With the introduction of the euro, the European bond markets have had to mature. The adoption of new issuance techniques such as roadshows, bookbuilding and the infamous pot system has changed the syndication process in the European markets almost beyond recognition. Philip Moore takes a look at the innovations that have taken place in the new issue market over the past five years.
Since December 1997, when she joined the Finnish Treasury as director of finance, Satu Huber has been consistently recognised as one of Europe’s most popular and successful borrowers in the euro market. That perhaps explains why, five years on, she is still struck by negative market reaction to a Eu525m five year deal led by HSBC, Merrill Lynch and Paribas for Finland issued shortly before Christmas 1998.
This deal tapped a Eu500m domestic government bond launched the previous month, and was a purely strategic means of bolstering liquidity in its benchmark bonds and broadening its investor base in the run-up to the launch of the euro in January 1999.
“That was the first time we used the pot system,” Huber recalls, “and it was one of the few deals I can remember where we were criticised by a number of banks for the way the transaction was executed.”
More specifically, the deal encountered flak from those European selling group members which were required to give up investors’ names to the leads. One disgruntled banker told EuroWeek at the time: “There is no way I’m going to give up the names of our clients to competitors, especially when in euroland a lot of the value added we have will be provided by our network.”
Five years later, Huber believes the rationale behind Finland’s pot deal made perfect sense for a time when borrowers were seeking to precisely identify and expand their investor base on the eve of the introduction of the single European currency. “We did not need the money at the time because we had completed our funding for 1998,” she says. “So we made it very clear to all the banks that had supported us in 1998 that this was a small pre-funding that we would do only if there was clear demand for the deal. We weren’t certain that there would be enough demand because the market was not very liquid in the week before Christmas and the last thing we wanted just before the launch of the new currency was a poorly performing bond.”
That might sound glaringly obvious today, but it is a neat summary of a concern that was preoccupying scores of borrowers by the late 1990s. Grasping that investors diversifying away from their domestic currencies for the first time would hold the whip hand — and also be spoiled for choice — Europe’s so-called peripheral government borrowers in particular recognised that selling new bonds in the era of the euro would be a very much changed discipline. The new discipline would call for meticulous marketing involving exhaustive roadshowing, careful bookbuilding and syndication via the pot system.
It would also call for issuers to do their utmost to compete with one another on the basis of liquidity, which was much easier said than done for those borrowers with relatively modest funding requirements.
The relatively new emphasis on liquidity — which soon became an emphasis on mega-liquidity — had important implications for the intermediaries in the market. With banks themselves increasingly being prodded by their more demanding owners into the delivery of enhanced shareholder value, not even those with the strongest balance sheets had the wherewithal to buy billion-plus mandates at the drop of a hat.
Decisively gone were the days of the bought deal; within the new euroland, distribution capabilities would come to the fore. In other words, as it is neatly encapsulated by Frank Czichowski, head of international capital markets at KfW, “using the pot system refocused attention away from balance sheet power to distribution capability.”
Going to pot
The increased institutionalisation of the market in the era of the euro was another influence calling for a re-think in syndication methods.
Henrik Raber was on the fixed income trading desk at Lehman Brothers in the mid-1990s, and joined UBS Warburg (as was) in May 2001, where he is now head of syndicate. He points out that a key change as monetary union became an increasingly real prospect was the withdrawal in relative terms of the retail investor from the fixed income market.
“Clearly in the mid-1990s retail demand was an important component of the market which encouraged the European banks to be very much retention-focused,” he says. “The deals were much smaller and so the underwriting risks were much lower. The euro completely changed that.”
Although the growing use of the pot system, which would soon extend to traditionally very insular markets such as the Pfandbrief sector, may have made eminent sense for European borrowers, in the initial stages at least that did not make its arrival any more popular among European banks, especially among smaller and regional players. “The European banks didn’t like the idea of name give-up for a very obvious reason,” says Olivier Khayat, head of capital markets at SG CIB. “What they were most scared about was opening their books up to the US banks, which at that time had limited access to investors in Europe.”
Jerome Lienhard, then senior vice president of global debt funding at Freddie Mac, says that as Europe moved from being a fragmented collection of idiosyncratic markets into a larger, integrated and homogeneous market, it was inevitable that it should have looked to the US as a role model.
“But there was a legitimate trepidation that the US model was going to dominate and that US style issuance would take over,” he says. “But I think those fears were allayed as the pot system developed in a Europeanised rather than an Americanised way.”
Nevertheless, Lienhard says that in retrospect he is struck by the strength of feeling that accompanied the changing way in which new issues were syndicated in the wake of the launch of the euro. “It wasn’t overt, but there was an undercurrent of fear about the Americans marching in, which surprised me,” says Lienhard.
That was ironic, because although Freddie Mac maintained a balance between US and European banks in its euro reference programme, it worked very closely with KfW in developing an issuance strategy that would appeal to the European investor base. “We were given a lot of good advice by KfW,” says Lienhard. “I felt very welcomed by what people would view as a competitor which, frankly, is in stark contrast with the way in which we interact with Fannie Mae in the US market.”
In the event, as today’s league tables show, the largest European banks were not overwhelmed by the apparent Americanisation of new issue dynamics, any more than they had been driven out of the market by the arrival of the fixed price re-offer at the start of the 1990s.
Bankers say that those banks that believed distribution would emerge as the be-all in the era of the euro probably overlooked two elements. First, as Paul Hearn, head of global primary credit at BNP Paribas, points out, they underestimated how deep-rooted and longstanding European banks’ relationships with investors were. The US investment banks, he says, tended to focus too intensively on the leading accounts and had little if no access to the large investor base below the upper echelons.
As cross-border investment gathered momentum, unshackled by currency constraints in the new euro zone, those second tier accounts became increasingly influential in the new issue market.
