In the hybrid capital revolution that has swept through the corporate bond market this year much attention has been paid to the rating agencies and the revised methodology of Moody's in particular.
But while this has undoubtedly acted as a catalyst for issuance, aided by investors' acceptance of the product and the attractive funding levels available, several other factors have to be taken into account by companies seeking to achieve strategic goals through issuing hybrids.
"When a client looks at the possibility of raising hybrid capital, he has to take a holistic view," says Alvaro Camara, a member of Merrill Lynch's global structured product group in London, "and consider the use of proceeds, tax efficiency, and accounting, and all of that within his domestic legal framework."
This is particularly true given that at least one of a company's tax, accounting and legal frameworks — like those of the rating agencies — is also likely to be in a state of flux at one time or another.
For instance, the switch to International Financial Reporting Standards by companies in the EU has resulted in changes to the definitions of debt and equity for accounting purposes that have an effect on the way hybrids need to be structured.
"Previous accounting standards were local Gaap and the rules varied from country to country, but now the constraints imposed by IFRS are the same for everybody," says Peter Jurdjevic, European head of global fixed income new products at Citigroup in London. "Under IFRS the question of whether an instrument is equity or debt is not driven by legal form, but instead by substance."
The relevant rules for accounting for hybrid capital under IFRS are in IAS (International Accounting Standard) 32. "The standard states the instrument is classified as a financial liability or as an equity instrument in accordance with the substance of the contractual arrangement," wrote analysts at JP Morgan in July research entitled All you ever wanted to know about corporate hybrids but were too afraid to ask.
"If there is a contractual obligation to deliver cash or another financial asset, or to exchange financial assets or liabilities on potentially unfavourable terms, then the instrument is a financial liability (see IAS 32 paragraph 11 and paragraphs 15-16). Coupons on financial liabilities are interest payments for the income statement and cashflow statement, while coupons for equity-accounted instruments will be regarded as dividends."
This means that hybrids that satisfy the needs of the rating agencies can also win equity treatment on the accounting front. "Because a capital security is by its nature providing the issuer with payment flexibility, if it is structured appropriately it can result in instruments being classified as equity under IFRS," says Jurdjevic. "And for that reason you have seen transactions like Dansk Olie og Naturgas (Dong) and Thomson that are expected to be accounted for as equity."
The financial impact of instruments structured to achieve equity accounting, wrote analysts at Credit Suisse First Boston in Corporate perps: who pays? in September, are that: net debt is reduced; the coupon is accounted for as a "preferred" dividend distribution, so unlike raising funds through conventional debt issuance, there is no interest expense, thus reported income is higher; earnings per share is unaffected, and preferred dividends are deducted from earnings.
Choosing the debt side
But while equity accounting has proven more popular, some issuers have chosen to account for their hybrids as debt. "When we look at the accounting treatment of the instrument, an almost surprising number are not so focussed on achieving equity accounting, but rather choosing debt, and we see two main reasons for that," says Malcolm Cruickshanks, associate, hybrid capital at JP Morgan in London.
The first is to ensure that the instruments are treated as debt for tax purposes and hence tax-deductible. "Sometimes it is quite difficult to marry equity accounting treatment with tax deductibility," says Cruickshanks.
"The second one is that for an issuer to achieve hedge accounting on any associated swaps with these instruments, you need it also as debt on the balance sheet, otherwise you would have to mark to market the associated swap."
If accounted for as equity, hedge accounting under IAS 39 is unavailable for swaps. That would mean that any hedging for fair value would result in mark-to-market volatility on the issuer's profit and loss account.
An issuer might also want to achieve debt accounting if it were aiming to exchange outstanding senior debt for new hybrid securities. "Under IAS 39 if you exchange bonds for like-for-like instruments then you are able to amortise any premium you have to pay as a result of the existing bonds trading above par over the life of the new bond, rather than take the hit up-front," says Asar Mashkoor, vice president in Merrill Lynch's restructuring and liability management group.
"In order to qualify for that exchange treatment," adds his colleague, Camara, "you need to ensure that the instrument is accounted for as debt."
Although Bayer for internal reasons chose to target debt accounting for its Eu1.3bn hybrid in June and bought back Eu863m of an outstanding senior bond, it did this through a tender rather than an exchange.
"Exchange treatment only spreads the premium over time," says Henryk Wuppermann, Bayer's head of capital markets in Leverkusen. "From a purely economic point of view it doesn't make a difference; it is just about how you show the results."
The decision was also taken because Bayer did not want to miss out on investors for the new issue who did not hold the outstanding bonds.
While the accounting and related frameworks might appear onerous, bankers are confident that they can meet the challenges. "IFRS is, after all, substance-driven more than form," says Camara, "so it is a matter of interpretation and application on a case-by-case basis. We will discuss with the accountants how to structure the features so that they are comfortable with the treatment without actually endangering the tax analysis if the client wants equity treatment.
"Alternatively, we can include features that would create debt accounting, if that is what the issuer is trying to achieve."
Accounting key for Otto
One company for whom equity accounting was key was not surprisingly the first unrated hybrid issuer of the current wave. Otto, a leading international mail order group and the second largest internet retailer in the world, launched a Eu150m perpetual non-call seven year hybrid security in late July.
