Corporates face tough decisions

  • 01 Jun 2002
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Many corporates are today having to rethink their approach to rethinking their balance sheets - some of them, at least, the victims of exuberance while capital was cheap and the stockmarkets were booming. Yet corporate treasurers are having to rely on advice from many of the same bankers that will have helped them get their companies into difficulties.

Although banks look better placed to provide more objective advice than they used to, scepticism remains that they have changed their tendency to promote products irrespective of their suitability for the borrower concerned.

After all, banks still have league tables to worry about, and bankers themselves have hefty mortgages to service, school fees to pay and holidays at Sandy Lane to subsidise. Those demands, say some, have led to an inexorable decline in the integrity of the industry.

"I am seeing some of my competitors quite deliberately making commitments to companies which they know full well they cannot deliver on," says one banker. "They do so because they know that several weeks will elapse between the time they are asked to make the commitment and the date on which they have to execute."

It is also unsurprising to find an external consultant such as Martin Ellis at Stern Stewart in New York insistent that banks are all too often prepared to push products that are entirely inappropriate. Ellis points to the example in the US market of convertibles that are in vogue today. "The funniest thing you hear the investment banks saying to companies is 'look what a great issue your convertible was, it was two times oversubscribed'," he says. "That is generally because the economics are so compelling for the investors, not because the company that's selling the convertible is creating value for its shareholders."

Even if this sort of approach is the exception rather than the rule, it is clear that large cross-sections of the corporate sector still have much to do if they are to address the shortcomings in their balance sheets that have been aggravated by the mistakes of recent years.

And while the banks can provide advice and encouragement, the buck stops with senior financial management. "I think a more conservative and more intelligent approach to managing the balance sheet and corporate liquidity is a very popular theme in executive suites and boardrooms these days," says Steve Bowman, head of European fixed income at Citigroup/SSMB.

As a pivotal part of that management, the first thing that many corporate borrowers could and should do, say some, is to reduce a reliance on short term funding that has left many of them staring over what Standard & Poor's (S&P) has recently identified as a "credit cliff" - a cliff that they can drop off in the event of short term facilities drying up.

At Moody's in London, senior managing director for Europe Mike Foley says that the issue of companies' liquidity was something that his agency started addressing in depth more than two years ago. "We began talking to the market about liquidity risk early in 2000, and at that point it was not on most people's radar screens," he says.

"But we suggested then that the pressure on organisations to increase their short term funding - and on the banks to provide the liquidity to support those short term obligations - was becoming more of a systemic risk."

Foley says that the analytical approach Moody's initiated at the start of 2000 was a protracted one. "We looked at each issuer's potential cash obligations and at their sources of internal cash on a week by week and month by month basis over the course of a year," he explains. "And we looked not just at CP maturing, but also at any MTNs that might be maturing, contingent claims on cash, rating triggers and at what would happen to any company if it was not able to access the capital market."

The findings of the Moody's analysis were more or less in line with the agency's expectations.

"We found that there is a very wide range of practice," says Foley. "Some companies have a substantial amount of cash and other assets on hand to cover themselves in a stress scenario for up to a year without having to rely on any external sources of funding. Others, which for the most part are Prime 1 (P1) issuers at the lower end of the ratings spectrum, are likely to exhaust their internal sources of funding very quickly and would then have to rely primarily on their bank standby agreements. A number of those come with some form of conditionality in the form of material adverse change clauses or other covenants, and some have terms that would require renegotiation over the course of a year."

Enlightenment

Foley says that he would describe the findings of the Moody's analysis as enlightening rather than disturbing. He also says that while it is not within the remit of Moody's to advise companies on how to address the issue of pressures exerted on short term liquidity sources, there are plenty of options that borrowers can (and should) explore.

"Many of the issues are within the control of the companies themselves," he says, "especially with regard to their willingness to absorb the cost of holding a larger amount of liquid assets on their balance sheets. They could also look at terming out short term funding and at renegotiating their bank back-up agreements to eliminate material adverse change clauses.

"All this might cost some money to achieve, but I do believe that as a result of our analysis a number of companies have taken a very close look at their short term funding strategy and several have taken positive and proactive steps to enhance their liquidity sources."

S&P's experience with its so-called "credit cliff" analysis was similar to the Moody's findings, with 23 out of 900 companies surveyed apparently seriously vulnerable to a liquidity crisis if their credit ratings are cut.

