Investment Banking - Lecture Notes PDF

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Prof. Gatti - Della Ragione...

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Lecture 2:

Syndicated Bank Loans/Facilities: This topic will be treated by taking a look at a case study, the Hong Kong Disney project, which took place in the early 2000s. Even if it is an old case, the principles of syndicated loans did not change. Moreover, it is one of the largest examples of syndicated loans, considering that the Asian market was experiencing a severe crisis at the time, implying a massive market spillover. Syndicated loan: financial relationship (i.e. loan) between one borrower and multiple lenders (not a bilateral relationship) 

Borrower: corporations, public entities/governments (e.g. USA) and specially created entities created to raise money for a specific investment (i.e. Special Purpose Vehicle)



Lender: before only banks, now a “melting pot” of institutional investors (i.e. mutual fund, leverage funds, CLOs, insurance companies, pension funds, etc.) o

In our case study, prevalently banks

The key issues to be dealt with are: 1. Analysis of the deal 2. Process of syndication a. Before the mandate (i.e. before the syndicate is structured) → identification of the bank that will lead the syndicate (i.e. the deal arranger, or MLA, mandated lead arranger) b. Organisation of the syndicate 3. Compensation of the syndicate (fees distribution)

Analysis of the deal:

The project provided for the construction of a Disney theme park in Hong Kong. This project was positively welcomed by the HK government (possibility of creating jobs + other advantages for the economy). So, the two sponsoring parties are the HK government and Disney. The two sponsors created through equity contribution an SPV, HK International Theme Park Ltd: 

HK contributed with HK$ 3.25 bn (57% of ownership)



Disney contributed with HK$ 2.45 bn (43% of ownership)

In the form of debt, the SPV received money by: 1



HK government: HK$ 6.1 bn of subordinated (i.e. lower priority of repayment) debt with maturity 25 years the repayment of which starts in the 11th year of operations o



Heavy commitment of the HK government

Bank Syndicate: HK$ 2.275 bn with maturity 15 years + HK$ 1 bn of Revolving Credit Facility o

RCF: loan that can be used multiple times (e.g. I have a loan of $ 1 bn and I use $ 700 mln, so I have $ 300 mln left; if I repay $ 200 mln, I can now use up to $ 500 mln); used to finance day-to-day working capital once the project is operative

Moreover, HK contributed also with the land on which the theme park will be built, worth HK$ 14 bn, including infrastructure development. The land is expropriated in the end of 2000. The construction starts at the beginning of 2002 and will end in 2005. Indeed, the park is first opened to the public at the end of 2005: 

During construction, cash is “burnt”, and none is realised



The loan stipulated with the syndicate will mature in 2016, so it covers the 4 years of construction and 11 years of operations (the only one in which cash is realised)



HK government will be repaid from the end 2016 onwards (subordinated)

Important: the syndicate is lending to the JV and not to the sponsors, so the sources of repayment are JV cash flows. The syndicate cannot ask for the intervention of the sponsors in the repayment. A guarantee on repayment is offered by the collateral (i.e. the assets of the SPV = theme park). To sum up:

Debt

Equity

Amount (HK$ millions)

%

Bank Term Loan

2,275

16.2

HK Government Loan

6,092

43.3

Subtotal

8,367

59.5

HK Government

3,250

23.1

Walt Disney

2,449

17.4

Subtotal

5,699

40.5

14,066

100

Total

The deal is relying quite heavily on debt, exploiting the power of leverage. Moreover, the syndicated loan covers a minimum part overall (16.2% of the SPV liability). The table above refers to the end of 2005, i.e. when most of the financing has been used. The HK$ 1 bn of RCF has not been used yet (used during operations to finance upswings and downswings of working capital).

