Occasionally in the capital markets, a blue chip company's use of an innovative instrument can give validity to a previously peripheral asset class. Siemens' Eu2bn equivalent euro and sterling hybrid issue in September did just that for corporate hybrids, with a heavily oversubscribed order book, competitive execution, and protection for the issuer against future changes to rating agency methodology. Given its success in the aftermarket, Siemens' transaction may be the green light other companies were hoping for before raising hybrid capital.
When Siemens AG launched the largest ever hybrid transaction for a non-financial company in September, the German electronics and electrical engineering group's decision wrong-footed many market participants.
"It wasn't one of the names that we had identified as a potential issuer of a hybrid instrument," says one fund manager in London. "We had naturally assumed that the sort of company that was going to bring these issues were going to be senior rated at either the low single-A or high triple-B level, and would be using hybrids to shore up their balance sheet after an acquisition or event risk related issue.
"So to see double-A rated Siemens was a surprise."
Indeed Siemens is the highest rated European corporate to have launched a hybrid and the only double-A rated non-financial company to have done so.
However, in the roadshow that preceded the Eu2bn equivalent issue, which was led by Deutsche Bank and UBS, it was clear that the company had its reasons for turning to the instrument.
"All along our message from senior management down has been that we would like to retain our Aa3/AA- ratings as this best supports the current business model given its leverage profile and margin targets," says Sebastian Ottmann, head of finance strategies at Siemens in Münich.
"A big acquisition that would address the shortfalls of the current business model, ie cashflow generation and margin growth, for example, might take us down a notch. However, we would like to maintain the current ratings as long as there is no general change in the business model."
The company's ratings had come under pressure when Siemens announced in late July that it was acquiring the diagnostics division of German chemical group Bayer (itself an issuer of hybrid capital) for Eu4.2bn to strengthen its Siemens Medical Solutions business. This had already received a boost in late April with the news that the business was acquiring US company Diagnostic Products Corp for $1.86bn.
The issuer's ratings were pressured by these moves, with Aa3/AA- Siemens on negative outlook at Moody's and negative CreditWatch at Standard & Poor's.
This prompted Siemens to turn to a hybrid capital issue, says Ottmann. "Since corporate hybrids came back into focus a year ago we have been following their development," he says. "Hybrids are now something that is considered as a part of the conventional financing toolkit that corporates should be aware of on an ongoing basis.
"It became apparent that a hybrid might potentially be a good fit for Siemens when the re-orientation of the company's business portfolio was announced early this year. It then became clear that there was quite a substantial amount of M&A in the pipeline and that our rating would come under pressure as a result of that."
The company could have issued equity, but the hybrid was seen as a more appropriate solution by management, partly because of the lower cost of capital that it offered. "That is of course a part of the equation when you are considering financing options," says Ottmann, "and in the case of the hybrid that was one of the clear selling points why the instrument, in the correct dose, can be a useful financing option."
Ottmann points out that although the instrument was ideally suited to the company's needs, it was not seen as a silver bullet by the company. "The hybrid is of course a testimony to our rating and the overall framework in which we run the company," he says. "However, the hybrid in itself was not designed to remove the negative outlook on our ratings.
"Rather, it was to send out the correct message and to give us some leeway as we integrate the new businesses and improve our free cashflow generation and margins."
The rating agencies have given a similar message. "This transaction had already been factored into the negative outlook assigned to Siemens' Aa3 rating on June 30, 2006 and will not materially enhance its headroom for financial investments," said Moody's when it rated the hybrid. "The negative rating outlook continues to reflect Moody's concern that Siemens' profitability improvements may lag behind plan, based on weak historical developments, and further changes to the business mix may require high debt financed investments.
"A rating downgrade would be considered, should Siemens not demonstrate material progress towards improved profitability and cash from operations, or if management does not maintain spending discipline during the next few quarters of restructuring."
The hybrid was nevertheless tailored to the rating agencies' requirements, and was given 'D' basket treatment by Moody's, meaing treated as 75% equity and 25% debt, while S&P assigned the instrument intermediate, or 50% equity content. "The issue will help to increase the equity-like content in the financing structure of the Bayer diagnostics acquisition," said Maria Bissinger, a credit analyst at S&P in Frankfurt.
But Siemens also took advantage of the most up to date structure to ensure that it would not suffer from any future changes in rating agency methodology. It followed the example set by Linde, the German industrial gases and forklift truck group, in July by including a condition under which it could call the hybrid if its equity credit fell as a result of a change of heart by either Moody's or S&P.
