( (c) Euromoney Institutional Investor PLC Jan 2009)Note: Even in tough capital markets, open onlyto the few, it's still possible to craft gooddeals, attract new investors, bolsterbalance sheets and stave off disaster.For all their past sins and excesses,investment banks -- the good ones atleast -- will prove themselves invaluableover the coming 12 months
Top quality issuers boost debt capital markets
Forget the broken banking system
Even governments face supply constraints
The Future of Capital
The world is running out of capital just as companies realize they urgently need to raise equity, like the banks before them, to strengthen their finances as recession bites. The desperate search is on for wealthy investors willing and able to take strategic stakes to anchor big equity deals. Peter Lee reports.
AN ENGLISH INVESTMENT banker recounts the most troubling moment of a recent business trip abroad. "I was going through passport control and they asked me the purpose of my visit and what I did. For the first time in my career, I thought 'I can't say I'm a banker, I've got to say something else... maybe I can tell them that I'm a doctor'". Amused at this confession of shame and embarrassment at his own profession, the banker's colleague chips in helpfully: "He told them he was a masseur."
He shouldn't feel so bad. The irony is that, while they have been cast, probably rightly, as the villains of the piece, investment bankers and their core skills -- the ability to marry up the capital needs of financially stretched issuers and the investment objectives of those lucky few still with cash to put to work -- have never been more acutely needed than they are today. Those skills have never been more valuable.
Another investment banker recounts a recent visit to a corporate client in the truck-making business. He had been to see the company in the autumn of 2008, at a time when the survival of his own employers hung in the balance. The banker had wanted to talk about how the truck company was prepared to face the difficult times ahead. "They told me, 'look these are your problems in the financial industry, don't come and project them on to us'. At the time, they were sitting on an order book for 20,000 units." He went back to the company at the end of 2008. "I'm always interested in trucking because it tells you so much about the economy and other industries, obviously construction and other sectors as well. Do you know how many cancellations they had had?" Euromoney can't even begin to guess. "They had had 20,000 cancellations."
As a piece of anecdotal evidence, it's at the extreme. But corporate executives are quickly coming to terms with the need for urgent action: cutting expenditure, paying down debt, reducing costs, husbanding cash and wrestling with how to maintain access to credit while bolstering their capital structures.
As one head of capital markets puts it: "Since last October, we went from peacetime to wartime in a matter of weeks."
So 2009 promises not only to be one of the most challenging and fascinating years ever to be working in capital markets, it also promises to be hugely rewarding financially. As investment banking divisions within many universal banks have been cut back if not shuttered and several big independent firms have failed or disappeared into mergers, competition is diminishing just as margins start to rise and volumes, too, look set to recover.
The primary debt markets will be much busier this year than last. And even though much of that will be government and government-guaranteed issues, fees are going one way: up ( see story on predicted volumes of debt capital markets issuance ). As the countdown to Christmas quickened, one banker confided to Euromoney that for 2008, his bank's debt capital markets business enjoyed record profitability. "In revenues, we are 25% ahead of 2007, which was previously our record year, and we've done that after taking out 30% of the overhead costs."
Secondary markets are broken, volumes are down but don't underestimate the impact of wide bid-offer spreads on banks' capacity to make money from relatively risk-free customer business.
Equity is the new debt
The volume of new issuance in the equity capital market is hard to predict. One that can be made with confidence is that there will be more of it. In 2008, the primary equity market was largely the preserve of banks rebuilding their capital through large rights issues, with a handful of consumer companies following suit. The banks will continue to issue this year and more companies will follow where the banks have led.
A debt capital markets banker tells Euromoney: "Companies are fearful not just about what happens this year. We already have companies coming to us and talking about debt maturities falling due in 2010 and 2011 and asking what they can do to meet those."
At a rival bank, an equity capital markets banker poses an intriguing question for corporates. "With CDS indices now pricing in thousands of corporate defaults at low recovery rates and the debt markets only open to the best issuers at coupons close to double digits and spreads way over 500bp, companies should ask whether the present cost of debt is close to their long-term cost of equity," he says.