"We were actually quite surprised that so few companies were in dangerous situations," says Chris Legge, managing director and head of corporate ratings at S&P's London office. "A number of them clearly worked pretty hard behind the scenes to avoid inclusion in the credit cliff list. They recognised that they were exposed to some of the dangers we had highlighted and they worked on rectifying the situation before we published the report."

What of the broader lessons learned as a result of the S&P study? Patricia Ridpath, chief ratings criteria officer at S&P, says the agency is not telling borrowers to avoid covenants nor dictating to the market how it should lend money.

"What we are saying is, please look very carefully at your financing policy and at what you have agreed to give away to whom and at what repercussions that might have for you in the future."

Cutting free from CP

So-called Enronitis has done nothing to remove the perception that there are hazards associated with what might be interpreted as corporates' over-reliance on short term funding.

In fact, much of that perceived over-dependence has been reduced, partly because of macro-economic influences, and partly as a reflection of ratings downgrades and resulting changes in corporate strategy towards the CP market.

At Goldman Sachs in London, head of money market origination John Delaney says he attributes the decline in outstandings of US CP of some 50% to four factors: reduced demand for working capital owing to the economic slowdown; a reduction in M&A volumes for much the same reason; highly attractive longer term rates encouraging borrowers to term out their funding; and finally, the exogenous force of warnings from the rating agencies of borrowers' over-reliance on the CP market.

Those influences will have reduced concerns over the volumes of short term funding raised by borrowers. But Delaney believes that these worries were probably overstated in the first place. He explains that in spite of heightened volatility, in practice the CP market does not behave like a tap that can be turned on and off instantly, providing or withdrawing liquidity at the drop of a hat.

In the case of a borrower like ABB, he says, negative news was drip-fed to the market over several months, during which the company was continuously able to sell CP, albeit in steadily reducing volumes. "The normal procedure is that as a credit deteriorates the issuer's volume of outstanding CP gradually falls as notes mature and the borrower finds it harder to roll them over and as investors take the company off their lists," says Delaney. "At the same time, the use of the company's bank facility will gradually rise at more or less the same speed."

The rating agencies, perhaps predictably, are more cautious about the speed with which issuers in the CP market can fall out of favour. The problem, suggests Ridpath at S&P, arises from a situation where nobody wants to be left holding the proverbial baby. "I think disintermediation in the CP market has left it much more vulnerable than it may have been in the past," she says. "None of the investors that are holding short term debt have the same characteristics as the banks that used to lend to these companies. They are not willing to stand by credits that get into trouble. Their desire to get rid of paper before it loses too much of its value or ceases to meet their investment criteria means that prices are dropping much faster than they used to."

The result? Price decline and liquidity shortfalls "unlike everything we have seen before", according to Ridpath.

"And unfortunately when you start factoring in credit triggers you very quickly arrive at a point where if a company hasn't managed its short term liquidity very carefully, and diversified its sources of short term capital, it can encounter a serious credit crunch even if on a business and operating risk level it is every bit the same company as it was the week before. We don't believe that is exclusively or even mostly Enron-related, but it is certainly a factor we have to look at much more closely than we did a year ago because the fundamentals of the market have changed."

Common sense or folly?

It is probably for those reasons that S&P has publicly announced, to the surprise of some bankers, that it views the short term market as fundamentally unsuited to acquisition finance. The assertion is one that some bankers dispute, with Delaney pointing to the example of companies such as Unilever and Nestlé, both of which have used CP as highly effective bridge financing for acquisitions.

And while Unilever has seen its credit quality decline as a consequence of its recent acquisitiveness, Nestlé is a rock solid triple-A borrower that has maintained its optimal rating in spite of its $11.7bn purchase of Ralston-Purina, which some analysts believed would leave its rating vulnerable. "Nestlé is an absolute cash machine," says Delaney. "It makes no sense for Nestlé to issue 30 year bonds because its cashflow is so strong and stable as to allow it to repay any borrowings quickly."

Against that background, Delaney suggests, it is neither surprising nor alarming that a company like Nestlé should make more use of short term funding for acquisitions than a company with a more modest rating or less predictable cashflow.

Nestlé, of course, hardly provides a representative or reliable barometer of how much CP is sustainable, even for a triple-A borrower. General Electric Capital Corp (GECC), after all, has been the subject of public misgivings from investors including the influential Pimco over the size of its short term borrowings.

