This article originally appeared in Finance Magazine, January 2016.
Hybrid capital issued by companies has been around for some time, but it is only recently that we have seen its popularity take off, with over €100 billion of new issuance in the past three years writes Danske Bank’s Marc Caron. He explains the background to hybrid capital and what makes it so attractive to both issuers and investors.
As the name suggests, hybrid capital displays elements of both debt and equity in its structure. One of its particular advantages is that while coupon payments are tax deductible, the instrument can be accounted for as equity under IFRS rules. The first hybrids were issued back in 2005, but it was the standardisation of the structure in 2011/12 that acted as a catalyst for their rapid growth and resulted in them becoming an increasingly important instrument in the corporate funding toolkit.
Reducing the average cost of capital
Rating agencies, as well as many banks, determine nearly all hybrids to have 50% equity and 50% debt for the purposes of their credit analysis. Many issuers consider their hybrids in this way too. However, when looking at how hybrid capital is priced by the market and then comparing it to the issuer’s cost of equity and cost of debt, it comes out at as being closer to one third equity and two thirds debt.
It is this divergence in view between different stakeholders that makes hybrid capital so appealing as it can be seen as offering the issuer access to “cheap” equity and reducing the average cost of capital.
The key dynamic is the inherent conflict between, on the one hand, investors and the tax authorities, who want the instrument to pay a fixed coupon and have a fixed maturity date, and on the other hand, accounting standards and rating agencies, which require the issuer to retain significant discretion over the payment of principal and interest. These different agendas are reconciled by including call options and deferral mechanisms within the key terms.
Although hybrid capital has an extremely long tenor, or indeed can be a perpetual, the issuer will have an incentive to call it at the first call date.
Due to these various features and the fact that it is deeply subordinated, hybrid capital generally trades at 200-300bps over the equivalent senior debt level, though this can vary, depending mainly on the issuer’s credit and the time remaining until the first call date.
Present in most sectors now
Much of the growth in the hybrid market was initially driven by the utility and energy sectors. Due to deteriorating dynamics and high capital requirements in these markets, companies decided to issue hybrid capital in order to defend their credit rating, as just tapping the senior debt market would likely have led to a ratings downgrade. More recently hybrid capital has broadened in its appeal and is present across a wide variety of sectors, such as telecoms, airlines, autos and pharmaceuticals. The rationale for using hybrids has also extended beyond ratings defence, and is now frequently used to help fund acquisitions, reduce pension deficits and meet financial covenants. Whatever the reason though, hybrid capital gives companies an additional funding option beyond the binary choices of senior debt and equity.
Another important driver in the market has been the relative standardisation of the key terms and conditions. In its early days, each hybrid capital issue was substantially different in structure to the next one. Influenced mainly by the criteria developed by rating agencies in recent years, issuers and investors alike have a structure that is both well established and understood. The main differences that we now see are usually due to local tax regulations and issuers’ preferences on the type of accounting treatment. Above is an example of a typical rated hybrid security with a first call date between five and ten years, which represents the majority of hybrids issued to date.
In this structure, the key incentive that investors rely upon that the issue will be called is the loss of equity credit from S&P at the first call date. S&P remove the equity credit 20 years before the effective maturity date and they consider the effective maturity date to occur when the coupon rate has risen by at least 100bps since the issue date.
While this loss of equity credit can be a significant incentive, in a rising interest rate and/or deteriorating credit environment calling and refinancing the hybrid may be a costly decision to make. Until now this extension risk has not been an issue, though we expect this dilemma to come more to the fore in coming years.
Unrated hybrids becoming more popular
Though the majority of hybrids are issued by rated companies, there is a growing unrated hybrid market as well. Most unrated issuers choose to issue hybrids in order to meet financial covenants, since the hybrid is usually considered as equity in such calculations. The only Irish hybrid issuer so far is the speciality baking company, Aryzta who has successfully issued a number of unrated hybrids.
Since unrated hybrids are not restricted by the requirements of the rating agencies, they can be less standardised, but even here we have seen a good deal of convergence in structure. They are also smaller issue sizes; while a rated hybrid is generally at least benchmark size (€500m), unrated hybrid issues are usually in the €50-300m range.
A key difference between the rated and unrated structure is around the incentive to call. As an unrated issuer, the loss of equity credit by S&P is not applicable, instead the incentive used is a significant step-up in the coupon payable after the first call date, usually between 250-500bps.
A flexible tool to support an efficient capital structure Hybrid capital should be seen as a useful instrument in the corporate funding toolkit, to complement rather than replace other sources of finance. In 2015, Danske Bank helped arrange over €3 billion of new hybrid capital and we expect 2016 to be equally strong.
Hybrid capital provides issuers with an opportunity to reduce their average cost of capital and shore up their balance sheets, while it provides investors with a substantial pick up over senior debt, something that is particularly attractive in their QE environment. At the same time, though, there are clear risks associated with hybrid capital over senior debt: subordination risk; non-call risk; coupon deferral risk; and special event risks.
A major challenge for investors is that, other than perhaps subordination risk, the other three risks are extremely difficult to quantify - much recent attention has been on the risk that one of the rating agencies might change their criteria and reduce or eliminate the amount of equity credit they assign to hybrids. However, as the market continues to mature and expand, we expect that we will be better able to understand, and quantify, these risks.
Marc Caron is head of client advisory for Danske Bank’s Ireland and international units, advising the bank’s largest clients on areas such as capital structure, funding and liquidity. Based in Dublin, he is also responsible for advising energy and utility clients across the Danske Bank Group. He has been the lead advisor on all hybrid capital issues that have been arranged by the bank.
Marc joined Danske Bank in 2011, having previously worked at KPMG Corporate Finance, KBC Bank and Citibank in Dublin and London.