Equity-linked issuance continues to bloom. Jules Stewart reports

on the product innovations, new issuers and investor appetite that are

likely to keep the market growing even as volatility drops and interest

rates rise.

Equity-linked issuance has soared to unprecedented levels on the back

of a cocktail of favourable market conditions. High volatility,

historically low interest rates and a lack of well-balanced

convertibles in the secondary markets have made equity-linked an

increasingly attractive core asset for capital raising. Convertibles

accounted for nearly 50% of total global equity issuance this year,

compared with an historical average of something closer to half that

level. Convertible issuance in Europe alone in the first three quarters

of 2003 was 21% higher than the whole of last year, with volumes of up

to €29.7bn.

Convertibles attractive

While interest rates have risen and volatility has dropped somewhat,

compared with ordinary equity and bond financings, the convertible is

still a very attractive product. “Due to fundamental trends in the

investor base and in the secondary market, we expect investor demand

for new issues to remain quite strong as long as deals are structured

and priced correctly,” says Martin Fisch, Deutsche Bank’s European head

of equity-linked origination.

The attraction of convertible bonds clearly lies in more than

favourable market conditions; one factor is the sheer speed at which

transactions can be carried out. “We’ve done convertible bond issues

for some clients this year that have taken less than a week from

beginning to end,” says Frank McKirgan, head of equity-linked

origination at ABN Amro. “Clearly, the risk profile from the issuer’s

point of view is also attractive. This is a debt instrument that is

cheaper than straight debt and if it’s converted, you end up issuing

equity at a higher price than the current equity price. If you are

doing an equity issue, it would be done at par or at a slight discount

to the current market price.”

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Frank McKirgan: ‘We’ve done convertible bond issues for some clients

this year that have taken less than a week from beginning to end’

Issuers are back

Issuers came flocking back to the market this year after a 40% drop in

issuance in 2002. Last year’s decline was a result of a steady fall in

share prices, leaving most issuer companies on the sidelines. “Last

year, the investor base was still hungry for convertibles but issuers

were not in a deal mode,” says Mr Fisch. “While standard convertible

bond issuance took a breather, mandatory convertibles had a real

breakthrough as the companies who did come to market were usually

forced to shore up their balance sheets and thus chose mandatories as

an efficient way to strengthen their finances.”

New issuers are also entering the market, such as the German and

Austrian governments, which issued convertibles for the first time this

year, following successful convertible issues by National Bank of

Greece, Hellenic Telecom and Hellenic Petroleum, which were backed by

the Greek government. Colin Bennett, head of equity derivatives

research at Dresdner Kleinwort Wasserstein, says: “We’re seeing

different companies in the market and future issuance is likely to come

from tech and media as well as financials,” he says.

There are three basic categories of issuance, explains Adrian Lewis,

executive director, equity capital markets at UBS. “We’ve seen

traditional issuers doing opportunistic deals, and Siemens is a classic

example of that,” he says. “Then there are lower rated companies that

may have struggled to access the capital markets recently. Now they’ve

seen amazing terms and an open window. There have also been many more

bespoke unusual circumstances, where it’s turned out that an

equity-linked transaction has fitted a very specific corporate

requirement, such as the Suez disposal of its Fortis stake. One thing

we’ve seen is that from absolutely zero there’s been a rise in

mandatory convertibles in Europe.

“Suez had a stake in Fortis that it wanted to dispose of without

negatively affecting its balance sheet. The existing share price was

below the book value. In the end, the company sold part of it through

equity and part through a mandatory exchangeable. This was tailored to

the specific requirements of Suez. The exchange price was in line with

the book value of its shares on the balance sheet. The company did a

mixture of placing about one-third in stock and two-thirds in

mandatories.”

Mandatories are one of the innovative structures to emerge in the

convertible market, to meet the ever more complex and sophisticated

requirements of issuer clients. The simplest mandatory is when a client

likes the idea of issuing some type of equity-linked instrument that

ultimately enables the corporate to convert into equity at a premium to

the current stock price. However, the one risk they’re left with is the

chance that at the end of the period, the stock price may not have

risen above that conversion price and the bond has not been converted.

The bond remains as a debt obligation and has to be refinanced. The

mandatory comes into play as a way of taking away that non-conversion

risk. For corporates looking to dispose of large cross-shareholdings,

the mandatory structure is very attractive because they know at the end

of the period they will have disposed of the underlying asset, with no

risk that the asset will be left on their books.