There is no easy definition for what is now the appropriate capital structure with which companies in any sector should face the economic downturn. One simple rule of thumb for companies is to do whatever it takes to maintain investment-grade status. Without that, they are likely to be shut out of the debt capital markets at a time when banks have severely limited appetite for lending. That's a life-threatening position to be in. How do you stay investment grade? You raise equity by whatever means: selling assets, or selling shares.
Selling non-core assets sounds great: but at what price and who to? Debt-financed acquisitions will be very tough to do in 2009, although theoretically they make sense, as prices have come down. "The good news is that assets are cheap," says an M&A banker. "The bad news is that no one has any money."
So the menu of options for companies looking for a bigger capital cushion is not long. How about selling shares?
Corporate chief executives and chief financial officers resisted the idea last year. They didn't want to sell more equity when their share prices had already tanked, nor further to dilute earnings that are likely to be lower this year. And they might genuinely have held a more optimistic long-term view of their business than debt or equity investors and feared that they were being pushed into raising too much capital and later would be damned for producing too low a return on it.
Matthew Koder, joint head of global capital markets at UBS, says: "In the third quarter of 2008 we tried to talk to corporations about raising equity and many wouldn't even discuss it with us. But by the end of last year it was a prominent part of every conversation we were having with clients."
It's one thing to recognize the need to raise equity, quite another to get the job done. It's not a straightforward proposition.
Jim Amine, co-head of the global investment banking department at Credit Suisse, says: "When I look at the equity markets I see continued volatility and little stability for the next two to three quarters. That makes it very difficult to do IPOs. All the action will be in secondaries and, given investors' preoccupation with liquidity, in large caps. Over the next two years, a number of companies will be raising equity to reduce leverage. Companies will be focusing less on dilution and more on risk reduction. Capital-intensive industries such as energy and natural resources that have financed capex out of cashflow when product prices were high may have to resort to equity now that prices are falling. General industries will want their capital structure to be as robust as possible going into a recession." Companies that follow banks' advice now will find it a costly exercise.
European banks that were doing secondary share offerings for fees of 125bp or 150bp in the first half of 2007 will now be charging 250bp or 300bp. Fees have doubled, although the banks will claim that the underwriting risks have too... and maybe more than doubled.
Outcomes will be binary. Those corporate and financial issuers that succeed with equity and debt raising will live: those that fail... will not. With their very survival at stake, companies will pay almost whatever it takes to raise capital through higher spreads and higher fees.
In the last years of the age of excess, investment banking went virtual. Quants created synthetic products to sell to fabricated investment vehicles or leveraged funds that could only buy the repackaged garbage the banks were selling them with money the banks were lending. When they weren't warehousing risk, banks were essentially dealing with themselves.
For a while, actual corporations, which had strengthened their balance sheets and built up cash after the dotcom bust at the start of the decade, and traditional long-only investors looked on bemused. Leveraged buyouts of some companies were undertaken at ludicrous leverage multiples and others were sucked into borrowing cash to buy back equity and boost shareholder returns through capital structure engineering. Some investors were lured into taking on excessive credit and structure risk in the search for yield. But mostly, investment banks turned away from these old-fashioned clients. The old investment banking day jobs of dealing with corporate fund-raising and trading insurance company and pension fund money in and out of conventional cash markets were delegated to the firms' plodders, or left to computers.
Not now. Ivor Dunbar, co-head of global capital markets at Deutsche Bank, says: "Solving client's capital problems today is every bit as complex as was devising the next-generation structured product. This is still a business model based on intellectual capital. Where and how that capital is deployed has changed. Providing a thoughtful analysis of companies' balance sheets and cashflows and how they might be affected through an economic downturn of uncertain duration and severity is challenging. And, having undertaken that analysis, then providing the right combination of sources of potential capital is extremely challenging. The opportunity for investment banks to make money in capital markets has not been dented by the downturn... but you probably have to work 10 times harder for it."
