CSFB dusts off underwriting with capital raising success

Once a staple of the equity markets, the practice has rusted in virtual disuse for a decade or more, superseded in bigger issues by the book-building process.

But in a provocatively inventive initial public offering (IPO) for UK food producer RHM, Credit Suisse First Boston (CSFB) has hauled underwriting out of retirement.

The RHM deal notched up a number of firsts. It was the first UK equity issue subject to the new EU Prospectus Directive, although that did not exactly cause a stir. It was also the first under new UK pensions legislation. What set the market buzzing, though, was that it was the first equity deal anywhere to combine both underwriting and book-building.

RHM (originally Rank Hovis McDougall) had a former life as a public company before being taken private by UK industrial conglomerate Tomkins in the early 1990s. In 2000, Tomkins sold it on to UK buyout group Doughty Hanson, which considered flotation as an exit strategy in 2002. It changed its mind, partly because of poor market conditions and partly because it realised that it could do better by first sprucing up the business.

CSFB and Doughty Hanson

In the following two years, a new RHM management team set about streamlining and rationalising the operation. At the time Doughty Hanson, advised by CSFB, had a relatively open mind about its next step. CSFB had maintained a relationship with Doughty Hanson since the latter half of the 1990s, spearheaded by James Leigh-Pemberton, then CSFB’s head of European equity capital markets.

“RHM is a fantastic company in terms of its heritage and installed asset base,” says Mr Leigh-Pemberton, who joined CSFB from SG Warburg Securities in 1994 and is now chairman of both European corporate and investment banking and European ECM. As he points out, RHM brands such as Hovis bread, Mr Kipling cakes and Frank Cooper’s marmalade are bought by 98% of British households. “The challenge was how to take that set of advantages and create maximum financial value in the medium term,” he says.

By autumn 2004, as the reorganisation was bedding down, it seemed that an IPO this summer could be the way to do just that. If a public offering was to take place – and at that point there was no guarantee of one – certain tasks had to be completed, and some had to be done anyway, flotation or no flotation.

IPO preparations

“A capital restructuring was needed to allow an IPO to happen,” says George Maddison, a managing director in CSFB’s investment banking division, and the man who eventually led the IPO process. “A £45m commitment to restructuring the cakes business had to be funded. There were non-core disposals to be done and a pension fund deficit to be fixed.”

In February 2005, as the team was pondering all these issues, there came a point when flotation stopped being a mere gleam in the eye as client and bankers determined to go ahead. From that moment on, the question that loomed above all others was how to get the best price for the business, particularly since there was a spectre hovering over the feast.

Avoiding the spectre

There were two obviously comparable UK stocks for valuation purposes: Northern Foods and Premier Foods. The closest comparison was provided by Premier Foods, which had been floated in July 2004. The flotation was an unhappy affair. Investors spurned initial valuations (very publicly) and ABN AMRO, JPMorgan and Merrill Lynch finally disposed of the shares at the bottom end of a lowered price range.

Only a month earlier, a similar fiasco had left Doughty Hanson itself feeling bruised when it tried to reduce its stake in sportswear maker Umbro. Having advertised a range of 150p-200p, sole bookrunner Cazenove ultimately priced the shares at 100p. Doughty Hanson had an understandable desire not to relive that experience nor to replicate Premier’s story, and the subject of underwriting had been raised even before a firm decision to float.

Underwriting fell out of favour during the boom years of the 1990s. As equity markets rose and rose, underwriting fees came to be seen as an unnecessarily costly form of insurance. The argument ran: why peg achievable proceeds to the underwritten price when book-building could allow it to float upwards to a more natural market level?

The decision to underwrite

Like Premier Foods and Umbro, however, many recent European IPOs have priced at the middle or bottom of their ranges. While recent statistics show that CSFB priced more deals more accurately than its peers, the team clearly had to tread carefully. “We decided the best thing would be to underwrite the IPO when we announced the price range,” says Mr Leigh-Pemberton. “Then there couldn’t be any debate about pricing outside the range, because the bottom would be guaranteed from the beginning.”

The CSFB bankers knew that if the underwriting failed to convince the market, the result would be disastrous. Instead of providing a floor, the underwritten price would become a ceiling, at best. Alternatively, the underwritten price could be pitched so low, with the price achieved so much higher, that the underwriting fees would prove a waste of money.

Persuading the market

The secret would be to persuade the market that because CSFB was so familiar with the company and its management, it was putting its money where its mouth was with a realistic low-end estimate. “Our view was that we could monetise acceptance in the marketplace of our valuation, and of our conviction, with underwriting from us,” says Tom Ahearne, head of European equity syndicate at CSFB.

“Sceptics would say that the underwritten price would be a magnet for the institutional market,” Mr Leigh-Pemberton says. “We said it would be a trampoline and that the price would bounce off it to an area where buyers and sellers could naturally meet.”

The team concedes that underwriting could have worked only with certain kinds of stock, of which RHM was a perfect example. “RHM is a highly cash-generative business,” Mr Ahearne says. “It is also a fundamentally defensive stock.

“Then there are very clearly defined comparable companies, which is helpful because there is substantial familiarity with the sector among both buy-side and sell-side analysts.”

And so it was decided that, while the offering would be underwritten by sole bookrunner CSFB, there would also be a book-building process to establish a final offer price. “The underwriting was to ensure not just the certainty of proceeds, but the certainty of the IPO itself,” observes Hasnen Varawalla, a director in CSFB’s corporate and investment banking division, responsible for preparing RHM for the IPO, including compliance with the new legislation and new IFRS accounting standards.

That the deal would be underwritten was kept secret even from co-lead managers Citigroup, Deutsche Bank, HSBC and JP Morgan Cazenove. They were not best pleased to find out just as the price range was announced. “It had to remain confidential,” says Mr Ahearne. “If it had slipped out, the market would have started speculating over the price at which the deal would have been underwritten, and it would have been taken as a sign of weakness.”

Prediction plays out

Launched in early July, the transaction played out just the way CSFB had predicted. From a range of 228p-285p a share, underwritten at 228p, the flotation price was set at 275p after the offer had been six times oversubscribed. The shares closed 6% higher on their first day – enough but not too much. Once a greenshoe had been exercised, the IPO raised £475m of new capital for RHM and £197m of secondary financing, leaving Doughty Hanson with about 30% of the company.

Equity markets remained steady during the offer, which helped to support the transaction’s success. Because the deal had a financial rather than a trade sponsor, it was also particularly important to persuade investors that there was more good news to come from RHM. “It was key to the investment story that, while the new management already had a track record, they had not had sufficient time to carry out their plan of execution in its entirety,” Mr Ahearne says. “So buyers could expect the benefits of three more years of cost savings.” So there was satisfaction all round.

Is the future of underwriting now assured? “I think we will see it again,” says Mr Ahearne. “But it will remain rare.”