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WorldFebruary 3 2014

Europe’s ECM market set to thrive

Europe’s equity capital markets picked up in 2013 after three years of declining volumes. Equity bankers are confident that this year will be just as busy, even if supply from Europe’s banks – traditionally the biggest issuers – wanes.
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Europe’s ECM market set to thrive

Life for Europe’s equity capital markets (ECM) bankers is looking up. Last year, their market went from strength to strength. According to investment banking data provider Dealogic, ECM volumes for Europe, the Middle East and Africa (EMEA) rose 63% to €170bn, the highest total for the region since 2009. The supply of initial public offerings more than doubled to €29bn.

“We saw a strong recovery in 2013,” says Richard Cormack, co-head of ECM for EMEA at Goldman Sachs. “It was the first year since the crisis in which there was a strong performance, broadly speaking, in every quarter.”

A year of promise

Bankers are optimistic that this year will be similarly good. “Assuming interest rates don’t start racing up and there are no external shocks, Europe’s equity capital markets could have a fantastic 2014,” says Enrique Febrer-Bowen, Barclays’ head of financial institutions group (FIG) ECM.

Bankers are excited about the prospects not only for straight equity issuance, but also for convertible bonds. Equity-linked supply, which had been fairly low, picked up quickly in the second half of 2013. “In 2013 issuance was strong,” says Gareth McCartney, head of equity syndicate at UBS. “It was almost a perfect storm for the asset class. Share prices were high, interest rates were low and investors were cash rich. All those factors are still in play, which means we think there will be more equity-linked issuance this year.”

Much of the bullishness stems from the improving outlook for Europe. While the continent’s economy may be recovering more slowly than the US, most analysts believe it is finally out of its doldrums. The consensus is that the euro area will expand about 1% in 2014, which would mark the first year of positive growth since 2011. Germany is forecast to increase its output by almost 2% and the UK by not much less than 3%.

Another attraction for investors is that European stocks, unlike US ones, are yet to reprice much in response to the upbeat economic data. “European shares are trading at an approximate 20% discount to peak profits,” says Mr McCartney. “The US is trading at an approximate 20% premium. So, European stocks will make sense to a lot of global investors.”

Investors crave FIG

The economic buoyancy, combined with concerns that the winding down of the US central bank’s huge quantitative easing programme will cause interest rates to climb and hurt fixed-income returns, has led some bankers to predict that investors will shift out of bonds into equities. “We saw some of that last year,” says Mr Cormack. “That will likely continue. When you look at future returns for each asset class, fixed income is expected to underperform the equity market by a significant degree.”

Forecasting the amount of equity issuance from European banks is more complicated, say analysts. The FIG sector traditionally provides more ECM deals than any other. In 2013, it accounted for roughly €60bn of the transactions in EMEA.

Bankers say that FIG issuers will again be prominent in 2014, although many believe supply from them will dip slightly compared with 2013. This has little to do with investor demand, which is high. “Investors are keen to get exposure to the European recovery, and banks are a good way of playing that,” says Gustav Steuch, a managing director at BNP Paribas.

Rather, issuance levels could be constrained because European banks have less need to raise equity. Over the past few years, they have bolstered their capital bases substantially, particularly with regards to increasing their core Tier 1 ratios to meet the requirements of the Basel III framework. “The extent of balance sheet repair that has already been carried out by the bigger banks is phenomenal,” says Simone Verri, head of European FIG financing and risk management at Goldman Sachs. “Now, they are more focused on how they make money and are trying not to further dilute their shareholders.”

Equity vs AT1

Some prominent eurozone banks plan to raise equity in the coming 12 months, including Austria’s Raiffeisen Bank International, which expects to complete the sale of up to €2.9bn of shares in the middle of February, and Monte dei Paschi, Italy’s third biggest lender by assets, which is seeking to complete a €3bn cash call.

For banks that are short of core capital, there is pressure not just from regulators to make up the shortfall, but from shareholders too. “Investors are looking for decisive action on the part of banks,” says Craig Coben, who leads the EMEA ECM business at Bank of America Merrill Lynch. “The lesson from the crisis is that a comprehensive recapitalisation is usually a catalyst for a stock re-rating. The better capitalised banks have seen their share prices perform well over the past two years.”

Yet much of the capital that banks still have to issue is going to be in the form of subordinated or hybrid bonds instead of equity. Most of the large-scale European banks have core Tier 1 capital ratios high enough for the liking of their regulators, or are at least close enough that they can use retained earnings to make up the difference in the next few years. And few bankers expect that the European Central Bank’s asset quality review (AQR) and stress-tests – due to be published in the second half of 2014 – will result in many eurozone lenders having turn to their shareholders.

“In the latter part of last year, people were very focused on the AQR,” says Barclays’ Mr Febrer-Bowen. “But what has changed is that most big banks are expected to pass with flying colours. Investors don’t think it will cause major surprises.”

There is still a shortfall, however, when it comes to total capital requirements. But to meet these, banks can, unlike for core capital requirements, use additional Tier 1 and Tier 2 bonds. Given that these tend to be cheaper to issue than equity and are non-dilutive, banks will probably prefer them to equity.

“The wave of big equity deals that reinforced banks’ core Tier 1 ratios is probably behind us,” says Mr Steuch of BNP Paribas. “There will still be some of that this year, but it is largely going to be from the peripheral eurozone banks. So, not all the extra capital [that banks need] will be raised as equity. We actually think this will be the year of the hybrid bond. We expect significant issuance of those.”

Government sell-downs

One potential source of activity for ECM bankers this year is governments selling down banks they were forced to bail out during the financial crisis. Several European governments still hold stakes in large lenders that came unstuck, including the UK (Lloyds Banking Group and Royal Bank of Scotland), Germany (Commerzbank), the Netherlands (ABN Amro), Spain (Bankia) and Ireland (Allied Irish Banks and Bank of Ireland).

Some states began sale processes last year. The UK made £3.2bn ($5.1bn) from its sale of 6% of Lloyds in September, which reduced its holding to 33%. Bankers say the success of that transaction and ones similar to it has helped persuade governments, which are under pressure from taxpayers to get a high price for their assets, that equity markets are strong enough to absorb such deals. Analysts forecast that there will be €10bn to €15bn of FIG issuance in the next 18 months from governments returning their banks to private ownership.

“Market conditions have generally improved,” says Mr Febrer-Bowen. “If you’re looking at doing large transactions and you want to get them done at politically acceptable prices, now is a good time. As well as that, most banks have completed or nearly completed their clean-ups following the crisis.”

For ECM bankers, 2014 looks set to be an exciting year. Their fixed-income counterparts have been the main beneficiaries of the of central bank quantitative easing programmes since 2009, which drove interest rates lower as policy-makers sought to stimulate their economies. Now that those economies mostly look as if they are on the mend, it could be the turn of equity markets to shine.

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