But it is not just rating agencies and fixed income investors that are applying pressure on the corporate sector to reduce its use of CP. "Liquidity has become such a hot topic that we have seen some issuers believing that they will be rewarded by the equity market if they slim down their CP borrowing," says one observer. "To me, one of the most extreme examples of that came when Citibank announced its first quarter results and at the same time said that it had reduced its use of CP by about 30%. To my mind, that was completely ludicrous. This is a double-A rated bank that is supposed to borrow short and lend long. That's its business. So why did it feel the need to reduce its CP borrowing in order to play to the gallery of the equity market?"

Under the microscope

Much of the debate over short term funding strategies revolves around the broader relationship between borrowers, agencies and investors, which again will have been put under the microscope as a result of the Enron fiasco, much of which arose from the consistent supply by the company of disinformation to the market.

The rating agencies insist that they have played their part responsibly by continuing to rate through the cycle rather than being distracted by short term economic volatility, and by devoting huge resources in terms of time, manpower and paperwork to clarifying the rating process.

To the suggestion that the agencies were made excessively twitchy about short term debt in the aftermath of Enron, S&P's Ridpath has an emphatic response. "I would contend that point vociferously," she says. "We were very careful to say we would look at the lessons learned from Enron without acting precipitously. And we have been given very clear messages from investors that they don't want more volatility in the ratings.

"We have been very explicit in saying that it would be all too easy for us to become very conservative and reduce ratings across the board, but that is not what the market needs from us. If anything, going forward if we genuinely think that companies are being impacted by short term trading or liquidity blips, and that if because of a lack of capacity in the market prices are dropping more than the credit warrants, you may well see us coming out with more ratings affirmations in spite of the market noise."

In return, say the agencies, companies could help themselves and the broader financial community by being more open and transparent. At Moody's, Foley believes that in the case of many borrowers there is still what he describes as a "market penalty" to be paid for inadequate disclosure, which will be reflected in a company's cost of borrowing, but which in many cases is avoidable.

"Investors are looking for improved disclosure from the companies themselves and that relates to off-balance sheet obligations, derivatives exposure and transactions, SPVs and rating triggers," Foley argues.

"It is always extremely helpful from the standpoint of efficient capital markets if companies made sure that we have access to complete and timely information when we are making our ratings judgements, and the market would be best served if companies made these disclosures public."

Others agree that the credibility of management has an enormously important - but possibly underestimated - influence on investors' perception of credit and, in turn, on the pricing terms borrowers can command both in the primary and secondary market. "Look at the example of Vodafone," says one banker. "It announces the biggest loss in UK corporate history, of £13bn, and what happens? The share price actually goes up. Granted, the share price has been hammered pretty horribly over the last two years, but there does seem to be more belief in the Vodafone story than you might think."

The securitisation option

Aside from terming out short term debt, another option that has been increasingly appealing to the corporate sector is fundraising via the asset backed market. This was a favoured route for Telecom Italia last year, when it raised Eu700m in a transaction backed by telephone bills that was the first of its kind and - at the time - was heralded as a deal that could open the floodgates for other issuers in the sector such as France Télécom and Deutsche Telekom.

Another industry that has used the asset backed market to good effect has been the retail sector. Last December, Marks & Spencer securitised the rental income from 45 of its UK retail outlets in a £331m transaction led by Morgan Stanley. "It was our first securitisation," says Jeff Denton, head of corporate finance at Marks & Spencer's in London, "and the principal benefit from a corporate's point of view is that it allows you to monetise some of your assets on the one hand and to access a different investor base on the other.

"We always indicated that we saw securitisation principally as a means of raising funding rather than removing debt from the balance sheet or influencing our rating, and the securitisation we arranged allowed us to keep the equity upside and secure a good loan to value ratio."

Not that securitisation is universally viewed by the corporate world as an efficient or even investor-friendly way of generating funding. "We don't really believe that securitisation on its own expands debt capacity, which is often cited as a benefit," says Andy Longden, group treasurer at BT. "In fact I have often argued that it shrinks debt capacity. Because it takes out the most valuable and liquid double-A or triple-A assets proportionally it leverages up the rest of the group and therefore weakens overall credit quality."

Although BT has securitised much of its property portfolio, most notably through last year's £1.8bn Telereal sale and leaseback transaction, Longden says that he does not see securitisation of receivables as being a major source of funding going forward. "Having said that, for very large groups that find themselves in the low triple-B area, it might be one of the only ways of sourcing the liquidity they need."

