There has been a strong resurgence in the hybrid securities market, which had been largely dormant since the onset of the GFC, with a number of recent issues by financial issuers (including ANZ, Westpac and Colonial) and corporate issuers (including Woolworths, Origin Energy, Tabcorp and AGL Energy).
Hybrid securities, which combine both debt and equity characteristics, can provide a cost effective funding alternative for issuers looking to supplement their traditional sources of capital, particularly in the current market given the continued upward pressure on pricing of bank loans and the tightening of liquidity in the bank loan market in Australia. Hybrid securities can also provide an attractive investment for investors looking for "fixed income" style returns that typically exceed those payable on bank deposits and more conventional debt products.
Investor demand for the recently issued products has been strong and it is expected that further issues will soon follow.
In this article we consider some of the key features of hybrid securities as well as some of the factors that influence the structuring of hybrid securities. We also look at recent trends in structuring of hybrids and set out some of the legal considerations arising in relation to issues of hybrid securities by corporate issuers.
What are some of the key features of hybrid securities?
Hybrid securities are securities which combine features of both debt and equity. They offer payment of regular distributions at a predetermined rate for a specified period, similar to conventional debt, and are often described as "fixed income securities". However, hybrid securities will also have one or more equity characteristics such as the ability of the issuer to defer distributions, subordination to creditors and convertibility to equity, which mean they carry greater risk of loss of investment than conventional debt products.
There is no fixed definition of what constitutes a "hybrid security" and the expression encompasses a diverse array of financial instruments, such as converting or redeemable preference shares, convertible notes and other forms of unsecured notes, and a wide variety of commercial terms. This means that, in terms of risk and return, hybrids can sit anywhere across the debt/equity spectrum.
Regardless of the underlying nature of instrument used, hybrid securities can be categorised by reference to certain key structural features, such as:
- whether the "dividends" or "distributions" paid on the security are fixed or floating;
- whether the payments of distributions may be deferred and, if so, in what circumstances – some hybrids provide for voluntary deferral at the discretion of the issuer, others provide for mandatory deferral where the issuer is in breach of certain financial ratios, such as interest cover or leverage ratios and some have no deferral rights;
- whether deferred distributions are cumulative or non-cumulative. Recently, a number of issuers (including Paperlinx and Elders) have deferred payments where payments are non-cumulative, with significant value implications for holders;
- whether distributions are franked or unfranked;
- the maturity date of the securities – while some hybrids are technically perpetual, most hybrids have an initial "call date', when the issuer can redeem or convert the securities, of between 5-10 years. Often there are potential disincentives for the issuer to leave the securities on foot after this initial call date such as an automatic "step-up" in the interest rate on the securities or a change in the treatment of the securities for ratings purposes;
- whether the hybrids may, or must, convert into ordinary shares – the recent trend is away from conversion rights;
- whether the security has any "equity optionality" – some hybrids enable holders to benefit from share price increases above a specified level but most do not;
- the level of subordination – most hybrids are subordinated to all other creditors and rank either ahead of or equally with equity; and
- what happens on a change of control – the rights of holders on a change of control vary greatly from the right to convert to participate in any "takeover premium" to no right to redeem unless the rating of the issuer is adversely affected. Care needs to be taken to ensure the hybrids do not operate as a poison pill on a change of control.
What are some of the key factors that affect the structuring of hybrids?
The way in which a hybrid security is structured is largely affected by commercial factors, rather than legal ones, in particular:
- for regulated financial entities, capital adequacy requirements imposed by APRA;
- for entities with a credit rating, the level of "equity credit" that ratings agencies will attribute to the security (ie the extent to which the ratings agency will treat the hybrid as equity rather than debt);
- the accounting treatment of the hybrid;
- the taxation treatment for both the issuer, including whether distributions are deductible or whether they can be franked, and the investor;
- the issuer's financial position and its existing capital structure and debt facilities; and
- investor demand for particular types of products (which in turn may reflect prevailing economic and market conditions).
However, an issuer of hybrid securities still needs to consider a number of key legal issues when preparing their issue which are considered in section 5 below.
Recent trends in structuring of hybrids
Recent experience suggests that hybrid securities which have structural features closer to corporate bonds than ordinary equity are becoming increasingly popular in Australia amongst corporate issuers.
Of the five hybrid issues since October 2011 by non-financial issuers, four (Woolworths, Origin Energy, Tabcorp and AGL Energy) have involved the issue of slightly varied forms of unsecured, subordinated notes which:
- pay cumulative, unfranked, quarterly floating rate distributions of between 3.25% and 4.00% above the bank bill rate;
- provide for deferral of distributions either at the discretion of the issuer or mandatorily where there would be a breach of interest cover or leverage ratios for a maximum of 5 years;
- have an initial call date of between approximately 5 and 7 years, after which the margin will "step-up" by 0.25% (Tabcorp and AGL Energy) or 1.00% (Woolworths and Origin Energy) if the securities are not redeemed;
- provide between 50% and 100% equity credit by Standard and Poors until their initial call date, when they will cease to have equity credit;
- do not provide holders with any rights to convert their notes into ordinary shares of the issuer;
- restrict redemption of the notes in certain circumstances unless the issuer has issued similar securities or ordinary shares prior to redemption; and
- rank above the ordinary shares of the issuer but behind all other forms of secured and unsecured creditors of the issuer.
We expect there will be a continuing trend towards this type of hybrid which has primarily debt characteristics but provides some equity credit for rating purposes.
For the type of notes currently being issued by corporate issuers, key legal considerations include:
- (Disclosure requirements) the issuer will need to issue a prospectus to enable retail investors to participate in the offer. The prospectus must comply with applicable Corporations Act disclosure requirements including, as a minimum, disclosing all material information that has not been disclosed under the ASX continuous disclosure rules. Accordingly, timing of the offer can be critical with a number of companies launching their offer in conjunction with the announcement of their annual or half yearly results; and
- (Debenture trustee for notes) a requirement to appoint a debenture trustee and comply with regular reporting requirements.
Additional considerations will apply if the security takes the form of a preference share or is convertible into equity, including:
- (Shareholder approval of preference shares) if the hybrid takes the form of a preference share, shareholder approval will be required unless the issuer's constitution contains appropriate provisions in relation to the issue of the preference shares;
- (Listing Rule 7.1 placement capacity) if the hybrid security may be converted into ordinary shares, shareholder approval of the issue will be required under the ASX Listing Rules if conversion could result in breach of the entity's 15% placement capacity (based on a notional conversion using the current share price); and
- (ASX approval of terms) if the hybrid security may be converted into equity, the issuer must satisfy ASX that the terms of issue are appropriate and equitable and if the hybrid is a preference share, the ASX Listing Rules require that all preference securities have preferential rights to distributions and on a winding up to ordinary securities.