Asia-Pacific Structured Equity House
The creators - Two hundred million dollars: in 2007, Merrill Lynch earned more than that on one single structured equity deal for Resona. The transaction was a striking vindication of Merrill’s structured equity strategy – to pursue high margin private trades. Resona was the most outstanding example of that initiative, but the bank did a string of profitable, innovative deals and is IFR’s Asia-Pacific Structured Equity House of the Year.
There are many ways to build a strong structured equity house. There is the agency route, favoured by many: build an origination and distribution machine, establish some league table credentials and fight like hell for every single public mandate.
That has not been the path followed by Merrill Lynch. The bank is a pretty modest player in public-markets business and it is not its strength – as shown by a difficult experience on the US$175m CB that the bank led for India’s Orchid Chemicals & Pharmaceuticals in February 2007.
After upsizing the deal without informing all of those in the book, the bank had to refund some accounts, while the stock price dropped 9% and the bonds traded below par.
And while Merrill was involved in some cleanly executed public deals in 2007 as a joint bookrunner (for Genting, Champion REIT and Galaxy Entertainment), its only standout public sole books deal was a 20-year £258m (US$513m) Lyons-style bond for Australia’s QBE.
The new Merrill
In March 2005 Andrew Cooper turned up at Merrill Lynch as the bank’s new head of Asia-Pacific equity-linked markets. Cooper had recently lost his position at JPMorgan, where he was head of Asia-Pacific ECM, after the bank made him an offer he could only refuse.
JPM had asked Cooper to relocate to London to do a less interesting job, and he promptly resigned. But while he could have opted for early retirement, by taking a lesser position at Merrill Lynch he did something much more ambitious.
Cooper’s move to Merrill was well timed. At Merrill he plugged into a like-minded team of bankers who exactly matched his ambitions. Damian Chunilal, head of Pacific Rim investment banking at Merrill, was pushing a high-margin business strategy at the bank with a new radical approach.
That strategy has been evident – for better and for worse – across Merrill Lynch business lines globally. But in Asia, it has been most apparent in the firm’s approach to structured equity.
“In Merrill’s case, they [Chunilal and senior management] took the view that public CBs were not going to make money,” said Cooper. “They wanted to do more private business and more structured business. So did I, and we changed the business very rapidly.”
In that vein, Chunilal also hired Sheldon Trainor, who arrived at Merrill just after Cooper as the bank’s head of Asian investment banking. Trainor had great success helping build Morgan Stanley’s Asian high-yield bond franchise, and was drawn to the Merrill’s more open-ended, creative approach to banking.
Perhaps most fortuitously, Cooper hooked up with Soofian Zuberi (a co-head of Asian ECM) who also has a taste for structured deals and a long list of clients with unique funding needs.
As this team gelled the bank started to bring consecutively well crafted private deals that were extremely profitable. The business was not competitively tendered, as is the case with most CBs, so the fees are better. Merrill also often took positions in these deals alongside its hedge-fund co-investors.
The client roster increasingly turned to highly obscure names with little or no markets track record. Hints of this emerging Merrill model came out in 2006, when it did deals for little-known issuers such as Golden State, Berau Coal and Asia Aluminum.
In 2007, the bank really hit its stride. Perhaps the deal that best exemplified this new approach to banking was the Merrill-engineered buyout of Neptune Marine. In January 2007, CEO Idar Iversen approached Zuberi about a straightforward equity raising. The issuer was an oddity: the Singapore-headquartered, Norway-listed and Cyprus-registered company claimed two oil-drill ships as its main assets.
Other bulge-bracket investment banks might have politely declined this piece of business. Instead Merrill turned Iversen’s request into a far grander proposal: a management buyout that would give the 30-year oil veteran control of the company he had helped to build.
In less than two months the bank was in front of hedge funds with a US$185.4m privately placed deal to fund that buyout. It was a distinctly Merrill transaction. It was a high yield offer bundled with an array of warrants and options that gave investors upside should management sell Neptune via a trade sale or secondary float. The deal yielded 20% and Merrill got its taste – it took an 8% fee.
It was also a risky trade in that Iversen was aggressively leveraging up two skimpy assets. Investors were taking a chance that Neptune would not go into default. More specifically, they were gambling on Iversen and the company being able to quickly refinance the expensive deal.
When hedge funds who were invested in the Norway-traded Neptune shares challenged the legality of the Neptune deal in the Cypriot courts, the whole matter had the whiff of adventurism. What on earth was Merrill doing in Cyprus defending the legality of an over-structured deal for a small-time enterprise?
Merrill won its case: in his ruling, the judge scolded the hedge-fund plaintiffs for using the court to force Neptune into a higher buyout price. In November 2007, Iversen completed a trade sale of the company to Ashmore, a specialist investment fund. The hedge funds made their 20% return and Iversen hooked up with a supportive investor partner.
Merrill implemented a highly structured deal and took out that financing within a 12-month period – a perfect outcome for that kind of transaction. Few banks would have seen such opportunities in an entity such as Neptune. No other bank would have had the nerve, imagination or structuring ability to actually do the deals.
The Merrill model has another constructive trait: it is investment banking-led. Other banks, such as Goldman Sachs, consistently earn outsized profits trading via their prop book or principal investing (for example). Merrill Lynch makes outsized profits doing deals with companies, which gives the bank traction with investors, and sets itself up for repeat business from these issuers.
“We are focused on doing the right deals that transcend the capital structure,” said Zuberi. “Whether it’s debt, equity or hybrids, it’s all capital.”
Resona!
Through 2007 Merrill kept returning with similar deals for similarly obscure entities: Sky Fame Realty, Aban Singapore, Xinyuan Real Estate, China South City, and the like. Each deal had an original structure that addressed a particular issuer’s funding needs.
The connecting thread through the deals was that they were all big earners, and they were all for entities with highly promising growth stories. They were very willing to pay high rates for their capital, which drew hedge funds into the deals.
Then Merrill hit the mother lode. In April 2007 the bank did a ¥350bn (US$3.16bn) convertible preference share for Resona, a Japanese bank. The deal, codenamed Project Bert, was about six months in the making, and at several critical moments looked like it would slip away.
Such was the attractiveness of this deal that according to market sources Merrill was able to sell risk on the Resona pref shares to investors at about 107. That level would imply revenue of about 7% for the arranger, or a gross spread of about ¥24.5bn. But a finer look at the deal reveals less robust commission. To give the offer maximum flexibility of timing and to build in investor financing, Merrill structured the deal as a total return swap with a 10-year tenor. Underlying that swap were Resona's perpetual convertible preference shares that yield 93bp and convert at a 15% premium.
So to create this deal Merrill had to borrow ¥350bn. A significant amount of market risk was transferred to investors, but as part of financing the investors and taking the ensuing basis and credit risks in the deal, industry sources say Merrill would be required for regulatory reasons to maintain a capital cushion on its balance sheet.
Merrill policy presumably mirrors that of investment banks generally, who aim to achieve a minimum return on such regulatory capital. Merrill is committed to hold onto this position for at least two years, and hedge funds say they are paying ¥14bn of financing and risk charges, implying an actual fee in the region of 3%.
Nevertheless, these were big numbers all around and the Resona deal strikingly vindicated the new Merrill model. It would be tempting to predict that Merrill’s problems in the US will force it into a more conservative style of banking in Asia in 2008. But it was noteworthy that the bank did four private structured equity trades in the region during the July–August 2007 meltdown. As credit conditions tighten globally and issuers become desperate for capital, Merrill is likely to be standing by with an original idea.
Jasper Moiseiwitsch