Favourable forecast or equity-linked issuance growth
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.”
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.
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.”