Hybrid Securities the Agenda * What Determines the Optimal Mix of Debt and Equity for a Company? * How Does Altering the Mix Of

Giddy/SIM Hybrid Securities-1

SIM/NYU The Job of the CFO

Hybrid Securities

Prof. Ian Giddy New York University

The Agenda

l What determines the optimal mix of debt and equity for a company?

l How does altering the mix of debt and equity affect the value of a company?

l What is the right kind of debt for a company?

Corporate Finance

CORPORATECORPORATE FINANCEFINANCE DECISONSDECISONS

INVESTMENTINVESTMENT FINANCINGFINANCING RISKRISK MGT MGT

PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY M&A TOOLS

FINANCING ALTERNATIVES AVAILABLE TO MAJOR CORPORATIONS Debt?Debt? Subsidized funds Project finance Bank Term loan Equity?Equity? debt Fixed Revolving facility WhatWhat kind?kind? Dollar Real estate Private Leasing placement Long Asset term DEBT backed Unsecured Non- Floating Domestic dollar Public offering Eurobond US CP MTN Short ARP term FRN Euro CP VRN Bank debt

Hybrid Straight

Callable Stripped EQUITY Index-linked Unstripped Convertible With warrants Equity options

Private sale Full rights Domestic Public offering Restricted International Giddy/SIM Hybrid Securities-3

When Debt and Equity are Not Enough

Assets Liabilities

ValueValue ClaimsClaims onon ofof futurefuture thethe cashcash flowsflows cashcash flowsflows

When Debt and Equity are Not Enough

Assets Liabilities

Debt Contractual int. & principal Value Contractual int. & principal Value NoNo upside upside ofof futurefuture SeniorSenior claims claims Control via restrictions cashcash flowsflows Control via restrictions Equity ResidualResidual payments payments UpsideUpside and and downside downside ResidualResidual claims claims VotingVoting control control rights rights

When Debt and Equity are Not Enough

What if... Assets Liabilities

Claims Debt are inadequate? Contractual int. & principal Value Contractual int. & principal Value NoNo upside upside ofof futurefuture SeniorSenior claims claims cash flows ControlControl via via restrictions restrictions cash flows Returns Equity are inadequate? ResidualResidual payments payments UpsideUpside and and downside downside ResidualResidual claims claims VotingVoting control control rights rights

When Debt and Equity are Not Enough

Alternatives Assets Liabilities

n Collateralized Debt n Asset-securitized Contractual int. & principal n Project financing Value Contractual int. & principal Value NoNo upside upside ofof futurefuture SeniorSenior claims claims ControlControl via via restrictions restrictions cashcash flowsflows n Preferred Equity n Warrants n Convertible ResidualResidual payments payments UpsideUpside and and downside downside ResidualResidual claims claims VotingVoting control control rights rights

Managing Hybrid Securities

l Principles of hybrid instruments

l Market imperfections as motives for hybrids l Hybrids in the Eurobond market: uAsset-backed securities uWarrant bonds and convertibles uIndex-linked bonds

l Application: callable bonds

A Day in the Life of the Eurobond Market

l Examine the deals uWhy were each done in that particular form? uWhat determines the pricing?

l Can you break the hybrids into their component parts?

Why Use a Hybrid?

Motivations for Hybrids

Linked to Driven by investor business risk needs

Linked to Company Company market risk hedges does not hedge

Cannot hedge Debt or with derivatives equity are Not good enough

A Day in the Life...

NEW INTERNATIONAL BOND ISSUES

Borrower Amount m. CouponCoupon %% PricePrice Maturity Fees Book runner Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse Marui Corp* US$500 (4 3/8) 100 1995 2 1/4-1 1/2 Nomura Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB Battle Mountaingold!! US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch SNCF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BNL Eurofima (a) Pta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank Irish Bldg Soc.! (a) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IBJ Bank of Montreal! (c) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit ¶Final terms. *With equity warrants. !Private placement. !!Convertible. (a) Non-callable. (b) Callable at par after 5 years. If call not exercised, bond pays 50bp over Libor in last year. (c) Redemption linked to Nikkei stock index.

