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KfW’s Eu4bn ‘dream ticket’ DT sale ends in nightmare

KfW's Eu4bn sale of shares in Deutsche Telekom on Monday was meant to be one of the highlights of the year for the European equity capital markets. But the deal turned sour as an aggressive auction and a flawed sale of warrants put off investors.

Equity bankers say it is likely to have hurt the equity market reputation of KfW, the German development bank ? and perhaps those of the leads, Citigroup, JP Morgan and Morgan Stanley.

Before the deal KfW had a reputation as one of Europe's most investor friendly issuers, but the process by which it auctioned 266m Deutsche Telekom shares to banks last Sunday left little value for buyers and disappointed many.

KfW chose to sell the 6% stake in Deutsche Telekom through a combined offering of shares and warrants, a technique that had not been used since the privatisations of the early 1990s.

The poor performance of the deal has discredited the method for the time being.

Some equity-linked bankers blamed the way the sale was executed, but others said it was fundamentally wrong to try and sell Eu1bn of derivatives through an accelerated bookbuild of the kind normally used for liquid stocks.

Finally, the deal has burnt another hole in the pocket of investment banks. In their fight for market share they have let another issuer use them to sell a block of shares at a price that much of the market said was unrealistic.

Though the losses for Citigroup, JP Morgan and Morgan Stanley, estimated to be about Eu10m-Eu20m in total, may be within a range they are prepared to tolerate on a bold transaction like this, such deals unquestionably annoy inv-estors.Equity bankers acknowledge that most of the top firms sometimes go too far when competing for high profile deals, but they are now openly asking when the bidding madness will end.

One banker pointed out that issuers are also partly to blame, particularly in their fear of taking market risk through a deal marketed over an extended period.

Auctioning the equity
All the leading equity banks knew this sale was coming and had spent the last three months preparing for the trade, which had been described as the ?dream ticket' because of its combination of KfW as a seller and Deutsche Telekom, one of Europe's most liquid and desirable stocks.

The auction began on Sunday when KfW approached a group of about 10 banks to bid for a block of 199m shares in Deutsche Telekom, as well as four tranches of warrants, each with different maturities and premiums. The banks were given 90 minutes to submit full bids.

Citigroup, JP Morgan and Morgan Stanley won the auction, displacing KfW stalwarts such as Deutsche Bank and Goldman Sachs. They did not actually buy the shares, but bid on the basis of a backstop minimum price that they guaranteed to KfW for the full equity placement.

The leads approached the market on Monday morning with a range of Eu15.05-Eu15.15 for the shares, valuing the full stake at between Eu2.995bn and Eu3.015bn.

The price range represented a tight 0.5% discount to last Friday's (October 8) close at the top of the range and a 1.1% discount at the bottom.

However, the banks did not get the early momentum they needed to sell the stock. By midday speculation had begun to spread that the deal was only half covered.

That led to widespread shorting of the stock ? even though, as one banker working on the deal noted, many of those shorting it were also increasing their orders for the stock at the same time.

The shares were priced at the bottom of the range, but when the book closed at the end of the day the deal was still not covered, and the leads announced that they retained a holding in the stock.

?We were transparent throughout the sale and the stock has outperformed the index,? said a head of syndicate at one of the lead managers.

DT's shares closed at Eu15.05 after the sale on Monday, and declined slightly to Eu14.90 by Thursday's (yesterday's) close.

None of the lead managers would comment on what backstop price they had offered KfW or what fees they would receive, but equity bankers who had failed to win the auction guessed the backstop to have been in a range of Eu15.12-Eu15.15, with fees (paid irrespective of performance) of 30bp.

A banker at one of the lead managers said yesterday that his bank's holding in DT was not substantial, and most bankers agreed that the leads had probably sold most of the stock by Thursday, though at little or no profit.

But while the straight equity placement was far from a clean and easy sale, it was nothing compared to the disaster of the warrant offer.

Optimising receipts
In July 2003 KfW used a Eu5bn exchangeable bond, lead managed by Deutsche Bank and JP Morgan, to offload a 6% stake in Deutsche Telekom.

Market participants were not expecting another exchangeable for this disposal, but although a combined equity and warrant structure had been suggested to KfW many times over the last year, it was still a surprise when the agency chose to use it.

An official at one of the lead managers said the warrants had not been the idea of any of the leads.

?We considered an exchangeable bond, but we decided we wanted to exploit the short term volatility of Deutsche Telekom's share price,? said Günther Bräunig, a general manager at KfW who oversaw the deal. ?An exchangeable bond would only have made sense if we had wanted a maturity of two or more years.

?The idea was to make an offering that appealed to the whole universe of investors. I don't think investors had a problem with the structure of the deal. Our priority was the direct equity sale, but with this structure we were able to optimise our receipts.?

The banks bought the warrants from KfW in the auction, paying a fraction of the strike price in each case. They then endeavoured to sell them on to investors.

