Last year credit rating agency Moody’s published a rethink on its criteria for rating so-called ‘hybrid bonds’. The move, coupled with last year’s International Financial Reporting Standards (IFRS) acccounting changes, pressed the button on what some analysts are predicting will be the capital markets story of 2006.
Hybrid bonds, which combine features of both debt and equity in one instrument, are not new. As Allen & Overy (A&O) finance partner Stephen Miller says: “The techniques have been around for years and have been used regularly for regulated industries. They are highly developed.”
What is new is the organisations issuing them. Although relatively common in the banking and insurance sectors, it is only since early in 2005, when Moody’s issued its guidance, that the market for corporate-issued hybrid bonds really began to take off.
Investors view hybrids as deeply subordinated debt and they are treated as such by the tax authorities in jurisdictions such as France and Germany – the European markets that have been most active in the past year. Accordingly, there is a corresponding tax deduction, making the financing cost lower. They are also treated as equity by the ratings agencies, providing a buffer for the issuer’s credit rating.
The latest trend is for corporates looking to raise funds, possibly to ride the current M&A boom or simply to access relatively cheap money, to use them.
Certain analysts have estimated that 2006 issuance could reach $40bn (£22.76bn). If that comes to pass it will be a tenfold increase on 2005, and Europe’s leading capital markets practices are gearing up for the onslaught.
So far there have only been a handful of deals across Europe, and none out of London. But already a leading pack of law firms which have won roles on the deals has emerged.
Linklaters is among the most prominent of firms on the most recent boom in hybrid deals. It generally appears for the banks, and took that role on one of the most recent deals, the €500m (£350.1m) issue by Vinci (advised by Clifford Chance) in February this year.
So far the European market has been concentrated in relatively few jurisdictions, with deals in Scandinavia alongside those in France and Germany. There have been none out of London in the past 12 months, although it’s probabaly only a matter of time.
As Linklaters London-based finance partner Nigel Pridmore puts it: “In the UK, it’s more a question of why hasn’t it been promoted rather than what’s stopping it. I’d be surprised if a UK corporate treasurer didn’t find the need to take advantage of this this year.”
Hybrids are highly complex, premium-rate deals and the advisory roles have so far been limited to a handful of firms. They require a mixture of a leading capital markets practice, strong tax capability and international coverage. In addition, because of the various restrictions that need to be observed, the drafting of these instruments is critical to get the right tax and accounting treatment. That limits the pool of potential advisers even further.
As former Clifford Chance, now Skadden Arps Slate Meagher & Flom, tax partner James Anderson puts it: “Accountancy firms won’t have this ability, but the top US and UK law firms will, especially the US firms who’ve advised on hybrids in the US and those UK firms who’ve developed recognised expertise in the bank regulatory capital field.”
Skadden has advised on a number of hybrid deals in the US, but none so far out of London. So far US firm representation in Europe has been limited to Latham & Watkins, which advised the banks on TUI’s €300m (£210.1m) high-yield hybrid in November 2005 (Freshfields Bruck-haus Deringer advised TUI) and Shearman & Sterling, which advised the guarantor on Südzucker’s June 2005 bond issue.
The group of UK firms with particular strengths in the area of bank regulatory capital is limited to two – A&O and Linklaters – and, indeed, Linklaters’ track record in advising the banks on hybrid deals over the past year is testament to that fact.
Outside the magic circle there are few contenders for the market so far, although Simmons & Simmons picked up a role last January advising Groupe Casino on its €500m (£350.1m) issue.
Simmons partner Mark Cannon agrees with Linklaters’ Pridmore that this is a market set to take off. “There’s a constant stream of banks coming through the door talking to our FTSE100 and FTSE250 clients trying to sell them these deals at the moment,” he claims. “And a lot of the corporates are starting to ask the right questions about them.”
As one partner, who was asked by The Lawyer what was stopping the market from starting in the UK, puts it: “I wish I bloody knew.”
So far the market for these instruments, and the pickings for the lawyers advising on them, looks rosy. But then, nothing lasts forever.
“The hybrid UK market has to take off before the credit crunch arrives,” says Skadden’s Anderson. He argues that investors are currently happy to take equity-type risk and get higher yield because they’re not getting called on that equity risk; it’s more like debt risk.
“But when the credit crunch comes and the corporate cycle turns again, those equity investments are going to have to start to absorb losses, which is their job, hence why rating agencies allow them equity credit rating in the first place,” he adds. “If the hybrid UK market does not get properly going before that credit crunch, it might be stillborn.”