Lecture 9 – DCM - ECM and Rights Issues

1 Potential Financing Alternatives for Corporate

Debt Equity Credit Spectrum Equity

Straight Debt: Bonds and Loans Convert w/call spread overlay Convertible Bond Equity Capital Increase

Structure Bonds  Five year convertible bond  Five year convertible bond  Capital increase with or without  All major markets open in size – US$,  Longer maturities possible  Longer maturities possible pre-emptive right Euro and £  Conversion premium of 32–37%  Conversion premium of 32–37%  Could include a roadshow  Public transaction  Sale and purchase of call options  Cash coupon: 2.375–2.875%  Typically priced at a discount to the  Benchmark maturities of 3–12 years in structure to achieve 60%+ premium (assuming current dividends) market price Euro, out to 30-years+ in US$ and £  Annual cost saving relative to straight  Full amount would be treated as debt Loans debt rate by rating agencies  Private transactions  Option premium on upper strike  Option component would be treated treated as equity for accounting and as equity for accounting purposes rating agencies Advantages and  Non-dilutive  Low cash coupon vs. straight debt  Low cash coupon vs. straight debt  Full equity credit potential issues  Tax deductible  Lower EPS dilution than a traditional  Can be structured to minimise With pre-emptive rights  No equity credit given by convertible bond EPS impact  Not dilutive for existing shareholders rating agencies  Potential sale of shares at premium to  No equity credit given by if they exercise their rights  Good demand across markets the current share price rating agencies  Allow existing shareholders to benefit  Issuance windows will continue to be  Option premium on upper strike  Potential temporary negative share from potential upside following M&A somewhat volatile treated as equity by rating agencies price impact, but less than with equity  Possibly large discount or mandatory convertible issues  Issuance dependant on market  The IB will be a buyer of the issuers  Longer process and execution sentiment at the time of issuance shares on the day of the convertible offering, minimising potential share Excluding pre-emptive rights price impact  Leaner and shorter process  Lower proceeds raised vs. a traditional  Some execution risk convertible bond, hence higher all-in- cost

Market  Market is open for issuance  Market is open for issuance  Market is open for issuance receptivity

Structuring Investment Strategies Hedging Strategies Capital Management Special Situations solutions to  Yield enhancement  Financing and volatility  Return of capital  Income repatriation enhance yield  Hedged investments  Complex assets  ESOP  Income management and manage  Illiquid assets  Liability management  Tax risks / claims risk (e.g. convertible restructuring)  Monetisation 2 ECM and DCM

Debt Capital Markets

3 Debt Capital Markets

 Debt Financing for Corporations

 DCM Deal Structure and Types of Transaction

 Credit Rating

4 Debt Capital Markets role with Corporate

Debt Capital Markets Loan/Bond Financing

Capital Structure – Hybrids/Convertibles/ M&A Ratings Advisory Private Placements

Risk Management - Finance Department FX/Interest Rate Contingent Hedging Daily Decisions Management

Tax Pensions

Cash Management

5 Credit Ratings Categories

 Rating is a “risk category” assigned by objective ratings agencies to corporate, sovereigns and specific issuances  They represent the relative degree of credit risk  Leverage (i.e. debt) is a key factor in determining the credit risk

Long-term Rating Symbols

Moody’s S&P / Fitch Risk of P&I Not Being Paid When Due Aaa AAA Extremely low risk of default Investment Lowest Aa AA Very low risk Grade A A Low risk (high grade) Default Baa BBB Moderate risk Rates Ba BB Moderately speculative

B B Highly speculative Non- Investment Caa CCC Very high risk Highest Grade Ca, C CC, C Highest risk (high yield; “junk”) - D Default (agency definition)

6 Straight Debt - Deal Structure

Currency  Major funding currencies – USD, EUR, STG, CHF  Arbitrage funding – AUD, NOK, CAD, NZD  Considerations:  All-in cost of funding – comparison of levels swapped back into funding currency  Investor diversification vs. absolute funding costs

Maturity  Currency  STG/USD – strong investor appetite for long-dated securities  EUR/CHF – rarely see issuance beyond 12/15yrs  Issuer’s outstanding maturity profile  Funding needs – cash flow generative consumer company compared vs. utility with long-term assets to fund  Depth of investor demand – investors looking for longer-dated assets in the current low yield environment  Shape of the curve

