For the novices, and there will be many given the relative newness of this market in Europe at least, a hybrid financial instrument simply has both debt and equity characteristics, in the sense that it acts like debt but has the ability to convert into equity at a future date. The beauty of hybrid bonds for corporates issuing them in Europe, however, is that while they act like equity on the balance sheet they are treated like debt for tax purposes so interest payments can be deducted from a corporate’s tax liabilities.
This only works in Europe where IFRS accounting practices apply. In the US the situation is more complex because US GAAP accounting practices understand hybrids to be debt and so no favourable tax treatment is granted. Although this hasn’t hindered the hybrid market in the US entirely, which has tended to structure its hybrid issues as preference shares, thereby guaranteeing tax deductibility for them under US GAAP regulations.
The favourable tax treatment of hybrid bonds is the first step in attracting the attention of private equity sponsors to such instruments. Next is their flexibility. Most hybrid bonds have no fixed maturity date, instead converting to floating rate pricing plus circa 100bps after around 10 years, although at this point it is in the interests of the issuer to refinance. Interest payments on hybrid bonds can be deferred without those missed payments accruing interest and the status of hybrid bonds within the capital structure is so deeply subordinated that this deferred interest would be treated as equity in the event of an insolvency. It is only in the event of insolvency that investors holding hybrid bonds are able to declare the bonds due for repayment.
But while hybrid bonds look very interesting to private equity sponsors as a way of funding their leveraged buyout transactions more cheaply than using PIK instruments (which are part equity and so therefore more expensive than hybrids bonds that are structured to behave like debt), it’s by no means a foregone conclusion that leveraged buyout transactions will move hybrid bonds easily into the financing structures of their investee companies.
Vincent Allilaire, hybrid credit analyst at Standard & Poor’s, says: “I would be wary that in these types of situations the permanence of these type of [hybrid] instruments would not be respected by PE sponsors, who are typically looking at refinancing loans after a very short time. We expect these types of instruments to be a long-standing part of the capital structure of a corporate: even though they can refinance the instruments after 10 years, we would expect them to be refinanced by other equity or a similar instrument. I would differentiate according to who the sponsor is; a corporate widely held or a corporate held by PE sponsor.”
Allilaire is referring to the fact that, given the hugely liquid nature of the debt capital markets in Europe over the last two years, by far the majority of leveraged finance packages with private equity sponsors involved have gone back to the market, typically within an 18 month time frame, and refinanced the capital structure, often pulling out dividends or repaying equity capital to their limited partners.
Allilaire explains Standard & Poor’s rationale for this view: “We assign corporate ratings to companies, we don’t rate a financing structure. We don’t limit our time horizon to the life of a specific funding structure, although for structured finance transactions we pay attention to the cash flow restrictions, which may enhance the rating of specific debt tranches. In order for us to believe [an hybrid bond is] something more than subordinated debt, to grant it any type of equity credit, we need to believe that it can act as buffer for the financial viability of the company if need be, we therefore need to be reasonably certain that the bond will still be there for the company if it comes under financial duress.”
Given that no corporate could reasonably be expected to retain a seemingly static capital structure over a 10-year period; market improvements, downturns, acquisitions, disposals and so forth all being part of most corporates lives, this seems a bit of a dogmatic approach. On top of this, given the predominance of private equity-backed leveraged financing in the debt markets over recent years, and the likelihood their importance will grow throughout Europe rather than diminish in coming years, it seems unlikely that private equity firms will allow themselves to be cut out of this cheaper funding source.
Allilaire understandably has reservations regarding the argument that when corporate capital structures change over time, particularly when this is triggered by a clear event such as a leveraged refinancing, that the market will re-price the risk effectively. It is widely acknowledged, and proven in Standard & Poor’s research papers, that European debt markets still fail to adequately price risk into a leveraged finance transaction. This is partly blamed on lack of defaults and a deep pool of investors eager to buy higher yielding paper.
If a private equity-backed corporate goes back into the debt markets 18 months post the original financing and takes out a hybrid bond, say with senior debt, the market is unlikely to price the increased risk associated with an increased debt multiple (if indeed the debt multiple is increased).
Interestingly, Alex Simic, who structured the hybrid bond issue for TUI, the private equity-backed company when it bought CP Ships, on behalf of Deutsche Bank, where he is MD responsible for credit advisory in Europe, says: “I am almost blind to who the issuer is, the benefit is the same. I think there is room [for PE sponsors] to do it. Hybrids are usually rated two notches below the senior debt, so they will only work for BB- or B+ credits, then they become B or B-. In the US you can go down to a CCC rating because the market is much more developed.”
While Deutsche Bank could be accused of being primarily in the business of pushing product, at the end of the day, as Simic points out, hybrid bonds are structured and then listed on an index so there is a good degree of liquidity attached to them, meaning over time their true value and risk ought to be reflected in pricing. Admittedly, given their relative newness in Europe and the desperate scramble among investors for higher yielding paper, it may be some time before true risk is reflected in the pricing. But it would be silly to argue that private equity sponsors should hold off issuing cheaper hybrid instruments because of a concern over whether the purchasers understand what they are getting into, after all, buyer beware!
So it’s no surprise to hear Simic conclude: “Hybrids will become an important component of the capital structure.” Bryant Edwards, partner at Latham & Watkins, concurs: “Pricing is great. If sponsors can get the type of pricing corporates have, it’s a home run; they can use this as substitute for their own equity and can get tax deductions on interest they pay on it.”
Interestingly, given how Europe tends to import all of its financial innovation from the US, the rise of private equity-backed corporates tapping into cheaper hybrid bond financing may cut new ground in Europe since the hybrid bond market has juddered to a bit of a halt in recent months. Edwards explains: “[Hybrid bonds] have run into trouble in US; the National Association of Insurance Commissioners in US said [hybrid bonds] would have to be treated as equity and not debt for [its members’] investment portfolios and so insurance companies stopped buying. It’s a preliminary ruling and there has been a lot of debate about it.”