Treasury leads Warburg to anger big clients over BT3

By Rosemary Bennett 

SG Warburg is the global coordinator of the British Treasury’s third British Telecom offer (BT3). It was never going to be a simple task and it may turn into a job Warburg wishes it had never taken. The firm has stirred up extraordinary dissent over the offering in the primary equity markets. Since the bidding started for places in the selling group, Warburg and the Treasury have heard grumblings from other merchant banks. Now institutional investors are complaining loudly.

During an equity offering, there ought to be a particular tension between lead manager and issuer. The issuer wants the price of existing shares to stay up and the investor wants the shares to be sold as cheaply as possible. The lead manager acts between these two and a price is reached. But in this case, Warburg has thrown in its lot with the Treasury. Much of the deal’s structure has been planned by Steve Robson, the head of the department which deals with privatizations. He is undoubtedly an experienced and intelligent man. One banker calls him "one of the most talented individuals I have come across". But Robson’s cleverness has not stopped the transaction becoming an unhappy one: where the deal has broken down is in the manner that Warburg has allowed the Treasury to have it all its own way.

Institutional investors say that the conditions laid down by Warburg constitute market rigging. They are particularly angry over attempts to protect the share price in the run-up to placement. In May, Warburg and the Treasury imposed an incentive scheme which would reward institutions known to have increased their holdings ahead of the issue. This was the carrot to match the stick used in BT2: it insisted then that institutions which sold ahead of the offering would be penalized. Tony Whalley, an investment director at Scottish Widows, a British institutional investor, does not like it: "When you come out with an issue and say, ‘those seen to buy beforehand will get more,’ it is offering an inducement which is considered immoral at Scottish Widows. Last time we had the stick, and this time a carrot as well. The market is effectively rigged.”

Dick Barfield, chief investment manager at Standard Life Assurance, is also not pleased: "It is rather bizarre to try and get investors to buy ahead of a huge new issue. But then, there have been a lot of bizarre things about this issue. All along the line they have been attempting to rig this market." 

Mark Wasilewski, a director at CIN Management, a British pension fund, is also perturbed. "The whole point of a market is to equate demand with supply so a price is found." He says that, if there is to be a huge increase in the supply side, it is foolish to believe the price can be maintained unless there is an equally big increase in demand. This can only come if the present stock looks cheap. "It cannot be right to buy stock ahead of a big placement, unless the shares look cheap. And they are not cheap at the moment." Wasilewski says that the move has destroyed normal business behaviour: "It has all become a bit of a game, trying to get on the side of Warburg by buying. It is not the normal sort of decision you have to take ahead of an offering." 

Warburg and the Treasury give the same reason for the incentive. James Sassoon, a director of SG Warburg, says: "We do not think it is rigging the market. We believe it is a good test of likely long-term holders of BT. Allocation policy is typically opaque. We are trying to be open about it." 

The Treasury has always been firm about protecting the share price. It is under pressure to get the most possible from the sale: it is facing a public-sector borrowing requirement likely to be more than £50 billion ($75 billion) this year. Officials at the Treasury and Warburg cite the 1992 Welcome offering, which saw the share price collapse from 1,113p to 800p in the three months between the announcement of the offer and the closing of the deal. Warburg and the Treasury do not intend a similar thing to happen to BT3.

But, while there may be a problem with maintaining prices before an issue, Wellcome is not the best example of a share forced down through manipulation by institutional investors. Pharmaceuticals and healthcare stocks fell out of favour last summer; last month, Wellcome shares were trading below the issue price. This suggests that a false market had not been created. Also, a stock exchange inquiry said it found no evidence to suggest any trading took place which attempted to manipulate the price.

The Treasury made it a condition of joining the selling group that all managers report every week on any secondary market dealings they have been involved in, or even heard about. The Treasury thought this would help to monitor share dealing ahead of the issue; but then decided that it was not rigorous enough. In June, Warburg made a request to the stock exchange asking that all British Telecom share transactions be cash-settled in the run-up to the offering. (This would allow it to update the share register every 48 hours instead of every two weeks, as under the normal settlement period.) The stock exchange – to the amazement of many – agreed to break with established market practices. It asked market makers for their opinion. The market makers responded swiftly: they were furious at the attempt to give preferential treatment to a government deal.