Before the mandate:

2

From a technical standpoint, Disney prepared in April 2000 the term sheet to be presented to JP Morgan Chase. The key points of the term sheet are: 1. Amount of money required (HK$ 3.3 bn) and how this amount of money should be split (L-T loan and RCF) 2. Tenor (i.e. maturity, 15 years) 3. No recourse clause: the loan is to the vehicle and HK and Disney cannot intervene, usually embedded with project financing (different from corporate financing, in which an existing entity is asking for a loan) 4. Fully underwritten: in case no lender is found, the investment bank will finance (i.e. the loan is fully committed) 5. Possibility to use cash to further expand the park: additional Capex is allowed 6. No subordination of Disney’s management fee: paid after debt Condition 1, 2 and 4 are standard in the world of syndication. The last two are tailor-made. The last two conditions are problematic for creditors (also the 3 rd). For the 5th: Unlevered FCF = EBIT – Taxes + D&A – Changes in WC – Capex If this FCF > 0 in the operational phase, it is used to pay the principal + interests of the syndicated loan. If anything is left, dividends are distributed to Disney and the HK government. In normal project financing, in operations Capex = 0. According to the 5 th condition, this may not be the case and may imply concerns for creditors. Notice: Disney gets money from the project through dividends and management fees. Form the point of view of the lender, some pros and cons are included in the term sheet: Pros

Cons

Experienced sponsor and key customer (i.e. Disney)

Absolute size and maturity, especially after exiting the Asian crisis

Strong commitment from the HK government → GSE (Government Supported Entities), inheriting the high credit worthiness of HK

No recourse clause + condition 5 and 6

Relative size (only 16% + seniority)

Illiquidity of collateral

The bank can consider three possible strategies: 1. No bid: it can’t be done because Disney is a key customer 2. Aggressive bid: to win the deal, if true interested 3. Less aggressive bid: to lose the deal, if not truly interested Chase’s reply specifies some additional points to the term sheet:



Terms of the offer o

Arranging Fees, paid for the organisation of the syndicate, usually benchmarked on precedent deals (125 basis points on HK$ 3.3 bn) 3

o

Interest Rate built as HIBOR + spread (to match bank’s assets and liabilities in the L-T) according to a step-up pricing scheme (to match the SPV’s CFs) 

Construction + up to 2008: HIBOR + 100 bp



2008 – 2013: HIBOR + 125 bp



2013 – 2016: HIBOR + 137.5 bp

Lecture 3:

Syndicated Loans (2): The key points will be: 1. After the mandate a. Syndication strategies b. The 3 key questions for the MLA (Mandated Lead Arranger) 2. Fees calculation and distribution The moment of financial close: amount agreed upon is provided + arranging fees (1.25% * HK$3.3 bn) are paid upfront, upon the fulfilment of certain conditions. As borrower, you pay only once to the MLA (i.e. Chase) and the fees are then distributed to the other banks of the syndicate. From 2002 onwards, the HK$2.3 bn will be used in “stacks” and can be divided into: 1. Used/drawn funds, on which interest are paid (i.e. HIBOR + spread) 2. Unused/undrawn funds, on which a commitment fee is paid (i.e. fee to be able to use the unused amount later and pay for the commitment of the syndicate), amounting usually to 50 – 70 % of the spread a. Goes to 0 as construction is completed (i.e. funds have been depleted) So, pricing in syndication has three main components: upfront arranging fees, interests on used and commitment on unused. This part coincides with the offer made by Chase to the SPV. The offer, in general, can be: 

One-round: received and accepted



Two-round: received, renegotiated and accepted

To finalise the definition of the mandate, approximately 3 -4 months, especially for complex deals. Once the arranging fees have been paid, Chase is obliged to fulfil its part and eventually provide for the full amount since the loan is fully committed.

After the mandate: Syndication strategies: There are two strategies that the MLA can follow: 1. Single-stage syndication 2. Dual stage syndication 4

Single-stage syndication: Chase has a commitment on the books of HK$ 3.3 bn but it’s confident to build a syndicate. So, Chase offers to participating banks to “transfer” a portion of the loan in their books (single stage syndication), promising in return a portion of fees collected. The fees are distributed according to the “tier” of a given bank (i.e. the amount provided). CHASE

PARTICIPATING BANKS

This mechanism embeds a great deal of risk for the IB deriving from the possibility of not placing the loan on the market ( → higher return). Given the complexity and size of the deal and market condition, a single stage syndication appears to be very risky (only when the MLA is certain it can form a syndicate + very liquid and healthy markets). Dual stage syndication: An alternative strategy is selecting in the first stage a restricted pool of large financial institutions, usually conglomerates (6 in this case), and asking them to split the loan in the “worst case scenario” before going to general syndication. These banks are called “sub-underwriters”. This 7 members (underwriters) then try to form a syndicate. So, lower risk for Chase but lower returns. Notice: 7 syndication desks working on the deal. This strategy is preferred when market conditions are more difficult.