Equity-Linked Eurobonds

l Eurobonds with warrants uMarui

l Convertible Eurobonds uBattle Mountaingold

l Index-linked Eurobonds uBank of Montreal

Warrants

V a l u e o f W a Market r Value r Theoretical a Market Premium n Value t ($)

0 Price Per Share of Common Stock ($)

Convertibles

V Conversion a l Value u e o Market f Value C Market Premium o n v e r t Straight i b Bond Value l e B o n d ($) 0 Price Per Share of Common Stock Copyright ©2001 Ian H. Giddy giddy.org Hybrid Securities 15

Nikkei-Linked

PRINCIPAL REPAYMENT

19,000 28,000

Bank of Montreal Nikkei-Linked Note

Bankers Trust Bank of Montreal Nippon Credit

US pension fund Japanese with Japan insurance portfolio companies

Structured Notes

l Bundling and unbundling basic instruments

l Exploiting market imperfections (sometimes temporary)

l Creating value added for investor and issuer by tailoring securities to their particular needs

Key: For the innovation to work, it must provide value added to both issuer and investor.

Carps III

100% CAPITAL-PROTECTED ZERO-COUPON USD EMTN LINKED TO FRANK RUSSELL JAPAN EQUITY FUND

l Basic Structure

l a. This is a USD Euro-Medium Term Note with a maturity of 3 years.

l b. It carries a 100% capital guarantee on maturity (provided by Societe Generale rated Aa3 by Moody’s and AA- by S&P)

l c. Being a zero-coupon Note, the yield is linked to the performance of the Frank Russell Japan Equity Fund.

l Client Suitability

l Appropriate for ‘sophisticated investors’ who:

l a. require only 100% guarantee on capital on maturity

l b. believe that Japan is on a recovery path and that the stock market of Japan will see significant gains over the medium term

l c. believe that the Frank Russell Japan Equity Fund is capable of delivering a consistently above-market return with reduced risks.

Carps III

l Client’s objectives

l The “Guaranteed Minimum Return” product

l How is this priced? Who else could benefit from it?

60% Profit (Loss) with 100% Principal Protection 50% Profit (Loss) with 90% Principal Protection

40%

30%

Profit (Loss) 20%

10% 80 85 95 0% 90 100 110 120 105 115 125 130 135 140 145 150

-10%

-20%

Index Level at maturity (Initial index level = 100)

Medium-Term Notes: Anatomy of a Deal

Anatomy of a Deal

Issuer: uLooking for large amounts of floating-rate USD and DEM funding for its loan porfolio. uWants low-cost funds: target CP-.10 uIs not too concerned about specific timing of issue, amount or maturity uIs willing to consider hybrid structures.

Anatomy of a Deal

Investor: uHas distinctive preference for high grade investments uLooking for investments that will improve portfolio returns relative to relevant indexes uInvests in both floating rate and fixed rate sterling and dollar securities uCan buy options to hedge portfolio but cannot sell options

Anatomy of a Deal

Intermediary: uHas experience and technical and legal background in structure finance uHas active swap and option trading and positioning capabilities uHas clients looking for caps and other forms of interest rate protection.

The Deal

1 Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures 2 Structuring a MTN in such a way as to meet the investor’s needs and constraints 3 Line up all potential counterparties and negociate numbers acceptable to all sides 4 Upon issuer’s and investor’s approval, place the securities

The Deal / 2

5 For the issuer, swap and strip the issue into the form of funding that he requires 6 Offer a degree of liquidity to the issuer by standing willing to buy back the securities at a later date.

The Issue

l Issuer: Deutsche Bank AG

l Amount: US$ 40 Million

l Coupon: First three years: semi-annual LIBOR + 3/8% p.a., paid semi-annually Last 5 years: 8.35%

l Price: 100

l Maturity: February 10, 2000

l Call: Issuer may redeem the notes in full at par on February 10, 1995

l Fees: 30 bp

l Arranger: Credit Swiss First Boston

The Parties in the Deal

SCOTTISH DEUTSCHE LIFE

CSFB

The Deal in Detail

Deutsche sells 3-year floating rate note paying SCOTTISH DEUTSCHE LIBOR - 3/8% LIFE

CSFB

The Deal in Detail

Deutsche sells 3-year floating rate note paying SCOTTISH DEUTSCHE LIBOR - 3/8% LIFE For an additional 3/4% p.a., Deutsche buys three- year put option on 5-year fixed-rate 8.35% note to SL in 3 years

CSFB

The Deal in Detail

Deutsche sells 3-year floating rate note paying SCOTTISH DEUTSCHE LIBOR - 3/8% LIFE For an additional 3/4% p.a., For 1% p.a., Deutsche buys three- Deutsche sells year put option on 5-year CSFB a swaption fixed-rate 8.35% note to (the right to pay SL in 3 years fixed 8.35% for 5 years in 3 years)

CSFB

The Deal in Detail

What’s Really Going On?

Note:

l Issuer has agreed to pay an above-market rate on both the floating rate note and the fixed rate bond segment of the issue FRN portion: .75 % above normal cost Fixed portion: .50% above normal cost

l Issuer has in effect purchased the right to pay a fixed rate of 8.35% on a five-year bond to be issued in three years time.