Fixed vs. Floating  Fixed rate - typically offers the deepest investor base and access across the curve  Key accounts: Asset Managers, Private Banks, Insurance/Pension Funds, Hedge Funds  Floating rate investors – typically shorter-dated maturities with focus on financial issuers given buyer base  Key accounts: Bank Treasuries, Money market funds  Interest Rate Expectations

7 An Example - Telecom Italia Group Euro Medium Term Note Programme by €20bn for issuances on the Euromarket

8 Telecom Italia Rating Profile

Source: Bloomberg as of 14 August 2015 9 An Example - Telecom Italia Group Notes issued by Telecom Italia SpA

Source: Bloomberg as of 14 August 2015 10 Straight Debt - Main Types of Transaction

Best Efforts Basis The issuer is taking the risk of execution of final terms Lead managers receive a flat fee – may be some additional incentive fee based on meeting specific goals Issuer considerations: Execution capabilities and distribution Lending and client relationship

Underwritten Bond / Backstop Underwrite/”Bought Deal” – typically the Investment Bank buys the bond at a pre agreed level and the bank’s profit is based on its ability to distribute the bond through the underwrite level Backstop – The Investment Bank provides issuers with a backstop level at which they have certainty on price. Typically the Investment Bank is paid a pre-agreed fee retaining the upside potential Issuer considerations: Ultimate pricing terms available Execution capabilities and distribution – a badly placed bond can have long-term implications on issuer’s access to the market

11 ECM and DCM

Equity Capital Markets

12 Equity Capital Markets

 ECM Role in an Investment Bank

 Product Range

 Execution Strategies

13 ECM Role in an Investment Bank  Equity Capital Markets sits between issuers and investors and as such, is the conduit that facilitates dialogue and activity between our corporate and institutional clients  ECM sits on top of the Chinese wall - receiving information from both sides of the wall  Extensive information on investor behavior and preferences and interest from sales and research with flow of capital information coming from the trading side

Chinese Wall

Research Corporate Clients

Equity Capital Sales Investors Markets Investment Banking

Trading

14 ECM Product Range

Equity-linked Derivative IPO Follow-on Offerings Securities Transactions

 Sale of private company to  Sale of shares to investors  Sale of securities is  Structured products used to institutional investors (including capital increases) contingent and linked to a hedge or dispose of stakes

 No existing reference price  Stock already listed and fixed income or preferred discreetly

 Valuation methodology and traded on a recognised security  Tailor-made solutions with research credibility are key stock exchange  Highly tailored and material tax advantages in the preparation process  Simpler pricing decision due structured solutions possible  Marketing strategy including to existence of reference (refinancing, disposals etc.)  Only possible on listed pre-marketing and price  Marketing period between 1 stock

Description roadshow  Marketing strategies range day and 2 weeks in length  Private transactions away from salesforce briefing to from the market place complete pre-marketing and

roadshow

Examples

15 Cash Equity Financing Alternatives

Rights Issue Fully Marketed Capital Increase Accelerated Capital Increase

 Offering of Company’s shares at fixed price  Offering of Company’s shares via open  Issue of Company’s shares through an (at or at a discount to market share price) priced bookbuild (non pre-emptive) over up undocumented, rapidly bookbuilt offering Description with pre-emptive rights for existing to 2 weeks, with marketing roadshow without marketing shareholders

 Simplest and most rapid execution (up to 2  Avoids ownership dilution for existing  Platform to maximise size days but usually completed in 24 hours) shareholders, if required  Maximum demand generation / price tension  Very limited transaction documentation (no  Opportunity to convey renewed equity story offering document)  Opportunity to convey renewed equity story Advantages to new and existing investors to new and existing investors  Very limited involvement of the Company  Rights issues for acquisition financing well- management  Potential retail participation received by investors  Possibility for core shareholders to participate through order book

 Vendor carries price risk during  Vendor carries price risk during  More complicated and lengthy process bookbuilding bookbuilding  Prospectus and other transaction  Reduced investor penetration relative to  Prospectus and other transaction documentation – extended preparation Fully Marketed Offer Considerations documentation – extended preparation  Longer exposure to market  No opportunity to convey equity story and (typically less than in rights issue) acquisition rationale  Longer exposure to market  No retail participation

