A remarkable new market has grown up in Japan in the last two years, of companies raising capital in the stockmarkets through private placements. Investment banks are eager to underwrite these bespoke equity financings, in which they give their clients funding upfront and then place shares in the market over time. Banks like the deals because they are profitable, and issuers like the flexibility and lack of hassle involved.
As Japan emerges from a long period of economic darkness, corporations big and small are hungry for equity funding to finance growth and acquisitions.
In many countries, the natural way for companies like this to raise capital would be to sell equity in the open market, through a rights issue to existing shareholders or a follow-on equity placement.
But in Japan, there is no legal requirement to offer any new issue of equity to the incumbent shareholders. Instead, a company can issue new stock to new investors under Japan's third party allotment rules, with the slightly imprecise caveat that the pricing must not be "especially favourable" to the new investors.
This regime has allowed a new market to flourish in privately placed equity, which avoids many of the drawbacks of a direct, public sale.
Since 2004, a growing group of investment banks has been structuring deals for issuers in which they issue convertible bonds or warrants straight to the investment bank. The bank then converts the instruments into shares, often little by little over a period of months, and sells the shares in the market.
Whereas a standard convertible bond converts to equity at a premium to the share price on day one, in these transactions conversion is at a discount to the prevailing share price when conversion takes place.
That gives the investment bank a safe return for taking the underwriting risk. It could be unattractive for the issuer to sell equity at a discount if its share price fell, but there are usually clauses in the contracts to wind deals up if that happens.
And in practice, issuing equity publicly nearly always involves paying a discount. Proponents of the new structured equity deals argue that they allow for better execution by giving either the underwriter or the issuer much more control and flexibility over the timing of stock sales than in a public sale, when it all has to be done on one day.
These deals are declared to the stockmarket, so existing investors are not being diluted without knowing it, but the ability to spread out the actual sales of stock over time and conduct them privately can help to protect the share price.
Banks are deploying a rich variety of structures, all offering issuers a solution crafted for their particular needs.
By most estimates, the market surpassed ¥1tr ($9bn) of issuance in calendar 2005, a roughly threefold growth over 2004, which was the first full year in which this product had been marketed in its modern form. Many market participants hope the issuance will grow a further 50% this year.
UBS, one of the leading underwriters of these issues, estimates that about 120 transactions were concluded in 2005, with an average size of roughly ¥8.3bn ($73m).
"We have seen significant growth in this very Japan-specific product over the last two years, and the product has become an established financing alternative for domestic companies," says Michel Lee, head of equity risk management products at UBS in Tokyo.
"Previously, mid-cap corporations had very limited avenues for equity financing, and more choice is definitely a good thing. The variations of the product and the way they are underwritten and traded have evolved significantly for the benefit of issuers and investors, and we would expect there to be continuous innovation and improvements."
|Kanto Tsukuba's share price bonanza|
| Kanto Tsukuba Bank, a first tier regional bank, is a regular visitor to the public capital markets and since late 2004 has employed Merrill Lynch to underwrite three private equity funding transactions.
Each deal was followed by a sharp rise in the bank's share price and helped Kanto Tsukuba become the seventh fastest rising Japanese stock of 2005, racing up around 350%.
Merrill Lynch's policy of selecting its clients from among the country's more alluring equity stories appears to have paid off as Kanto Tsukuba Bank's market valuation has soared from less than $200m equivalent in November 2004 to more than $800m by mid-February this year.
As Kanto Tsukuba Bank has grown in stature, Merrill Lynch has helped by offering new and innovative structures to meet its needs. Its first two issues were convertible bonds. The July 2005 issue was not a bond but a convertible preference share issue, formulated in order to bolster the bank's tier one capital ratio.
"At ¥4.7bn, this was a much larger issue than the first and enabled the bank to improve rather than weaken capital ratios prior to conversion," says Alex Woodthorpe, head of Australia and Japan equity capital markets at Merrill Lynch in Tokyo. "Far from scaring the investor base, it had precisely the effect we had hoped for, as the stock price surged more than 200% post-issuance."
