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Japan's new equity market

27 Mar 2006

As Japanese companies emerge from a long period of economic darkness, they are stretching their limbs and beginning to grow. Many need fresh equity capital to finance acquisitions or organic growth, and investment banks have a new technique to offer them. More and more, the banks are underwriting equity issues privately and then selling them into the market later. A rich variety of structures is being deployed, and they offer the issuers many advantages.

The vitality of Japan's stockmarkets in the last few years is one of the surest signs of the returning health of the country's economy.

But one of the most interesting developments is that much of the new equity capital raising, particularly by smaller and fast growing companies, is being done not through traditional public issues, but privately, in transactions that are bought by investment banks and then sold into the market later.

As a private market, this activity is not widely understood and few firm data exist. There is not even an agreed name for it, since several different products are used, particularly warrants and moving strike convertible bonds.

Various investment banks also employ proprietary terms for their structures, such as Pipes (private investment in public equities, a term familiar from the US market) and Nomura's word MPOs (multiple private offerings).

EuroWeek has been tempted to coin its own umbrella term, which perhaps describes the market most accurately: privately underwritten non-transferable securities (Punts).

But all these fast-evolving products and techniques fit comfortably into the general category of structured equity finance.

Investment banks produce various estimates of market size but the trend is clear — the use in Japan of privately placed structured equity transactions is growing apace.

The commonest product in this category is moving strike convertible bonds (MSCBs) and most observers agree that more than ¥1tr ($8.4bn) of them were issued in calendar 2005.

That was a roughly threefold increase over 2004, which was the first full year of widespread MSCB issuance. This year many market participants hope that the market might grow by 50%.

UBS, one of the leading underwriters of these issues, estimates that there were about 120 transactions in 2005, with an average size of about ¥8.3bn ($70m).

Appealing to mid-caps

"We have seen significant growth in this very Japan-specific product over the last two years, and the product has become a very 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."

The typical issuers are companies with market capitalisations of ¥50bn to ¥500bn ($40m-$400m).

Plenty of companies are still restructuring after Japan's long period of deflation and need equity to strengthen their balance sheets.

Then there are high growth companies, for example in the property and IT sectors, that need rapid access to capital to seize on opportunities. Many middle-market and regional banks and other financial institutions also need fresh capital.

And of course there is the growing 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 friendly investment banks to gain some protection against an unfriendly takeover bid. If a third party owns, for example, 15%-25% of a company's share capital, it is difficult for a hostile bidder to contemplate a takeover bid.

Issuers with lower ratings can raise funds with relatively little cost, and proponents of the technique argue that private convertible bond or equity warrants issues often hurt the issuer's share price much less than issuing new stock publicly 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. "The offer could be exposed to market risk for about seven to 10 days, during which the issuer's share price might drop anywhere between 1% and 15%. Aside from that, those offers involve management time, a lot of due diligence work and a big marketing effort."

Defining the market

What are these instruments? Most of the structured equity financings under discussion are issues by small to mid-capitalisation Japanese listed companies, which expand their equity capital by 5%-15%.

The deals are prevalent in Japan because it does not have the same laws that exist in many other countries, which compel companies raising new equity to offer it first to existing shareholders in a rights issue.

Instead, Japanese firms can issue new stock to new investors under third party allotment rules, provided the pricing is not especially favourable to the new investors, and hence unfair to existing shareholders.

That freedom means companies can raise equity while avoiding much of the hassle of a public issue. However, although the deals are private, they are disclosed to the market on day one, so existing shareholders are fully aware of any dilution of their shares.

Companies typically issue equity, warrants or equity-linked debt that are privately bought by the lead arrangers — usually just one bank, occasionally two.

The underwriter gives the issuer guaranteed funding, either up front, or at some point or points during the lifetime of the financial instrument.

Usually the instrument converts into common stock at some point during its life — either new stock or existing shares held by the company as treasury stock.

At this point the underwriting bank is free to retain the shares or sell them in the market. But the arranger always agrees not to sell the structured securities themselves, but to retain them until they have been converted into equity.