 Execution: approx. 3 months  Execution: approx. 2-3 months Timing /  Flexible, execution within 2 weeks Execution  Offer period: minimum 5 – 20 business days  Offer period: approx 10 business days

 Undocumented transaction based on a  Prospectus  Prospectus Documentation placement agreement

 Significant size achievable, but potentially  Significant size achievable (also as % of  Significant size achievable (also as % of lower than in rights issue / fully marketed Size existing share capital) existing share capital) placement

16 Monetization Strategies

Accelerated Bookbuilding Block Trade Fully Marketed Offer Optional Exchangeable Mandatory Exchangeable

 Open priced bookbuild over  Open-priced bookbuild   Sale at fixed net price to bank up to 2 weeks Exchangeable which mandatory  Pricing at or close to market exchanges into shares at  Discount to prevailing price  Intensive management at end of bookbuild maturity reflects transfer of risk roadshow  Debt with embedded call  Broad distribution targeted  Equates to a forward sale of  Immediate re-offer to  Pricing at or close to market options over underlying shares  Can be backstopped (or equity where the issuer

Structure investors at end of bookbuild executed through multiple benefits from some of the  Competitive auction possible  Broadest distribution targeted placings for larger size) subsequent share price upside  Potential to include retail

 Combined offering with ABB  Platform to maximise size creates price tension  Maximum demand between equity and equity-  Achieves significant size  Combined offering with ABB  Certainty of execution generation, price tension linked offering  Minimises market exposure creates price tension  Elimination of market risk  Achieves highest price in  Positive signal to the market  Good price tension and deal between equity and equity-  Reduces scope for stable or rising markets  Guaranteed disposal at a momentum linked offering institutional positioning  Vendor leverages removal of  Positive signal to the market potential premium to current  Simple documentation and  Transparent and verifiable near-term overhang share price  Potential sale of shares at a Pros quick access to market process  Broadest universe of  Eliminates downside risk on  Minimal disruption for premium to the current  Simple documentation investors share price the underlying shares while management allowing to retain partial  Minimal disruption for  Benefits from management  Low coupon  Should price at or close to management marketing upside  Market capacity up to full size market  Creates very high profile  Takes advantage of low liquidity event volatility levels  Market capacity up to full size

 Banks still charge for taking risk in stable market  Higher coupon payments (tax  No upside for vendor in  Vendor carries price risk deductible) rising market  No certainty of disposal of  Vendor carries price risk during bookbuilding  Upside participation limited  Fastest possible, narrow underlying shares during bookbuilding  Historically scope for above the upper call strike distribution can damage  Results in market to market Cons (unless backstopped) institutional position taking (market is however receptive aftermarket and perception of the short call option during execution to mandatory structures with of deal success higher call strikes)  No benefit from bookbuilding process

17 Equity-linked Products

Mergers & acquisitions- Capital management Capital raising Employee share schemes related  Stock option plans  Convertible securities  Leveraged employee share  Strategic stake-building  Convertible / exchangeable  Hybrid convertibles ownership plans (LESOP)  Contingent value rights / restructuring  Mandatory convertibles  Option plan tax optimisation certificat de valeur garantie  Equity-linked securities (CVR / CVG) liability management  Maintenance of free-float  Contingent capital

Monetisation Share financing Structuring

 Gamma / volatility trades  Gap risk trades / margin loans  Tax  Delta trades  Swaps  Accounting  Exchangeable securities  Share repurchase (repo)  Private Bank  Synthetic exchangeables  Mandatory exchangeables

18 ECM and DCM

Rights Issues

19 Rights Issues

 Definition & Terminology

 Discounts & Dilution

 Value & Trading

20 What is a Rights Issue?

 Pre-emptive offering of new shares to all existing shareholders

 Rights provide shareholders the right but not the obligation to subscribe for new shares  Cash payment for subscription

 Fixed price (issue/subscription price) and ratio (new: Existing shares)

 Rights tradable/sellable  By both existing and new investors

 Relatively practical source of funds for issuers in 2008/2009  Recent changes in rights issue timetables and guidelines to facilitate execution

 Typically underwritten

 Well understood by market

 Take-up % often binary and usually 90–95%

A rights issue is a method by which a company can execute an equity capital increase through the pre-emptive issue of rights to existing shareholders allowing them to subscribe for new shares pro rata to their existing holdings

21 Rights Issue – Terminology

Issue price  The price at which shareholders can acquire new shares in the rights issue

