Hybrid capital is back with a bang. While European financial institutions routinely issue subordinated bonds treated as part-equity by rating agencies, corporates have been avoiding them. But changing agency attitudes have prompted a slew of recent corporate issues. The biggest – in fact, the biggest European corporate bond issue ever – was structured by a team at Citigroup for Sweden’s Vattenfall.
The attraction of hybrid capital is that, as perpetual debt, it looks like equity on the balance sheet, with a muted or even benign effect on ratings. As debt, it is non-dilutive and cheaper to raise than equity capital, while coupon payments, unlike dividend payments, remain tax deductible.
Long relationship
Vattenfall has been contemplating the possibility of a hybrid issue for some years. The company is Sweden’s largest – and Europe’s third-largest – electricity utility. It is also state-owned, which makes it awkward to raise equity funding. Its relationship with Citigroup goes back to the mid-1990s, though it has known some of the key people on the account for longer.
One of those is team leader Eirik Winter, Citigroup’s co-head of European fixed income capital markets. A Swede born in Finland, he was head of European capital markets origination at Chase Manhattan before joining Salomon Brothers in 1996. Earlier he worked for Manufacturers Hanover in Sweden and London, and it was during that period that he first got to know Vattenfall.
“It’s a very market-savvy organisation, and was one of the pioneers into the emerging credit market in Europe,” Mr Winter says.
European first
Early deals involving Citigroup were a 10-year US dollar Eurobond in 1998, followed by Vattenfall’s first euro-denominated transaction – a 12-year issue – in 1999. “Vattenfall was one of the first corporates to undertake 10 year-plus funding in Europe,” says Peter Charles, Citigroup’s London head of corporate fixed income syndicate. As another of the group’s Salomon Brothers intake, Mr Charles traded Eurobonds in London and Tokyo before moving to the primary market business.
Vattenfall and certain other corporates may have looked longingly at hybrid capital, but until recently there was one problem. The rating agencies were neither consistent nor particularly generous with the equity credit they were prepared to bestow on corporate deals. This was in contrast to the way they treated issues from financial institutions.
“Since the Basel Committee issued guidelines on regulatory capital for banks in 1998, there has been a lot of hybrid capital issuance in the bank space,” observes Peter Jurdjevic, European head of fixed income new products, and yet another Salomon alumnus. “Structured as tax-deductible mezzanine capital, it counts as equity for regulatory purposes and forms part of the Tier 1 capital base of the bank.”
This February, however, Moody’s announced that it would increase the amount of equity credit assigned to such capital securities, if structured appropriately, from a maximum of 50% to 75%. “A necessary condition for achieving this Basket D category is a mandatory cash non-payment trigger,” Mr Jurdjevic explains.
Step-up clause
Standard & Poor’s was always willing to give more equity credit than Moody’s, but historically was reluctant to assign any meaningful amount if the deal carried a step-up clause. “Standard & Poor’s is now more comfortable about assigning credit to step-ups as long as the transaction has strongly-worded replacement language – in other words, a clear intention to refinance with similar instruments or equity in the event of redemption,” Mr Jurdjevic says.
These changes have opened the door to a string of corporate issues. There had been a handful of earlier hybrid capital deals, from the likes of Linde and Casino. But these received equity credit of less than 50% and, in one case, zero.
So, when the news from Moody’s sunk in, Vattenfall wasted little time in taking another look at the possibility of a hybrid capital issue. Other positive developments began to combine to make such a deal look even more promising.
“Now the agencies had created some clarity,” says Mr Winter. “And underlying interest rates had also taken a new direction: down.” Mr Charles adds that the new International Financial Reporting Standards accounting rules would allow the securities they had in mind to qualify for equity treatment on the balance sheet.
Vattenfall was not the only corporate checking out the new possibilities, but it was certainly the most ambitious, as the code name for the project suggests. As the Citibank team worked on the transaction, they referred to it, with typical bankers’ modesty, as Operation Big. Preparation began in earnest in early May.
No guarantees
There was no guarantee, however, that the market was going to give Operation Big the welcome its creators believed it deserved. Even two weeks before the launch, corporate bond investors were still anxious, prompted by the downgrading of the two major US automotive names, General Motors and Ford, to junk status. By early June, however, with a sudden change of sentiment, the market recovered its nerve and the deal was finally announced on June 7.
“After two extremely volatile months, it became evident that market conditions could now support such a transaction,” Mr Charles says. The roadshow wheels started turning the following day, taking in Stockholm, London and Paris, as well as stops in Germany and the Netherlands.
“Vattenfall to test appetite for risk” ran the headline in the Financial Times. After a month in which not a single new deal had been completed in the European high-yield market, that just about summed it up. The Swedish utility was initially looking for €750m, with price guidance of mid-swaps plus 187.5 to 200 basis points (bp).
High rating
Moody’s had given the deal 75% equity rating, the highest ever in a European corporate transaction. On announcement of the deal, the agency also changed the outlook on Vattenfall’s senior unsecured ratings from stable to positive. Standard & Poor’s awarded it 60% equity credit.
To achieve those levels of equity credit, the structure included no specified maturity, indefinite cumulative optional deferral, a mandatory interest payment cancellation clause and provision for capital replacement.
Though Citigroup was the sole structuring adviser, it was joined at this stage by JPMorgan and Merrill Lynch as bookrunners.
And investors liked what they saw. It was not lost on them that the coupon – with the Kingdom of Sweden standing behind the credit – was going to be decidedly generous versus its senior debt.
“It was evident from the response that we had the attention and focus of the market, and we rapidly built a strong order book,” Mr Charles recalls.
Orders worth €2.1bn came in. Vattenfall and its advisers responded by upping the issue size to €1bn, making this the largest-ever European corporate capital securities offering. They also reduced the spread to 195bp, the tightest of its kind.
Other hybrids
Two similar hybrid deals hit the marketplace in the same week that Vattenfall launched, one from Danish oil company Dansk Olie Og Naturgas (Dong), another from German sugar producer Südzucker. But neither of them achieved the same levels of equity credit or spread as the Swedish deal.
If the issue grabbed the attention of investors, it also focused the minds of European corporate issuers. “Every European corporate will be looking at this deal,” says Tomas Lundquist, Citigroup’s key relationship manager on the Vattenfall account.
“Many companies have been theoretically interested in this structure for the past six months or more, but when they see how much Vattenfall raised and at such good rates, they will want to know more.”
Mr Winter puts it another way. “The last 18 to 24 months have been the era of liability management, with buy-backs and exchange offers,” he says. “Now it’s the era of hybrid capital.”
