By using a convertible hybrid structure the Morgan Stanley team were able to solve the privatisation predicament of Hungarian hydrocarbons company MOL. Edward Russell-Walling finds out how they did it.

Corporate hybrid capital just carries on forging new frontiers. Quite literally. Hungarian oil and gas company MOL’s recent €610m corporate hybrid convertible issue, engineered by Morgan Stanley, is the first hybrid out of corporate eastern Europe and the first such convertible anywhere with a non-investment grade rating. Like most frontier exploits, it required a certain grim persistence.

The expanding hydrocarbons company had an unusual problem, which Morgan Stanley has helped it to solve. Its previous owner, the Hungarian government, sold off much of the stock during the 1990s and another 12% in 2004 (bad timing, before oil stocks took off), leaving it with a rump holding of 12%.

Sell-off zest

“MOL was keen to complete the privatisation, and determined to play an active part in the process,” says Gergely Voros, Morgan Stanley’s head of Russian and central and eastern European equity capital markets. “Before last Christmas, it secured an option to buy a 10% government block at the market price over the following few months.”

However, the company already held 7% of its own treasury stock (shares that have been issued but are not outstanding, meaning they are owned by the company itself) and Hungarian companies are not allowed to own more than 10% of their own shares. “So it had to find a permanent home for a large amount of share capital,” Mr Voros points out, “and to finance it in a way that did not constrain its ability to grow strategically.”

With a market cap of some €10bn – thanks to its buoyant sector and its own improving cost structure – MOL is already one of the largest companies in central Europe. It is also becoming more of a regional presence, having acquired Slovenia’s Slovneft as well as a strategic stake in Ina, the Croatian refiner. It wants to continue this regional growth and to expand its upstream activities, and does not want to overburden its balance sheet with debt unnecessarily.

Until recently, the company had funded itself principally via bank loans at attractive rates. But last summer it made an inaugural visit to the bond markets with a very successful, loan-replacing, 10-year €750m issue, having gained a BBB rating. That was another factor to be considered in any privatisation strategy. “With a rating at the lowest investment grade level, MOL had to maintain a conservative approach to its capital structure,” Mr Voros explains.

Strategic partnership

Morgan Stanley had known MOL for some time, having worked on earlier M&A deals. For more than a year before the hybrid issue, the two had been having a dialogue on future strategy. By last summer, a solution had been agreed in concept, one that would allow the company to digest at least part of the outstanding government stake within the constraints it had set itself.

About 6% of its treasury stock would be sold to a Jersey-registered special purpose vehicle called Magnolia Finance. Magnolia would then issue bonds, convertible into the shares. “The bonds were perpetual convertibles with a fixed coupon, subordinated, with an ability to defer,” says Shyam Parekh, a London-based managing director in the global capital markets group and part of the financial institutions coverage team.

He led the origination and structuring discussions with MOL and was closely involved in the eventual pricing of the offer. The other members of the team were John Travis, who co-heads capital market structuring, Alan Apter, head of investment banking for emerging markets, and Melanie Chan, a managing director in the energy banking group.

The hybrid structure had the advantage of appearing largely as debt on the balance sheet. The option to convert carries a value, so the convertible element lowered the cost – a pure hybrid would have been more expensive – while increasing the amount it was possible to raise. “A straight hybrid would have cost 6.5% to 7%, with a capacity this side of €500m,” Mr Voros says. “The convertible helped to reduce the cost to 4%. It also increased capacity to €600m-€700m, because it appealed to a different investor base, one that is more sophisticated and more prepared to take risk.”

The structure that went to market was a bond exchangeable into MOL shares between years five and 10, and unconditionally callable at par after year 10. It was marketed with a coupon of 3.5% to 4% and a 35% to 40% conversion premium. If not called after 10 years, it had a coupon step-up to three-month Euribor plus 375bps. As is customary for a hybrid, the deal was rated by Standard & Poor’s below the borrower’s rating, at BB.

Timing was not on the team’s side. Launched on Thursday, March 9, the transaction happened to coincide with a slide in emerging market equities and, crucially, the Hungarian forint. “The day we launched, the forint moved out of its two-year trading range and went from 240 to 260 [to the euro],” Mr Voros recalls. “That unnerved quite a few investors, who remembered 2003, when it did much the same and then went to 270 and beyond.”

At close of play on Friday, March 10, the team felt that the market’s appetite wasn’t quite at the level needed to close out the deal on acceptable terms. “We said we would come back on Monday,” Mr Voros relates.

By Monday, some stability had returned to the market. With the Hungarian elections looming, the team reckoned it either had to take advantage of that stability or postpone for some time. “We relaunched the transaction on Monday and got it done in a couple of hours,” says Mr Voros.

There was a price to be paid, however, in the shape of both sweetened terms and an altered structure. These things happen out on the frontier.

Feedback from investors had suggested some unhappiness with the level of the conversion premium. “Because of the combination of debt and equity, a number of investors wanted to see more equity sensitivity, so that they could participate more as the equity price went up,” says Mr Parekh. “After consultation, we lowered the conversion premium to 30%.”

The coupon was set at the more generous end of guidance, at 4%. And there was a change to the dividend structure as well. Originally, the dividends from the underlying shares were to be paid to Magnolia. In the revised structure they will now be passed through to investors. Finally, as a clincher, the step-up was raised to Euribor plus 550bps.

The higher the step-up, the higher the incentive for the issuer to call the bond – and that makes it less equity-like in the eyes of rating agencies. As a result, Standard & Poor’s reduced its view of the equity content from “intermediate” to “minimal”. More importantly, from MOL’s strategic point of view, the bonds will count as 80% equity on the balance sheet for international financial reporting standards (IFRS)-rated accounting purposes.

Positive outcome

In the end, MOL raised €610m, comfortably covered by demand. About half the issue went to investors in the UK, home to many convertible-lovers. The Swiss took 20%, and the rest of Europe and US offshore accounts bought 15% apiece. The bonds have traded handsomely in the aftermarket, not least because the underlying shares have been on the up.

Vicissitudes aside, the issue remains a milestone, pointing the way to further issuance both from the region and from non-investment grade borrowers. “Eastern Europe as a whole is becoming a more sophisticated user of structured equity and structured financing,” Mr Voros maintains. “This transaction highlights a trend that has just started, and we will see more equity-linked products in the region.”

Mr Parekh agrees: “This deal shows that the growth of corporate hybrid is set to continue across the spectrum, from non-investment grade as well as investment grade issuers. It sets out the logic of combining convertible and hybrid products in terms of both cost and accessing a different investor base.”

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