With multi-billion dollar acquisitions to finance, banks need inexpensive ways to replenish their capital. Tax and cost-effective, preferred shares are the answer to their prayers, but convincing the regulators to count them as Tier One can be challenging. Jules Stewart reports on the twists and turns to keep the issuers and the authorities happy.
When Royal Bank of Scotland (RBS) launched its £26bn bid for NatWest last year, the Scottish bank began casting about for ways to reduce its acquisition financing costs to make its offer more attractive to shareholders than a rival bid on the table from Bank of Scotland (BoS).
Enter hybrid securities, so called because they have characteristics intermediate between equity and senior subordinated debt. Royal Bank went to its advisers Goldman Sachs and Merrill Lynch who put together an innovative three-tranche, dual-currency, $2.2bn equivalent preference-share offering, structured to qualify as Tier One capital under Bank of England regulations, while at the same time allowing for distribution in the global institutional markets. The bank raised hybrid equity to rebuild its Tier One ratios due to the goodwill it had to take on board in the NatWest deal. This is a critical factor in any takeover situation, since the alternative is to raise common equity. To maintain capital ratios, the acquirer needs to pay for the goodwill by issuing expensive equity or by raising hybrid Tier One capital. In the case of RBS, the use of preference shares reduced the overall amount of common stock used in the acquisition.
The bank also provided an extra equity sweetener in the form of additional value shares (AVS) to NatWest investors in the form of a special dividend. Its investment bank advisers restructured that so it could be sold in the fixed-income market.
Preference share issue
"We launched a preference share issue with a stock settlement feature," says Ron Huggett, the bank's director for capital raising. "Within this issue, e500m and e750m were in the form of ordinary perpetual preferences that allow the bank to call the issue after five years. If we do not call it, the investors have the right to require us to convert the shares into ordinary common stock which they can then sell. On the $Onebn tranche, this option kicked in after One years."
Following the issue, Royal Bank was left with nearly 40% of its regulatory capital in the form of preference shares, which Mr Huggett acknowledges is "slightly on the high side". However, he says he is confident that the additional revenue generated from the NatWest acquisition will enable Royal Bank to bring that down to a "more realistic level".
Banks have proved extremely crafty designing these esoteric structures. Last year, Barclays Capital invented a product called reserve capital instruments (RCI), which has stock settlement on the coupons and exploits an accounting loophole in the UK that is the subject of dispute by some accountancy firms over whether to accept this instrument as equity. Barclays Capital launched a Tier One deal for its parent bank of e850m of undated securities. The RCIs were issued directly by Barclays Bank instead of a traditional off-shore special purpose vehicle. Also, they contained stock settlement on the coupons, an innovative feature that gives the issuer the right to pay coupons by raising new equity. This mechanism raises the bonds to the category of Tier One hybrid securities, providing the accountants accept them as such.
Significantly, the market showed its enthusiasm for Barclays' innovative product when the first RCI deal was issued on the same day as HSBC's e600m offering. Both were priced over the same 10-year benchmark, yet the RCIs saved Barclays at least 10bp compared with HSBC.
Capital costs
Hybrid securities are used mostly in acquisitions and, until the mid-1990s, takeover deals were normally on a more modest scale and banks could comfortably fund them through internal resources. This is no longer the case and banks do not want to go to the equity markets where the cost of raising capital can be 3-4% higher than in the debt markets. HSBC funded its acquisitions of the Republic Bank of New York and Crédit Commercial de France with preference shares, as did Lloyds TSB its takeover of Scottish Widows. The three acquisitions involved multi-billion-pound transactions.
The growth of Europe's institutional investor base boosted by the advent of the euro has enabled banks to raise large amounts of hybrid capital. The entry of the UK banks into this market, starting with a Halifax transaction in 1999, is really what kick-started the trend toward hybrid Tier One issuance. This was quickly followed by the Lloyds TSB deal; then Abbey National jumped into the market with a $1bn hybrid offering led by Goldman Sachs and Lehman Brothers.
Hybrid's detractors
It all sounds neat and tidy, but hybrid instruments are not to everyone's taste. For starters, the rating agencies are a bit wary about what one analyst defined as "a lot of funny money creeping into the system".
One investment banker concedes that the term "explain" is often a euphemism for "persuade" when convincing regulators to accept hybrid instruments as regulatory capital. "Definitions and flexibility vary widely from country to country," he says. "For instance, Spanish banks have been using retail-targeted preference shares for years to fund their spending spree in Latin America, a perpetual note with no step-up and a call after five years. They have an extremely high proportion of their overall Tier One, which includes core equity and hybrids, in the form of preference shares. So much so that the rating agencies have begun to feel uncomfortable."
Over-leveraging on hybrid capital has not yet become a disaster scenario for OECD member banks, since almost all bank failures in recent years have taken place outside the system regulated by the Basel Committee. Hence, the value of capital has not been truly tested and contested to the extent that creditors have claimed that debt is not available to meet the obligations of a bank in the same way as is equity.
The ability to absorb losses may become more of an issue for US banks as the economy teeters on the brink of recession. There are deepening concerns, particularly on the part of the rating agencies, over the credit quality of banks' loan portfolios, particularly since the structure of US preference shares make them less loss-absorbing and therefore poorer quality capital than their European counterparts.