Institutional investors were also angered by such a sharp departure from market practice. Whalley at Scottish Widows says: "Cash settlement would not really affect the way we do business, but it is an invasion of privacy.” The stock exchange had to make an embarrassing about-face and withdraw the request.

But Warburg still pushed for something to be done to prevent selling ahead of the issue. The stock exchange said it would request trades of 100,000 shares or more to be reported to allow investigation into accusations of market manipulation. But, to the irritation of Warburg and the Treasury, the stock exchange said it would keep this information confidential. (Maybe Warburg should have tried kindly persuasion at the stock exchange instead: there have been complaints of bullying by "highly-paid, pompous and aggressive merchant bankers" against "junior stock exchange staff, who are really just administrators".) Syndicate managers are convinced that, had it been anything other than a government deal, the stock exchange would not have given in.

The offering has raised questions about the efficiency of the London market. It is usual practice to reduce a holding of existing lower-yielding stock before a large offering of new, high-yielding stock (the new stock is only partly paid, yet it is entitled to the full 1992/93 dividend). The pre-offer sale often contributes to the cash for the new shares. This is especially important for British pension funds, because they have restricted cash flow: first, because of numerous contributions holidays, and second, because they have to absorb huge gilt issuance. Lower-yielding stocks have to be sold to generate cash for new issues. The trouble (as the Treasury and Warburg see it) is that this drives the share price down.

Short selling before an issue is perhaps a more dubious practice. It can result in a share falling well below a fair price; but regulations such as the up-tick rule – which operates in America and prevents short selling in a falling market – could prevent prices being driven down ahead of offerings. A stock exchange official says that the American regulation had been looked at, but that it was considered "very difficult" to implement in a market-making system.

Warburg’s behaviour in support of the Treasury has damaged relationships with some of its oldest institutional clients. They accuse Warburg of hubris. Wasilewski at CIN says: "l think it will affect business for Warburg in the future. It is clear that many big investors are very upset about the way the firm has conducted itself during this deal. As an intermediary it should be sensitive to its clients. To try and push through the cash settlement following the outcry from investors shows a complete disregard for clients." Some syndicate members say that Warburg has soured things for them, too: they now must begin meetings with investors with a defence of Warburg’s behaviour.

Investors fear that when it comes to pricing, the Treasury – keen to get as much money as possible from this last big state sell-off – will push the pricing to the limit of the indicated range and Warburg will concede. Already the 15p discount to retail investors in BT2 has been cut by 5p a share to 10p; that will save the government £50 million. Investors also suspect that, in an effort to save even more for the government, a larger proportion of this offering will go to institutions (which do not qualify for the discount) than did in BT2.

It is a very unhappy offering, and the reasons for the unhappiness go back to BT2. The Treasury had been pleased with the £5.35 billion it made from BT2 in November 1991. But it did not like the syndication, which Warburg also led. BT2 had 10 regional syndicates containing 114 banks. The Treasury complained that the large selling group contained some "freeloaders" who sold little and picked up management fees. One man in the Treasury summed it up: "We felt our selling-dollar was not working fully."

The Treasury looked for another structure and had the experience to find one. The government has been selling state-owned companies for 10 years. Officials at the Treasury are frequently in contact with many of the world’s investment bankers. It asked some of them about alternatives to the regional structure of BT2. It also asked for ideas from a shortlist of British houses which had been invited to bid for the global coordinating mandate. The structure chosen was one that pulled out an exempt list of investors. They would be approached only by a small group of global sellers – houses with sufficient experience in selling equities around the world. There would also be a group of regional managers. They would try to find orders from smaller institutions and retail investors abroad. The Treasury hoped this structure would give it the coverage and control lacking in BT2.

