Hybrid Capital – A Simple Introduction

21 February 2006

1. Introduction

We are familiar with debt and equity.  Payments on debt are tax deductible, but there is a fixed obligation to make these payments and to repay the original borrowing, which can lead to financial distress.  Equity carries no obligation to repay, and no obligation to make periodical payments.  While this avoids the risk of financial distress, there is no tax relief for periodical payments on equity (i.e. dividends).

Hybrid capital is something economically “in between”.  Payments on it are tax deductible.  However, unlike ordinary debt, it is structured to avoid the risk of causing financial distress.  In other words it has “equity characteristics”.

2. What equity characteristics are used?

(i) Hybrids are very long dated.  Looking at five major issues last year (Bayer, Suedzucker, Vattentall, DONG, Thomson SA) one was for 100 years, one for 1,000 and three were perpetual.  (The information mentioned here is from a stockbroker’s circular and has not been independently verified). In practice, companies can almost forget about the need to repay hybrids.

(ii) Interest payments can be suspended if things “get bad”.  This suspension can be optional or even mandatory.  The suspended coupon payment may be cumulated for future payment or may be lost to the investor entirely.  Typically, there will be some “costs” to the company, such as prohibition of equity dividends while the hybrid coupon payments are suspended.  However the key point is that while business is “bad” there is no obligation to make payments on the hybrid.

(iii) The hybrid is subordinated to all other debt.

Obviously hybrid investors are paid a coupon greater than straight debt to compensate them for taking on these risks.

3. What is the extra cost of a hybrid?

Surprisingly little.  The issues mentioned earlier were all in euro, and paid coupons ranging from 5% to 5.75%.  The precise amount is of course dependent upon the exact terms and the company’s existing credit rating.  This compares with current euro yields on AAA rated corporate bonds in excess of 3%, so the extra coupon on the hybrid is of the order of 2%.

To encourage the issuer to repay the debt, there is typically an increase in the coupon after 10 years.  At the same time, to enable the issuer to effect repayment, there will be an issuer call option.  The coupon step up at 10 years cannot be set too high, as it would increase the burden of the hybrid and thereby increase its debt characteristics.

For the five issues mentioned, the coupon step up at 10 years is only 100 basis points, i.e. 1%.  All of these hybrids contain an issuer call option at par, exercisable quarterly after 10 years.

4. What are the benefits?

From an accounting perspective, depending on the details, the hybrid will be included in either debt or equity.  Of the five issues discussed, two are accounted for as debt and three as equity. 

More important than the accounting is the treatment given by credit ratings agencies.  For the five issues, Moody’s gave a 75% equity credit for three of them, and a 50% equity credit for the other two.  What the percentage (e.g. 75%) means is that, for ratings purposes, a company issuing €1,000 million of hybrid is treated as if it had issued €750 million of new equity and €250 million of new debt.

There are several benefits from the company’s perspective:

(a) If it had issued €1,000 million of new simple debt, its credit rating might have been marked down, increasing its effective borrowing costs.

(b) An issue of new real equity would be potentially dilutive of existing shareholders.

(c) By issuing the hybrid, the company will in many cases strengthen its credit rating, as a result of being deemed to have issued €750m new equity and only €250m new debt.  While there is a cost in the form of a higher coupon than simple debt, this cost is potentially ameliorated by the scope to reduce other borrowing costs as a result of the strengthened credit rating.

5. Is the idea new?

There is nothing new under the sun!  In the financial sector, for many years organisations such as banks have issued what is referred to as “innovative tier one capital”.  See for example section 5 of the “Interim Prudential Sourcebook: Banks” available electronically from the FSA website.  However, it has been relatively unusual for non-financial companies to issue such hybrid capital.  What seems to have triggered the change is a more uniform approach by ratings agencies when assessing the effect of hybrid issuance.

6. How do you go about making an issue?

Many investment banks will be willing to assist in structuring the issue and placing the hybrid securities with investors.  There are three key areas which need to be addressed:

(a) How will the rating agencies treat the instrument?  Specifically how much “equity credit” will they give.

(b) Where will the issue sit on the balance sheet? i.e. will it be classified as debt or as equity.  The accounting treatment may matter to shareholders and should be agreed with the auditors in advance.

(c) How to ensure that the coupon payments are tax deductible?  This can be a challenge for UK issuers.  In the UK, tax law contains several provisions aimed at denying tax relief for interest paid on debts that have excessive equity characteristics.  In particular, ICTA 1988 s.209(2)(e)(iii) denies tax relief on any interest on “securities under which the consideration given by the company for the use of the principal secured is to any extent dependent on the results of the company’s business or any part of it”.  Direct issuance of a hybrid by the UK parent company runs a serious risk of not getting tax relief for the interest expense because the various provisions for interest deferral are likely to violate this statute.

Accordingly, it would be more natural in the UK to have the hybrid issued by a special purpose vehicle (SPV).  The precise structure used will depend upon the circumstances of the client and to a significant extent upon what is fashionable.  The type of approach used is illustrated by the following diagram (click image to enlarge):

Hybrid_capital_fig2_2

The securities issued to the investors are the hybrid capital.  They have all of the deferral and subordination features required.  Legally they are limited partnership interests in the Jersey Limited Partnership (JLP). 

General Partner Ltd would be a wholly owned subsidiary of Issuer plc formed purely to act as general partner of JLP.

JLP will use the cash raised from the investors to subscribe for Subordinated Notes issued by Issuer plc.  Since these notes are between the UK issuer and JLP, rather than being held by the outside investors, they do not need to have identical commercial features to the external hybrid.  For example, interest can continue to be paid to JLP on the Subordinated Notes even when the group’s overall difficulties have caused JLP to suspend coupon payments to the external investors.  The cash received by JLP as interest on the Subordinated Notes can then simply be lent back to Issuer plc.

Overall, structures of this type mean that the debt between the UK parent and the SPV can avoid violating the provisions of ICTA 1988 s.209(e)(iii) even if the terms of the externally issued hybrid capital would fall foul of it.

The introduction of the SPV does of course introduce its own potential tax concerns.  For example, Finance (No2) Act 2005 introduced a new set of rules to counter “Avoidance involving tax arbitrage” and it is essential to ensure that the structure used does not fall foul of them. One of my colleagues is involved with a live issue as I write.

7. Transaction size

The five transactions discussed ranged from €500m to €1,300m.  The lower end of this range suggests that hybrid issuance is potentially open to a reasonable number of UK groups, if it matches their commercial requirements.

8. Conclusions

Hybrids have received a significant amount of press attention recently.  Accordingly, I would expect to see an increase in issuance by UK corporates.  The key thing is to be satisfied on the pricing, and to ensure that the ratings, accounting and tax treatments are satisfactorily addressed in advance.

This article was originally written and published by Mohammed Amin.

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