When energy producer Drax’s equity began to rise along with the rest of the market, it was a choice of sale or IPO. Lead adviser Deutsche Bank explains why it chose the latter. Edward Russell-Walling reports.

Drax bondholders cast a firm vote of confidence in the equity markets when they chose an initial public offering (IPO), rather than a trade sale, to draw a line under the company’s close brush with bankruptcy. But it was Deutsche Bank’s shrewd structuring of the sale that smoothed the transformation of once-distressed debt into equity with the minimum of pain.

Drax, located in Yorkshire, UK, is Europe’s largest coal-fired power station It was first auctioned off by the UK’s National Power in 1998, under pressure from the national energy regulator. It was sold to AES Corp of the US with an enterprise value of around £1.8bn, in a transaction underpinned by a complex and highly leveraged structure. That structure was heavily dependent on a long-term supply contract with the electricity utility TXU Europe.

When the power market nosedived in 2002, TXU Europe collapsed, nearly taking Drax with it. After a failed attempt at restructuring, AES walked away, leaving ownership in the hands of creditors, mainly composed of lending banks, including Deutsche Bank.

A restructuring in late 2003 created multiple tranches of debt, most trading below par, and much of which eventually ended up in the hands of hedge funds. The equity, stapled to one of the tranches, was implicitly worthless, though it would not remain so.

“Deutsche Bank had a substantial position, and we were the facilitating agents for the restructuring,” explains Alan Brown, director in charge of corporate finance coverage for UK utilities at Deutsche. “So different parts of the bank have known and understood Drax for some time.”

Gradually, the shift that creditors had been holding out for began to take place as the power market turned upwards. Gross margins or ‘dark spread’ (the difference between power prices and the price of coal less carbon permits) were again on the rise. “Drax’s prospects were improving, and its implied equity value became positive around the spring of 2004,” Mr Brown says.

Evaluating the options

In 2004, Dresdner Kleinwort Wasserstein was appointed to evaluate the options open to the bondholders. Its advice was to refinance the debt, unstaple the equity element and possibly float the business.

Deutsche Bank won the beauty parade for a lead adviser and sponsor. “We were appointed to execute that plan,” says Mark Cross, managing director, natural resources M&A, “and to pursue all other strategic alternatives.”

There were quite a few of those. Full or partial refinancing? List the equity or find an M&A buyer? Acquire other power stations to create a portfolio before putting the company up for sale? “We concluded that a full refinancing with the intention to list was the best plan in the immediate term,” Mr Cross recalls, pointing out that this was not an end in itself and did not preclude other options such as asset acquisition or a sale to a trade buyer if the price was right.

Best course to take

The next challenge was to persuade a majority of shareholders that this was the most sensible course of action. “They were a diverse group,” says Sam Dean, co-head of European equity capital markets. “In terms of their mandates, some were able to own equity while others would be forced to sell it. We tried to make them all feel that this was the best solution.”

The Drax board, chaired since 2003 by former PriceWaterhouseCoopers accountant Gordon Horsfield, put a premium on open communication with the shareholders. Deutsche acknowledged the good sense of the approach, and organised a roadshow to share its views with larger investors, and to hear their thoughts in return.

The capital structure to which they finally agreed would consist of investment grade debt – £877m in new facilities – and common equity. In summer 2005, shareholders generally consented to a listing in mid-December.

Everyone realised that a dual-track process can have a life of its own. “There was a risk with a formal M&A process that, if the company was not sold, the IPO might be seen as merely the second-best option,” says Mr Cross. But, as he and his colleagues emphasise, it was very difficult at the outset to know which route was likely to deliver the best price.

The first of a number of approaches appeared in the autumn. The offer came from Constellation Energy and Perry Capital of the US and gave Drax an enterprise value of some £1.9bn. “We had put in place a procedure that allowed us to compare M&A offers with the possible value in a listing,” Mr Cross explains. “And we felt that this first offer was substantially below fair value.”

Next came another US consortium offer, from Apollo, Texas Pacific and TowerBrook, worth £2.1bn. A slightly lower bid came in from International Power of the UK together with Japan’s Mitsui. Finally, there was a revised offer from the Constellation consortium, which had taken on new partners, including private equity firm Blackstone Group. This was the highest yet, at £2.2bn, and Constellation mounted its own roadshow for shareholders.

The price at which the debt was trading provided an implied market valuation. Alongside that was a valuation based on more fundamental analysis. “All three bidders were deemed to fall short of both valuations,” Mr Cross says. “A large majority of the shareholders concurred – in fact, the investors saw off the bids before the company did.”

The last bid was withdrawn in mid-November, and everyone’s focus turned to track number two, the IPO. Preparations for this route had been proceeding quietly in the wings, regardless of the trade negotiations, and a grey market in ‘when and if issued’ shares had been in place since September. But now the IPO moved to centre-stage.

No greenshoe

Of course, this wouldn’t be a normal IPO. There would be no bookbuilding exercise to find the right price, for one thing, and no possibility of a greenshoe – the option to sell additional shares if demand is high – to support it. No one knew for certain how the shareholders, who held all the stock, would behave. They might all sell; none might sell. The potential for disorganised aftermarket trading was considerable, and the thought of British Energy was never far from anyone’s mind.

Having experienced a crisis, for similar reasons, British Energy was relisted in London during January 2005. The shares fell nearly 10% in the first fortnight and it was more than a month before they regained float price levels. Certain other debt-for-equity swaps in recent times have fared even worse. The biggest problem here is investor perceptions of a stock overhang with the bondholders, which can prompt a buyers’ strike.

Deutsche Bank’s solution was both didactic and mechanical. Now that the IPO was definitely on, the company and its advisers could intensify the process of educating potential investors, with a series of analysts’ meetings and a roadshow from late November to early December. The listing was set for 15 December.

Besides this, generating more interest in the shares, was the Deutsche-initiated over-the-counter market in ‘when and if’ equity. Though others made markets in these instruments, Deutsche Bank claims to have dominated the trade, which totalled some £500bn.

The bank added one innovative twist to ease the transfer of stock from debtholders to equity investors. This was its pre-listing organised order-matching mechanism (Ploom). Ploom facilitated a two-way auction in which debtholders could sell and investors buy, allowing the price to be set wherever the maximum volume could be executed - at 500p, as it happened. The highest M&A offer had been worth 422p.

Exceeding expectations

“Ploom gave buyers the opportunity to come in, in size, and let the market feel it had got rid of the natural overhang,” Mr Dean says. “We thought we might execute £60m-£70m via the Ploom but, in fact, it was £173m – not far off 10% of the market cap. It was a highly successful exercise, and gave the market a serious reference point as to where natural interest in the stock lay.”

At an opening price of 500p, Drax had an enterprise value of nearly £2.5bn. Most satisfying of all, the aftermarket price did not fall off a cliff. True, it closed 10p down on day one, but that was the merest of blips, and by early in the new year the price was up by nearly 10%.

“We delivered on all our promises,” says Mr Cross. “And we have a very happy client.”

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