Letter number 15 of April 2006


News : Hybrid securities

Debt and equity have their own specific features (1). An investor can either focus on their advantages – potentially high gains for equity and low risk for debt, or on their drawbacks – high risk for equity, low returns for debt. There are times however, when the investor may seek to combine the advantages of both products. In such cases, hybrid securities are the answer.

We have seen a large number of subordinated securities recently (both in terms of number of issues and volumes), which is being driven by a real demand from investors who are finding companies that are keen to issue such securities.

These are some recent issues of subordinated securities by non-financial companies:

But what exactly is a subordinated security ?

It is a category of securities issued by a company which is inserted between normal debt (bank loans or bonds) and equity. They are the riskiest debt securities that could possibly be imagined:

•If the company goes into liquidation, they are repaid after all other debts (but before shareholders’ equity, since they are debts).
• They either have a very long period to maturity (99 years for Henkel, 1,000 years for the Dong issue!) or no contractual maturity date at all.
• Interest is fixed but can be suspended (2) (in particular when the issuer does not pay a dividend).

Given this higher risk, the returns are obviously substantially higher than for other debt securities.  For example, Dong (the Danish oil and gas exploration services company) issued standard 7-year bonds and hybrid securities simultaneously.  The standard 7-year bonds were issued at an interest rate of 3.5% (a spread of 52 basis points), while the hybrid securities paid interest of 5.5% (spread of 220 basis points).

For the company, these securities present the major advantage of not giving investors access to capital, and consequently, no voting rights.  They strengthen the quality of other debts that have been contracted, which are senior to subordinated debts, which gives them a preferential right to the proceeds of the issue of the subordinated securities if the issuer should get into difficulties.  Only shareholders’ equity could have a similar effect, but issuers are very keen on the fact that interest paid on subordinated securities is tax deductible, which as we all know, is not the same for dividends. 

These securities, which are being issued more and more frequently, have in fact been around for a long time. Until recently, they were mainly used by banks or insurance companies. These products have the significant advantage of strengthening equity capital (Tier 1 capital), which means better solvency ratios for financial institutions. And accordingly, the arbitrage between high cost and strengthening financial solidity is expressed in banks by the amount of subordinated securities issued.

The increased issue of subordinated securities by other companies has been encouraged by several fundamental changes in finance.  The first is certainly the growing importance of rating agencies, and more generally of financial rating, for companies.  Financial rating is a form of external monitoring (3) of the financial solidity of the company, just like solvency ratios are relied on for assessing financial institutions.  When rating agencies calculate the ratios that they will use for determining the rating of a company, they “credit” issues of subordinated securities with a component of equity capital, ie, they split the issue into a debt component and an equity component.  The equity credit that they grant to the issue can vary between 40 to 75% (40-60% for S&P, 50 to 75% for Moody’s) and depends on the specific features of each issue (4). Additionally, under IFRS, some issues can be considered as equity, which improves the balance sheet, although in our view, this is inconsistent with a financial approach.
For the investor, subordinated securities offer something that is very rare these days - high returns.  With low interest rates and plummeting spread (under 1% for all investment grade companies), investors are finding it hard to get enough paper that will yield a high interest rate. Loans recently contracted to fund acquisitions and LBOs remain a limited source of returns for investors, notwithstanding the recent increase in operations. 
Additionally, even if there is no short-term repayment date, there is a mechanism that encourages the company to pay back the securities after a certain number of years.  Accordingly, for some issues, the margin paid by the company increases over time (this is known as step-up, which is generally 100 basis points, or 1%), encouraging the company to repay the loan on which interest payments are becoming prohibitive.  The “economic maturity” of the loan will then be lower than its contractual maturity (5).
From the issuer’s point of view, the reduction in market volatility has reduced the options for attractive financings.  What happens is that subordinated securities are competing on the markets with other hybrid securities,  especially securities using optional products (convertible bonds, bonds with warrants attached, etc.). These securities, which were highly sought after in 2000-2002, are not as popular today.  Market volatility has in fact halved since then, and the optional aspect of the product is now a lot less attractive.  So companies prefer to pay the cost of risk, at a fair price, on subordinated securities, than to sell off future access to their capital at a knock-down price. The introduction of IFRS has also reduced the “accounting attractiveness” of convertible bonds. 
We may wonder why subordinated securities have been more successful than preference shares which have rather similar features.  We believe that there are two main reasons.  The first is the fact that interest on subordinated debts is tax deductible, unlike dividends on preference shares.  The second is the investors likely to be interested in these products do not have the same investor profile as those keen on preference shares.  Subordinated securities are mainly placed with long-term investors (insurance companies, private banking clients) who are seeking attractive returns over the long term.  Such investors are relatively indifferent to the low liquidity of the security (a feature subordinated securities and preference shares have in common) (6).
On the other hand, recent history has shown that preference shares were difficult to value, difficult to get rid of if necessary and often heavily discounted because of their reduced liquidity compared with ordinary shares.  Increasing the different types of bonds results in a better breakdown of demand from bond investors, which means they can be issued in better conditions.  Increasing the different types of shares has the opposite effect, by reducing the liquidity of each line, when liquidity is the watch word of many investors in equity and not the chief concerns of investors in bonds.
Subordinated securities seem to have found their place on the market.  They are issued by companies seeking to strengthen their financial solidity without diluting their shareholdings and they come with a tax break.  They are bought by long-term investors seeking comfortable returns, but who are prepared to take a certain amount of risk and to sacrifice the liquidity on their investment.
(1) For more information, see chapter 25 of the Vernimmen.
(2) Depending on the product, interest is either waived definitively (non cumulative interest) or capitalised and paid at a later stage  The suspension of interest payments may either be optional, if decided by the issuer, or automatic if certain ratios are reached.
(3) And objective.
(4) See Refinement to Moody’s Tool Kit, published in February 2005 which sets out the rules for granting a Moody’s equity credit.  The publication of this change in the way Moody‘s appreciated the equity content of hybrid securities, was certainly a key factor behind the acceleration of the hybrid securities market.
(5) Fixing an economic maturity date is very important if the securities are to be placed mainly with institutional investors, which is generally the case
(6) Investors in subordinated securities are bond investors while investors in securities like priority dividend shares are equity investors. Anglo-Saxon style preferred shares can however be similar to subordinated securities.  