Balance sheet power
Second, investment banks focusing on the potential of the integrated European capital market possibly underestimated the importance of balance sheet power. As the euro capital market took shape, it became apparent that borrowers in the increasingly important corporate market demanded balance sheet support as well as distribution capabilities, which played neatly into the hands of the so-called European universal or commercial-cum-investment banking giants.
The result, say bankers, has been the emergence in Europe of a balance between indigenous players and the bulge bracket firms from Wall Street, and a broad acceptance among both camps of mechanisms such as the use of the pot that have supported the all-round expansion of the euro capital market.
To Raber at UBS, the chief beneficiaries of the pot system have been investors in Europe’s fixed income market. “The pot system has revolutionised markets from investors’ perspective because they can now see whether or not a deal has been fully placed at pricing,” he says. “But it also gives them access to information about the geographic breakdown of placement, so there is increased clarity as far as investors are concerned.”
Borrowers say that the use of the pot system has been quantifiably positive as far as their borrowing costs have been concerned. “In the case of our first pot deal at the end of 1998 we finished up with a transaction that was very well distributed and priced considerably below our interpolated curve,” says Huber at the Finnish Treasury.
Others testify to a similar experience. “Before the launch of the euro there were certainly some imperfections in the European capital market,” says KfW’s Czichowski. “In particular, the fact that many deals were underwritten limited investor participation in the initial phase.”
“Clearly the market was ripe for a change and needed the more important end investors to be more closely involved at the distribution stage,” Czichowski adds. “I would argue that KfW was one of the pioneers in using the pot system in its larger benchmark transactions, and the way price discovery evolved in our bookbuilt pot-based deals served as a blueprint for a number of other benchmark borrowers.”
KfW, says Czichowski, immediately felt the benefit of the new approach when it used the pot system in the curtain-raiser to its euro benchmark issuance programme, which was a Eu5bn 10 year global bond led in March 2001 by Deutsche Bank, Schroder Salomon Smith Barney and UBS Warburg.
It may seem run of the euro mill today, but that transaction generated orders of more than Eu9.5bn, allowing for pricing to be set at the tighter end of its range, or bp over Bunds. As well as representing a pricing level that was through KfW’s own curve, this also equated to 2bp through Italy — meaning that for the first time a non-sovereign borrower had priced through an EU sovereign in the 10 year maturity.
“The pricing we achieved with our euro benchmark number one would have been quite impossible if we had gone for an underwritten transaction taken on by the banks and subsequently sold in to the market,” says Czichowski.
To Czichowski, the arrival of new syndication and distribution methods fundamentally changed the structure of the market. “Everybody appeared to embrace the integration of the European capital market, but I think everybody also embraced the concept of much closer collaboration between issuers, investors and investment banks alike,” he says. “That allowed the market to be taken to a new level and has established the rule rather than the exception for large benchmark transactions.”
KfW a driving force
Importantly, as far as the European capital market is concerned, KfW did more than simply superimpose the existing pot mechanism on its benchmark borrowing programme. By the time of its benchmark number five, launched in June 2002, it had refined the syndication process with the introduction of the so-called “flexi-pot” system aimed, says Czichowski, at giving co-leads more incentives to focus on the quality rather than the quantity of their orders.
One feature of the KfW benchmark programme has been its demonstration that for smaller European banks there has been life after the launch of the single currency, in spite of the widespread acceptance of the pot system and its accompanying dreaded name give-up. Czichowski says that selling groups have made an extremely positive contribution to the KfW programme. “We have found that there are a number of banks that would never pretend to be bulge bracket firms but which do have very impressive distribution power in their own right,” he says.
If the pot system and selling groups have become part of the landscape in the fixed income market of Euroland, then so too have bookbuilding and roadshowing. “The consolidation of national markets in Europe created a pool of entirely new liquidity supporting transactions of unprecedented size, which in turn required a fresh and completely different approach to new issue syndication,” says René Karsenti, who has been director general of finance at the EIB since 1995. “It soon became clear that bookbuilding was the appropriate method of price discovery in the context of very large issues and that transactions would need to be syndicated through a wide range of banks.”
Sean Park, then of Banque Paribas and now of Dresdner Kleinwort Wasserstein, remembers the seminal Eu1bn April 2004 transaction launched by the EIB in January 1997 as the first benchmark deal in the single European currency to price on the basis of a US-style bookbulding. “Deals weren’t done like that in Europe in those days,” recalls Park. “But it was a phenomenal success, which was six or seven times oversubscribed and tightened by 5bp or 6bp on the break.
“Much of the credit for that should go to the EIB, which did a lot of communication and preparation work in the run-up to the deal. It was a far cry from the typical Deutschmark or French franc deal which would be announced and put on the screen all at once.”
Careful marketing of that groundbreaking EIB deal allowed for the construction of a much more diverse investor base than anybody had imagined would be possible.
Park says that for the first time ever, domestic fund managers and insurance companies that had been the bread and butter of inward-looking Deutschmark or French franc markets put their name down for allocations, and that recollection is supported by the bookrunner’s comment published in EuroWeek on February 7, 1997, which reported that 80% of demand represented new money accounts.
SG CIB’s Khayat says that the concept of roadshowing had started to emerge at the end of the 1990s for larger borrowers aiming to capture investor interest in a number of different countries.
“I remember when I was at CDC one of the first big roadshows we organised was for Cades, when it was marketing a very big parallel three tranche deal in French francs, Deutschmarks and Dutch guilders,” he says. “We roadshowed that deal all over Europe because it was the only way of capturing investor interest in all the tranches.
“But while the process of roadshowing started with the parallel or tributary bonds, it really took off with the emergence of the credit market in 2000 and 2001.”