MSCBs: upfront funds

The most popular instrument so far is the moving strike convertible bond (MSCB).

A company issues convertible bonds at par to the underwriter, which holds them for its own account and immediately provides the funds to the issuer.

The MSCBs are generally zero coupon, with maturities of about two years, and allow the underwriter to convert them into stock whenever it chooses during the bond's life.

Conversion is made at a fixed price, but that price is reset every few weeks after closing so that it remains at an agreed discount below the prevailing market price. That discount is usually between 7% and 10%.

If the share price falls, the investment bank will receive more shares when it converts. It will always be able to convert all its cash investment into shares, below the market price.

The only limitations are that deals are often callable or redeemable in cash at the issuer's option.

The investment bank makes money by converting the bonds into stock and then attempting to sell the stock closer to the market price. In the unlikely event that the bank does not convert all of the bond to equity, it is redeemed at par or a slight premium at maturity.

Banks select issuers with shares that are liquid enough to allow them to trade out of their positions as early as possible by selling shares without damaging the stock price.

The degree of dilution of most issues — typically 5% to 15% — is manageable for shareholders and should not necessarily be worse than an ordinary share issue.

Granted, dilution will be steeper if the share price falls and the underwriting bank converts at a lower price — but against that is the benefit of being able to sell the stock into the market more slowly, which could lessen its drag on the share price.

Issuers are turning to MSCBs as a faster and often more efficient way to raise money than many public equity or equity-linked alternatives.

Another fast-growing product is privately underwritten equity warrants. The main difference from an MSCB is that in a basic warrant structure, the investment bank only gives the issuer principal when it exercises the warrant and buys the shares. Hence the issuer might receive funding in small amounts during the life of the deal.

But there are many variants and in some of them the underwriter is obliged to supply funding at certain times.

The trade-off for getting the funds later is often that the contracts for a warrants deal give the issuer more control over the timing of the exercise of the warrants and therefore the market impact of the new stock.

Beating the alternatives

These products are flourishing because they offer advantages over other financing options.

Doug Howland, head of equity capital markets for Asia Pacific at Deutsche Securities in Tokyo, believes the market is now well established and here to stay. "MSCBs are great products for any company that wants to raise equity capital in a size that is large relative to its market valuation," he says, "and for companies looking to raise capital quickly compared to the time required for public offerings of equity or conventional convertible bonds."

For small to mid-cap companies, public equity issues are expensive, time-consuming and uncertain.

The well-established alternative for small and mid-cap firms of issuing a public convertible bond has offered largely unappealing terms for most of the last two years.

The domestic convertible market is thin and largely retail oriented. Deals usually have low conversion premiums, and while these might be more attractive than issuing a private MSCB at a discount to market price, the advantage is diminished by the fact that public CBs offer no certainty that the bond will ever convert to equity.

"A major advantage of MSCBs for companies with less robust balance sheets is the speed at which they convert to equity and the very high probability that conversion will take place," says Alex Large, managing director of equity capital markets at JP Morgan in Tokyo.

Takashi Shirata, managing director, investment banking at Nikko Citigroup in Tokyo, draws an even sharper distinction: "If an issuer wanted debt rather than equity it would perhaps choose the public convertible bond route, whereas this private funding structure is considered equity from the outset by both issuers and investors, as it offers certainty of conversion, whether from bonds, preference stock or warrants."

The long period between launch and completion of a public deal also exposes the issuer to price risk.

Japanese companies can also sell CBs internationally. Larger Japanese companies used to issue in dollars or yen in the global or Euromarkets.

But that market has been lacklustre for the last year as global equity volatility has sagged and there is little or no activity for medium sized Japanese issuers. Many CB issuers have also got caught in the past by hedge fund investors shorting their stock as a hedge.

Smaller Japanese companies have tended rather to issue deals aimed at Swiss investors. The Alpine yen convertible bond market — yen bonds sold in Switzerland — remains open to this kind of issuer, as does the Swiss franc convertible market. But the MSCB has drawn many potential issuers back home.

