JPMorgan’s innovative equity-linked deal for the German government, involving an exchangeable bond for Frankfurt airport operator Fraport, could set the template for future privatisations. Alan McNee meets the team that structured the transaction.
When JPMorgan acted as sole bookrunner on a €272m exchangeable bond into Fraport shares on behalf of the German government, it took a new step in the equity-linked world and may have helped to establish a new privatisation model.
The use of exchangeables as a privatisation tool is not new per se; a €5bn deal in July 2003 for the state-owned KfW banking group in Deutsche Telekom set the pace for a flurry of sovereigns looking at the exchangeable market, with several deals done by the Swiss, Austrian and Hungarian governments, among others.
However, the Fraport deal is unique in that JPMorgan is the issuer, rather than the German government. “The government participates in all the economics and shareholder rights of having issued an exchangeable, but it has chosen only to sell the option portion of the transaction,” says Viswas Raghavan, head of equity and equity-linked capital markets at JPMorgan. “This takes the exchangeable concept to the next level.”
In essence, the German government sold call options on six million Fraport shares to JPMorgan, which it used to structure the zero-coupon exchangeable bond. The government retains the shares underlying the options, but has sold other Fraport shares in a €405m accelerated bookbuild with Morgan Stanley and JPMorgan. The government therefore gets the price paid for the call options by JPMorgan, plus, if the share price reaches the option strike price of €45.25 in 17 months (when the bond becomes callable), it will sell the shares at that price to JPMorgan and realise the upside between the option strike price and the price (€38.40) at which the first, cash shares were sold in the accelerated bookbuild.
The reason behind the structure is that the German government did not want the exchangeable bond on its books. This way, it isn’t government debt, and, in fact, the government earns extra revenue from the option price.
“The German government’s approach to this has been recognised as innovative, and other governments may now be open to this kind of solution. To be able to privatise your holding at a premium and get a blended share price above the previous close is very attractive and maximises taxpayers’ returns,” says Klaus Hessberger, JPMorgan’s head of equity-linked capital markets (ECM) for Germany, Austria and Switzerland
State sell-offs
Privatisations of state assets have been the main driver of growth in the equity and equity-linked market. European government privatisations have accounted for the bulk of primary market issuance in the European capital markets in the past two years: Germany, Austria, Switzerland, France and the Nordic countries have all accessed the market, and bankers believe there is a lot more to come.
“Even in the UK, where most big privatisations have already taken place, there is still the sale of defence advisory company QinetiQ, for which JPMorgan is a joint bookrunner. In the rest of Europe, there are still a lot of privatisations to come, particularly in Greece. This will expand to emerging markets in Turkey, eastern Europe and Asia-Pacific, where the $30bn privatisation of Telstra in Australia is causing a lot of excitement,” says Mr Raghavan.
The use of exchangeables to fulfil privatisation objectives has been encouraged by fairly stable and supportive markets. Issuers are looking to participate in the upside of the stock: they want to sell, but they remain bullish and want to capture upside.
“The combination of equity and equity-linked instruments to meet their objective has been tried and tested already. It’s a proven model of monetising and privatising, while at the same time having an instrument which allows you to still participate in the upside,” says Mr Raghavan. “The price you get, assuming all the shares convert, is much better than you would get by selling spot alone. This was one of the drivers behind Germany looking at this combined structure to do this exchangeable structure.”
Monika Weiler, vice-president, ECM, says that the government had to decide what exactly it wanted from the call options – in the auction process that followed, the banks were given the parameters, in terms of the strike price, the maturity of the call options and other features. “All the details and documentation were provided, and we knew not only how the call option would be put together but also what they wanted the exchangeable to look like,” she says.
“The government was very clear that it wasn’t an option just to go and buy those call options – they actually had to be repackaged as an exchangeable and sold into the market.”
JPMorgan therefore structured the exchangeable to match the call options precisely: the private call to be purchased from the government mirrors the public exchangeable to be issued to the market.
Prior knowledge
With a roughly 40% share of the European equity-linked market, JPMorgan has been bookrunner on $5.53bn of equity-linked securities in 2005 to date, a breadth of experience that the team believes counted when it came to putting together its proposal. “We had the benefit of already having done two big self-issued exchangeables this year, for Allianz and Banca Monte dei Paschi di Siena,” says Ms Weiler.
“However, the structure of the Fraport deal was very different from those. In the previous two deals we bought shares and then issued equity-like exchangeables on the back of them. In this deal there were no shares – we just bought call options. So we had to figure out how to structure this in an efficient way.”
Being able to place the stock and the exchangeable component with minimal impact on the share price was key to the transaction’s success. JPMorgan jointly bookran the accelerated bookbuild with Morgan Stanley, but worked alone on the exchangeable.
The size of the block – which in terms of liquidity represented 142 days’ trading – also brought its own challenges. Bankers needed to analyse what would happen when the market opened the following day and investors began to realise that someone was long that much volume. “Structuring the way we went out on the cash side and on the equity-linked side to manage that was very important,” says Luis Vaz-Pinto, head of equity syndicate at JPMorgan.
It was crucial to ensure that any selling pressure as a result of people buying the option did not impede the equity. The equivalent of 142 days’ trading is a huge amount of equity to place, and the last thing anyone wanted was the delta of the equity-linked piece polluting the placement of the equity piece.
“What we did was to effectively make sure that we tried to allocate the equity-linked piece as close as possible to the price of the equity piece, so that investors out there had no idea that it was worth their while shorting stock,” says Mr Raghaven. “So we delayed the placement of the equity-linked piece until the very end of the equity piece. Once the equity piece was solid and had momentum, there was no pressure from shorting stock. The fact that the equity element caught momentum meant everyone subscribed to the view that there was momentum in the equity story, so there was no incentive to short the stock.”
The stock closed at €40.04, compared with a bookbuilding range of €38 to €38.4. The transaction was already half-covered by the time the markets opened, and fully covered shortly thereafter. “The positive momentum meant that investors were comfortable holding the underlying,” says Mr Vaz-Pinto. “At the end of the day, the stock price recovered very quickly once people saw this momentum, and it is now trading above €42.”
Buying interest from the US was stronger than expected, with around 26% of the equity piece being placed there and 33% of the equity-linked offering being taken by offshore US institutions through Reg S. Reg S are rules relating to offers and sales made outside the US without Securities and Exchange Commission registration.
Infrastructure action
The question remains of whether the options will be exercised – if they are not, then obviously the shares underlying the options will not be monetised. But Mr Raghavan argues that the amount of activity on infrastructure deals at present – with many banks setting up infrastructure funds and Australian bank Macquarie bidding aggressively for European infrastructure assets – means that many funds view the Fraport transaction as a liquidity event.
“If you want to take a position on infrastructure, this is a good time to do so when a big shareholder is exiting,” he says. “They take the view that they should build up a position when they can do so as a result of a primary sell-down, rather than in the secondary market where these assets could get very expensive. The price on the exchangeable was €45.25, and the stock is above €42 already, so the exchangeable is a lot closer to being acted upon. That vindicates the German government’s desire to participate in the upside – the approach of using the exchangeable as a way of doing this is working, as they’re close to the option being in-the-money.”
Mr Raghavan also points to the size of the placement as evidence of the market’s appetite for this kind of security: it was sold in a matter of hours, despite representing almost half a year’s trading.
“That’s testament to the liquidity that is available for the right stock, and it means that this deal takes exchangeables to the next level,” he says. “The government no longer has to issue itself, but can still get the benefits. This could mean that other governments which have been unable to issue for various reasons could now do so, and exchangeables could provide stimulus to further European privatisation.”