Banks are quick to draw a key lesson from their own near-death experiences and preach it to corporate clients. Move fast. The world is running out of capital, so grab some while you still can. Those banks that raised equity quickly as the crisis hit the financial industry in the second half of 2007 and the first half of 2008 raised more money on better terms than did most of those who waited and hoped that the storm would soon pass and miss them on the way through.
"When we meet with clients, we tell them to assume that things will be bad, and to deal with it proactively. Cash is king to a degree we have never seen before"
Walid Chammah, Morgan Stanley
Walid Chammah, co-president of Morgan Stanley and chairman of Morgan Stanley International, says: "When we meet with clients, we advise them not to put their heads in the sand or to tell themselves that there is a 50:50 chance that the environment could worsen and that things could turn out badly. We tell them to assume that things will be bad, and to deal with it proactively. Cash is king to a degree we have never seen before. Unsecured finance, which used to be so abundant as almost to be free and taken for granted, is suddenly extremely scarce and valuable. Large firms will have to rely on internally generated working capital, like small, family businesses do. In this environment, equity almost equates to working capital."
Going cap in hand to shareholders and asking them for more money is never an easy thing for corporate executives to do, and especially not when their share prices are 50% below their recent highs. "There is a double sticker shock," says Chammah. "First, there is the shock of how far valuations have fallen, and then there is the second shock of how big a discount might be needed beyond even that to raise primary capital, especially to attract new investors." He adds: "In September, when Morgan Stanley converted into a bank holding company and raised $9 billion by selling preferred stock at 10% to Mitsubishi UFG with the right to convert into a 21% strategic shareholding, we didn't have our heads in the sand. The market was talking to us. And no matter whether you think the market is right or wrong, the market has a vote. And it can vote you out of the game."
Grab it while you can
The challenge for companies right now is particularly acute. The banking system is essentially broken. Spin it however you like, but there is barely a bank in the world that could raise term finance without the explicit or implicit support of governments. Even those selling senior unsecured non-government guaranteed debt can only do so because governments are standing by to guarantee their other liabilities.
Companies that have already drawn down on back-stop bank lines of credit might be in for an unpleasant shock when these come up for renewal. And although the banks might prop up companies to which they are heavily exposed by rolling over financing, they will do so reluctantly, selectively and at the highest cost they can extract.
The debt capital markets are open -- but only to strong, investment-grade credits willing and able to pay wide spreads. Credit default swap spreads have widened for most borrowers and where that widening indicates investor concern over an imminent liquidity event -- such as the need to repay maturing debt -- that gives the equity markets a clear signal to go short and so equity prices fall as CDS spreads widen.
Yet crucial capital-raising deals can still be done, even in the most troubled sectors. Take real estate, where leverage has been high and share prices have collapsed. Australia's real estate sector has been hit hard. But, at the end of November 2008, troubled industry leader GPT was able to complete the first large recapitalization of a listed real estate investment trust, raising A$1.6 billion ($1.07 billion) in a rights offer that was oversubscribed by institutions.
It was a crunch moment. Announcing the rights offer was the final act of chief executive Nic Lyons before he left the company. But its success reduced gearing, prompted ratings agency Standard & Poor's to take the company off negative outlook, gave the company the confidence to renegotiate covenants with bankers to give it more flexibility and bought it time to proceed with asset disposals this year. It also drew in a new, key strategic investor, the real estate investment arm of the government of Singapore.
It was a success but perhaps a mixed one. The rest of the Australian real estate sector was rated down on news of the deal, as investors pondered the implications for other companies of the sector leader's need to recapitalize and as they priced in new supply for this year.
And while it is all very well for the investment banks to tell companies to jostle to the front of the queue with their begging bowls and raise equity capital early, investors have also learnt a painful lesson from the first rounds of bank recapitalization. Even those who bought into the later deals didn't fare so well.