 The discount between the closing share price pre-announcement of the rights issue and the Gross discount

offer price

Nil Paid Rights  The rights that a shareholder is given to acquire new shares at the offer price. These are

Pricing (“NPRs”) traded on the Stock Exchange alongside the ordinary shares

Theoretical Ex-Rights  The theoretical price per share immediately following the issue of the nil paid rights Price (“TERP”)

Discount to TERP  The discount between the theoretical ex-rights price, or TERP, and the issue price

22 Rights Issue – Terminology (Cont’d)

 The day after which, the ordinary shares are declared “ex-rights” and the nil-paid rights begin Ex-rights Date

to trade on the Stock Exchange

Rights Trading Period  The period during which rights can be traded as a separate security Process Process

 The period during which right-holders can exercise their rights to subscribe for a new share Subscription Period

at the issue price Timetable / Timetable

 Sale of shares not subscribed for by shareholders. Takes place after the end of the Rump Placing subscription period. Proceeds of the rump placing are remitted to shareholders

 The process by which a shareholder sells sufficient nil-paid rights in order to subscribe to

Tail Swallowing the balance of their available rights, without investing additional funds. In the case of company directors, this sends a more positive signal to the market vs. no exercise at all

 A shareholder who does not subscribe for or sell his / her nil-paid rights during the

Behaviour Behaviour subscription period. Those rights are sold in the market in the “rump placing”, at the end of

Shareholder Shareholder “Lazy” shareholder the subscription period, with proceeds over the subscription price being passed on to those lazy shareholders

23 Rights Issue – Discount

 The gross discount represents the discount of the subscription price to the market price pre-announcement

 The discount to TERP represents the discount of the subscription price to the price at which shares should theoretically trade upon launch of the rights offering when shares are ex-rights  The theoretical ex-rights price (TERP) represents a weighted average price of the existing shares and the new shares  From an arithmetical point of view it can be expressed as follows:

Cum-rights share price X Pre-issue # of shares + Subscription price X New # of shares issued (i.e. pre-issue market cap) (i.e. rights issue proceeds)

TERP = Pre-issue # of shares + New # of shares issued (i.e. total # of shares outstanding post-issue)

24 Rights Issue – Discount (Cont’d) Example

Assumptions Pre-Rights Offering =(Subscription Price (€) / Share Price (€))-1 Shares Outstanding 100 =(6.25/10)-1

Share Price (€) 10.00

Market Cap (€) 1,000 =Rights Offering Size (€) / Subscription Price (€) =500/6.25

Rights Offering Size (€) 500

Subscription Price (€) 6.25 =New Shares Offered / Shares Outstanding =80/100 Gross Discount (37.5%)

New Shares Offered 80 =New Shares Offered + Shares Outstanding =80+100 Subscription Ratio 0.8

(New : Old) (4 : 5) =((New Shares Offered * Suscription Price) + (Shares Outstanding* Share Price))/(Pro-Forma Pro-Forma Shares 180 Shares) =(80*6.25+100*10)/(180)

TERP (€) 8.33 =(TERP (€) / Share Price (€)) -1 =8.33/10-1 TERP Discount (16.7%)

25 Rights Issue – EPS Impact

 On a EPS basis, rights issue are usually dilutive  Dilution will depend upon: 1) the return expected on the capital raised and 2) the number of new shares to be issued, mainly affected by:  Rights issue size  Gross discount to share price

 Illustrative example:

Status quo Rights Issue Impact

Market Cap. pre R.I. € 10,000,000 Net profit for the year € 1,200,000 R.I. size (10% of mkt cap) € 1,000,000

Share price pre R.I. € 20

Gross % discount to Share Price (25.0%) Weighted average number of equity shares outstanding during the year 500,000 Price per issued share € 15.00

Number of newly issued shares 66,667 Average fair value of one equity share during the year € 20.00 Additional Earnings1 € 20,000

Pro forma Earnings € 1,220,000

EPS pro forma € 2.15 Basic earning per share € 2.40 % dilution (10.3%)