The structure, unlike almost everything else about the offering, is not a cause of complaint. Exempt lists are nothing new. They have been a part of recent large offerings such as Argentaria and Repsol. The thinking behind them is simple: everyone knows the top 500 or so large institutions in the world, so there is no need to spend time searching them out. Better coverage can be had if the top institutions are targeted by a small group in an orderly way. Other, smaller brokers can then concentrate on winning the orders of smaller investors.

Within the BT3 global syndicate, 11 firms are competing for orders from the exempt list of 474 big names. To make competition between global managers work, the fee structure has been weighted heavily towards sales. Of total fees, 80% will be sales driven; 20% of that will be held back to compensate for costs incurred during stabilization following the placement. It will be paid out 30 days later. (Twenty per cent of fees will be for management, 80% of which will be divided equally between the 11 global managers and 20% between the 18 regional managers.) 

Warburg says the fee structure shows it is trying to be fair. But if Warburg loses in the fee structure, it is making up for it elsewhere. The firm put in place a crafty pre-marketing period from June 10 to 24. Then it divided the global syndicate into smaller groups. During this time, members could talk only to a small number of the big 474 investors – except for Warburg, which could talk to all of them. Rothschild/Smith New Court, Cazenove and Barclays de Zoete Wedd (BZW) were allowed to market to just 184 British institutions; Paribas, Deutsche Bank and Union Bank of Switzerland were confined to 90 investors on the continent; Merrill Lynch, Morgan Stanley and NatWest Securities could see 154 North American investors; and Daiwa could approach the 46 institutions in Asia-Pacific, including 30 in Japan.

Even when the global managers were able to break out of their regions, most complained that they would only have time to market heavily in one more region.

Warburg staff say that this early start for themselves is designed to create orderly marketing. According to Maurice Thompson, director of equity syndication at Warburg Securities: "We have tried to get the balance right so global managers get good access, but are not overbearing.” He says that the decision to give Warburg worldwide access from the first day means the firm can see how demand is building up. More to the point, it is a perk of the job as global coordinator.

Some of the global managers have other opinions: "They have ruined the global nature of the offering by restricting access in the first two weeks," one manager says. "The point was supposed to be ‘We all compete on an equal basis.’ That clearly has not happened." Another says, "If you have confidence in your sales staff, you do not need to restrict others from selling.”

But they have been ready to participate in the deal largely because they believe the Treasury’s Robson will make it fair. Already, the Treasury has tried to take away some of Warburg’s advantage. It told Warburg to inform all the large institutional investors that where they place their order will have no bearing on allocation. The Treasury has also made it clear who will have the say in allocation procedure during the weekend of July 16. Robson will be at Warburg’s offices while the allocations are being made. Warburg salesmen will be interviewed just like other teams.

Treasury staff say they will ensure that the allocation procedure will be fair, because "if you want the best deal, you have to be in charge of the allocation decisions. Too many leave it to the lead manager, and they generally place the shares to serve other objectives. Too many vendors fail to realize this. We have made it quite plain that the Treasury takes all the decisions and that no preference will be given to orders through Warburg." 

But British investors do not think Warburg’s early lead is unimportant. One investor says: "Outwardly, all the brokers are equal, but there is a very clear pecking order. From day one, the broker with the widest coverage will have the most indicative quotes. They can give the greatest feedback to us and will probably get the order." And that is Warburg.

Warburg has also made sure it is seen as much as possible during the selling period. It will be the only bank allowed to speak at roadshows. It will be the only firm present in the one-to-one meetings between British Telecom staff and investors. Sassoon explains it this way: "Only 15 or so one-to-one meetings will take place. Not enough for all the global managers to attend." He stresses that representatives from Warburg’s corporate finance arm, not salesmen, will be present. They will report to all the global syndicate members. Sassoon says that he resisted requests from syndicate members to send a Warburg salesman. He says this indicates that the firm is trying to be fair. But some syndicate members have said that it might have been more fair if Warburg had allowed other firms’ representatives to attend.

