Is hybrid capital still considered expensive debt or cheap non-dilutive capital for corporates? Will the change in rates environment off the back of US QE mean the recent deluge of corporate hybrid issuance is a flash in the pan?
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Unlike the creatures in George Orwell’s Animal Farm, not all deals are made the same. Some are born special.
Take EDF’s hybrid perpetual issue in late January, a deal that grabbed this year’s market by the scruff of the neck and shook it hard. It wasn’t just its sheer size that drew applause – though at €6.2bn, in a market accustomed to deals ranging from US$500m–$1bn, it marked the largest corporate hybrid ever.
Nor was this a case of merely marvelling at the supple-minded ambition of the firm and its more than 20 financial advisers. EDF issued four tranches spread across three currencies, including the first 144A/Reg S hybrid ever priced by a European corporate, enlarging its pool of equity capital, at a time when the firm’s market cap was just €27bn, by a staggering 11%.
No, what really remains in the mind months later, as 2013 draws to a close, is the deal’s legacy. By printing a US dollar hybrid bond along with offerings of hybrid capital securities in euros and sterling, all with very long call dates, the French utility took the market to the next level.
“It changed the way the product was viewed by large-cap issuers,” said Frazer Ross, managing director of corporate syndicate at Deutsche Bank. Morven Jones, head of corporate and public sector DCM at Nomura, said it was “clear that the hybrid market has come of age this year. It’s an asset class in its own right, and is a now standard part of the corporate toolkit”.
Legacies are often intangible things; difficult to see. Not this time. Prior to EDF, said Ross, “no one would have thought of doing €6bn worth of hybrids in one go”. Yet rival French utility GDF Suez completed a tricky €1.7bn sale in July. And in September Italy’s Enel sold US$2.3bn worth of hybrids in euros and sterling, followed in short order by a €1.75bn sale from Spain’s Telefonica. Those latter two sales by corporates in peripheral Europe were highlighted by bankers not involved in either sale as impressive in terms of their size and ability to satisfy yield-hungry investors.
Rapid evolution
Moreover, this is a market that is evolving fast, growing in scale – according to Thomson Reuters, total hybrid issuance rose at an annualised rate of 70% in the current year to September 25, to US$32.2bn – as well as industry and geography.
Not so long ago, this was a largely euro-denominated market dotted with sterling and issuance. Issuers were typically large, worthy but stodgy European utilities. Hybrids bridged any dip or gap in credit ratios and protected against any threat of a ratings downgrade.
Yet this year’s market has been transformed. EDF set the ball rolling in January by pricing nearly half its deal in US dollars. In the current year to September 25 the greenback comprised 31% of all hybrid funding, against just 12% last year. Other deals have also peppered the market, fully or partially, denominated in everything from Canadian dollars to Malaysian ringgit to Swiss francs.
All these deals, said Christoph Seibel, head of corporate DCM Europe at RBC Capital Markets, “have expanded out the investor base. Companies are able to raise more money than ever before in a far wider range of currencies, opening up a new world to potential issuers”. Marco Baldini, head of corporate and SSA syndicate Europe at Barclays said the asset class had now become “officially mainstream, appealing to multiple investor bases the world over”.
Corporate location has also come to matter less. Hong Kong-based Hutchison Whampoa issued a €1.75bn hybrid in May. Mexico’s America Movil’s US$2.9bn in early September priced a three-part hybrid split between euros and sterling, the first ever by a Latin American corporate. Despite hearty protestations by Movil chief financial officer Carlos Garcia Moreno that the sale was designed to preserve the firm’s credit rating, rather than a shrewd way of raising funds to complete a proposed €7.2bn buyout of Dutch telecoms group KPN (which itself issued a tidy little hybrid this year), it was clear the deal ticked both boxes.
Issuance is even entering uncharted industrial territory. Hybrid bonds benefit corporates looking to protect their credit rating while strengthen their balance sheet with no dilution to shareholders. Hence the attraction for utilities and telecoms (EDF, Enel, Telecom Italia), which look to the asset class to finance capital-intensive, long-term projects like power plants and communication grids.
Yet change exists even here. Volkswagen’s August dual-tranche offering marked the first hybrid by a carmaker in seven years, and the first ever issued in euros. VW didn’t need to protect its credit rating, nor was it building a pre-acquisition capital buffer. But the sale allowed one of the corporate Europe’s strongest names to raise non-dilutive capital while strengthening its core ratios.
The deal delighted both issuers and underwriters, proving that the market is moving beyond its safe, traditional confines. “We’re beginning to see a more diverse range of sectors start looking at hybrids,” said Thomas Flichy, head of European corporate hybrids at Barclays. “That’s a very positive sign.”
The pros and cons
Hybrids are not simple products to sell, at least in terms of lead-time, which can take anything up to eight weeks. They remain unattractive stateside, if only because of the lack of tax deductibility on hybrids under US law. And like all securities, they need to be delicately marketed. GDF Suez’s lukewarm reception in early July, in a tricky and volatile market, was heavily criticised for being overambitious and poorly timed.
But they have one compelling advantage: flexibility. Are hybrids expensive debt, or cheap non-dilutive capital? Opinions vary. Barclays’ Flichy sees it as “cost-effective capital”, pure and simple. RBC’s Seibel said the answer depends very much on the “identity and the needs of the issuer. If you don’t have a reason to issue a hybrid, such as a major project to fund, it’s expensive debt. But if you want to make an acquisition, and you need to layer on equity without losing your rating, it’s cheap non-dilutive equity”.
One of key questions is how much appetite remains for the rising asset class. Investors still love the allure of hybrids, which offer “higher yield in a lower-yield environment”, said Simon McGeary, head of new products, EMEA, at Citigroup. Rates are likely to remain super-low in Europe and North America for some time to come. But when they do the market’s reaction is likely to be “interesting”, said Deutsche Bank’s Ross, who wonders whether that would “lead directly to a slowing hybrid demand”.
Then there are the not inconsiderable benefits of consistency. Ratings agencies used to fiddle with rules governing hybrid oversight a little too boisterously for nervous investors. In recent months, that tendency to meddle has been tempered, with hybrid structures becoming “far more uniform”, said AJ Davidson, head of hybrid capital at RBS. This has “added to their attraction by allowing investors to spend more time on fundamental credit research and less time ruminating over the structural variations of different deals”, he said.
Few expect deal flow to suddenly balloon. This is a market that, aside from experiencing a near-complete shutdown in late 2008, has tended to grow at a strong and steady pace. Investors still see hybrids as an “esoteric product that isn’t ‘standardised’ and won’t become mainstream any time soon”, said Barclays’ Baldini. Issuance tends to come in reasonably organised clumps – most recently in the early autumn days leading up to the German elections and the Federal Reserve’s September FOMC meeting – before quietly scaling back.
General market consensus is that deal flow is unlikely to pick up sharply before the year is out, but that 2014 should be another strong and even stellar year for the asset class. Macro concerns – Italian politics, US debt, Syria – likely to crimp sales lingered through the autumn. Issuance could also be dented by ratings agencies again being tempted by a new bout of rule fiddling.
But with both investors becoming increasingly familiar with hybrids, and corporates across the world using the asset class strategically to strengthen balance sheets, the market, the market, said Chris Tuffey, head of debt syndicate at Credit Suisse in London, “given the current benefits, is only going to grow in size and stature for many years to come”.