Rapid growth

It all adds up to the private structured equity market enjoying very rapid growth since 2004.

"This is a form of funding that is growing in popularity amongst companies in Japan," says Shirata. "The typical issuers have thus far been high growth companies that need large funding relative to their balance sheets. Or the issuers might be companies undergoing restructuring that want to refinance more dilutive and costly convertible preference stock owned by the banks following earlier debt-for-equity swaps when the companies were under rehabilitation."

These convertible preference issues, which were made when banks were bailing out struggling companies, are sometimes more dilutive than a new MSCB issue because they were issued when the companies' share prices were depressed. They can be worth calling if they have not yet been converted into stock.

Banks are making big efforts to coordinate the various arms of their investment banks to compete vigorously in this market.

In October 2004 UBS recruited Michio Yasuda from Nomura. While he was at Nomura, Yasuda's team developed the first multiple private offering (MPO — Nomura's in-house term) for Isuzu Motors in late 2003.

"In his role as managing director and head of equity solutions at UBS, Yasuda brings 20 years of experience in the exchange traded fund and portfolio trading business, and more recently in private convertible origination," says Michel Lee at UBS, who heads the firm's overall initiative in this market. "The three other bankers Yasuda brought with him have all added substantial weight to UBS's effort."

Public versus private

These are tailormade, privately negotiated products. David Hancock, general manager of equity capital markets at Shinsei Bank, observes: "This privately underwritten market 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."

And despite the bespoke structuring, there is no upfront 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.

Bankers argue that the one-to-one nature of the agreement and the simple documentation help to minimise the risk that news of the trade leaks out before it is executed, and therefore any effect on the share price.

The simple process reduces overheads and lowers the administrative burden for the issuer, something that is particularly important for smaller, high growth companies that have fewer resources than a large blue chip.

"The speed and efficiency of the execution and documentation process are key factors appreciated by the management teams of smaller to mid-market companies," observes Alex Large at JP Morgan.

Nevertheless, the instruments face challenges from the public market that are becoming stronger as the Japanese economy and stock markets improve.

Already this year there have been many public issues of new shares, indicating that the market is becoming more receptive to dilutive issues.

Megabank Sumitomo Mitsui Financial Group, trading company Mitsui & Co, All Nippon Airways and Rakuten, Japan's biggest online retailer, have all launched share issues of more than ¥100bn this year and there are plenty more deals on the way, according to investment bankers in Tokyo.

"Rising stock indices and liquidity are combining to make plain vanilla equity and equity-linked issues easier to consider and execute in the public markets," says Large. "Moreover, the banks are, for the first time in years, starting to expand loans again to the middle tier companies."

Large observes that the drivers for some of the larger deals are also changing. "The economic momentum and health of the financial markets mean that there are fewer distressed company situations," he says. "We nevertheless think this will be offset by the role these products play in the growing world of M&A in Japan."

The evidence from the equity new issues market in the past six months or so is certainly that Japan's biggest and most familiar companies are tending to use the public route.

Bigger firms stay away

As the economy and domestic demand improve and Japanese companies become more expansionary overseas, issuers seeking fresh capital want to issue publicly to spread their story far and wide.

However, they are also willing to consider private alternatives. "We have noticed that more such companies want to know more about these funding alternatives," says Takeshi Hasebe, director of equity capital markets at Merrill Lynch in Tokyo. "However, there is as yet no indication that they will employ such structures as mainstream funding tools."

Hasebe explains that the larger the company, the more funding alternatives it usually has, and that there is a certain kudos about a big public issue of equity or convertible bonds. Bigger firms are also usually more sensitive to the price at which they sell stock, as they have more leverage over the market.

"The reset of conversion prices both upwards and downwards would therefore be a challenge," Hasebe concludes, "and the discount level would also likely be squeezed, should these instruments migrate up the corporate food chain [and be used by bigger firms]."