More than a year into the financial crisis, in September 2008, Goldman Sachs sold a strategic stake to Warren Buffett and followed this up with a $5 billion offering in the public equity market priced at $123. The stock rallied on the news up to $130. By mid-December, Goldman's stock price stood at $67. Just a few days after Goldman in September, JPMorgan sold $10 billion of stock in the public market as part of its acquisition of Washington Mutual, pricing newly offered shares at $40.50, a 7% discount to their prevailing price. Investors saw the capital raise as great news and the stock went to $44.50. By mid December, it was down to $30. In October, Bank of America raised $10 billion at $22 a share, an 8% discount. Two months later, the stock price stood at $15.
And as for those investors who supported early equity offerings from Citi, UBS and Merrill: ouch!
Anchor investors are crucial
Michael Sherwood, co-chief executive of Goldman Sachs International, says: "Many of the private equity funds and sovereign wealth funds that went into the early bank recapitalizations lost money and they will be more circumspect in future. I don't think you'll see many more of those big, strategic investments concluded over a weekend with no adviser on the investor side."
"I don't think you'll see many more of those big, strategic investments concluded over a weekend with no adviser on the investor side"
Michael Sherwood, Goldman Sachs International
Goldman famously acted as an adviser to Sheikh Mansour Bin Zayed Al Nahya last October in his investments, alongside Qatar Holdings and Challenger, of pound(s)5 billion ($7.5 billion) in reserve capital instruments paying 14%, mandatory convertible notes and warrants of Barclays. Compared with those sovereign wealth funds that invested early in the banks, he got good terms and good protections in a deal that shows if you've got deep pockets and low leverage, this is a lender's market. But such pockets will only open to the select few.
Sherwood wonders whether, even at the new high fee schedule, underwriting rights issues for three to six weeks is a good way for banks to deploy their capital. He recommends being discerning in supporting equity capital-raising. "On the rights issue underwriting side, there will be no shortage of opportunities to do business for the banks."
The Barclays deal is a pointer to the kinds of investment banking skills needed in a bear market and a recession. The securities themselves -- reserve capital instruments, mandatory convertible notes and warrants -- are nothing complex: devising them requires no doctorates in rocket science. Although technically simple, though, this was a far from straightforward deal. Unearthing key strategic investors, negotiating the right mix of instruments and the balance of their distribution to new strategic and conventional investors, preparing for the angry market reaction to any capital-raising that bypasses pre-emption rights, and making a case for this when the UK government was offering apparently sweeter terms, all required great skill, market intelligence, contacts, capacity to innovate and sheer smarts.
It is a return to investment banking as classical art rather than science. The banker who can fill the role of trusted adviser is invaluable. It's a job for grown-ups -- ideally with business as well as capital markets experience and for leaders who have brought their own financial institutions through the shock of coping with a broken business model and capital and liquidity crunch -- not one for bright boffins who are just very good at maths.
For companies, it is an even more demanding time. Chammah says: "Clients must be flexible, entrepreneurial, and open-minded. In a normal downturn you proceed on the assumption that most companies will make it through. But this time, some will and some will not."
Knowing that if they bring a deal to market and fail with it their company could be launched into a death spiral, corporate executives need to do all the work they can with bankers, existing shareholders and potential new strategic investors to structure deals correctly in the first place.
The extraordinary volatility in the secondary equity markets -- with share prices rising 10% one day and falling 10% the next, on the basis of nothing more than the latest harebrained bail-out plan announcement from the US Treasury -- makes it very difficult to issue in the primary market.
Low earnings multiples might suggest that stocks are cheap, but investors worry that this year's earnings might be only a fraction of last year's. "We need some kind of stability for the equity new-issue market to function," says UBS's Koder. "We don't necessarily need to see the start of an uptrend or even to hit the bottom. It would be enough for a consensus to emerge as to how much lower stocks are likely to go and for the volatility to subside. At that point, perhaps the top quartile of companies in any sector -- even real estate, autos, retail -- will be able to raise equity."
It's an urgent task. There's $1.5 trillion of capital markets debt falling due in the next 18 months and not all of it is going to get refinanced.
