Lottomatica showed what would happen if the high yield market met the young hybrid sector. And despite the subordinated market coming under pressure and suffering from bouts of volatility in recent months, Lottomatica has consistently traded above par. Alistair Dawber reports.
At the end of 2005, bankers in the European high yield market said that the year had represented the high water mark of innovation as bankers and investors lapped up the latest products such as payment-in-kind notes and mezzanine financing.
But, at the same time, there was also something of a revolution taking place in the investment grade sector, with an increasing number of issuers bringing hybrid bonds. It was only a matter of time before the two would overlap, and produce a sub-investment grade subordinated deal.
When Italian lottery operator Lottomatica announced it was buying Gtech, a US lottery group, for $5bn to create the world's biggest lottery business, the group's management board faced a dilemma. The acquisition would be good for the company, but at the same time, more debt would have seen the ratings agencies downgrade the company from its investment grade status of Baa1/BBB to junk — a move the Italian regulator would not permit.
"It was absolutely paramount to protect the investment grade rating," says Fabio Celadon, finance director at Lottomatica in Rome. "We operate in a heavily regulated industry and had to be careful about the instrument we were to issue. The whole process needed a lot of input from the ratings agencies."
The solution was, of course, to issue a high yield hybrid, which is regarded as being equity-like debt by the ratings agencies because of, among other things, its subordinated nature and the duration of the instrument.
Lottomatica has a triple-B senior rating, while Moody's and Standard & Poor's rated the hybrid Ba3/BB, which was "in line with expectations" according to Celadon
In addition to the bond, Eu1.4bn was raised in a rights issue, while a Eu2bn credit facility was also set up. The hybrid was classified as basket 'D' by Moody's giving it a 75% equity content.
Notwithstanding the favourable market conditions at the time, the execution of the Eu750m 60 year non-call 10 transaction, led by Credit Suisse, was lauded by all sections of the market.
The deal was launched in March and while it was not actually the first high yield hybrid, it was the first to be sold to institutional investors and the first benchmark. German tourism group Tui had brought a Eu300m deal last December, but that was largely sold to domestic retail accounts. That deal only has a 25% equity content.
"There was no benchmark for us to price this against so in that respect it was a tricky trade," says Celadon. "But we had discussions with some key investors and in the end priced the deal to include a small premium to bondholders to take account of the subordinated nature of the instrument."
The book for the deal was four times oversubscribed, which allowed the issue to be priced at the tight end of the 8.25%-8.5% coupon guidance and while the hybrid sector as a whole has suffered from widening spreads with the equity sell-off, Lottomatica's offering has remained steadfast, trading above par.
"The trade was very well received by investors," says Mathew Cestar, head of high yield capital markets in the leveraged finance team at Credit Suisse in London. "The structure is very rare for the high yield market and an instrument that has a very long duration and a coupon deferral is unusual for traditional accounts, but accounts agreed with the compelling reasons for the transaction."
Investors, who were generally pleased with the trade, cited the structure as being particularly bondholder friendly. "This was a complete blow-out. I hear the book reached around Eu3.5bn, and they had orders of over Eu2bn at the mid-swaps plus 405bp price," said a Frankfurt-based investor at the time of the trade.
"The structure was a winner. For the first time with a European hybrid, the borrower adopted a US structure. It was a 60 year non-call 10 rather than a perpetual, it had change of control language, a replacement provision if the deal is called and if it is not called, it swaps to a floating rate note."
Full steam ahead
The hybrid market has enjoyed a mixed reception since it gained traction with several big issues last year. The market has been rife with rumours about new issuers ever since the first flurry of deals.
The deals that have worked best, such as Lottomatica's, are those that have been brought because they made sense to investors — Lottomatica's transaction was brought to protect the group's investment grade rating.
"The rationale for doing a hybrid, to protect its investment grade rating, was fine and welcomed. In all we were very comfortable with the credit — they did a great job," said an investor who bought the bond in May.
German industrial gases group Linde made history in July when it offered a hybrid deal for the second time.
Whether Lottomatica would consider a second such deal is a matter of debate. Celadon says that the company would have to consider the implications before rushing back to the market.
"We are very happy with the way this issue went," he says. "But to do another deal would be a real issue. The instrument allowed us to reduce our borrowing costs, but the hybrid is a permanent aspect of the capital structure and we would not want to add to the deal lightly. If we make another acquisition we would consider it, but there are no immediate plans to return to the market."