One technical problem that might prevent Japan's larger companies from adopting this technique is accounting issues. "Most of the major Japanese corporations report in US GAAP, in which the discount structured into these deals is considered a cost," says Nobuo Nakasone, executive director in the capital solution department at Nomura Securities in Tokyo. "In standard Japanese accounting, the discount would have no impact on the P&L [profit and loss] statement. Similarly, issuing a warrants structure with a predetermined discount would also have a P&L impact under US GAAP."

The early years

The market originated in 2003. Nakasone dates its origins to January 2004, when Nomura raised ¥30bn for truck and bus maker Isuzu Motors and ¥3bn for Tokyo Tomin Bank.

"At that time," he recalls, "the stock market was beginning to recover from the lows plumbed in 2003 but it was still both illiquid and uncertain of Japan's future. Isuzu needed the money immediately and could not wait until its stock price or the market was higher. The solution we provided was fast and efficient and set Nomura on track to become not only the market founder but also the dominant force in this space."

Isuzu returned to the structure for a similar deal in August 2004 to raise ¥100bn, although it soon called ¥40bn of that transaction.

Nakasone emphasises that traditional public convertibles are intended either to raise cheap debt or to replace more expensive funding. "In these [private] issues," he says, "the objective is to raise fresh equity."

Some of the early deals after Isuzu's involved companies that wanted to dispose of treasury stock they had bought during the difficult years of the financial crisis. Banks were trying to pare down their cross-shareholdings and companies that could afford to often bought their shares back from the banks.

A representative transaction, Nakasone says, was the ¥10bn funding Nomura put in place for fast food chain Yoshinoya D&C Co to conduct just such an exercise in October 2004. "The objective was simple," he explains, "as the companies would issue convertible bonds backed by treasury stock."

Several regional banks have also issued convertible preference shares, seeking to achieve tier one capital treatment from the outset.

Negative spin

Despite these arguments that the product is a benign, market-friendly instrument, it has attracted adverse comment from time to time,  arising from a few high profile deals after which the issuers' share prices tumbled. The deals, notably a ¥126bn issue by Mitsubishi Motors in 2004 (see profile in Chapter 5) and a transaction for internet portal Livedoor, caused widespread concern, especially among those who knew little or nothing about the true nature of the market.

Specialists argue that it is vital to dissociate the market from deals like the Mitsubishi Motors transaction, which was more of a club deal arranged by JP Morgan to help rescue the issuer. Proponents of the technique claim that the Mitsubishi Motors and Livedoor transactions are the exceptions that prove the rule that these transactions are not like the so-called 'death spiral' CBs issued for troubled companies in the late 1990s in the US and sold mainly to hedge funds.

Nevertheless, there are a number of instances when issues have not had the results the issuer or arranger had planned. For example, deals have been redeemed far earlier than expected due to falling share prices after their announcement, leading to potentially far greater dilution than the issuer had wanted.

Where next?

The future is an exciting one, especially with the equity markets getting stronger. There are likely to be more product innovations and most arrangers expect a strong flow of deals.

Above all, arrangers believe that this is not just a bull market product. In a more bearish environment, companies might have diminished access to the public markets and this product might assume more importance, provided there is enough liquidity in the shares to justify the underwriters' commitments.

"This is a market destined to play a major role in Japan's capital markets," concludes Woodthorpe. "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. There are even some who argue that the entire equity new issues market in Japan might in the future go private, but that seems somewhat far-fetched. Nevertheless, assuming the arrangers continue to accurately assess the relationship between credit and liquidity risk and there are no major disasters, the outlook is very rosy." 

The top sectors in Japan's privately underwritten equity market, 2003-2005
Industry groupAmount (¥bn)No of deals
Real estate15621
Auto manufacturers1302
Electrical components & equip1236
Home builders1086
Distribution / wholesale10111
Engineering & construction9917
Machinery - diversified698
Diversified financial serv.625
Commercial services457
Investment companies301
Home furnishings195
Total of whole market1.68tr201
Source: Merrill Lynch (includes CBs, warrants and other deal types)
27 Mar 2006