Buyers scramble up the capital structure
Across the capital structure, natural providers of capital are looking to move up one notch. So, for example, traditional equity investors are moving into equity-linked debt, attracted by wide secondary market spreads and a senior position in the capital structure with some equity upside in warrants that high volatility makes valuable. Other value investors that can trade across asset classes and who previously bought equity are now buying junior debt tranches -- sometimes even senior debt tranches -- in expectation of being crammed down into equity in restructurings.
Equity income funds, which typically buy safer, utility-like stocks with stable dividend policies, are moving into the investment-grade credit market where spreads are wide on names unlikely to default and there is an arguable prospect for capital appreciation.
In credit markets, investors are moving up the rating spectrum in an exact reverse of what many did during the scramble for yield from 2005 to 2007. High-yield buyers are buying cross-over credits, cross-over buyers are moving into investment-grade bonds, investment-grade buyers that are not won over by the wide spreads on strong single-A names coming to the market are pushing up into the supranational and agency and new government-guaranteed markets.
Is an Irish building society selling 22-month debt, guaranteed by the Irish government, really going to attract rates buyers? It is paying 80bp over mid-swaps. Isn't that a credit product, or perhaps a cross-over between a rates product and a credit investment?
"When I look at the equity markets I see continued volatility and little stability for the next two to three quarters"
Jim Amine, Credit Suisse
And when you look back at the lowest end of the credit spectrum, where high-yield buyers are now exiting in search of investment-grade credit, there is a vacuum. Jim Amine at Credit Suisse says: "Non-investment-grade credit in Europe is an orphan asset class. High-yield bond funds have had disappointing performance and redemptions, hedge funds have had liquidity pressure as they deleverage, most CLOs are severely impaired and syndicate banks are capital constrained. There are very few natural buyers."
Bankers take note of another potentially worrying trend: a reduction in cross-border investment flows as risk aversion prompts investors to look closer to home at companies they know. "We have seen this in recent placements," says Jean-Francois Mazaud, deputy global head of capital raising and financing at Societe Generale. "In Europe for example, where there are big domestic investor bases in the UK, Germany, Netherlands, issuers can expect a refocusing onto these investor bases accounting for 40% or more of new issues, much more than they did before." That raises a worrying question for issuers from countries with a smaller home base of insurance company and pension fund money.
And all this raises another tricky question. When every buyer is jostling up the capital structure, who is the new natural provider of equity at the bottom?
A nervous equity investor base looks on. Thierry Olive, global head of equity capital markets at BNP Paribas, says: "Sovereign wealth funds are much more cautious now. Hedge funds, which used to buy maybe half of any new issue, are facing great difficulties. Traditional long-only investors have less money. They are still trying to do their job and assess the fundamentals but the problem is that equity prices are developing without regard to the fundamentals and there is no trust any more. That means there is no standard way to do a deal. What worked yesterday might not work in two weeks' time."
Olive points to the InBev deeply discounted rights issue in November 2008, by which the company raised [Euro]6.36 billion to reduce leverage after its debt-financed acquisition of Anheuser-Busch. "It probably looks like a normal rights issue. But behind the deal, when it finally came, lay weeks of discussions and deliberations on how best to structure it. Because the best way to do a deal is not always the easiest."
The deal had been due to launch in October but was delayed amid the market turbulence as the global financial system teetered on the brink. The deal was further complicated by decisions of the family interests behind the Belgian company over how much of their rights to subscribe to, how to fund purchases of rights taken up by selling shares, and how underwriters should then distribute unsubscribed rights and develop a theoretical ex-rights price for a share that had been badly beaten down.
Olive says: "You have to be ready to wait, go, wait, go. We were ready with InBev one month earlier but had to halt the process at the last minute when we took the view the market wouldn't support it. We wanted the existing shareholders to subscribe more and they did put more money in. We had to rework it before effectively launching it. The lesson is that all sides have to be very flexible and prepared to do absolutely whatever it takes, because once you launch the deal, if it doesn't work and you don't get the money... you're in serious trouble."