The privately owned company is considering seeking a rating in the medium term, but its primary objective was to achieve equity accounting. "The intention behind the hybrid was to improve our balance sheet," says Michael Crüsemann, CFO and member of the board of directors at Otto in Hamburg, "and first of all we considered how the banks would look at it, and they say it is 100% equity."
Otto was also pleased to be able to combine the best of the tax and accounting worlds. "It was of course important for us to have this as equity on the one hand and tax-deductible on the other," says Crüsemann. "That is the charm of it, to have something that is considered as equity, but on which the interest is treated as tax-deductible."
As mentioned briefly earlier, making sure that a hybrid instrument will count as debt for the tax authorities of the relevant country, thereby lowering the cost to the issuer, is crucial when structuring an instrument.
In a piece entitled Hybrid capital: non-dilutive equity at a fraction of the cost, bankers at Deutsche Bank highlighted three features that generally assist qualification as debt for tax purposes: a stated maturity; cumulative coupons (even though they may be settled in non-cash forms such as additional hybrid or equity securities); a liquidation claim as a debt-holder.
However, as Camara at Merrill Lynch points out, the exact criteria can differ from one jurisdiction to another, with implications for the structuring of hybrids.
"While the rating agencies may require that a security is non-cumulative, tax authorities say that if there is a chance that the instrument is profit-dependent then it will not be deductible, and profit-dependent is interpreted differently in different jurisdictions," he says. "In France a non-cumulative structure could be tax-deductable as long as it is accounted for as a liability under French Gaap.
"But in the UK it would clearly be a non-deductible item and that is why we saw the concept of stock settlement introduced by Barclays on its Tons [tier one notes] in 2001. It is a way to bridge the difference between the tax authorities and regulators, and now in the corporate market between the tax authorities and the rating agencies."
The question of maturity can also differ from one jurisdiction to the next. Most hybrids are perpetual non-call 10 year issues, but there have been exceptions to the rule.
Dong's hybrid, for example, pays a coupon of 5.5% to the first call in 10 years, then steps up to three month Euribor plus 320bp until 2505, and to three month Euribor plus 420bp until its maturity of 29 June 3005.
The reason for the 1,000 year maturity rather than the typical perpetual maturity was that it strengthened the tax analysis of the hybrid as debt. As there is no specific law governing the concept of corporate hybrids in Denmark, Dong looked at the law governing bank capital for guidance. Its only alternative would have been to wait until after the law had been changed or proceed without the certainty that its instrument would be tax-deductible.
"Under the Danish tax system it would have been difficult to get pre-approval for the tax treatment if we had done a perpetual," says Morten Buchgreitz, senior vice president in Dong's treasury team in Hørsholm. "That is not to say that it could not be done, but we could not wait to get pre-approval for it, so we went down a route where we were absolutely sure about its treatment."
Bayer, meanwhile, chose to have the shortest maturity of any of the hybrids issued — 100 years. "We understand that Bayer did that because it wanted to achieve liability accounting and a final maturity generally results in liability accounting unless it is extremely long," says one banker, "and we understand that 1,000, which Dong used, would have been treated as effectively being perpetual."
Issuers and bankers have to be specific when crafting features such as change of control covenants. What an investor might ideally want would be a put option in the event of certain changes of control, but this is not a covenant that an issuer seeking equity accounting could include on a hybrid.
"Under IFRS, anything that creates an obligation to make a payment would trigger debt accounting," says Camara at Merrill Lynch, "and that includes an obligation to make a redemption payment if there is a change of control."
The first corporate issue to include a change of control covenant was also that where equity accounting was paramount: Otto. The covenant stated that in the event of a change of control the issuer would have to achieve an investment grade rating within six months or else then redeem the securities.
"We crafted the language in a way that still actually got them equity treatment," says one banker involved in the issue.
Thomson, which also targeted equity accounting for its hybrid, included a change of control covenant under which it can either call the bonds at par in such an event or pay a coupon step-up of 500bp.
Stoppers and pushers
Among the structuring technology borrowed from the bank capital sector for corporate hybrids have been dividend stoppers and dividend pushers.
These are included to ensure that the holders of hybrid securities do not have their coupons deferred when a company is paying dividends to shareholders.
The simplest structure is to say that if a coupon is not paid then a dividend cannot be. However, this is not possible in some jurisdictions.
"The mechanism has different colours in continental Europe versus the UK, due to differences in corporate law," says Camara at Merrill Lynch. "In the UK there is the concept of a dividend stopper, so if a company does not pay a coupon then it commits not to pay dividends.
"That, in Germany and elsewhere, is difficult to achieve because dividends are declared by the shareholders, not the board of directors. So instead of a dividend stopper you have a dividend pusher, meaning that if you have paid a distribution in the last 12 months you have to pay on the hybrid."
|Rating, tax and accounting treatment of recent European hybrid transactions|
|Linde Finance||Dong||Südzucker International||Bayer||Casino Guichard-Perrachon||Otto Finance Luxembourg||Vattenfall Treasury|
|Equity credit: S&P||Minimal||Intermediate||Intermediate||Intermediate||Intermediate||NR||Intermediate|
|Equity credit: Moody's||B*||C||D||D||NR||NR||D|
|Maturity||Perpetual||1,000 years||Perpetual||100 years||Perpetual||Perpetual||Perpetual|
|B* Assigned before refinements to Moody's methodology|
|Sources: CSFB, Deutsche Bank|