Statistics : Corporate income tax rates worldwide

Once again this year, KPMG’s annual study shows a decline in the average corporate income tax rate, to 25.04%, in the European Union.

In addition, Austria and the Netherlands significantly reduced their rates.

Research : Are poison pills harmful?

Just for a change, we’re not going to discuss the results of recent research.  Instead, we’d like to look at the findings of two economists dating back to the mid 1990s but not disproved by more recent work.  The topic is very much in the news in Europe at the moment – what impact do poison pills (1) have on the value of a company's share, on the likelihood of it becoming a target for a takeover, and on whether it will be able to fend off predators or have to succumb to their overtures.  In other words, how effective are they?

The French parliament has hust adopted a law that, subject to conditions, allows targets of takeovers to allocate free warrants to their shareholders to subscribe new shares at a price that is (much) lower than the market price. 

his means that hostile assailants will be taking the risk of acquiring 97% of the target’s capital, at for example €100 per share, only to see their investment immediately diluted to 19.4% if, and still speaking hypothetically, four warrants had been allocated to each share entitling the shareholder to subscribe a new share at €1. The share would now not be worth more than €20.80.  This is a very poisonous pill indeed and should encourage even the most daring of assailants to think long and hard about whether it really does want to launch a hostile bid.  

Robert Comment and G. William Schwert (2) showed how poison pills, including the warrants described above, appeared in the USA in the 1980s and were very soon quite common – in the early 1990s, one-third of listed US companies had poison pills. Contrary to a commonly-held idea at the time, their appearance and general adoption were not responsible for the end of the M&A boom in the late 1980s.  The blame for that can be placed squarely on the economic recession that started in 1990 and the disappearance of the large, undervalued conglomerates, which were the favourite targets for restructurings at the time (3).

Relying on the work of other researchers, Comment and Schwert show that the introduction of poison pills only reduced the share price of companies that made use of them by less than 2%, which is a negligible amount.

Unsurprisingly, they also show that the probability of a company which puts a poison pill in place becoming the target of a hostile bid is much higher than for a company without a poison pill.  The reasoning behind this is obviously endogenous – a company that fears being taken over generally has good reason to do so (low share price, poor operating performances, dispersed shareholder base, etc.) and accordingly, there's a good change that it'll become a target for a takeover, and by extension, a good chance that it'll introduce a poison pill.

But more importantly, the authors show that takeover premiums are highest for companies that have put a poison pill in place than for others.  These companies are thus in a better negotiating position, not for protecting management, but for obtaining better financial terms from the buyer in exchange for waiving the exercise of their warrants, which is very good news for their shareholders.

We might well ask why the share price drops a little when the introduction of a poison pill is announced, when this poison pill could ultimately result in a higher control premium being paid in the event of a takeover bid? Common and Schwert find that the market overestimated the harmful effects of poison pills and underestimated the greater negotiating power they give the target.

It should be clear then that the poison pill does not provide absolute protection either.  Even if in the USA, no buyer has acquired a company that had issued dillutive warrants without reaching an agreement with the target before hand, ensuring that they will be waived.
(1) For more information on poison pills see chapter 41 of the Vernimmen.
(2) Poison or placebo ? Evidence on the deterrance and wealth effects of modern anti take over measures. Journal of Financial Economics, 1995.
(3) For more information see chapter 42 of the Vernimmen.

Q&A : Definition of some equity capital market terms

Bookbuilding:Book-building is a technique used to place securities on the market. It is the process whereby the bank marketing the offering gets to know investor’s intentions regarding the volumes and prices they are prepared to offer for the security.

Bought deal: A bought deal takes place when a bank buys the securities from the seller/issuer and then re-sells them to investors. The remaining unsold securities go onto the bank’s balance sheet. Bought deals are used most often for transactions such as block trades of already existing shares or a bond issue.

Clawback:Claw-back clause allows the securities allocated to one class of investors to be reallocated to the other class of investors, should the structure of actual market demand (retail, institutional, etc) differ from that planned originally.

Flowback:Flow-back is the excessive sale of securities immediately after their placement.

Greenshoe: A greenshoe is an option granted by the seller/issuer to the bank to buy at the price of offering a number of supplementary shares over and above the number offered to investors.

Lock up: A shareholder who has sold a large number of shares or a company which has issued new shares is frequently required not to proceed with a supplementary sale/issue of shares for a given period called the lock up period. Most of the time it lasts between 3 and 9 months.

One on one: Private meeting between the CEO or the CFO of a company and one of its (large) shareholders or potential investors. Most of them take place during roadshows.

Over hang: Overhang is a problem caused by fear that the arrival of a large number of shares on the market will depress the share price.

Roadshow: A roadshow is a meeting of the company’s management with potential investors. It usually takes place as a part of a placement of a company’s securities.

Warm up: Warm up sessions are meetings of investment banks with investors to test the latters’ sentiment. Warm up meetings are especially important when the size of an issue is large.
For more, have a look on chapter 31 of the Vernimmen devoted to how securities are sold to investors.