Banks like hybrid instruments because they provide issuers with an advantageous after-tax cost of capital, relative to straight preferred or common stock. Hence, they entail less earnings dilution than common equity and are highly flattering to a bank's return on equity ratio. Whereas dividends on equity have to be paid out of post-tax earnings, hybrid instruments can pay more efficiently. If a bank wishes to pay £100m in dividends on earnings of £500m, its hybrid capital allows that £100m to be deducted before tax, hence the impact is a lower tax bill. The principal way of qualifying for this benefit is for the preference shares to be issued by a wholly owned special purpose vehicle (SPV), set up offshore in another tax jurisdiction. The cash proceeds of the preference share issue are passed from the SPV to the bank in the form of a loan. The bank pays interest to the SPV on the loan, which allows the SPV to pay the dividend on the preference shares. The tax benefit to the bank is derived from the tax deductibility of the interest payment on the loan, in some cases, while in other jurisdictions the SPV may also enjoy the tax exemption of dividend payments, thus allowing it to achieve cheaper funding.
"We don't like to see an institution replace a lot of pure common equity with hybrid," says Michelle Brennan, analyst at Standard & Poor's. "Occasionally, if capital ratios are weakening and we don't see an improvement in risk management, a rating can be constrained."
Ms Brennan cautions that the trend towards weaker capitalisation, when banks are already being challenged by changing competitive and technological environments, could place downward pressure on ratings in the sector. "While such pressures will be offset to some extent by improvements in operating efficiency and risk management procedures, continued declines in the amount and quality of capital will make it more difficult for banks to maintain their current ratings," she says.
Hybrid rated
lower Analyst Ian Linnell of rating agency Fitch explains that hybrid instruments represent junior claims on the cash flow and assets of a bank relative to those of senior debt. They are therefore typically rated lower than senior debt. He says that tax deductibility is a significant carrot to their issuance. "Hybrid instruments generally have a weaker claim than subordinated debt," he says. "This is because of provisions that allow the issuer to defer interest or dividend payments, limit the holder's rights to accelerate payment and establish a very junior position in bankruptcy or liquidation."
Mr Linnell says he feels comfortable when preference shares and other hybrids together do not amount to more than 25% of a bank's common equity. Fitch generally rates preference shares and hybrid capital one notch below senior debt for issuers in the senior debt rating categories of AAA to A.
Preference shares and hybrid capital instruments have flooded the market over the past few years. This has been driven by the regulators, namely the US Federal Reserve and the Basel Committee, who now accept them as Tier One capital. Despite the rating agencies' qualms, the market seems to have a healthy appetite for Tier One preference share capital, which last year amounted to $21.5bn equivalent issuance by European banks alone compared with $15bn equivalent in the previous year.
But it is not only Tier One issues that are booming. There is strong investor demand also for Upper Tier Two issues which are more bond-like (interest payments are cumulative and cannot be suspended) than preference issues in which, technically, interest or dividend payments could be suspended. ABN Amro's head of financial institutions, Spiro Pappas, says with equity markets performing poorly, investors are looking for an investment without the volatility of equity but with a higher yield than standard fixed income. ABN has structured a number of deals across the spectrum including a Tier One deal for Lloyds TSB, Upper Tier Two deals for Euroclear and ABN itself, and Lower Tier Two deals for Banca Popolare di Lodi and itself.
"The European retail market in the Netherlands has really taken off," says Mr Pappas, "and, unlike institutional investors, they are prepared to take issues without a step-up feature [an agreement to pay more interest in future years]."
Retail investors are less concerned about term risk and not worried by call features which are only likely to be exercised if the interest rate environment changes dramatically. By contrast institutional deals often have a step up and a call which is more likely to be exercised to avoid paying higher interest. "The regulators prefer the retail-type issue without a step-up/call feature as it is a more permanent form of capital," says Mr Pappas.
Steady increase
The bank capital market's development has clearly depended on the attitude of the regulators. "The Basel Committee has allowed these hybrid instruments for bank capital since October 1998 and we've seen a steady increase since then," says Robert Motyka, director, capital markets group at UBS Warburg. "Before 1998, there was some issuance in Europe from non-special purpose vehicle operating subsidiaries. But it wasn't until the British banks began using this instrument, starting with Halifax in December 1999 for the acquisition of Clerical Medical, that the UK market took off. This was the first innovative preference share from a UK bank." The Halifax deal was ground breaking for the UK since it was the first tax-deductible Tier One security to be issued in the market. Other banks in Europe took their cue from this transaction, as their regulators began allowing their banks to set up SPVs and issue tax deductible instruments. France's SG and Italy's Banca Lombarda, UniCredito and San Paolo IMI followed in swift succession. Italian banks generally suffer from a weaker capital structure than do their European counterparts and one way to capitalise them is through the use of these instruments. Hence, bankers expect to see more hybrid issuance from Italy this year.
Mr Motyka says the good news is that banks are now able to use products that are innovative and that can lower their marginal cost of capital by issuing tax-deductible instruments. "The investor base likes this product and it has been a very stable product," he says. "Tier One bank capital has outperformed every industry except the tobacco industry over the past year. Despite the recent volatility in the equity markets it is impressive how spreads in dollars, euros and sterling have not only remained stable but have actually tightened. The investors rely on the banking system as a stable environment and a well-regulated one."
The investment banks are busily engaged in designing what one banker calls "twists on twists on twists" - ever more complex products to help banks bring down the cost of raising capital and improve their balance sheet management.
In doing so, the process becomes a bit of a cat-and-mouse game as the investment banks push to the limit the regulators' tolerance for these instruments. The revised Basel Accord does not address the issue but talks only about risk-adjusted assets, in what one rating agency analyst termed "a bit of a cop-out by Basel".
"Hybrid securities are treated differently in different countries around the world," says Norman Bernard, director of financial services consultancy First Consulting. "Each regulator is responsible for interpreting the instruments of its own banks. The rating agencies don't like some of the more esoteric instruments, but if the investment banks can convince the regulators that this is Tier 1 capital, they're on to a win-win situation."
