The structural flexibility of hybrid capital means that it should be an essential instrument in the acquisitions toolbox, and ideal in helping to provide the optimal solution for banks in an environment of cross-border consolidation, writes Nigel Howells.
To achieve the optimal level of capital is a challenging exercise for banks that need to take into consideration regulators and rating agencies’ requirements, and create maximum value for shareholders.
In a cross-border consolidation environment, the creation of a capital buffer to be deployed for future acquisitions makes the capital management exercise even more complex for banks that face a unique set of funding challenges as they must construct the optimal solution that:
- delivers an attractive acquisition bid;
- provides funding for potentially multi-billion euro transactions;
- maintains a solid capital base that meets regulatory and rating agencies capital requirements;
- meets shareholders’ interests.
In this scenario, the full suite of hybrid capital products should be considered as part of a potential funding solution.
The use of hybrid capital as a tool for acquisition finance is not a new phenomenon. The consolidation in Europe in 2000 resulted in an estimated €15bn of hybrid capital being specifically raised by banks (according to issuers’ public statements) to support acquisitions. Royal Bank of Scotland’s $2.2bn hybrid capital, raised as part of a funding package for the £24bn ($44.46bn) acquisition of NatWest Bank, is a key example.
When consolidation returned to the European banking sector in 2005-06, hybrid capital was back on the agenda as an acquisition finance tool. The resurgence in mergers and acquisitions (M&A) coincides with a period in the debt capital markets characterised by compressed credit spreads and a deep institutional and retail hybrid capital investor base, both of which are open for business. As a result, this has created a ‘perfect storm’ for banks that are raising hybrid capital for acquisition purposes.
How significant is hybrid capital as a proportion of overall acquisition funding? The deal sample shown in graph 1(see below story) includes European bank acquisitions greater than €1bn where hybrid capital either expressly formed part of the funding package (stated in public information) or was issued in the month preceding the acquisition announcement, during the acquisition period or two months subsequent to the acquisition date.
Funding tool
The following features relate primarily to Tier 1 hybrid capital instruments used to maintain a minimum Tier 1 ratio, but with lower Tier 2 and upper Tier 2 hybrid capital offering a tax-deductible solution that supports the total capital ratio. These are often used as part of a total hybrid funding package, as seen in the UniCredit case study later in this article.
No tax frictions
As banks must hold a minimum level of Tier 1 and total regulatory capital, the cost of funding is a critical consideration in meeting regulatory capital needs. Hence, bank treasury teams use tax-deductible hybrid capital as part of their normal operations to supplement equity (the ‘purest’ but non tax-deductible form of capital), and hold a buffer above the minimum regulatory margins (usually total capital ratios at least 8% risk-weighted assets [RWAs] and a Tier 1 capital ratio a minimum of 4% RWAs).
Regulatory capital base
Goodwill arising as a result of acquisitions must be deducted from Tier 1 capital, thereby causing both Tier 1 and total capital ratios to fall. However, because banks seek to maintain a buffer above minimum regulatory capital ratios, and demonstrate strength at a time when stakeholders (regulators, shareholders and rating agencies) will be monitoring a post-acquisition business model closely, maintaining stable capital ratios is critically important.
When comparing the components of Tier 1 capital (paid-up common stock, disclosed reserves, interim profits, minority interests and Tier 1 hybrid capital up to specified regulatory limits) in relation to the sources of external funding, a clear cost advantage exists for hybrid capital vis-à-vis common equity.
Accounting and rating
Since the implementation of International Financial Reporting Standards (IFRS) in 2005, issuers have been able to engineer either debt or equity treatment for accounting purposes under the IAS32 standard. The perceived benefits of classification as either debt or equity treatment varies between issuers. Broadly speaking, equity accounting may benefit leverage or interest coverage ratios, whereby debt accounting has the benefit of enabling an issuer to apply hedge accounting to an associated interest rate swap under the IAS39 standard.
Another factor that is often overlooked when banks raise hybrid capital is the rating agency’s perspective. As a rule, banks do not seek incremental benefit from the rating agencies but DZ Bank, Banco Pastor and Fortis Bank have structured Tier 1 new issues for Moody’s equity credit (albeit not in an acquisition context).
Market access
Hybrid capital can be issued (subject to market conditions) at very short notice, possibly in a matter of weeks rather than months depending on the target market and regulator approvals. In addition, subject to the individual regulator’s limitations, certain elements may be varied to best capture investor demand and issuer needs (for example, the opportunity to tap an issue/longer call dates, etc).
In fact, the reasons for banks not issuing tax-deductible hybrid as part of an acquisition strategy may be dictated largely by the innovative and non-innovative Tier 1 regulatory capital limits imposed (varying by country), and the utilisation of that headroom as part of ongoing efficient capital management.
Case studies
Unicredito Italiano SpA (UniCredit) acquired HVB Group through a share-for-share offer with all newly issued shares in June 2005, with the transaction completed in November 2005. The capital ratios, according to Standard and Poor’s (S&P), declined sharply post-acquisition with HVB’s weakened capitalisation cited by the rating agency as the reason. As a result, S&P put UniCredit on a negative outlook with an expectation that it rebuilt its capital ratios over the next two years. Hence, UniCredit went to the hybrid market in October 2005 with a dual-tranche Tier 1 issue (€750m and £300m) and again in January 2006 with another dual-tranche issue, this time in UT2 (€900m and £450m) using the flexibility and cost advantages of the hybrid capital spectrum of products to rebuild target capital ratios.
Commerzbank’s €5.6bn acquisition of Eurohypo stands out in its use of hybrid capital as an acquisition tool. Based on estimates, Commerzbank funded 39% of the total acquisition with hybrid capital, about twice the average level used in European bank acquisition financing in 2006 to date. This was Commerzbank’s debut in the Tier 1 market and the dual-tranche Tier 1 issue (£800m and €1bn respectively) achieved two records: the largest Tier 1 issue by a German bank and the largest sterling Tier 1 by a European issuer. The deal is particularly significant because it demonstrates the potential use of hybrid capital as an acquisition financing tool for an infrequent issuer in terms of the depth of the market and the ability of new issuers to access cheap capital.
Structural flexibility
In the context of a bank acquisition, whether as part of the original funding package or the capital management process afterwards, the structural flexibility of hybrid capital means that it should be part of any acquisition toolbox, subject to existing headroom and regulatory capital.
The critical benefit of the most deeply subordinated forms of hybrid capital is the arbitrage that is possible between the different stakeholders. In practice, this means that equity for regulatory capital purposes can not only be debt for tax purposes, but also equity again for accounting or rating agency purposes (or another combination). In the context of an acquisition, this makes for a powerful solution because the product can be specifically tailored and thereby used as a complementary tool with other funding.
Nigel Howells is director of hybrid capital structuring, ABN AMRO.