US innovation

But the real innovation came this year from the US – the emergence of

high premium convertibles (HiPr) – whereby issuers issue a convertible

bond with a much higher conversion price than normal convertible bonds.

“In order to attract investors, issuers grant additional warrants to a

number of shares that the convertible bond controls. Only if the common

stock price goes through this higher conversion price will investors

have the ability to exercise those warrants and, in turn, effectively

lower that higher conversion price,” says Michael Hammond, managing

director, head of international equity-linked origination at Merrill

Lynch.

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Michael Hammond: issuers grant additional warrants to shares to attract investors

Merrill Lynch was lead manager on a $3bn convertible transaction using

this technology for Wells Fargo. The initial conversion price was set

at a 110.75% premium to the then prevailing stock price, one of the

highest ever for a convertible bond.

Financing and conversion

Mr Fisch agrees that this has been the year of the high premium

convertible. “With volatility high and interest rates low, companies

were able to achieve very cheap financing yet command very high

conversion premiums above current share price levels,” he says.

“Whereas in previous years convertibles with even a 50% premium were

rare, this year has seen a flood of issuance with 50% to even 100%

conversion premiums.”

Deutsche Bank has also used another innovative structure, called the

contingent conversion (CoCo) to do a deal for Adidas, under which

the company was able to treat the potential dilution of the convertible

for EPS purposes in line with the real world impact of the convertible.

This feature allows the company to only include the shares underlying

the convertible in diluted EPS calculations once the share price is

trading above the conversion price. This feature, like most innovative

structures, was exported from the US, where it has enjoyed much success

under US GAAP, but Adidas was the first company to use it under

International Accounting Standards (IAS).

Varied investor base

Equity-linked originators point to the surprising spread of different

types of clients. Because it is a hybrid instrument, they say,

equity-linked is able to cover a greater number of clients than can a

straight equity or debt product. Apart from institutional investors,

private banks and high-net-worth individuals are also seen as a natural

client base for convertible bonds, since they provide a certain amount

of capital protection with some equity exposure, which is quite an

attractive risk profile for an individual investor.

There has been an explosive growth of money under management by

convertible arbitrage hedge funds since they arrived on the

equity-linked scene a couple of years ago. These non-traditional

investors have been driving convertible issuance in terms of being the

buyers of anything in excess of 60% to 80% of all transactions, and

they’ve brought a level of sophistication to the European market that

was previously only present in the US.

In spite of trends such as declining volatility and the likelihood of

higher interest rates, most people in the market remain confident that

convertible issuance can sustain strong levels of growth in the future.

For one thing, there’s more money looking to be invested than there are

deals to invest in. The number of existing deals due to redeem over the

next year to 18 months points to higher investor demand for the

product.

“Investor demand for new issues will remain high due to a combination

of an increase in the available funds for investment and the redemption

and conversion of existing issues,” says Mr McKirgan. “In every cycle

of equity-linked issuance, which tends to last around six to nine

months, the first deals that come out are priced quite attractively

from the investor’s point of view. As the cycle advances, banks become

more aggressive on pricing, which means that bonds end up priced much

closer to fair value. Usually, somebody gets too aggressive and pitches

too big a deal at too tight a price, and suffers some type of loss on

the transaction. At this point, issuance cools down for a couple of

months as everyone digests what’s happened, and then picks up again. In

the current cycle, we are currently in the process of pricing becoming

tighter.”

Tech and media growth

Continued growth is likely to be sustained by sectors such as

technology and media, with some issuance from financials, according to

Mr Bennett. “Companies with upcoming redemptions are always strong

candidates for new issues,” he says. “Issuance of European tech and

telco convertibles has ballooned from the 2002 low and comprises a

greater percentage of European issuance than any time since 2000,” he

says.

The client base is showing quite a shift in Europe, says Mr Lewis. “The

US has always been mainly sub-investment grade smaller companies in

general terms. In Europe, it’s traditionally an investment grade A or

BBB type. Because there’s been something of a starvation in issuance,

there’s been a lot of demand. This year we’ve seen a lot of lower-rated

issuers in the European market. There’s been a large broadening in

terms of credit quality, and there have also been more smaller deals.”

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