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Investment bankingDecember 30 2009

Naftogaz prises open financial pipeline

The successful debt restructuring by Ukraine's gas importer has eased short-term difficulties and offered hope for better government and corporate financial management in the future. However, the country's track record of disappointment in such matters still hangs heavy. Writer Philip Alexander
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Naftogaz prises open financial pipeline

Gas distributors across Europe breathed a sigh of relief in late November, when Russian gas producer Gazprom signed a new supply deal with Naftogaz, the Ukrainian gas importer that distributes much of Russia's gas exports to the rest of Europe. An agreement not to fine Naftogaz for its failure to take up, in 2009, the quantities of gas originally envisaged in its contract means that Ukraine should avoid a rerun of the supply stoppages that have dogged previous winters.

This is a rare sign of improved stability in Ukraine at a time of unparalleled political noise, as the country gears up for a hard-fought presidential election, which will begin in January 2010. In fact, the conditions could hardly have been more difficult when Naftogaz indicated in mid-2009 that it would not be able to repay a $500m loan participation note (LPN) issued through Standard Bank, which was due to mature on September 30, 2009.

Ukraine is deep in recession, with gross domestic product (GDP) expected to contract by as much as 14% in 2009. Many locally owned banks had been reliant on foreign capital market funding for ambitious expansion programmes during the boom years. When that funding dried up from October 2008, it plunged the banking sector into crisis. Liquidity drained away, pressuring foreign exchange reserves as dollars became scarce. After foreign exchange reserves fell 15% in one month, the National Bank of Ukraine (NBU) was forced to let go of its previously tight hold on the exchange rate, which then plunged nearly 60% by January 2009.

The International Monetary Fund (IMF) stepped in quickly, approving a $16.3bn loan package in November 2008. However, a fractious Ukrainian government has struggled to meet conditions attached to the loan, especially due to disputes between election rivals president Viktor Yushchenko and prime minister Yulia Tymoshenko. In November 2009, the IMF chose to postpone its next disbursement until after the presidential elections have hopefully clarified the policy agenda.

Direct impact

This turmoil has particular significance for Naftogaz, which has a high foreign exchange turnover as it buys about $500m in gas from Russian supplier Gazprom every month. At one stage in the restructuring process, the dispute between Mr Yushchenko and Ms Tymoshenko directly hit the company, according to Alexey Olshansky, managing director of the private investment fund Corlblow that held $11m of the LPN.

"Amid this power struggle, Naftogaz lost the sources of domestic funding in Ukraine. The National Bank of Ukraine is controlled by the president. Naftogaz is controlled by the prime minister. The National Bank technically closed all the channels of liquidity for the government and for Naftogaz. The situation became grotesque," says Mr Olshansky.

Naftogaz had about $3bn in Ministry of Finance bonds on its books, which could not be sold for cash in the local market due to the liquidity squeeze. The NBU refused to provide alternative liquidity, so the government was obliged to sell to the NBU special drawing rights (SDRs) received from the IMF, which were originally intended for currency-stabilisation purposes. This generated the cash dollars that the government could channel to Naftogaz to pay both the final coupon on the LPN and the gas import bill for September and October.

Restructuring plan

Even the choice of restructuring advisors generated political controversy. Naftogaz initially selected a newly formed three-man partnership called Squire Capital, prompting criticism from President Yuschenko's camp that no proper tender had been held.

In practice, the qualifications of the Squire Capital team were clear enough. One of the three, Timur Khromaev had been a debt management official at the Ukrainian finance ministry before setting up his own advisory firm, ARTA, in 2002. Simon Drake-Brockman had been the head of capital markets at Royal Bank of Scotland and Robert Grant had been the head of ING Bank in Ukraine. Previously, Mr Drake-Brockman too had worked at ING and the two bankers had met Mr Khromaev when they managed a number of refinancings and restructurings for the Ukrainian finance ministry. The largest of these was in 2000, when Ukraine restructured six classes of bonds worth about $3bn, including a Deutschemark-denominated issue held by about 20,000 retail investors, whom the ING team reached out to through the internet.

