Equity-linked debt: Reaping rewards

(This article appears courtesy of International Financial Law Review,  sign up for a free trial here)

Gradually, the convertible bond market is changing. Issuers are becoming more innovative, pre-IPO deals and mandatory exchangeables are becoming more common, and the dominant firms in what was once a highly commoditized market are reaping the benefits.

The changes are hard to pick up, largely because the convertible bond market is very cyclical: when equity markets are hot, as they are now, investors want different ways to access it; when the markets cool off, investors return to fixed income or alternative assets. So it's only at the peak of the cycle that the innovations and fundamental shifts in demand can be seen.

Pre-IPO convertibles, which give bondholders a way in to an expected flotation before other investors, have been around for a good few years – they were particularly popular in Asia during the technology boom there. But 2005 saw the first two completed in Germany, a furore over new issues in Hong Kong and the first shariah-compliant issue from Dubai.

The problem in Hong Kong was that some issuers and their legal advisors tried to change the structure of the convertible to give investors a guaranteed return on IPO. Rather than allow bondholders to exchange their notes for shares at a certain (favourable) price after the flotation, the bonds allowed them to do so for a certain percentage discount on whatever the IPO price turned out to be. The Hong Kong regulator took against this guaranteed profit and refused to approve the notes.

But this furore was itself a result of the fact that there were simply more pre-IPO convertibles coming out of Asia this year. A lot of property companies in China were looking to list or exit private equity investments, and any producer connected with raw materials such as oil, gold or steel was looking to float and benefit from high commodity prices.

Law firms and banks are also becoming more creative with equity-linked products. For example, German chemicals group Bayer issued a €2.3 billion mandatory convertible in June this year that was not only unusual in its size and mandatory nature, but was also one of the first to be used as part of a company's regulatory capital. And Weather Capital Finance issued a novel €825 million pre-IPO convertible (see table) that was initially convertible into shares of Orascom Telecom but, on a qualifying event, could be converted into alternative stock.

Simon Sinclair, a partner at Clifford Chance in London, says: "Although convertible bonds are really driven by frothy equity markets, there has been an increase in issuance and creativity in recent years. This has been particularly evident in the last five years as hedge funds have become more active in this area, looking to convertibles as another way to access the stock markets."

Convertible bonds have also gradually crept down the credit spectrum in recent years, fuelling a rise in issuance. Says Ben Dulieu, partner at Linklaters in London: "Convertible bonds used to be seen as investment grade, big company products. But in recent years more and more small, high-growth companies have been looking to convertibles as a way to raise growth capital, as an alternative to private equity funding." Recent examples include oil exploration company Afren, which issued an as-yet unlisted bond this year, and Angara (see table at end of article).

Not only does the table reveal the number of smaller, high yield issuers of pre-IPO convertibles this year, it also illustrates the dominance of a few firms in the roles advising the banks and issuers. Linklaters has always had a dominant role in equity-linked advice. In IFLR's equity survey in 2005, for example, the firm completed 119 bonds, 103 more than its nearest competitor, Clifford Chance. The majority, 79, of those were in Asia, and on all but three Linklaters advised the banks. That trend can be seen on the table here, where Linklaters advised on four of the five selected deals, and all for the underwriters.

It had been suggested in the past that Linklaters' domination of the equity-linked market wasn't necessarily the most profitable one, as deals became more and more commoditized and fees were squeezed accordingly. But this recent rise in innovation suggests that the firm is now reaping the benefits of its position in the market, with more structured, profitable deals. Dulieu confirms that one mandate tends to follow another: "Winning work in this area is becoming more self-perpetuating. Doing the last deal pushes you onto the next, particularly if you introduced something innovative and can go into the market and talk about it."

Other firms that have performed well in Asian convertible this year are Herbert Smith and Sidley Austin. Herbert Smith advised the issuer on both the Golden State and Greentown China pre-IPO convertibles this year, and says it has several others in the pipeline. Equally Sidley Austin, though it works on more private transactions that are not listed here, says it has two more in the pipeline in Asia that should close this year.