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Strategic Finance

The rise of hybrid finance – debt that looks like equity

Monday, 04 December 2006

Like any market, corporate bonds have their fads and fashions, and the latest hot product is the corporate hybrid. The great attraction is that it can look like equity when viewed through a gearing lens, but like debt when it comes to the cost of capital. Hybrid capital in its present form has been around since 1999, but until recently, it was used mainly by banks and insurance companies to raise regulatory capital. The attractions of hybrid capital to financial institutions are pretty much the same as they are to corporates. It behaves as part equity, part debt and is structured to exploit the benefits of both.

As such, it can show up in the balance sheet as equity, so having a muted or even positive effect on gearing and ratings. But it is structured and issued as debt, so it does not dilute shareholders’ interests and is cheaper to raise than equity. Yet another attraction is that coupon payments are tax deductible.

While financial issuers climbed aboard the hybrid bandwagon with some zeal, companies were more hesitant and, with very few exceptions, steered clear of these new structures for some years.

One cause for caution was uncertainty over how investors would receive them. Another, even more powerful, restraint was a lack of clarity over the vital matter of equity credit – the proportion of a debt issue that credit rating agencies are prepared to recognise as equity – and exactly how much an issue could expect to be assigned. The received wisdom was that agencies were more generous to financials with equity credit than they were prepared to be to corporates.

The basic principle is that the more equity-like the structure, the more equity will be assigned. Among the features rating agencies look for when assigning equity are the lack of a maturity date, the absence of a fixed payment obligation and a ranking as the most junior form of capital, meaning no capital provider ranks below it. So the agencies would consider a hybrid security more equity-like the more distant its maturity date, the more discretion the issuer had in making coupon payments and the more junior the issue.

A couple of corporate issuers were brave enough to test the market in 2003, although they achieved little or no equity recognition. In 2005, however, the corporate market began to take notice. Among the catalysts were the rating agencies clarifying how they would treat corporate hybrid and new IFRS accounting standards making clear how the rules would treat it.

On the other side of the equation, in a low-yield environment, investor appetite for higher yielding securities was growing – hybrids yield more than conventional debt. But what really moved the market forward was a 2005 note from rating agency Moody’s entitled Refinements to Moody’s Tool Kit.

The original Tool Kit was issued in 1999 and kicked off the hybrid market for financials. It set out Moody’s basic framework for evaluating the debt and equity characteristics of hybrid securities. It positions them in baskets labelled A to E, with E representing the most equity-like.

In its 2005 refinements, the agency promised greater tolerance in assigning equity content and, importantly, a willingness to award basket D status (75% equity) in the presence of mandatory non-payment triggers – the suspension of coupon payments once certain ratios are breached – and strong replacement language, a clear intention to refinance with similar instruments or equity in the event of redemption.

Rival agency Standard & Poor’s, on the other hand, had traditionally been reluctant to assign any meaningful amount of equity if a deal carried a step-up clause – a commitment to increase the coupon payment if the issue was not redeemed after a defined period. It regarded a step-up as an inducement to redeem, making the paper less equity-like. S&P has now restated its position and assigns more equity credit to deals with step-ups, as long as they have suitably strong replacement language. It has also spelt out in more detail how it assesses mandatory coupon deferrals, giving more weight to triggers based on credit ratios.

These changes gave investment bankers the ammunition they needed to start marketing hybrid transactions more aggressively to corporates, and more deals began to come to market. Early hybrid issuers, which had not enjoyed much in the way of equity assignment, had included German industrials group Linde, tyremaker Michelin and Casino. But then came a rash of transactions from German sugar manufacturer Südzucker, Swedish state-owned electricity utility Vattenfall, Danish state-owned gas company Dansk Olie Og Naturgas (Dong) and Bayer, the pharmaceutical group, with equity content that was worth having.

No two structures have been identical, partly because of local legal and tax variations, partly because each company has to trade off its strategic, equity and rating goals with the price and marketability of the issue.

Vattenfall achieved the highest equity content assigned so far – 75% from Moody’s, 60% from Standard & Poor’s. Its €1bn issue was structured as a perpetual non-call 10 years – no redemption for at least 10 years – with a 1% step-up and a mandatory deferral trigger. Südzucker’s €500m perpetual, very similar in structure, made it into the Moody’s D basket, but was assigned only 50% equity by Standard & Poor’s. Unlike these two, Dong’s €1.1bn hybrid had no mandatory trigger and a 1,000-year maturity – to comply with Danish tax law. It got 50% equity treatment from both agencies.

These were fairly conservative companies. But the market pushed further with a €500m hybrid issue from French media group Thomson. Its business sector was more flashy than anything that had gone before, and its novel change of control covenant took the market some time to digest. Investors saw Thomson as a possible candidate for a leveraged buyout, and wanted a covenant promising redemption in the event of a change of control. In the end, they settled for the promise of a coupon step-up should ownership change.

The Thomson deal demonstrated yet another reason why a company might find the hybrid structure attractive. Its share price had been weak and it felt am issue would be over-dilutive. A convertible structure, which the company had used before, had become less cost-efficient due to changes in tax treatment under the IFRS accountancy regime.

Not long ago, corporates worried more about operations than about capital structure. But bankers said companies are now responding to increased shareholder activism and the need to maximise returns by seeking to optimise their capital structures. Some see hybrid capital as having a role in that process.

Others see it simply as a cost-effective funding tool for M&A activity. Porsche, the German carmaker, issued $1bn in hybrid securities as part of a larger funding to finance purchase of a stake in Volkswagen. In doing so, it became the first unrated company to enter this market – its reputation is such that it does not feel the need to submit to rating agency assessment. That did not hold back investors; they clamoured for the paper, including a large element of Asian retail investors waking up to the hybrid market.

Other firsts include a €610m hybrid convertible from Hungarian oil refiner Mol, the first corporate hybrid from eastern Europe and the first such convertible with a non-investment grade anywhere. Bankers believe more sub-investment grade paper will be seen in the hybrid market.

While most novel financial structures start in the US before being exported to Europe, corporate hybrid has evolved in the opposite direction. With Europe having shown the way, US corporates are only now beginning to appreciate its possibilities.

Just how far this market will go remains to be seen. Bankers continue to promote the concept enthusiastically, some more responsibly than others. But some investors believe that as economic fundamentals worsen, corporate hybrid spreads will be the first to widen, making them more risky.

And as one banker pointed out, companies need to be very clear on why they choose the structure – or they could end up with expensive debt, rather than cheap equity.