CHASE

SUB-UNDERWRITERS

PARTICIPATING BANKS

This second strategy is called dual stage and it is particularly goods in markets under distress. However, this structure implies a more complex hierarchical structure. After participating banks have been reached, the general syndication phase starts. Chase is simultaneously the MLA, an underwriter and a lender (impossible to place the full amount on the market). On the other hand, the group of sub-underwriters are underwriters and lenders (concept of fees accumulation). MLA and sub-underwriters will be paid for each “role”, while participating banks will only get the closing fees.

The 3 key questions to the MLA: The questions are (regardless of the strategy): 1. Small v. Big syndicate (how many banks) 2. Which banks to invite 3. How much final take (amount of money directly lent by the MLA) on your books

1st question: LARGE GROUP Pros + More lucrative for the MLA given small bargaining of the participating

SMALL GROUP Cons

- Coordination costs

Pros

Cons

+ Strengthen business relationship with banks

- Less lucrative for MLA

5

+ Avoiding strategic default of the borrower (when dealing with a government)

+ Small coordination costs and smoother decision-making process + Confidentiality for the borrower

2nd question: To find the ideal banks to invite, we must look at: 1. Characteristic of the deal 2. Involvement of the Government of HK 3. Currency of the loan (i.e. avoid currency mismatch) 4. Business relationships (to foster relationships with other banks) 5. Borrowers’ request By analysing these points, Asian banks may be worth looking at.

3rd question: On average, 10 % is held: 

If = 0, it signals no confidence in the deal



If too high, higher capital requirements (Basel) and higher risk

Calculation of Fees: During the 1st stage of syndication: 

SPV gives 1.25% (HK$ 41.25 m) of arrangement fees to Chase o

Chase distribute 0.25% to sub-underwriters and 0.7% of closing fees to top tier participating banks

o

Chase retain the extra 0.3% of fees.

So, the final allocation is: UW FEES FOR MLA MLA (1)

9.9 m (0.3%*3.3 bn)

SUB-UW FEES

% CLOSING FEES

FINAL TAKE

1.178 m (0.25%*3.3 bn)/7

0.7%

130 m

7.072 m (0.25%*3.3 bn)*6/7

0.7%

780 m

SUB-UNDERWRITERS (6)

-

ARRANGERS (18)

-

-

0.7%

1,890 m

CO-ARRANGERS (3)

-

-

0.6%

255 m

6

LEAD-MANAGERS (2)

-

-

0.5%

140 m

LEAD-MANAGERS (2)

-

-

0.5%

105 m

The first two columns (totalling HK$ 18.15 m) indicate what is paid in the 1 st stage of the syndication. In the 2nd column, we have assumed that the commitment was shared in an equal way. The amount of fees left to distribute are: 41.25 – 18.15 = 23.1. The % closing fees (i.e. compensation for the final take) are paid on 23.1. The total closing fees are calculated by multiplying the third and the fourth column and they amount to 22.355 m. This leaves out 0.745 m (i.e. 23.1 – 22.355) of residual pool. This amount can go both go to the MLA only (if strong bank) or to the MLA and the sub-underwriters. Lecture 4:

European Debt Capital Markets (Société Générale): In 2018, the market activity in bond markets significantly decreased (i.e. € 337 bn) due to political and economic concerns. In 2019, the start has been relatively positive. In terms of volumes, the final balance of 2019 is expected to be below that of 2018 and far below the peak of 2017 (i.e. € 392 bn).

Technicalities of Credit Markets: What are the main advantages of bond issuances? 

