bn of replacement converts included a freeze of conversion rights until the existing paper is redeemed, thereby preventing double dilution.

Goodwill also hoped to tackle dilution by fixing the number of shares that would be issue as part of its floored warrants trade, allowing it to raise quick money without the dilutionary impact of MSCBs.

Even the Liberty trade had a dilution element as Sumitomo Corp chose to buy back shares in the market to prevent dilution as a result of the block trade.

Show of commitment

Another unifying factor for the deals is the willingness of banks to provide a long term commitment to the issuer and agree to extensive obligations that bind the fate of both issuer and bank.

Merrill Lynch took on ¥350bn of Resona paper in May and agreed to extensive hedging and transfer restrictions in order to satisfy both the issuer and the government. Those commitments were a central plank of the deal’s architecture and were an important factor in the calculation of the final pricing of the paper.

Nikko Citi was equally willing to take on board obligations attached to Fujitsu’s ¥200bn refinancing and it agreed to give up conversion rights on the new bonds until 2009, effectively tying itself to the firm for the next two years.

Clearly both banks do not plan to simply sit on the risk they have taken, with both designing ways to cut up and distribute the investment risks. However, the willingness of banks to provide the almost bottomless financing resources to Japanese corporates and to take on long term commitments may be a reflection of the recent liquidity boom.

With market volatility rising and credit conditions deteriorating, bankers are beginning to worry about the ability of investment banks to continue to execute these types of deal. “The trend may change after sub-prime, especially if banks’ balance sheets are hit,” one Japanese banker warned.

If the curtain does fall prematurely on these structured trades, bankers in Japan would be set for a huge disappointment as they have proven an extremely lucrative business in a tough capital markets environment.

Just how profitable these trades have become, has been a key subject of speculation but it is universally believed that Merrill has come out of the Resona deal exceptionally well, although estimates of a US$700m premium appear excessive.

Nikko Citi also looks set to reap a hearty reward from the Fujitsu trade with rival bankers allocating a theoretical value of almost ¥110bn for each of the two ¥100bn tranches.

But bankers argue that the complexity of the solutions and time required for these trades to develop justifies any value being created for the banks.

“It’s usually a highly interactive process. The prototypes may not always turn out to be the best fit so there is a great deal of collaboration in refining the solutions,” Bruce Wu co-head of ECM at Nikko Citi explained.

Most structured deals have also required extensive cross asset class and often cross-continent cooperation and bankers note that not every department involved will make money from these deals.

“Integrated solutions require various groups within the firm to address client needs together and look beyond individual group’s profit and loss potential,” Wu added.

It certainly appears to be an exciting time to be pitching structured ideas in Japan and bankers note that issuers are increasingly open to the complicated structures and technologies that are being touted.

The shift appears to highlight a growing sophistication among Japanese corporate planners, although with so much investment bank revenue being generated from these structured deals, financing sophistication could be called into question as Japanese corporates appear to be giving away more value than ever.

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