Hybrid capital has been hailed as the Next Big Thing – but is it just hype? No, say enthusiasts, who believe the market can only expand. Yes, say doubters, who warn it is not for everyone. 

“It’s the era of hybrid capital,” proclaimed one London-based investment banker recently. The bond markets are always stirred up by a new product, and this year’s hot European property has been hybrid capital for corporates.

Bankers, it must be said, are displaying more enthusiasm for hybrid capital than the corporates themselves right now, not least because of the agreeable fees the work involves. Yet issuance this year has been steady, if somewhat slower than expected. And if reality has yet to live up to the hype, this new financing tool has unquestionable benefits for the right kind of issuer.

Hybrid capital behaves as part equity, part debt, and is structured to exploit the benefits of both. It can show up in the balance sheet as equity, with a positive effect on gearing and ratings. Since it is structured as debt, however, it does not dilute shareholders’ interests and is cheaper to raise than equity. What is more, coupon payments are tax deductible.

European debut

Hybrid finance came to Europe in a big way at the end of the 1990s, when European banks (and, later, insurance companies) recognised its advantages as a form of regulatory capital. The advantages were less clear to corporates that, for the most part, avoided the new structures. For one thing, they were not sure how investors would receive them. There was also uncertainty over the key question of equity credit and how much of it an issue could expect to be assigned. It seemed that the rating agencies were kinder to financials on this score than they were prepared to be to corporates.

In principle, the more equity-like the structure, the more equity is assigned. “Equity is marked by the lack of a maturity date and an absence of fixed payment obligation, and it is the most junior form of capital, meaning that no capital provider ranks below it,” says Karsten Frankfurth, a director at Fitch Ratings. “Therefore, a hybrid security will typically be considered more equity-like the more distant its maturity date, the more discretion the issuer has in making payments and the more junior the issue.”

Early test

A couple of corporate issuers tested the waters in 2003, achieving little or even no equity recognition. It was not until this year that the corporate market gathered any kind of momentum.
“A number of important constituencies came together,” says Chris van Niekerk, Barclays Capital’s head of corporate capital markets origination. “Rating agencies further clarified how they would treat corporate hybrids and accounting firms also expanded on how they would apply IFRS standards. Those were two important steps forward in terms of corporates’ understanding of how they could use this instrument.”

The sanction of tax authorities in different jurisdictions has been equally important, but what really broke the logjam was a February 2005 note from rating agency Moody’s, entitled ‘Refinements to Moody’s Tool Kit’.

Introduced in 1999, the Tool Kit is Moody’s framework for evaluating the relative debt and equity characteristics of hybrid securities. It positions them in baskets labelled A to E, with E representing the most equity-like. Its refinements heralded greater tolerance in assigning equity content and, notably, a willingness to award basket D status (75% equity) in the presence of mandatory non-payment triggers and strong replacement language.

“We felt we had not been generous enough in the interpretation of different features of hybrid instruments,” says Niel Bisset, a senior vice-president at Moody’s and a member of its new instruments committee. “So we took another look at how to factor in the existence of calls, and their impact on maturity. We also tweaked the equity credit attributed to certain other features.”

In some ways, Standard & Poor’s (S&P) had traditionally been more open-handed than Moody’s when it came to equity assignment, but it had always taken a dim view of step-up clauses. It, too, has restated its position.

“If step-ups provide a clear incentive to buy back, that contradicts the equity requirement for permanence,” says Emmanuel Dubois-Pelerin, a managing director at S&P. “So we spent a lot of time with arrangers discussing replacement language. Previously, an issuer could declare intent to replace with an equity-like instrument, but no-one agreed what was equity-like.” Given suitably strong replacement language, S&P is now prepared to assign more equity credit to deals with step-up clauses. It has also spelt out in more detail how it assesses mandatory coupon deferrals, giving more weight to triggers based on credit ratios.