The convertibles option

For companies needing to access as broad an investor base as possible, another route that has been especially favoured over the last two years has been the equity-linked market. It is not difficult to grasp why the convertibles market should have presented itself as such an attractive option for companies with stretched balance sheets (as well as for those without) in recent times.

First, for those companies that have knocked repeatedly on the door of fixed income investors, the equity-linked route goes a long way towards opening up an entirely new investor base, populated not just by bond investors but, more importantly, by hedge funds and the growing band of dedicated convertible investors.

Second, the economics of financing via the convertibles market are compelling. "Issuers in the convertible market are paid a premium for their shares, typically of about 30%," says Simon McGuire, managing director and head of global equity-linked at UBS Warburg in London. "Granted, they have to pay bondholders a coupon, but that is lower than in the straight fixed income market, and the costs of servicing the coupon are usually much lower than the costs of paying dividends on newly issued equity."

Third, McGuire points out that the equity-linked market offers borrowers the opportunity of raising considerable sums in a very short time. A clear example of this phenomenon was the Eu3.5bn equity-linked deal launched last November by France Télécom via BNP Paribas and Morgan Stanley, which was the largest European convertible bond ever. The transaction was launched after the close of the Paris market and by the following morning the book was four times covered.

So much for the clear benefits associated with issuing through the booming equity linked market. Bankers say that the France Télécom transaction, however, is also likely to provide an example of one of the main drawbacks of the market for companies using convertibles as a means of deleveraging their balance sheets.

An important feature of the France Télécom deal was that the conversion premium was set at a level that makes the likelihood of conversion - an important objective as far as the borrower is concerned - remote in the extreme. A conversion price of Eu72, versus a reference price for the issue of Eu49, translated into a conversion premium of close to 47%, or the third highest ever in a European convertible bond. Even under the assumption that equity markets have been oversold, that is asking for a very dramatic rebound in European TMT shares.

Conversion is especially important - and indeed a prerequisite - for those borrowers that view the equity-linked market as a constructive means of reducing their overall gearing.

That is because for the most part the ratings agencies treat convertibles as debt rather than equity as has the accounting profession, although, as McGuire says, this is changing. "The treatment of convertibles by accountants is something of a moving feast," he says. "In the old days when life was simple both accountants and ratings agencies treated them as debt, but as we move towards IAS, which everybody is supposed to adopt in Europe, convertibles will have to be split - or bifurcated, to use the official term - into their component debt and equity parts."

Stamping the rare equity brand

As for the rating agencies, although they continue to treat traditional convertibles as debt for the purposes of assessing overall gearing levels, there are any number of circumstances in which a so-called "equity credit" will be given to convertible issues.

The most extreme example is in the market for mandatory convertibles, in which issues can qualify for equity credits of up to 80% or 90%.

Although the mandatory market is beginning to gather momentum in Europe, chiefly in the form of reverse convertibles issued by financial institutions, they have yet to become a feature of corporate financial strategy as they are in the US.

As a result, most equity-linked issues still need to be viewed in the pre-conversion stage as debt, and while in the 1980s and 1990s most borrowers in the convertible market could count with some reliability on their bonds converting on schedule, today they can do anything but - for two related reasons.

The first of these is that with equity markets no longer motoring ahead with the power that they did before March 2000, even relatively modest premiums are becoming more challenging in terms of achieving their conversion objective.

That challenge, says McGuire, is being compounded by the second reason explaining the reduction in the number of bonds that convert, which is the shortening of effective maturities in the equity-linked market. "A decade or so ago the average convertible had an effective maturity of 15 years, which meant that issuers could ride out cycles of weakness in the stockmarket," says McGuire. "Downturns lasting three or four years weren't a problem because as long as your share price had risen to the conversion premium within 15 years you would be fine. Today, many of these bonds have maturities of three years or, if they have put clauses in them, even shorter, and at the same time they are being sold at higher premiums.

"Fifteen years ago the typical convertible issue called for a compound growth rate in the share price of about 1% in order to guarantee conversion. Today in some cases that compound growth rate has risen to more than 20%."

Against that background, it is not surprising that according to McGuire, more convertible bonds are being redeemed (rather than converted into shares) than at any time in living memory, and the consequences for those companies looking to use the equity-linked market as a means of reducing their total indebtedness are stark. On maturity, the likelihood is that busted convertibles will need to be refinanced, possibly with debt-like instruments, so the idea that the market provides some form of deus ex machina for troubled balance sheets is illusory.