In support of Kanto Tsukuba's investor relations efforts and also as a sign of its belief in the bank and the equity story, Merrill Lynch arranged a series of meetings with investors in association with each deal. "This virtuous circle has meant that there has been a regular and natural source of demand for us to sell the shares," Woodthorpe says.
The typical companies that enter these transactions are in the ¥50bn-¥500bn ($440m-$4.4bn) market capitalisation range. Companies in the lower half of this bracket often have only limited equity or debt funding options available to them, especially if their balance sheets are small, as is often the case for fast-growing businesses.
Typical issuers might be in the middle of restructuring and need equity to strengthen their balance sheets; they might be rapidly growing companies, for example in the property or IT sector, that need quick access to funds to seize on opportunities; or they might be mid-market or regional banks that need an easy way to raise fresh capital.
There is also Japan's accelerating merger and acquisition market, in which a guarantee of funding can be the vital ingredient that helps a bidder win a deal.
Finally, some companies issue these securities to investment banks with which they have a good relationship, hoping to gain some level of protection against a hostile takeover bid.
If, for example, a supportive third party owns bonds or warrants that may be converted into 15%-25% of the fully diluted share capital, that would make it difficult for a hostile bidder to contemplate a takeover bid.
While the high yield bond market in Japan remains tiny, structured equity deals are one of the easiest ways for issuers with lowly credit ratings but a good equity story to raise funds with little market risk and at a modest upfront cost.
Private convertible bond or equity warrant issues, bankers claim, often do much less harm to the share price than issuing new stock at a hefty discount.
"A traditional equity issue would have fees of about 5%, a new issue discount of up to 5% and documentation costs of about 1%," says Alex Woodthorpe, head of Australia and Japan equity capital markets at Merrill Lynch in Tokyo.
A standard public equity issue might expose the stock to market risk for about seven to 10 days, during which the issuer's share price might drop anywhere between 1% and 15%. Even if everything goes perfectly, public follow-on equity issues involve a lot of management time, lengthy due diligence work and a big marketing effort.
Public offers also do not allow for much product design because many investors have to be brought in at once. But in a private deal, the underwriter, as sole investor, can collaborate with the issuer to design an instrument that meets the company's precise needs, in particular for the timing of conversion.
"It is very flexible as the terms are negotiated between the issuer and the purchaser, as opposed to public offerings, which are trying to appeal to a wide variety of investor needs," says David Hancock, general manager of equity capital markets at Shinsei Bank.
Moreover, there is no cash cost to the issuer, as the return to the underwriter is entirely embedded in the discount at which it can convert the bonds or exercise the warrants.
Defining the market
Various investment banks employ proprietary terms for their structures, such as Merrill Lynch's Pipes (private investment in public equities, a term familiar from the US market) and Nomura's trademarked MPO (multiple private offering).
However, none of these terms captures the whole of this private structured equity market particularly well.
What is clear is that the most popular instrument within the market has so far been the moving strike convertible bond (MSCB).
In this structure the company raising funds issues a convertible bond at par to the underwriter, which usually acts on a sole basis. The bank immediately provides the funds to the issuer and holds the convertible bonds for its own account.
Technically the underwriter could sell the MSCBs to third parties, but there is invariably an agreement that it will not. Instead, it must convert the bonds into the allotted new equity or treasury stock and then sell those into the market.
The underwriter can retain the underlying shares if it wishes, but the explicit or implicit understanding is that it will sell them to third parties.
MSCBs usually carry zero coupons, mature after two years and are convertible to equity at a fixed discount to the prevailing market price — usually between 7% and 10%. The conversion price normally resets every few weeks of the bond's lifetime, to keep pace with the prevailing equity price.
Key to the attractiveness of such a deal for the underwriter is whether the stock is liquid enough to allow it to trade out of its position as early as possible without hurting the stock price.
