Tough Decisions Ahead

The current low-interest environment means now is the optimum time for boards to consider capital markets as a way to raise funds, but do such transactions offer long-term shareholder value?

The current low-interest environment means now is the optimum time for boards to consider capital markets as a way to raise funds, but do such transactions offer long-term shareholder value? Alexandra Cain reports.

The confluence of events in capital markets is making life even more complex for those charged with governing large and small businesses. This is especially the case when it comes to decisions about the right time to raise funds or bring a deal to market.

Two recent transactions explain the conundrum facing directors. In November 2015, oil and gas company Santos brought a $25 billion 1 for 1.7 rights offer to market, priced below the share price, the proceeds of which will largely be used to pay back $9 billion in debt. Shareholders had virtually no choice but to accept the offer, or see the value of their shareholding severely diluted. This is because the new shares issued as part of the offer will make existing shareholdings less valuable. The offer was issued concurrent with a considerable drop in the oil price.

Had Santos brought the offer to market sooner, when conditions were more favourable, it may have been able to achieve better pricing for the offer and shareholders may have been more open to it. But as it stands, the business had to approach the market with this deal from a position of weakness.

Contrast this to the $10.26 billion sale of the New South Wales poles and wires assets held in TransGrid, which also came to market in November 2015. Certainty in the revenue produced by the assets, which operate in an industry investors favour, combined with strength in the underlying business, provided the foundation for a number of strong buyer groups to put forward significant offers.

These deals serve to demonstrate some hard truths directors face when bringing a deal to market. If the asset is in an industry investors like, it’s likely it will achieve a good price. But the market will savage businesses that approach the market with defensive deals. Given this backdrop, what’s the outlook for capital markets for this year?

According to Gregg Johnston, an executive general manager in institutional banking at Commonwealth Bank (CBA), one of the fundamental choices for boards planning to raise equity in capital markets is choosing between a placement or rights structure. A placement generally involves specific institutional investors and is done off-market, whereas a rights offer is normally announced in parallel to all shareholders.

From the board’s perspective, placements offer greater surety about price and volume of distribution and arguably less volatility in forward trading. “But there’s no such thing as a free lunch. The issue price of placements will incorporate the cost of achieving the enhanced surety,” Johnston explains.

He notes one area that has historically been a challenge for companies in rights structures is the extended duration of the offer period, particularly for companies with a large shareholder base. These transactions require sufficient time for shareholders to consider and respond to the offer. In the past, placements structures provided significant timing advantages, particularly if market or company specific conditions had some uncertainties.

But more recent structures which accelerate rights transactions and trading can now provide enhanced certainty and assist companies to balance the pros and cons of placements and rights offers.

The outlook for M&A

Taking a look at the transactions market, Vivek Prabhu GAICD, Perpetual Investment’s deputy head of credit and fixed income, notes that recent deals have been driven by their debt portion, largely as a result of companies taking advantage of historically low interest rates. He points to global brewer Anheuser-Busch InBev’s acquisition of competitor SABMiller as an example. The US$100 billion deal comprised $70 billion in debt and $30 billion in equity.

“The debt will need to be financed in the bond market. At the moment it’s financed by a banking consortium,” Prabhu explains. It’s expected there will be healthy demand in the secondary market.

Another example is computer company Dell’s purchase of EMC, whose largest asset is the cloud computing company VMWare. The deal is made up of US$50 billion in debt and only US$4 billion in equity. Dell previously had only US$10 billion in debt. This deal demonstrates how companies are using a low borrowing cost environment to drive growth. This dynamic is something all boards must be currently examining to work out how they too can use debt markets to fund expansion plans when debt is so cheap.

However, as Johnston notes, there’s also been some understandable caution by management and boards regarding significant expansion. “Domestically, challenging factors have been the magnitude and speed of adjustment in commodity prices and the Australian dollar, prompting a level of caution on the nearer term implications,” he says.

Differing views regarding China’s growth outlook are also making some boards more cautious about investing for growth. “Consensus on China’s outlook represents a significant change in the overall growth rate, and the sectors that have been affected are significant for Australia. However, even the most pessimistic expectations of high 5 to 6 per cent growth are still massive numbers in value terms,” Johnston outlines.

He notes that even though some Australian companies have been cautious about initiating expansion plans, the majority are still very willing to commit capital when the right assets are up for sale. “There’s capital available and good assets have been well priced in both trade sales and the equities market. Once an asset sale process has been initiated, it often meets a wall of capital, especially in infrastructure and property or where combinations of assets will drive efficiencies.”

Johnston sees these trends as equivalent or stronger when foreign capital looks at Australian assets, particularly following the move downwards in the Australian dollar. Future returns in Australian dollars now provide extra incentive to operate in this market. Overall, there’s very strong interest in debt and equity markets for the right assets.