Option Pricing

Time value depends on Option Price Time value depends on nnTimeTime

nnVolatilityVolatility

nnDistanceDistance fromfrom thethe strikestrike priceprice Option Price = Intrinsic value + Time value

94.5 94.75 Underlying Price

Option Pricing Model

ENTER THESE DATA: ======

-> FUTURES PRICE 94.75 -> STRIKE PRICE 94.5 -> TIME IN DAYS 300 -> INTEREST RATE 7 -> STD DEVIATION 15

1.8 CALL PRICE IS...... 1.6 0.40 PUT PRICE IS...... 1.4 0.17

1.2

0.8

0.6 CALL OPTION PRICE 0.4

0.2

0 93 93 94 94 95 95 96 96 FUTURES PRICE

Value of Call Option

SHADED AREA: FUTURES Probability distribution of PRICE the log of the futures price on the expiration date for values above STRIKE the strike.

INTRINSIC VALUE TIME VALUE

EXPECTED VALUE OF PROFIT GIVEN EXERCISE

Black-Scholes Option Valuation

-rT Co = SoN(d1) - Xe N(d2) 2 1/2 d1 = [ln(So/X) + (r + s /2)T] / (s T ) 1/2 d2 = d1 - (s T ) where

Co = Current call option value.

So = Current stock price N(d) = probability that a random draw from a normal distribution will be less than d.

Breaking Down a Convertible: Unisys

l At the end of 1992, Unisys had a convertible bond, coming due in 2000, which was trading at $1400. It also had straight bonds, with the same maturity, trading in December 1992 at a yield of 8.4%. uWhat’s the straight bond component worth? uWhat’s the convertible option worth?

Breaking Down a Convertible: Unisys

Coupon rate on Convertible Bond = 8.25% Market Interest Rate on Straight Bond of same Risk = 8.40% Price of Convertible Bond = 1400 Maturity of Convertible Bond = 8

Value of Straight Bond Portion = $ 991.51 Value of Conversion Option = $ 408.49

Motivations for Issuing Hybrid Bonds

l Company has a view

l There are constraints on what the company can issue l The company can arbitrage to save money

l Always ask: given my goal, is there an alternative way of achieving the same effect (e.g., using derivatives?)

Economics of Financial Innovation

l Certain kinds of market imperfections allow hybrids to flourish

l But innovation are readily copied; so only certain kinds of firm can profit from innovations.

l There is a product cycle and profitability cycle of innovations.

What Conditions Permit Hybrids to Thrive?

l Government Rules and Regulations Example: Japan Air Lines Yen-linked Eurobond

l Tax Distortions Example: Money Market Preferred

l Constraint on Issuers or Investors Example: Nikkei-Linked Eurobond

l Segmentation-Driven Innovation Example: Collateralized Mortgage Obligations (CMOs)

Why Innovations Fail

l The rationale evaporates

l It’s too costly l It’s New Coke

Case Study: Banpu Convertible

nHow did this work?

nWhy did Banpu use this technique? nWhy did investors buy it?

Banpu Convertible

Huh?

Thai Time

n 1994 n 1997 n 1999 n 2004

Leveraged Finance

Prof. Ian Giddy New York University

M&A and Leverage

n Takeover? Company has n Leveraged unused buyout? debt capacity n Leveraged recapitalization?

Typical LBO Sequence

IPO or sale of Company gets bloated company or slack and stock price falls

LBO offer made LBO completed

Restructuring §Efficiencies §Divestiture s §Financial

? years 3-9 months 5-7 years

John M Case LBO

John Case, Managers, owner Company buyers $20 million

Payment:

n Bank debt $6m

n Seller note $4m

n Sub debt with warrants $9.5m

n Manager’s equity $0.5m

Simplified Balance Sheet for a restructured J.M.Case Company Assets Liabilities Cash $5762 Current Liab $1266 Other current 3236 Bank loan 6000 Fixed & other 2184 Case loan 4000 Good will 10084 Plug figure 9500 Managers’ 500 equity

Total 21,266 Total 21,266

John Case Cost of Capital

Liabilities Nominal Effective Weight Product Current $1,266 0% 0.00% 5.95% 0.00% Bank loan $6,000 12% 8.40% 28.21% 2.37% Seller note $4,000 4% 8.17% 18.81% 1.54% VC plug $9,500 9% 21.40% 44.67% 9.56% Managers' equity $500 30% 2.35% 0.71% $21,266 14.17%

giddyonline.com

Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 917-463-7629 [email protected] http://www.giddy.org