The theoretical dilution of most issues — ranging mostly from 5% to 15% — is manageable for the arranger and for shareholders. Some deals have higher dilution, but they are mostly executed to repurchase and refinance far more dilutive convertible preference share issues.
|Land Co lands its funding from UBS|
| When Land Co, a Japanese real estate developer, wanted some extra funds to expand its business in May 2005, it turned to UBS, which bought a ¥2.5bn moving strike convertible bond (MSCB).
The deal made a marked difference to Land's ability to expand its activities as prices rise and liquidity returns in Japan's reawakening real estate market.
Land wanted to expand its real estate securitisation, real estate brokerage business and condominium development businesses, as well as other areas. While it does all this, Land wants to maintain its equity ratio to 30%. The ¥2.5bn MSCB was integral to this effort.
Although a small issue by wider capital market standards, the deal was big compared to the market trading volume in Land's shares, being 46 times the average daily trading volume. Yet UBS managed to convert the bonds and sell off all the underlying shares in less than a month from signing the agreement with the issuer.
The conversion and sale process was helped by UBS and the company making a big effort to promote the stock after announcing the issue.
During the month after issue, Land Co's share price soared nearly 150% from the price on the announcement date, while the Jasdaq index remained roughly flat.
Warrants gain popularity
In the past 15 months there has been a rapid rise in a new sub-sector of Japan's privately underwritten equity securities market, diluting the dominance of the MSCB.
Moving strike equity warrants have become a common alternative, partly because issuers do not need to book the instruments as debt.
The Nikkei newspaper reported recently that by the end of January an estimated 40 companies had sold ¥200bn ($1.75bn) of such instruments in the last two years.
The fundamental structure of these deals is similar to that of MSCBs. Usually, however, the timing of when the underwriter may exercise the warrants is controlled by the contract between the bank and the issuer — rather than being left entirely up to the bank's discretion, as in most MSCBs.
In an equity warrants issue, the underwriter, usually on a sole basis, gives the issuer funding either upfront, or on a staggered basis throughout the life, or exercise period, of the warrants.
The technique is particularly appropriate for companies that want to stagger the issuance of equity over the two years or so after they issue the warrants. It is also ideal for companies whose balance sheets would strain under the weight of additional debt.
On the downside, there have been cases in which incumbent shareholders or other parties have challenged the fairness of equity warrant issues in the courts.
The claimants have argued that a particular warrant structure disadvantages the incumbent shareholders by giving new investors "especially favourable" terms, forbidden under Japan's rules on third party allotment of shares. At least one claimant has won such a case.
This is potentially troublesome, since equity warrants are difficult to value — there is no agreed legal basis for the valuation methodology or calculating the volatility of the share price, and therefore the warrant price, during its life.
High growth market
Apart from some so far marginal controversy and criticism, this new structured equity finance market has been making rapid progress since 2004.
"The speed and efficiency of the execution and documentation process are key factors appreciated by the management teams of smaller to mid-market companies," says Alex Large, managing director of equity capital markets at JP Morgan in Tokyo. "Another major advantage for companies with less robust balance sheets is the speed at which the MSCBs convert to equity and the very high probability that conversion will take place."
Takashi Shirata, managing director, investment banking at Nikko Citigroup in Tokyo, is also encouraged by developments. "This is a form of funding that is growing in popularity among companies in Japan," he says. "The typical issuers have thus far been high growth companies that need large funding relative to their balance sheets. Or they might be companies undergoing restructuring that want to refinance more dilutive and costly convertible preference stock owned by the banks after earlier debt-for-equity swaps when the companies were under rehabilitation."
Several regional banks have also issued instruments like MSCBs in the form of convertible preference shares, aiming to achieve tier one capital treatment from the outset.
Shirata notes that if an issuer wanted debt rather than equity it might choose to issue an ordinary public convertible bond. But the private, structured deals are considered equity from the outset, by both issuer and investors, as they offer virtual certainty of conversion, whether from bonds, preference stock or warrants.