"I certainly don't want to go to senior management five years down the road and tell them that the rating agencies have changed their minds and Siemens is stuck with a hybrid that doesn't work," says Ottmann. "If the rating agencies change their methodology that is outside your control and you cannot respond appropriately, and therefore the capital call was a prudent feature to have included to retain maximum flexibility from a management point of view."
Siemens also included a condition that allows it to redeem the hybrid upon conversion of at least 60% of a Eu2.5bn 2010 convertible bond it issued in May 2003, as this would remove the need for the equity-like capital currently provided by the hybrid. "If the share price develops favourably then we will be in a position from June next year onwards to convert the convertible early," says Ottmann.
"This feature, together with the capital call, shows that we were able to make use of a structure that was as flexible and advantageous as the most up to date market precedents," he adds. "Furthermore, both these options were priced at zero intrinsic value and were not features that we were prepared to or had to pay up for."
When it brought its hybrid to the market, Siemens was able to achieve the tightest pricing on a hybrid for a European company and a level inside initial expectations.
After a three day roadshow, Deutsche Bank and UBS opened the books for the issue with price guidance of 130bp-135bp over mid-swaps for the euro and sterling tranches. As demand poured in, the issue was increased from the initially planned Eu1.25bn minimum to Eu2bn, and guidance revised to 125bp-130bp over.
By the time the order books were closed after five hours, some Eu13.9bn of orders had been placed. More than 320 investors placed Eu8.4bn of orders for the euro tranche and over 170 had put in orders totalling £3.7bn for the sterling piece.
The 60 non-call 10 paper, with a 100bp step-up after 10 years, was re-offered at the tight end of the revised guidance, 125bp over mid-swaps, allowing Siemens to price its hybrid at less than 100bp more than its senior debt.
"We always had the ambition and expectation that we could bring the deal in line with our standing in the markets, with very tight execution" says Ottmann, "and the ultimate execution even exceeded our expectations. This was helped by the timing, with the issue coming in one of the more favourable weeks for the market [September 8], but overall we were very pleased with how things went."
The possibility of raising hybrid capital in both euros and sterling, which had been pioneered by Linde, was also welcomed by Siemens.
"On the one hand we were issuing the hybrid to support our rating," says Ottmann, "but on the other hand we were also doing it to diversify our investor base. Our strategy is to better match-fund our overall balance sheet structure in terms of duration and in terms of currency, which is something that we had not really done before.
"The UK is a key growth area for us, hence the sterling tranche, and we had also in August raised $5bn of senior funding in the US, which is clearly our largest market in terms of growth."
Strong investor interest
The worst aspect of the transaction for investors was that the average allocation received was 15%, although some received zero allocations. Otherwise investors appeared enthusiastic about having the opportunity to buy such a product from a blue chip corporate.
"Investors with relatively stringent ratings constraints who had been unable to participate in previous hybrid transactions were, for the first time, given the opportunity to dip their toes into the hybrid market," says Barry Donlon, director of corporate syndicate at UBS in London. "Siemens was the ideal name for these first-timers.
"With such a blue chip credit behind the transaction it allowed them to focus on the structure and get comfortable with the hybrid as a new asset class."
The transaction also attracted less risk averse investors. "I have kept a watching brief over Siemens, but it has never been particularly interesting for us given that it is a double-A name and trades so tight on the senior side," says one fund manager in London. "However, it was certainly interesting at a subordinated level."
Investors were also encouraged by the message they received from management at the roadshow. "You can take comfort from the huge diversity in its business," says one investor in London. "There are some changes going on, but there was a strong message from management that they are really committed to, if not double-A, then at least high single-A ratings as a floor.
"We also took a lot of comfort from their 40 year unbroken track record on dividends."
This is important for investors considering the likelihood of interest payments being deferred, since optional deferral can only occur if Siemens has paid no common dividend.
Fund managers took 53% of the euro tranche, insurance companies 16%, hedge funds 15%, banks 7%, pension funds 5%, and others 4%. Distribution of the sterling tranche was similar, with 53% again going to fund managers, insurance companies taking 26%, hedge funds 13%, banks 3%, central banks 3%, and others 2%.
Siemens' hybrid also caught the interest of other issuers. "We had a number of calls from clients on the back of the Siemens trade," says François Bleines, head of European corporate syndicate at Deutsche Bank in London. "People were a little surprised to see Siemens issuing a hybrid instrument and were trying to find out the underlying reasons for the transaction.
"This was partly because Siemens is so highly rated, and partly because, by the use of both euro and sterling markets, it showed just how large a size you could do in Europe."