After Orica’s success, it seems like hybrid capital raisings are driving the whole M&A market this year.
The Australian stockmarket is at an all-time high. The mergers and acquisitions business is booming, and the boom is bringing a wave of new capital-raising to the market. But if 2006 is to be known for anything, it will be the year of the hybrid step-up preference security (SPS).
The twist that has caught the market’s interest is that SPSs are structured so they are treated as equity on the balance sheet but offer funding near the cost of senior debt. Plus Standard & Poor’s now treats SPSs as half equity and half debt.
Hybrid markets are booming. In Europe, there have been 10 issues over the past six months from issuers such as Porsche, Bayer and Henkel. Japan has joined the frenzy, too, with banks and now corporates taking advantage of the SPS structure.
UBS’s managing director of hybrid capital, Steve Hawkins, says: “In Europe we’ve seen two things occur. We’ve seen rating agencies give issuers much more certainty as to what value they get for issuing a hybrid. Secondly, we’ve seen a yield environment and a change in the fixed-income base, which has allowed the price or the spread of the issue to reduce.
“That means you’ve more certainty and the pricing is very, very efficient. For a corporate treasurer who has an investment-grade rating, compared with a year ago, these securities are a lot more attractive and we’ll see more.
“Hybrids are often very good in a merger and acquisition scenario because a company will need to stretch its gearing [to raise capital] at the right price. What a hybrid will do is allow them to negotiate a stability of the rating with the rating agency.”
The head of new products for Citigroup’s fixed income business in Australia, Fraser Todd, says: “I would think there’s going to be a significant amount of issuance this year. Certainly there’s a lot of activity at the moment. What’s driving the market is innovation.”
Todd was part of the team at Citigroup that successfully brought the Orica deal to market (see “Hybrid breed”, CFO, April 2006), with Macquarie. Most recently, his team and UBS co-led the $600 million Woolworths SPS issue.
Launched on April 3, the unfranked perpetual non-call instruments have a five-year term and a 200-point step-up. They are first being offered to investors in Woolworths income notes at a minimum of 110 points over the swap rate. In May, the book will be opened to outside investors and the actual rate will be set in a book-build.
The Australian market for preference shares is mature, with $27 billion raised from 102 issues in the past 10 years. Last year about $3.5 billion of preference shares were issued in nine deals, satisfying demand from both institutional and retail investors.
By early April this year, there had been five hybrid SPS issues from Orica, Futuris, Commonwealth Bank of Australia, John Fairfax Holdings (CFO publisher) and Woolworths. Three of these deals were driven by acquisitions.
And more deals are in the pipeline, with Transpacific Industries saying that it will issue preference shares to help finance its proposed acquisition of Cleanaway Australia and Brambles Industrial Services with CHAMP Private Equity.
Deutsche Bank says there is strong demand for new issues as demand continues to be buoyed by strong equity inflows from superannuation funds, dividend reinvestment, buybacks, capital returns and the likely proceeds from cash takeovers.
In a market awash with capital raisings, Deutsche expects retail investors to be selective about which ones they participate in.
The Step-Up Preference Security is proving to be a winner, however.
When the Trade Me acquisition hit the radar of John Fairfax Holdings’ chief financial officer Sankar Narayan 10 days before Fairfax unveiled financial results, he asked his team to find a hybrid.
What they did was look to the success of Orica’s $400 million SPS at 135 points over the 180-day bank bill swap rate.
The attraction for Fairfax was that it could raise $300 million as equity from a balance sheet perspective. Narayan said in terms of the cost of capital, it was cheaper to take this route. “Of course, it’s a bit more expensive than debt, but compared with equity it is actually a lot better,” he says.
Fairfax was seeking $250 million plus $50 million. Narayan expected the first $250 million to come in somewhere between 155 and 160 basis points over the swap rate. In fact, $250 million was raised at 155 points over the swap rate.
Because of the market’s healthy appetite for SPSs, Narayan decided not to underwrite the issue. He says: “It was another $1 million to $2 million that we would have had to pay away without any benefit at all.”
What really impressed him was how quick-ly the issue got away – within two weeks. Futuris CFO Peter Zachert believes in diversity of funding sources and terms and thus chose an SPS. “As far as subordinated debt, I think it’s pretty cheap,” Zachert says.
“The sort of underlying interest rates that people are paying for some [hybrid capital raisings], it’s really damn good. It’s not that far away from senior debt, and it obviously has got all the benefits as far as rating agencies go. For accounting presentation, it’s below-the-line distributions rather than interest. It’s got a lot of upsides.” Part of the success of his issue was that it was fully franked. Zachert says: “If you’ve got a fully franked issue as ours is, you’re going to find a lot of interest from the retail market.”
Macquarie Equity Capital Markets executive director Paul Donnelly says the turning point for the market was last year when Standard & Poor’s decided to treat half as equity and half as debt.
Typically preference shares have been issued for 10 years with a 100-point step-up. But now Standard & Poor’s will accept a 200 to 250-point step-up after five years. “The rating agencies wanted replacement language, where the issuer commits to refinance at year five with either equity or a like instrument,” Donnelly says.
“If they do otherwise – replace with debt – it triggers a downgrade. The [key] clause is that the treasurer will refinance with regard to the company’s credit rating. Seeing as this is what treasurers do all the time – have regard to their ratings – there was no problem in the deal at all.
“The local S&P guys found themselves in the funny position that they were thought leaders globally.”
But the real attraction is the low cost of capital. Donnelly says: “Just compare this with the average weighted cost of capital . . . On average you are about 200 basis points better off than your equivalent whack with a hybrid. I wouldn’t doubt that, subject to having the right reasons, rated corporates will come to market with this new structure because it makes financial sense. That’s the big change.”