Variety of structures

Once the agencies had set out the terms and extent of the equity treatment they were prepared to give corporate deals, issuance began to gather steam. Early hybrid issuers such as Linde, Michelin and Casino were followed by companies such as Südzucker, Vattenfall, Dansk Olie Og Naturgas (Dong) and Bayer. No two structures have been identical, partly because of local legal and tax variations and partly because each company has to trade off its strategic, equity and rating goals with the price and marketability of the issue.

Vattenfall, the Swedish state-owned electricity utility, achieved the highest equity content assigned so far: 75% from Moody’s, 60% from S&P. Its €1bn issue was structured as a perpetual NC 10, with a 100 basis points step-up and a mandatory deferral trigger. Südzucker’s €500m perpetual, very similar in structure, made it into the Moody’s D basket but was only assigned 50% equity by S&P. Unlike these two, Dong’s €1.1bn hybrid had no mandatory trigger and a 1000-year maturity, to comply with Danish tax law. It got 50% equity treatment from both agencies.

France’s Thomson pushed the envelope further with its €500m issue. Its business sector, media, was more racy than anything that had gone before, and its novel change of control covenant took the market some time to digest (see this month’s Issuer Strategy).

“There’s no such thing as a plain vanilla hybrid,” observes Mr Bisset. “There is a meeting of minds on 90% of the security but, because it’s such a young market, some new twist is always being thrown into the mix. If the market broadens, the scope for twists will diminish.”

There have been common threads. All the issues so far have been investment grade, even after descending two or three notches from the issuer’s senior rating. And they have all been of considerable size, with Thomson’s €500m at the lower end of the range.

While investors want liquidity, issuers have other reasons for going large. “A relatively small transaction may not move the needle,” says Nik Dhanani, vice-president in charge of debt capital markets product structuring at Bank of America, referring to the impact on capital structure. “If a company is going to invest all that time and effort, it makes sense to consider an issue size that makes a meaningful difference.”

Bigger deals expected

The deals will probably grow larger still. “There may be constraints on hybrid capital as a percentage of capital structure,” acknowledges Barcap’s Mr van Niekerk. “That aside, will we see the first €2bn-plus corporate deal? Why not? I can see these transactions going up in size.”

He also predicts that the next development phase will include more investment grade names issuing hybrid paper carrying sub-investment grade ratings. “There are cost implications but we believe this segment has potential to open up and become available to select issuers,” he says. “The instrument is in a comparatively early stage of development, but it is definitely getting a higher place on issuers’ agendas – even if it means just being aware at this stage of another available capital raising tool.”

Many bankers expect a resurgence in M&A activity to precipitate more hybrid issuance. “Investors’ and issuers’ comprehension of the product continues to grow,” says Peter Charles, Citigroup’s London head of corporate fixed income syndicate. “That coincides with more opportunities for funding as M&A activity increases.” The inclusion next year of corporate hybrid issues in iBoxx fixed income indices should boost investor demand, he adds.

Weakening outlook

Investors have given the new instruments a warm reception so far – although the appetite of some is waning as the economic outlook weakens. “The first few offered good value in an environment where it was difficult to pick up spread,” notes Rebecca Seabrook, director of UK credit at fund managers Foreign & Colonial. “Vattenfall in particular was very cheaply priced.” Ms Seabrook says, however, that as economic fundamentals worsen, corporate hybrid spreads are likely to be the first to widen. “So we were short-term holders – we don’t want to take that risk in the current climate.”

Now that the underlying concept is more familiar, investors who stay in the market should become more sensitive to nuances of structural variation, and pricing may begin to reflect those differences more than it has done. Most agree, however, that issuance needs the right conditions to thrive and that increased market volatility will lead to plans going back on the shelf.

“This will remain a select part of the marketplace,” predicts JC Perrig, Bank of America’s head of international capital markets. “Corporate hybrid is not an instrument that fits all issuers.”

Mr van Niekerk seems to agree. “It naturally costs more than senior debt,” he points out. “So any issuer will think hard about the reasons for using a hybrid. Is the instrument helping to roll out the company’s strategic plans? If not, there’s a risk of ending up with an instrument that looks more like expensive debt, rather than cheap equity.”

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