Secondary market liquidity: securities are priced + access at any time



Diversification of sources of funding: if bank market doesn’t work/ high margins on loans, bonds provide a good alternative



Long-term financing: loans usually have tenures of 5, 7 or 10 years, while in the bond markets we can find longer tenures (better for matching purposes)



Free-up banks’ capital: banks have less commitment to issuers and capital is dedicated to other ops (M&A, others)

The typical structural features of bond in the European market are: 

Plain (i.e. coupon paying) or Hybrid (equity + debt features)



Fixed (typically for longer maturities, fixed CFs) or Floating (for maturities between 18 m and 5 y, depending to inflation, commodities indexes, interest rate, or others)

What is the role of financial institutions in the bond market? Matching the needs of investors (individual companies, insurance pension/mutual funds, hedge funds) and issuers (companies, central governments, municipalities, public corporations, financial institutions) by designing the right instruments to be offered.

General Features of the Eurobond Market: In general, a bond is defined as “any interest-bearing security that obligates the issuer to pay the bondholder a specific sum of money, usually at specific intervals and to repay the principal amount of the loan at maturity”. Its specific features include: 

Issuer, on whose assets the payment of coupons and principal is guaranteed



Guarantor: if bond is issued by an SPV, an IB is the guarantor



Credit rating of the issuer: if no credit rating available, each investor can perform credit analysis 7



Maturity date: can also be perpetual (equity-like instruments, redemption is created synthetically through the inclusion of call option in the contract)



Coupon: fixed v. floating



Price: in the market practice, the value assigned to a bond is not its cash price, but it is built relatively to some benchmarks (i.e. credit spread, expressed in basis points, over some government bond/swap curve)



Nominal value

Issuers and Investors: The typical issuers are corporates, sovereign and financials, each with their own needs. On the other side, the investors are: 

Banks: short-medium term buyers, to perform ALM, get the yield or to build relationships



CB: to perform reserve management



Asset managers: to perform their asset allocation (e.g. if mimicking a bond index)



Insurance companies/pension funds: long term investors, to match maturities (ALM)



Hedge funds: short term investors, seeking to exploit the secondary market



Money market funds: short term investors (up to 3 years), for low risk-return schemes



Retail investors: less rational than institutional investors, usually for saving management

Size: For the size of the issuance: 



Minimal amount required to ensure liquidity is €300 million, but no maximum limit o

If lower, private placement market (more selective dialogue with investors)

o

From € 300 million up to over € 1 billion in normal market conditions

Larger sizes achievable through multi-tranche (i.e. pick different maturities, to diversify and reach different investors), multi-currency issue

Maturity: In terms of maturity: 

The 5, 7 & 10-year tenors remain the most sought-after tenors on the EUR fixed rate market by investors as the best adapted to their portfolios requirements, although we have seen a very strong demand for shorter tenors o



Since the2000s, lengthening of the credit curve with the inception of the15-,20-,30-year segments

The Floating Rate Note market gives opportunities in the short-term maturities: 2-year up to 5years

Credit Rating: Credit Rating is a key issue to look at. It “quantifies” the credit worthiness of an entity (i.e. ability of to meet its financial commitments). Rating agencies provide independent credit assessment on a case-bycase basis for either a specific company or a specific issuance. The leading global agencies are Standard and Poor’s(S&P), Moody’s and Fitch. The credit rating is influenced by: 1. Industry risk: environment in which the company operates, key elements are cyclicality and barriers to entry 8

2. Business risk: attention to efficiency, competitive position, diversification and level of margins 3. Financial risk: i.e. financial ratios, flexibility and funding structure 4. Company’s strategy: i.e. development strategies, appetite for leverage and financial target ratios The first two elements determine the business profile of a company, while the last two its financial profile. To create the rating, agencies look at the ratio Total Debt/EBITDA, determining a distinction between investment and speculative grade securities.

New Bond Issuances (Pricing and Valuation): The IB crucial role is that of bond pricing. The pricing of a bond is based primarily on the issuer’s credit quality (i.e. higher probability of default = higher yield). To correctly price a bond, the following factors should be looked at: 

Credit quality (i.e. rating)



Comparables, when bon...