The release of the order forms to investors has also caused complaints: the 11 global managers are listed in alphabetical order, except Warburg, which is at the top.

But Warburg has been putting syndicate managers’ teeth on edge all year. As early as February, before the structure of the offering was disclosed, managers were irritated by the way the selling-group beauty parade was run. First, a letter was sent out by the Treasury asking all applicants about their equities sales and research operation. Nobody minded that: the Treasury wanted to be sure it selected the firms with the most experience at selling British equities around the world. Bidders were happy to go along.

But they felt that some of the questions from the Treasury went too far. Managers did not like being asked about the activities and earnings of salesmen. Says one manager who was particularly cross: "Why did they want to know the name of the salesman who talks to the Pru? What difference does it make?" Others say they refused to complete the section on salesmen’s earnings: "I would not mind talking about that to the Treasury, but not to Warburg. That would be just foolish," says one.

The beauty parade took place in February and March at Warburg’s offices. The panel comprised James Sassoon, Maurice Thompson and Warburg Securities’ director Rory Tapner; Steve Robson from the Treasury, along with an accountant on secondment to the Treasury; representatives from Rothschild (BT’s financial adviser); and several lawyers. Each contender was given about 10 minutes to present a case with no more than six members of staff present. Each was then questioned by the panel for 45 minutes.

The contenders did not like it. It was not so much the structure of the beauty parade which angered the participants, it was more the manner in which it was conducted. The business of winning mandates is highly competitive. To be summoned to the offices of a competitor and questioned in great detail on the internal workings of your operation is unpleasant and unsettling.

When the list of global managers was announced in April, there were some surprises. There were, of course, the predictable names of Morgan Stanley, Merrill Lynch and Paribas. But there were also names not strongly associated with the emerging equity bulge-bracket (that is, the half-dozen or so banks around the world which increasingly win top mandates for international equity issues). The surprises included Union Bank of Switzerland, Deutsche Bank, NatWest, Cazenove and Rothschild.

The British names in particular seem to be the result of favours returned: Rothschild is BT’s adviser and Cazenove its broker, so they were probably the recommendations of the company. NatWest and BZW were said to be given places because they had cooperated with the Treasury’s share shop scheme – an effort by the government to encourage retail Investment.

Some were surprised to see Kleinwort Benson missing from among the British houses. It has played leading roles in other British privatizations and it is believed the house was offered only a place on the regional syndicate which it turned down. Among the Americans, Lehman and Credit Suisse First Boston were offered places on the regional group. So were Swiss Bank Corporation and Crédit Lyonnais.

The most notable omission was Goldman Sachs. It led the American slice of BT2, but after going through the selection procedure for BT3 and being appointed to the group, it dropped out. The reason given by the firm was that its impending fine for share dealings with the Maxwell companies could embarrass the government. But there have been rumours that Goldman was excluded because of the way it handled BT2 in America. Goldman denies this and neither the Treasury nor Warburg would talk about the selection.

The ructions caused by Warburg over BT3 are all the more surprising because even the Treasury says the role of the investment bank is to be "the oil to ensure the smooth interface between vendor and investor”.

Many fund managers do not think Warburg has smoothed much for investors. One says: "There is a limit to what a lead manager should agree to do. Even if they think something is a good idea, if they sense it will cause upset, it is its job to come up with something else and not just agree to everything.”

Rival syndicate managers agree, but say that the house is under pressure to look tough.

"Warburg has not done itself any favours, but it wants to be seen getting good value for money for the government," says one. "But in not standing up for the investors it has shown itself as too arrogant and too cavalier.”

But early indications suggest the deal will go well. The partly-paid structure makes it good value for institutions, and the advertising campaign has created good demand in the British retail sector.

But successful placement of the shares may not be the end of the story. When Warburg got the BT3 mandate, it won a chance to climb into the equity bulge-bracket. However, its unpopular behaviour may ruin its chances for good.