Peter Mavromatis, chief investment officer at diversified financial services firm Beulah Capital agrees the M&A market is buoyant. “We’re currently in the best market for M&A since the global financial crisis, and activity is likely to step up again this year,” he notes.

The future for IPOs

There are strong expectations for the initial public offering (IPO) market going into 2016, with activity from corporate owners and start-ups expected, says Johnston.

“The right sort of businesses at the right price will meet strong demand. Australian businesses can expect to do well where operations benefit from the currency at more recent lower levels and have products or services relevant to meet domestic and international demand,” he says.

Many established local companies are looking to raise capital this year, which will lead to an increase in IPOs, says Mavromatis. “We expect to see a steady flow of IPOs through 2016 across many sectors – some particularly active sectors include health care and technology. Resources are likely to be quiet due to lower commodities prices.”

Similar to other markets, there’s strong demand for the right assets when it comes to trade sales and divestments.

“Many investors believe we are in a prolonged low-yield environment, which is driving interest in certain assets. There has been substantial inbound strategic capital, as well as financial capital from global investors,” says Johnston.

Transactions in this arena are often indicative of companies either in trouble or needing to fend off hostile takeovers. So there is likely to be more interest in both trade sales and asset divestments during 2016, mainly from companies with stretched balance sheets.

An example is Santos, which has sold a stake in a gas field. “The trend is not about attempting to improve operational efficiency,” says Mavromatis.

Corporate debt raisings

When it comes to the corporate market, the overarching question has been the US’s approach to raising interest rates. As Johnston notes, it has taken longer than consensus a year ago for the US Federal Reserve to begin raising rates. “This has affected bond markets. In 2015, there were periods of volatility as money sat on the sideline anticipating higher yields. This prompted sharp swings in the depth of the bond market, as money moved in and out around those evolving expectations.”

The outlook for 2016 is similar to conditions experienced in the second half of 2015. As Johnston suggests, potential issuers and arrangers need to look carefully at market conditions in the segment they are considering. “Be prepared to be flexible and take advantage of good market conditions when they prevail. There’s a lot of capacity when conditions are good, but market timing will be important.”

There are exceptions, says Johnston, such as the US private placement market, which displays consistent strength and depth for borrowers at the cusp of and into investment grade, especially those seeking longer maturities to match longer duration assets such as infrastructure.

Overall, however, bond markets remain relatively healthy, with substantial depth and capacity. But in 2016 expect investors to be more discerning about timing and specific risk issues.

Key issues for boards

Johnston’s main message to boards is to avoid raising capital until it’s really needed, unless it’s a good news situation.

“The timing of capital raisings is a challenging issue for boards, which has become more acute over the past year. We’ve seen decisions delayed when, with the benefit of hindsight, the business may have been able to raise capital earlier at higher prices,” he notes.

According to BDO corporate finance partner Scott Birkett, the perennial question for boards when it comes to capital markets is whether the transaction will create long-term shareholder value. “We always ask our clients if the raising they are considering is genuinely accretive. The full cycle needs to be considered and potential shocks taken into account,” he says.

Birkett says boards have to question whether the company can survive any missteps in corporate strategy with increased debt levels. They also need to look at what kind of shortfall on an acquisition target the business could cope with so the numbers still work for existing shareholders. “It’s important to leave all options on the table, including the status quo. Being patient doesn’t mean you’re not moving forward. Sometimes it’s prudent.”

He says strong capital raising advice is crucial for boards. “We have seen time and again that great businesses, run well operationally, can come unstuck because of poor capital-raising decisions. Be it too much debt, taking the wrong shareholders on board or not considering the timing of capital requirements or the most efficient quantums to raise relative to milestones. It’s invaluable to have someone who is external to the business, who knows the capital markets landscape, to assist with this process.”

A focus on governance

So what should boards concentrate on when it comes to the governance of capital raisings – especially in terms of ensuring equity for all shareholders in equity capital raisings, such as placements?

Birkett says the focus should be on accurate communication of why shareholders are being tapped for capital and what they can expect their capital to provide.

“Shareholders acknowledge that not everything goes according to plan, but they do not forgive unclear or misleading communication that can result in a different view being articulated within months of them stumping up capital.”

He argues that taking on a large institutional placement must be perceived as delivering value to all shareholders, rather than being presented as an opportunistic time for outsiders to “get on board” at the expense of existing shareholders.

When it comes to continuous disclosure, boards should err on the side of caution. “If a piece of information is not in the marketplace, but is something the director would reasonably like to know about as a shareholder, and there is enough certainty to communicate that information, disclose it.”

While boards can expect market conditions to remain volatile in 2016, especially in light of geopolitical conditions, the low-interest environment, as well as improving confidence among businesses and investors, should make for relatively positive conditions for the remainder of the year.