Companies looking to jettison noncore assets on a tax-free basis without riling the regulators might ring up Bell Atlantic Corp. for its answer: exchangeable notes. Nearly $6 billion worth of them this year, to be exact. Its $3.2 billion August offering of notes tied to the company's holding in London-based Cable & Wireless Communications (CWC) marked the largest exchangeables deal to date, eclipsing the $2.5 billion record set in February by the Bell Atlantic notes based on its stake in Telecom Corp. of New Zealand (TCNZ). In addition to realizing the entrapped value of investments in the two companies and bolstering Bell Atlantic's balance sheet, the deals provide something of a blueprint for corporations hampered by pooling restrictions.
To guard against disposals cloaked as poolings of interest, the Securities and Exchange Commission bars companies from shedding significant assets for two years after a pooling occurs. "Significant" typically means more than 10 percent of earnings, revenues, or total assets--either of the acquirer or the target companies. For safe measure, the SEC also rules out such sales for nine months before a merger takes place. Just to make matters more frustrating for growth-hungry companies, any subsequent pooling may handcuff restructurings for two additional years.
Contending with the restrictions when companies contemplate pooled transactions "is always a pain," says Lehman Brothers Inc. tax expert Robert Willens. "I've almost never seen a pooling where someone didn't want to get rid of some asset." Using exchangeables to get around the restriction is a terrific way to use exchangeables, Willens adds, and it's a technique he expects to see again "scores of times."
The plan to liberate captive capital at Bell Atlantic began gelling in late 1997, says vice president and treasurer Ellen Wolf, several months after its $25.6 billion merger with Nynex. First, top managers concluded that owning 24.95 percent of TCNZ--the remnant of a stake Bell Atlantic acquired when the New Zealand concern was privatized in 1990--may lay outside Bell Atlantic's core interests. Bell CFO Frederic V. Salerno "was the driving force behind the decision to monetize the assets," says investment banker Davis Terry, a managing director who heads Warburg Dillon Read's Telecom Group for the Americas. "Ellen was the one who made it happen: who to use, how to do it, how to price it." Wolf charged Warburg with a fourfold objective: create a vehicle for selling the shares of TCNZ; obtain funds at an attractive price; defer taxes; and satisfy all pooling restrictions.
Bell Atlantic explored several options before settling on exchangeable notes issued by its financial services unit. Mandatory exchangeables, close relatives of the securities it eventually chose, had attractive features but were handicapped by a requirement that their issuance be treated as deferred sales. Not so with ordinary exchangeables. When they mature in April 2003, Bell Atlantic can elect to repay investors in cash or with shares of TCNZ stock. Although outside observers agree that Bell Atlantic will ultimately fork over shares, the option to substitute cash escapes classification as a deferred sale. "This instrument lets us realize the value of the investment without selling," declares Wolf.
A Form of Selling Stock?
Besides satisfying regulators, notes also had to suit investors and the issuer. Toward that end, Bell Atlantic and Warburg crafted a conservative debt security that guarantees repayment of principal while also giving investors an opportunity to capture gains on the price of the underlying stock.
If shares rise in price, Bell Atlantic could decide to sell them, repay noteholders with cash, and pocket the difference any time after April 2001, when a call provision kicks in.
"We could do that," Wolf concedes. In practice, though, such a twist might backfire, especially if the excess gain is only marginal. Transaction costs alone might sweep away profits, even assuming the stock price could withstand a block of either TCNZ or CWC shares being liquidated. Were the share price to slip below the strike price after Bell Atlantic repaid investors with cash, the company would end up with noncore assets on its books, and lighter cash coffers.
These obstacles, plus faith in Bell Atlantic's good intentions, reassured investors. "In their minds, not in our mind," Wolf carefully notes, "there is a general belief that this is just a form of selling the stock." Transferring shares to noteholders in an orderly fashion would also be smoother from an accounting standpoint, Wolf insists.
Although the application of the exchangeable notes was novel, the form of security itself enjoys the virtues of familiarity and comparative simplicity. "You don't need a road show to determine the value of a Bell Atlantic fixed-income security," says Terry. Where advance legwork was needed, Warburg research analysts handled it. "[They] went out to help get people up the learning curve on the underlying equity," Terry says.
For Bell Atlantic, it's hard to envision a downside, other than the possibility that it could sacrifice a portion of the stock's value if it rises over the strike price. If share prices rise in accordance with expectations, then Bell Atlantic gets a fair price for its asset while trimming its cost of capital. Better still, no tax is triggered until investors receive the shares. If the price falls so low that Bell Atlantic decides to keep its stake, it still has the use of several billion dollars for less than the market would normally charge. Meanwhile, from a credit-rating agency's standpoint, a note with so much underlying equity doesn't really count as incremental debt.
The Market Chills Things
The first round of exchangeable notes was launched on February 9. The amount, $2.5 billion, represented the market value of Bell Atlantic's stake in TCNZ plus a 20 percent strike premium. Essentially, Bell Atlantic sold a stake worth US$4.68 a share for $5.62 a share. Satisfied that the share price will surpass $5.62 by the time the notes mature, investors accepted a 5.75 percent rate of interest--better than the going rate for straight debt. "Had we gone out and done it as straight debt," Wolf observes, "it would have cost us 6 percent." The difference of 25 basis points on a deal this large means an extra $6.1 million a year in cash flow for Bell Atlantic.
There was no need for Warburg to provide a backstop, as the investment bank was prepared to do. Indeed, orders exceeded supply by five to one, with U.S. investors snapping up 40 percent of the notes; Swiss investors taking 30 percent; and 15 percent ending up in portfolios in the U.K. "The market was loving this instrument," Wolf says, "and there was nothing I could do about it," because Bell Atlantic's underlying asset limited the offering's size.
But Bell Atlantic, encouraged by the result, was able to craft a similar deal linked to its 18.5 percent stake in CWC--even though by late July the stock market was considerably less cooperative. The launch date was Monday, August 3, with pricing slated to occur on August 5. That Monday, the Dow lost 97 points, a prelude to Tuesday's 299-point plunge. On Wednesday, the market ended up 59 points. Still, it was not a backdrop to inspire confidence in equity-linked notes. Sticking to its guns, Bell Atlantic went ahead with the offering. Market conditions notwithstanding, demand still outstripped supply-- though by a slim margin this time.
Subsequent events make the timing look brilliant. "The lesson is that management made a very principled decision and carried it out swiftly," says Warburg's Terry. Since late summer, the price of CWC shares has slid by 30 percent. "In hindsight, it was exactly the right thing to do. Had they gone back to do the same transaction today, they would have netted $1 billion less."
Terry acknowledges that any rush by others to turn to exchangeables offerings now may have to await a more stable stock market. But global demand and a good liquid market will mean that big deals can get done. "It's a structure investors like," he says. For prospective issuers with noncore assets and pooling restrictions, that's very good news.