Sceptics would call it the Mr Micawber approach to corporate finance - the Charles Dickens character believed that "something will turn up", with the "something" in this case being the issuer's share price.

The rights issue option

For those in the unfortunate position of finding that the securitisation and convertibles market are able to provide few if any of the answers, the painful alternative is the dreaded rights issue. The option is a dreaded one because it inevitably involves irritating the most important constituent of any company's stakeholder base, namely the equity holders - its owners.

Small wonder that Tim Scott was reportedly looking forward to this month's Jubilee bank holiday in the UK in a considerably happier mood than he had looked forward to last Christmas. Scott is chief financial officer at ICI, and while most people would have spent last Christmas Eve working out how to make others happy over the festive period, he spent the day with his bankers, locked in discussions aimed at determining which people he could make the least unhappy - bond or equity holders.

ICI traces its problems back to 1997 when, with its share price at a little over £7.50, it made the strategic decision to acquire Unilever's specialty chemicals operations for £4.9bn. That in turn committed the company to finding some £3bn through asset disposals over the coming three years, which some bankers - with the benefit of hindsight - say was over-ambitious in the extreme. "ICI bought some fantastic assets for which it paid a fantastic price," says one. "But the amazing thing about the deal was the financing, 100% of which was in the form of debt. Anybody who had any understanding of the company, its strategy and its future would have known at the time that the debt burden would be likely to strap itself up so much that it would severely restrict ICI's scope to expand over the coming years. And - surprise, surprise - it had real problems trying to sell off its assets and saw its share price halve over the next four years, ruining its equity base."

With its asset disposal programme not progressing as smoothly as had been hoped, its debt burden mounting, its share price collapsing and its rating slipping towards sub-investment grade, by the end of 2001 ICI had some very painful decisions to make.

Several potential solutions to the dilemma were explored - including tapping the convertibles market and casting around for more disposals that would raise some much needed funding - but ultimately it became clear that there were few feasible and sustainable options other than the launch of an £800m rights issue. "ICI wasn't frightened of gearing per se," says Jim Renwick, managing director and co-head of European equity capital markets at UBS Warburg, one of the underwriting firms.

"It had been highly geared in the past and could live with that. But what it was very nervous about was slipping into non-investment grade territory, which would have closed its access to the CP market, limited its options in the bond market and substantially increased the cost of servicing its existing debt. As such, the ICI rights issue was not a rescue transaction, but it was very much a balance sheet repair exercise."

The decision was by no means an easy one to make, even though it delighted rating agencies and bondholders alike. "ICI had set out its stall to say it could generate sufficient cash through the downturn and would not need to resort to shareholders to repair the balance sheet," says Renwick, "so given that it had been managing shareholders' expectations in that way it was quite a step to go the other way. But shareholders can also be quite forgiving, and if a rights issue is packaged properly and investors have long term confidence in the chairman and the board they will tend to back management.

"And if you look at what has happened to the adjusted ICI share price since the rights issue it has outperformed significantly. The company has been re-rated because a lot of the balance sheet risk has been stripped out."

More to come?

In terms of its size, the ICI rights issue was eclipsed several times over by the £5.2bn raised last year by BT. And given the amount of debt that has been taken on by the telecoms sector in particular, don't bet on that transaction remaining the largest ever rights issue in Europe for long.

"The whole premise of our rights issue was that BT had effectively exhausted its debt capacity," says BT's Longden, "and our view is that the same point will eventually be reached by France Télécom and Deutsche Telekom. I believe they will have to raise equity in one guise or another because they will need to reduce their debt burden and restore the balance between debt and equity financing."

UBS Warburg's Renwick, who is now working on a rights issue that is being launched by Kingfisher as part of the finance backing its planned acquisition of Castorama, agrees that there are plenty more rights issues in the pipeline.

"We are in a period when companies need to regroup and take their medicine," he says. "The debt providers are going to be less prepared to support companies in difficult market conditions where spreads are widening and cashflows are under pressure, and I am talking to a lot of highly geared companies out there that are now going through the same decision-making process as ICI and BT did."

That might mean that companies will look forward to a visit from Renwick with all the relish of a trip to the dentist, but the challenge of working on rights issues is one that he clearly enjoys. "Rights issues tend to be more fulfilling than IPOs," he says, "because it's not a question of pitching up and telling a company we can sell it for 20 times earnings. Much more thought and engineering goes into a rights issue, and with markets the way they are at the moment, it is a very active market for us." *

  • 01 Jun 2002

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