Crafting deals in a tough market
It is still possible to do fairly straightforward deals. Conventional long-only shareholders will not want to give up their degree of ownership of future earnings streams from strong companies that they believe will be winners at a time when general market declines have left their shares cheap. So after Standard Chartered announced its pound(s)1.8 billion rights issue, the share price rallied strongly, reflecting investor faith in the business model, the management team and the rationale for raising capital.
But such deals will be rare in 2009. The more frequent and not-so-subtle pitch to investors will be to consider the likely fate of a company, and the value of their own investment position in its stock, if they fail to support a rights issue. Rights issues will have to be priced to go, with steep discounts, high fees, big syndicates.
Even then, companies will have to explore all their options in a year when the requirement for new equity will exceed the supply. That means looking at ways to do deals with and without redemption rights, underwritten and non-underwritten, targeted at existing shareholders and at new ones.
The search will be on for new strategic investors to anchor deals, as the Qataris did for Barclays and Warren Buffett did for Goldman Sachs. One potential group is private equity companies. In the past, they have shied away from taking minority positions in publicly listed companies. Bankers pick up hints that some private equity funds are now considering the opportunity to put large slugs of money into public markets where they can see a more convincing prospect of realizing value in the next few years than in private market transactions.
"It is actually a good time to lend to private equity," suggests Sherwood at Goldman Sachs, "because prices for assets have come down, multiples are low, earnings are low and sponsors will be required to put in more equity." For all that, the syndication markets are so discombobulated and spreads are very high.
Sherwood points to another obvious source of strategic capital. "There are many large industrial companies with a lot of cash on their balance sheets. They will take out competitors as some sectors consolidate."
Traditional capital markets structures will be reshaped by the times. The agonies of RBS and HBOS have driven home the reality of what capital markets participants have been saying for years. There is nothing wrong with pre-emption rights in principle but the process has to be shortened. If ma and pa can't decide for six weeks whether to take up their rights or not, let's carve out a tranche for them but meanwhile go to Fidelity and Capital and Legal & General and give them 48 hours to decide, because that is time enough. Long underwriting periods leave deals exposed to now frequently occurring market seizures and offer an invitation for market participants to short, especially perhaps when a government provides the back-stop underwriting bid.
Koder at UBS sees a raft of new approaches to raising equity, especially for smaller amounts below the typical 10% limit that triggers the requirement to offer pre-emption rights to existing shareholders. "We'll see more small deals with no documentation, no prospectus or roadshow: quasi-private placements, often pre-circulated and corner-stoned with a key investor and done overnight with banks taking minimal underwriting risk." Koder points to the US market, where what are known as equity shelf programmes (ESPs) allow companies that are current on their regulatory filings to dribble stock out into the market each day. It's a marked change from the traditional approach whereby equity capital is raised in large chunks in public deals partly designed to broadcast the improvement in a company's capital position to various stakeholders including debt investors, bank lenders and trade and other creditors. ESPs enable companies to inch towards stronger capital ratios.
Another innovation -- a device popular in Australia, but little used in the capital markets of the US and Europe -- is the underwritten dividend reinvestment plan. This year, many of those companies that have not already done so will cut back on or abandon share repurchase programmes. The next logical way to reduce capital outlays is to cut or suspend the dividend. But this often weighs disproportionately heavily on a company's stock price, especially if its share register comprises largely equity income funds. One solution for companies is to give investors the option of taking a dividend in new shares at a discount or cash, in the hope that many will choose shares. If investors instead demand cash, a bank group stands by to sell equity to raise the cash to meet these payments.
In theory, the time is right for equity-linked deals. Volatility is high and equity-linked allows companies to monetize the value of their own equity volatility to subsidize debt costs and to raise potential future equity capital on conversion in a less dilutive way than through straight equity.
The problem is that hedge funds had become the core investor base for new issues of equity-linked and they have been devastated, putting many out of the game. Low secondary market valuations make the comparables unfavourable for new issuers; the debt component is hard to price given wide credit spreads and there is a lack of clarity on how to price medium-term equity options relative to extraordinarily high prevailing volatility. "Still, this year could be much busier for equity-linked than last," says Koder. And, rather ominously he suggests, "equity-linked might be easier to do than equity."