Moreover, size does not normally matter — MSCBs are popular with companies that want to raise equity capital in a size that is large relative to their market valuations.
The origin of the market dates back more than two years. Nobuo Nakasone, executive director in the capital solution department at Nomura Securities in Tokyo, says issuance began in January 2004, when Isuzu Motors raised ¥30bn and Tokyo Tomin Bank ¥3bn through Nomura. At that time, the stock market was struggling and mid-cap stocks were largely illiquid.
Some of the early deals that followed Isuzu's were from companies that wanted to dispose of treasury stock they had bought during the difficult years. During Japan's financial crisis, the banks were desperate to pare down their cross-shareholdings and companies that could afford to often bought the shares back from their banks.
Positives outweigh negatives
However, not all deals have been successes. For one reason or another, some companies' share prices have slumped after their announcement of one or more of these structures, as the prospect of dilutive equity sales at a discount has undermined confidence in the stock.
These occurrences have caused widespread concern, especially among those who know little or nothing about the true nature of the market.
But according to research by the investment banks, most issuers share prices have gone up after structured equity offerings; and, most deals include clauses to ensure that if the share price falls too far or fast, the deal will be called rather than converted.
Plenty of issuers and arrangers are enthusiastic about the product. Some argue that the entire equity new issues market in Japan might in the future go further down the private road, but that seems somewhat farfetched.
Nevertheless, assuming the arrangers continue to assess the relationship accurately between credit and liquidity risk and providing there are no deal disasters or regulatory changes, the outlook is encouraging.
"This is a market destined to play a major role in Japan's capital markets," says Woodthorpe at Merrill Lynch. "It is such an excellent product for the issuers and there is such competition to arrange the deals that the prospects look very good indeed."
|Street smart Urban takes control|
Urban Corp is a rapidly growing real estate company that among its other recent achievements has latched on to the latest corporate finance structures to give it fast and flexible funding.
In January, Deutsche Bank employed the moving strike equity warrants structure to underwrite ¥40bn of fresh equity for Urban. So far, this is another success for the privately underwritten equity securities market.
Urban Corp has grown exponentially in recent years. By January 17, when it announced the deal with Deutsche Bank, its market capitalisation had climbed to more than ¥508bn ($4.4bn) from just ¥131bn a year earlier.
"It truly is an outstanding performance and laid the foundations for our involvement," says Masahiro Oshige, director of the strategic equity transactions group at Deutsche Bank in Tokyo.
Deutsche Bank agreed to buy warrants to convert into ¥10bn of fresh equity, with a strike price of 98% of the higher of the closing price on January 17 or the five day average to January 24. Deutsche would be asked to exercise the warrants within five days any time after February 9.
On the same day, the company also said Deutsche also committed to provide another ¥30bn of equity funding through a second warrants issue. Under this agreement, Deutsche could be asked to provide up to ¥10bn of equity within 10 days of a request being submitted.
The warrant exercise price for this ¥30bn portion would be 97% of the average market price for the two days before the exercise date.
The ¥40bn deal was Japan's largest private issue of equity warrants, and the discounts of 2% and 3% for the two tranches were the tightest market participants had seen. "The discounts for this type of issue are normally in the 5%-10% range," says Oshige. "But Urban is an almost unique company that is enjoying remarkable growth in its business and remarkable liquidity, with a rising stock price."
The deal originated in the middle of 2005, when Deutsche first discussed a wide range of fundraising alternatives with Urban Corp, including a straight equity issue, ordinary public convertible bonds, the MSCB route and equity warrants.
"Urban and ourselves finally took this path because of speed of execution, because it was equity funding with no intermediate debt step, and because it gave the issuer a very considerable degree of control over the timing and size of each sale of the underlying shares," explains Oshige. "Urban is sensitive to how far and how fast its share price has moved and wanted a solution that would give it some control over the timing and dilution, while also ensuring a quantum of funding size."