Accelerated book builds: a risk worth taking?

In the battlefields of present day capital markets, with their merciless focus on the bottom line, it is assumed that profit is the only endgame. The truth, however, is more complicated. In Europe's hyper-competitive investment banking fraternity, a somewhat incongruous phenomenon has emerged, which reveals that there are matters at play beyond the brutal mathematics of the basis point.

The phenomenon has been observed in equity syndicates, where the intensively competitive practice of accelerated book builds (ABBs) has thrown up some bewildering results in recent months. ABBs are the placing of shares with little or no marketing over an extremely short period, designed to reduce the impact of price volatility for corporates and earn solid earnings for banks.

Facing drawbacks

Many of them are failing to achieve both aims. A recent anomaly was the placement of shares in Italy's Banca Monte dei Paschi di Siena, the oldest surviving bank in the world. In early June, Goldman Sachs sold $535m of Monte dei Paschi stock in an ABB on behalf of shareholder Fondazione Monte dei Paschi di Siena. Goldman priced the block of Monte dei Paschi stock at about a 5.2% discount on the market price. However, in the course of the ABB the shares fell and subsequently traded substantially down.

Rivals estimate that Goldman was left nursing a $30m headache, and the extent of its pain was confirmed when the bank was listed as a shareholder in Monte dei Paschi’s prospectus for its subsequent capital increase. “That was one big, ugly loss,” says the head of equity capital markets (ECM) at a rival bank. “Once the share price dropped [Goldman was] left staring into the Black Hole of Calcutta.”

Goldman is not the only market maker to get on the wrong side of an ABB. Commerzbank, Deutsche Bank and HSBC Trinkaus & Burkhardt were, in July, mandated to run a placement of treasury shares for German steelmaker and engineering company ThyssenKrupp, amounting to 9.6% of its capital stock. The banks sold only half of the 49.5 million allocation, according to rivals, and when the shares subsequently traded down each bank lost about $10m. A spokesman for Deutsche said neither of those figures were accurate.

More risk than reward

Quick execution, often combined with guaranteed pricing, make ABBs extremely attractive to European companies looking to raise quick cash, and ABB volumes in Europe, the Middle East and Africa (EMEA) stood at $37bn for the year to July 20, the highest figure since 2007. This represents close to 30% of all EMEA ECM activity, the highest percentage for four years, according to information provider Dealogic.

But for banks, margins are low compared with traditional offerings, and the risks are high. Some 50% to 60% of transactions are underwritten by bookrunners, and it is not unusual for them to lose money. Almost half of 2011 transactions above $500m subsequently traded below their book build price. These include Spain's ACS Actividades de Construcción y Servicios, communications firm Inmarsat and Banco de Sabadell.

“We have seen a few occasions where people get slightly over their skis in terms of pricing and risk,” says Edward Sankey, global co-head of equity syndicate at Deutsche Bank. “There are occasions when the risk-reward profile may not be skewed in the right way.”

Still, not all deals tank. In March, Goldman Sachs was appointed by German industrial company Schaeffler to sell a 15% stake in car parts manufacturer Continental to reduce its debt. The sale went according to plan, sources say, and Goldman made money.

“Over the past 18 months we have done 40 or 50 [ABB] deals and we have lost money once,” says Alasdair Warren, Goldman Sachs’s London-based head of ECM for EMEA. “In many ways it’s a good business, with decent margins.”

The secret of success in block trades is to focus on it as a standalone business, and many banks do not do that, Mr Warren adds.

All in the structure

Whether or not a bank profits from an ABB can often depend on the structure of the deal. In the simplest case, a company will approach a bank or group of banks and ask for a 'best effort' in offloading shares at the highest possible price. From the banks' point of view this is the ideal scenario, with little risk involved.

Recent best effort deals include the March sale by BASF, the world's largest chemical company by sales, of its €1.07bn stake in potash miner K+S, led by Bank of America Merrill Lynch, and the sale by Aviva Life Insurance of its stake in Dutch life insurer Delta Lloyd in May. The latter completed at a deep 9.5% discount to the share price, but again was at no risk to bookrunner Morgan Stanley.

A second, more common ABB format contains considerably more risk to the bank. Under this formula, the bookrunner provides a price guarantee to the share seller, so that the deal is hard underwritten, with the bank hoping to place the shares at a higher price than the guarantee. A twist on the contract is that the corporate and the bank agree to split any excess price at some mutually agreeable rate.

The third type of book build is the most dangerous for banks, and is the one that was employed in the Banca Monte dei Paschi di Siena and ThyssenKrupp deals. Under this process the share seller runs an auction with up to 10 banks invited to submit their best possible price, with the winner likely to be the one that bids the tightest spread to the market.

“There is a real winner's curse associated with this one,” says one banker in London. “Even if you get away with it, the whole game is the equivalent of picking up pennies in front of a steamroller – you can lose a lot but you are never going to win much.”

Banks charge fees of between 0% and 1% of the value of the deal for leading a book build, but given the competitive dynamics the figure is usually closer to the former than the latter.

Another way to make money is that the market moves in favour of the bookrunner, with the share price rising beyond the guaranteed price, generating an automatic profit. Certainly ABBs are more common following a few days of positive equity market sentiment, but no bank is confident enough in its predictions to predicate a capital markets business solely on market sentiment.

In addition, hedging is considered virtually impossible, with single stock options rarely available or too expensive for large short-term exposures, while macro hedges via index trades fail to capture idiosyncratic risk around single names.

For show

And there is the rub. If ABBs are risky, hedging virtually impossible and rewards low, then why do banks get involved?

The first reason is likely to be a market judgement call combined with relationship building. Corporates selling stakes in other companies tend to be big players, with hefty balance sheet requirements. Banks are aware that the short-term pain may be worth the long-term gain. Investing clients, on the other hand, appreciate the liquidity offered by block trades.

“You are supposed to be working for shareholders and we will do block trades if there is conviction on the stock, or there is good risk reward,” says Craig Coben, head of EMEA ECM at Bank of America Merrill Lynch.

However, there is another reason that banks do ABBs. It is not one they will readily admit to. The spoils of a successful ABB are recognition in the banking community and among corporate banking clients that a particular bank is a well-connected operator that can execute with impressive efficiency. Laurels are awarded for successful book builders, burnishing reputations and laying the groundwork for recognition by colleagues and bosses. These are key motivators, bankers say.

Bankers' pride

Bankers also argue, however, that the rise of ABBs as a proportion of market activity is driven more by a bank’s standing in the rolls of honour of the capital markets – the league tables published by providers such as Thomson Reuters, Bloomberg and Dealogic.

“The positive spin on success in aggressive bidding for accelerated book builds is that the team has confidence in its trading and distribution,” says one managing director at a large bank in London. “The realistic spin is that they are trying to buy their way to league table glory. It’s a mixture of internal pressure and institutional insecurity and anybody who tells you otherwise is not telling you the truth.”

The top three banks in EMEA ECM year-to-date are Goldman Sachs, Deutsche and Credit Suisse, according to Dealogic. More than half of Goldman’s deals were ABBs. “Sometimes block trades are a way some banks will look to gain market share in the volume league tables,” said Deutsche’s Mr Sankey.

In many cases that may involve losing money, but the honour of besting one peer’s may sometimes outweigh the inconvenience of the financial loss.