Back with a bang: Lloyds achieved Europe's largest fully underwritten capital-raising exercise to date

The £22.5bn recapitalisation of Lloyds Banking Group last November not only kept the institution free from outright government control, but helped to rehabilitate the financial markets. Writer Edward Russell-Walling

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Alex Wilmot-Sitwell, co-CEO of UBS Investment Bank

UBS

Alex Wilmot-Sitwell (pictured), co-CEO of UBS Investment Bank.

Chris Fox, managing director, financial institutions group (FIG).

Vinod Vasan, head of FIG debt capital markets (DCM), EMEA.

Chris Smith, head of UK equity capital markets.

Tim Waddell, joint head of UK investment banking, broking.

Rob Ellison, deputy head of FIG DCM.

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Matthew Greenburgh, head of international financial institutions advisory

BAML

Matthew Greenburgh (pictured), head of international financial institutions advisory.

Rupert Hume-Kendall, president of international equity capital markets.

Sid Prasad, head of EMEA FIG capital markets and financing.

Jim O'Neil, head of international corporate finance and restructuring.

John Cavanagh, head of EMEA liability management.

Lloyds Banking Group's whopping £22.5bn ($36.6bn) recapitalisation last November showed the financial markets doing what they do best. Europe's largest fully underwritten capital-raising exercise to date, embracing both debt and equity, it included a trailblazing contingent convertible (CoCo) note exchange and was absorbed by the market with no difficulty at all.

Lloyds itself, under CEO Eric Daniels, was anything but a silent partner in the conception and execution of the transaction, and deserves most of the credit for it, according to one of its advisers. But Bank of America Merrill Lynch (BAML) and UBS played a vital role in its design and - crucially - in persuading government and regulators that it was do-able.

Both banks have long-standing relationships with Lloyds and, indeed, both advised on its ill-fated acquisition of HBOS, agreed in autumn 2008. That left the enlarged group with many billions of pounds worth of questionable mortgage assets, and led to its nationalisation, after a capital injection by government gave the state 43.5% of the shares.

Lloyds then faced a number of different pressures. One was to participate in the government's Asset Protection Scheme (Gaps). In March 2009, it signed an agreement to place £260bn of assets into this toxic asset insurance scheme, for a participation fee of £15.6bn. On implementation, the government would convert its preference shares in Lloyds to ordinary shares, leaving it with a majority stake unless other investors were prepared to buy the stock.

Finding a solution

As markets recovered, Lloyds began to look for a better solution. The Financial Services Authority (one of the tripartite UK regulators, along with the Bank of England and the Treasury) had insisted on Gaps participation if Lloyds was to pass its stress test, designed to see how banks' balance sheets would cope with a worsening recession. The alternative was for Lloyds to raise its own new capital, which seemed less daunting as market conditions improved.

An alternative route out of Lloyds' problems was seen as hugely desirable. The bank had no wish to suffer the fate of Royal Bank of Scotland, falling completely under the government's thumb. "Avoiding Gaps, and providing a market solution to its financing needs, leaves Lloyds with the ability to direct its future largely independent of UK government control," says Alex Wilmot-Sitwell, co-CEO of UBS Investment Bank.

But Lloyds' troubles were not purely domestic. The EU, on the warpath against state aid, had demanded that the bank make certain disposals and, more germane to the capital structure, that it cease payments to holders of its Tier 1 preference stock - so that they could feel some pain. Apart from putting those investors in a pickle, it had alarmed Lloyds' Tier 2 bondholders, who worried that they might be subjected to similar treatment.

In July 2009, the FSA had yet to come up with a firm number for the amount of new (non-Gaps) capital needed to pass its stress test. Nonetheless, it had given an indication (lower than the final number) and Lloyds put forward a scheme to the government and regulators for a market-based solution.

It fell into two parts. The first was a straightforward rights issue to raise new equity. The second was altogether more daring. This was a proposal to exchange existing Tier 1 and upper Tier 2 securities for so-called 'enhanced capital notes' (ECNs), though the market prefers to call them CoCos. Those who liked the idea were dubbed 'CoCo nuts' by those who didn't, since they were much riskier for the holders.