26 Note: (1) Assumes capital employed at 2% after-tax return. Rights Issue – Value and Trading

Rights trading – worked examples  Rights received to subscribe for new shares at a discount TERP Discount 25.00% have an intrinsic value, calculated as: = (Ex-rights price – Sub  Difference between the ex-rights price and the Share Price Pre-offering (€) 10.00 price)* Subscription Ratio Subscription Price (€) 6.25 =(8.33-6.25)*(0.8) subscription price times subscription (i.e. rights) ratio TERP (€) 8.33 Subscription Ratio 0.8  The investment required by a non-shareholder for a given (New : Old) (4 : 5) percentage holding is fixed and does not depend on the Theoretical Rights Value (€) 1.67 discount to TERP = (Share Price – Sub Price) *  Buy new shares at the ex-rights price Subscription Ratio =(7.5-  Buy rights in market and subscribe for new shares at 6.25)*(0.8) subscription price Assumed Share Price (€) 7.5 Implied Rights Price (€) 1.00  Rights trade like shares on exchange throughout the rights trading period = Sub Price + Rights Price / Subscription Ratio =6.25+(0.9/0.8)  Rights trading is inherently more volatile than share trading due to the multiplier impact and sensitivity to share price Assumed Rights Price (€) 0.9 changes Implied Share Price (€) 7.38 =(Current Share Price / Share Price Implied by  Investors can arbitrage between the right and the share Current Rights Price) – 1 =7.5/7.375 – 1 Share vs. Rights Spread 1.69%

27 Issues Driving Rights Issue Pricing What Drives the Rights Issue Discount?

High Higher Larger High Long Issues Weak Lower discount

Incentive to Issue Equity Market Expected Volatility Risk Period Subscribe Size(1) Story Conditions take-up

Clean Low Lower Smaller Low Short Strong Higher discount slate

Does the discount matter?  A rights issue at a discount is equivalent to an issue at at-market price plus a ‘bonus’ issue (for zero consideration) of new shares  Reflected in accounting conventions – historic price, EPS and DPS adjusted to reflect the ‘bonus factor’ (i.e. # of new shares issued as a bonus to existing shareholders = TERP/share price)  Adjustments made mechanically by analysts, data providers (Bloomberg, Reuters), etc  The rights offering discount does not, by itself, cause:  Loss of value for issuer  Higher dilution for company shareholders  Lower multiple for issuer post offer  But mechanical adjustments do not fully capture the significance of the discount  The messaging impact of the discount itself (a tight discount is sometimes perceived as reflecting confidence in the issue)  Market’s perception of value creation (i.e. accretion / dilution) achieved through investment of rights proceeds

Setting the right price is key to determining the success of the rights issue. Rights issues where the stock trades at or near the subscription price for an extended period of time have low take-ups

28 Note: (1) As a % of existing market cap – i.e. rights issue ratio and as multiple of Average Daily Volume. Convertible Bond Refresher Description Economic Flows

At issue At issue  Bond nominal: €1,000 Convertible Bonds  Share price at issue: €20.0 Issuer Investors  Conversion premium: 25% Issue Proceeds  Conversion price: €25.0 (= €20.0 x (1+25%)) During the life  Conversion ratio: 40.0 (=Notional / Conversion pr.)

Issuer Investors When does an Investor convert her/his bond? Coupon Payments  If the share price at maturity is €30, the value of the shares is €1,200 Upon conversion → the Investor will convert Convertible Bonds  If the share price at maturity is €10, the value of the shares is €400.0 Issuer Investors → the Investor will not convert and Issuer has to redeem Underlying Shares €1,000 At maturity if no conversion

Issuer Investors Issue Proceeds

 On a EPS basis, dilution will depend upon: 1) the net after-tax cost of the convertible (return on proceeds – coupon), 2) the number of new shares to be issued, mainly affected by the conversion ratio

 If the convertible bond has mandatory features, upon crossing of the conversion price, the bond will automatically convert into new shares A convertible bond is a bond where the holder has the option to convert its bond into a pre- determined number of shares 29 Comparative Cost of Financing

Relative Cost of Capital Analysis as a Function of the Share Price at Maturity

Equity

Convertible

Debt Cost fundingof

If converted, equity sold at a premium to If not converted, instrument provides cheap funding stock price at issue

Equity is Cheapest Convertible is Cheapest Debt is Cheapest

Share price at maturity

30 References  Fleuriet, 2008. Investment banking explained, McGraw-Hill: chapters 10 - 13  Liaw, 2011. The Business of Investment Banking: A Comprehensive Overview, Wiley: chapter 8, 9