"The ministry liked how hard we fought on the earlier deals and thought it would be good to have us working with it once more. In 2000, we ended up getting the restructuring done with 98.6% of bondholders agreeing to the deal. Most bankers who pitched to it thought it was impossible to get that deal done," says Mr Grant.

So the team was a natural choice to provide strategic advice for the Naftogaz deal, and Credit Suisse was subsequently mandated to manage the transaction in the bond market. The eventual deal not only refinanced the maturing LPN for a further five years, but also included refinancing of three bilateral loan agreements with Credit Suisse, Deutsche Bank and Depfa, bringing the total of the new issue to $1.6bn.

Andrew Burton, director in the liability management team at Credit Suisse, says the LPN was widely held, with more than 150 private bank holdings, and many private or corporate investors holding small pieces of up to $200,000.

Mr Grant says the transaction quickly proved even more complicated than previous restructurings he had worked on. Corlblow assembled a group of noteholders with at least $112m of the LPN in total, potentially blocking the 75% supermajority needed for a restructuring and demanded specific improvements in the conditions offered.

Naftogaz executives suggested that Mr Olshansky, who had been head of the Gazprom insurance subsidiary Sogaz, was a stalking horse for Russia's own disputes with Ukraine over gas pricing and late payments. However, Mr Olshansky says he did not co-ordinate with Gazprom (he was an interim head of Sogaz for just one year) and that he was always motivated purely by trying to get the best deal as a creditor who had been surprised by Naftogaz's decision not to repay.

"I don't think Gazprom has more information than any of us. It is just keeping its fingers crossed and hoping every month that the gas import bill gets paid," he says.

Instead, Corlblow's focus was on co-ordinating with other dissenting noteholders through a public information campaign. "We had a hunch who some of them were and others came forward of their own accord after seeing our website. To our surprise, they came from pretty much all corners of the world, from Brazil and from private banking clients in Hong Kong, including many from Credit Suisse's own private banking arm," says Philipp Thomas, Corlblow director and legal advisor.

Sovereign guarantee

Corlblow initially pushed for immediate repayment in full, but as the activist group lacked cohesion, it settled for a compromise in extending the maturity for a further five years. Naftogaz offered a coupon of 9.5%, increased from the original proposal of 8.125%, and the company agreed to make the final coupon payment of 4% on the maturing LPN. The final restructuring offer achieved a 94% acceptance rate among noteholders, including Corlblow itself.

What proved most challenging was the noteholder demand for a sovereign guarantee on the new issue. "After we contacted other noteholders, it was clear that no one would exchange the LPN for standalone Naftogaz credit risk. In five years, the company may not exist any more - after all, that is what happened to Ukragazprom, the company that was replaced by Naftogaz in 1998," says Mr Olshansky.

The sovereign guarantee was a logical step, says Mr Burton, as the company is 100% state-owned, the prices for its imports are heavily influenced by the Ukrainian government in discussions with Russia and the prices for domestic sales are also set by the government. As the company had been selling gas domestically at below cost price, the government had also been subsidising Naftogaz to offset those built-in losses - the company reported losses of more than $230m in the first three quarters of 2009.

But while the principle of a sovereign guarantee was accepted by the finance ministry, the execution was far more complicated, especially given the growing significance of the credit default swap (CDS) market. Investors wanted a bond that could be delivered into both Naftogaz CDSs to protect creditors' existing CDS hedges, and Ukraine sovereign CDSs to provide an efficiently priced instrument for the debt extension.

It was also important to hold the auction process only after the single new Eurobond instrument was available, to provide certainty in the market about what debt instruments were eligible in the CDS auction following the Naftogaz CDS trigger on the existing LPN. This avoided the confusion in the CDS market that followed the default by BTA Bank in Kazakhstan earlier in 2009.

"Credit Suisse reached out to the CDS determination committee to build a consensus that, although a trigger had been hit, it was in the interests of the CDS participants to await the outcome of the restructuring process, to avoid both the new and the legacy bonds and loans from being involved in the CDS auction," says Mr Burton. The determination committee also carried out a 'pre-scrub' of the new Naftogaz bond documentation to reassure the banks who were transferring individual loan agreements into the new Eurobond that their CDS contracts would be deliverable in the auction.