The nub of the idea is that the bonds convert to equity capital at a predetermined exchange rate on breach of the trigger, in this case if Lloyds' core Tier 1 capital ratio falls below 5%. That would then have the effect of boosting the ratio. While in lower Tier 2 bullet format with non-deferrable coupons, the notes would qualify as core Tier 1 capital for purposes of the FSA tests. And as newly issued instruments, they would not be subject to the EU's strictures on payments. That would be a powerful inducement for Tier 1 investors to swap their old stock.

"The exchange rate is fixed upfront, so equity holders know that they won't get diluted more than a certain amount," explains Matthew Greenburgh, BAML's head of international financial institutions advisory. "This is a much better form of capital, but it had never been done before. The question was would people hold these bonds?"

Lloyds was treading on delicate ground here. Its advisers couldn't sound out the market because, if the plan was then scrapped, confidence in the bank's financial stability would be badly hit. For that reason, the government insisted that Lloyds should not embark on the scheme before and unless it (the government) was absolutely satisfied that the transaction could be achieved. The whole exercise had to be planned in secrecy.

Secrecy is a relative commodity in the markets and there was considerable speculation in the media, some of it wildly inaccurate, about what Lloyds was up to. But nobody really knew. The FSA finally confirmed the amount of capital that would be required for Lloyds to escape Gaps (and its large fee) as £21bn. It decided to look for £13.5bn via the rights issue and £7.5bn from the bond exchange.

Launching the rights issue

The two advisers worked long and hard to reassure government and regulators that, with their support, the deal would be a success, and they provided letters of comfort to that effect before involving any other participants. A new twist to the rights issue underwriting was that 'safety net' pricing took place before the approval of an extraordinary general meeting, and was then increased.

Underwriting was agreed the night before the launch, with BAML and UBS taking the (undisclosed) lion's share in both equity and debt deals, but with participation by Citigroup, Goldman Sachs, HSBC and JPMorgan. While a large part of the equity risk was passed on to the sub-underwriting market in the usual way, the syndicate retained all exposure to the ECN. "We took the view that there was no external market out there for sharing our risk," says Mr Greenburgh.

The secrecy veil was lifted a couple of days before the launch and courtesy calls made to key shareholders, and the transaction was announced on November 3. The CoCo exchange proved a hit, not least because the new notes were offered on a par-for-par basis and offered a coupon uplift of 1.5% to 2.5%. Offers to exchange worth more than £14bn came in, and the deal size was increased to £9bn. This was the largest European exchange offer to date from a financial institution, and the first to be underwritten.

"This is a completely new instrument," says Mr Wilmot-Sitwell. "It has never been used or traded before. So to be able to underwrite it and place it in the market is quite an achievement."

Success story

As news of its success reached the marketplace, it buoyed confidence in Lloyds' equities, which rose and outperformed the rest of the sector. The 1.34-for-one rights offer was the largest in the UK by some margin as a proportion of the market value of the underlying company. The discount to theoretical ex-rights price was set at 38.2%, tight compared to most of its peers in their own rights offers, but then the take-up, at 95.3%, was also slightly lower. The rump was placed at a mere 1.3% to the previous closing price.

The sub-underwriting sold very quickly, with £10bn of demand generated between breakfast and lunchtime. There were 10 separate orders of more than £200m, with the largest at £1bn.

In all, the new capital raises Lloyds' core ratio from 6.3% to 8.9%. It moves the bank away from Gaps, though it will have to pay a £2.5bn exit fee. And it is, its advisers argue, the first step in reinforcing the benefits to Lloyds of HBOS, and becoming, once again, a strong, independent bank.

It was also, in a way, a step in the rehabilitation of the markets themselves. "It shows that, whatever criticism the markets may have received during the credit crunch, they are still capable of delivering huge and complex innovations to the benefit of the financial system," concludes Mr Greenburgh. "It's an enormous confidence signal that the markets can provide the fuel to get us out of the credit crunch era."

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