There is little doubt that in financial terms KfW came out of the deal better than any of the lead managers or investors who bought it.

One banker away from the deal estimated that the leads were likely to have paid KfW about 5% of the strike price for the warrants, which would have given the development bank about Eu50m of cash up front.

Taking into account that it effectively sold the Eu3bn of shares to the banks at a tight discount, that would be enough to ensure that KfW sold that stake almost flat to the market price.

KfW may not sell any more DT shares in the open market for 180 days, but if DT's share price hits any of the warrant strike prices, KfW may begin to offload a further Eu1bn of shares.

Sale goes wrong
However, the sale of the warrants went badly awry. Bankers away from the deal believe the leads may still be holding 80%-90% of them, and one head of syndicate said the leads might even have the entire position on their books.

The leads conceded only that they still had some of the warrants.

This need not be a costly problem for the leads, as long as their positions are fully hedged and they are disciplined enough not to try to sell their positions independently of each other. The market would interpret that as a sign of weakness and punish the value of the warrants.

Though some bankers had doubts about the viability of the warrant offering, many were angry, not with the structure, but with the way the sale was executed.

The warrants were offered in three equal tranches with six month, 12 month and 18 month maturities. The strike prices were set at 0%, 5% and 10% above the share price.

However, instead of separating the warrants from the auction, as had originally been planned, KfW opted to price them off the equity sale.

The original plans for the combined offering, which are understood to have been given to KfW over a year ago by Dresdner Kleinwort Wasserstein, envisaged the warrants being used as a sweetener.

But, by including the warrants as part of the auction, and pricing them off the equity sale price, their cost became attached to the aggressive bidding of the main equity sale, making them expensive compared to other Deutsche Telekom derivative structures.

?We told KfW not to include the warrants in the auction,? said one equity-linked banker. ?When we saw they were included our hearts sank. It was possibly one of the worst moments of my career.?

Another problem with the warrant offering was the lack of time given to the banks and investors to price them.

?If you're given 90 minutes to price four warrant tranches, all with different maturities and premiums, only three of which will be used, as well as an Eu3bn block of stock, you're going to concentrate on the block,? said a syndicate banker. ?It doesn't surprise me that some banks got the pricing wrong, since they would have concentrated on the bid for the stock.?

The result was that the warrant sale ended up not satisfying any of the investor groups that might have been expected to buy it.

Convertible investors did not like the short maturities, and found the pricing expensive compared to KfW's exchangeable into DT last year.

One equity-linked banker estimated that the warrant sale had the by-product of knocking Eu50m off the value of the exchangeable bond, which the banker said was unlikely to have made CB investors more amenable to the warrant offer.

Hedge funds also disliked the pricing, and long-only equity investors found the warrants too complex to evaluate in an accelerated sale.

?Warrants are not something that can be sold in a one day bookbuild,? said one head of equity-linked origination at a bank not involved in the deal. ?They need to be placed over time ? the market is not geared to accept this type of offer.?

However, Bräunig at KfW said the bank had never intended that all the warrants should be placed in one go. ?We had expected the warrants may not all be sold immediately, but would be placed over time as the stock picked up,? he said.

But the head of equity-linked origination pointed out that if this had been the intention then using three lead managers to sell the shares made little sense.

One bank might have been able to unwind the holding over a period of time, but three banks were unlikely to trust each other to do a co-ordinated placement.

A last problem for all investors was the lack of special dividend protection offered by the warrants, unlike last July's exchangeable bond. One equity syndicate banker who took part in the share auction said he had raised the issue with KfW.

?How do you sell a warrant for a stock, which most investors are interested in for its dividend, which doesn't have any protection, and where there is a directly comparable bond that is cheaper and does?? asked the syndicate banker, based in London.

KfW changes tactics
The question most people were asking after the sale was why KfW would do a deal that annoyed so many of its banks and investors. Nearly all equity bankers contacted by EuroWeek expressed surprise at the way KfW had handled the sale.

KfW's Eu5bn exchangeable last July is now legendary in the equity-linked market, and remains the largest equity-linked offering ever. That deal was placed in just one day, and a major factor helping Deutsche and JP Morgan on the deal was KfW's commitment to a fair price that left upside for investors.

?This could have been a very successful deal, but KfW's actions this week have moved DT stock from a positive momentum to a negative,? said one head of equity-linked origination. ?Everybody had been looking forward to this deal, but [KfW] just went for the highest bids, so they can hardly now be annoyed with how the deal went.?

One explanation suggested by bankers is that KfW might be benchmarking itself against the French government.

One head of syndicate argued that KfW's outlook had changed on September 1 this year when the French government sold a Eu5.1bn block of France Télécom shares at a 0.1% discount to the day's closing price.

?I don't blame KfW ? imagine it was your own money,? said one head of syndicate in London. ?If there are five banks out there prepared to bid on these sort of terms for these deals they'd be foolish not to take the money.?  

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