Finally, the Eurobond also needed to be a direct obligation of Naftogaz, rather than an LPN, to achieve the CDS deliverability that investors wanted. This required specific authorisation from the Ukraine State Commission for Securities and Stock Exchanges, which had historically forbidden local companies from issuing bonds governed by foreign law. That restriction forced companies to make use of the indirect LPN structure, where an enabling bank (in this case, Standard Bank) makes a loan to the company and then issues a note into the Eurobond market linked to the performance on that loan.

In addition to creating complications for CDS deliverability, the LPN structure is more expensive for the issuer, so there was widespread hope that the Naftogaz special dispensation might also be the opportunity for a wholesale review of the restrictions on direct Eurobond issuance.

In practice, says Carter Brod, capital markets partner at law firm White & Case, who has worked on a number of Ukrainian LPN deals, the trend seems to be in the opposite direction. Partly, this is due to NBU efforts to minimise foreign exchange outflows and reduce pressure on the exchange rate.

"The NBU has recently re-introduced its maximum interest rate limitations on foreign borrowings, which are applicable to LPN deals, and has also introduced a new law that, among other things, prohibits Ukrainian debtors from making certain prepayments of their debts to foreign creditors," says Mr Brod.

Ukraine - External financial position, August 2008-November 2009

Ukraine - External financial position, August 2008-November 2009

Uncertain future

Ukraine's ongoing financial difficulties therefore continue to cast a shadow, even after Naftogaz has resolved its short-term difficulties. The IMF apparently met restructuring advisers early in the process to urge a consensual, market-based deal. Although the sovereign guarantee creates extra contingent liabilities for the government, Ukraine's public debt levels remain relatively low - at about 35% of GDP in 2009. Consequently, the deal was acceptable to the IMF, provided it is the precursor to a proper reform of the gas sector to ensure the guarantee will not be needed, says Ceyla Pazarbasioglu, the IMF's mission chief in Ukraine.

"The IMF programme includes increased gas prices to bring them in line with cost recovery, measures to improve collections, and more transparent financial reporting. Going forward, the government needs to be careful with other guarantees and to make state-owned companies work profitably so that they can service their own obligations," says Ms Pazarbasioglu.

Mr Grant says that the new Eurobond is structured like a sovereign issue, without specific corporate performance covenants. This means the guarantee can only be triggered by an actual failure to pay on the Eurobond.

The new bond gives the government a window of opportunity to make whatever changes are necessary to return the company to financial viability. With the sovereign guarantee in place, Mr Thomas says that bondholders can afford to be agnostic about whether the government will follow through. But Mr Olshansky, who is considering adapting Corlblow into a dedicated activist investment fund for the eastern Europe region, sounds a more optimistic note on the post-election perspective.

"Transit fees paid by Gazprom to Naftogaz will be doubled in 2010, which could improve profitability, and the government is currently considering breaking the company into three parts - production, transit and sales - and possibly privatising some or all of these," says Mr Olshansky.

Political implications

Like so much else, however, these crucial financial decisions will have heavy political implications. Naftogaz has proposed charging domestic customers 20% more per quarter in 2010 to close out its losses.

"If Ukrainian domestic gas prices are increased that much, the chemicals industry and metals industry will be hit and the wider population will not be able to pay, so it is crystal clear that Naftogaz will not be financially self-sufficient in the next few years. It will need support from the government, which does not yet have a clear plan to cover the budget deficit," says Marina Vlasenko, corporate credit analyst at Commerzbank.

She is at least reassured that there is little sign of the government allowing other companies to queue up for sovereign guarantees on their debt. Ukraine Railways (Ukrzaliznytsya) is already renegotiating a three-year $440m syndicated loan deal arranged by Barclays Capital in 2007, with Squire Capital once again advising. This suggests that the government is still committed to private sector solutions for companies that are privately owned and less strategically sensitive than Naftogaz.

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