In the old days banks lent money and out of this grew a business called syndicated lending. Today there’s a new phenomenon. Investment banks are now investing in Asian companies – side by side with hedge funds – in what might be termed ‘syndicated investing’.
Take the recent transaction involving Chinese property firm, Skyfame Realty. The US$200 million convertible bond saw Merrill Lynch lead the deal and also buy US$70 million of the bonds. It syndicated the remainder to six hedge funds. Merrill, alongside the hedge funds, evidently took a very strong view on Skyfame’s credit and equity story. The result: instead of just being paid an increasingly commoditised fee for lead managing the convertible, the US firm has the opportunity to realise a much higher investment gain down the road.
In this case, Merrill is co-investing with the six hedge funds in what might be termed a special situation. The deal will fund Skyfame’s growth – allowing the acquisition of a five-star hotel in Guangzhou operated by the Westin. Indeed, the special (and non-vanilla) nature of this CB is reflected in the fact that the size of the deal was bigger than the company’s existing market capitalisation.
‘Syndicated investing’ has grown out of such non-vanilla situations. It is about sophisticated investment banks putting their money to work alongside sophisticated hedge funds – with transformational consequences for companies like Skyfame.
Merrill has become one of the more visible players in the syndicated investing space. But it is by no means alone. Goldman Sachs, Credit Suisse and JPMorgan are very active. So too is Deutsche Bank which has about 50 staff working in the area – split between its credit trading team and its complex equity group. Morgan Stanley is a more recent entry and has just hired a team of five bankers to focus on it.
What makes syndicated investing unique is the collaborative relationship it creates between the investment bank and its hedge fund clients. The latter bring the capital, as well as the ability to purchase complex hybrid structures that combine a credit view with some equity upside. The investment banks bring the ability to source deals, do the due diligence and syndicate the risk to other hedge funds. And by taking a portion of the deal, the banks put their own ‘skin in the game’, giving an added comfort level that the investee company is a good one.
There is hence a very neat alignment of interests. “We are partners with the hedge funds,” says Damian Chunilal, Merrill Lynch’s head of Pacific Rim origination. “We are working collaboratively with the hedge funds.”
Teall Edds is a portfolio manager with Stark Investments, one of the biggest hedge fund players in the syndicated investing area. “This is a relatively new asset class and every deal is unique,” says Edds. “I joined Stark at the end of 2003 when there were few hedge funds in the region and most of this stuff wouldn’t have been considered for syndication by bankers. It is definitely a trend that is here to stay.” Investment bankers agree. “The volume of these deals has accelerated – both in size, number and country” says David Ryan, Goldman’s financing group head in Asia ex-Japan. “Most of what is done is privately placed, so it is difficult to quantify by how much it is growing with precision. But it is growing rather quickly.”
“It is a growing trend,” agrees Achintya Mangla, head of equity-linked and corporate derivative origination at JPMorgan. “We are currently looking at ten opportunities.”
“Anecdotally, we believe private investments by hedge funds and investment banks in Asia are four times the size of what traditional private equity funds have deployed in Asia,” says Tom Cheung, Deutsche Bank’s co-head of complex equity.
Edds of Stark estimates there could be US$3 billion of ‘syndicated investing’ deal volume this year, versus “almost zero” as recently as 2003.
“This business has been driven by the growth in Asia of hedge fund money,” says Credit Suisse’s Lars Sorensen, a managing director in the global structuring group, “The region has witnessed an avalanche of hedge fund money, and it has really only happened in the last couple of years. That money is being directed into these types of structures.”
“The business has grown as hedge fund activity in the region has grown,” concurs Deutsche’s Cheung. Apart from Stark, the major hedge fund buyers of these products include the likes of Citadel, Oasis, Ochziff and Farallon.
The big hedge funds tend to participate mostly through their “side-pocket” fund. This is a portion of money that hedge funds raise from their investors, and which typically cannot be withdrawn by those investors for at least three years. Given these funds are tied up for a longer period, the side-pocket is ideally suited to investing in more illiquid, hybrid structures.
No one knows precisely how much (leveraged) side-pocket money is dedicated to Asia, but in researching this article estimates ran to anything between US$3-7 billion. (There is estimated to be US$100 billion invested in Asian hedge funds.)
Asia’s growing hedge fund industry has a significance which is twofold. It not only brings lots of new capital to the region but a new sort of capital – one with an appetite for hybrid products. “Hedge fund investors have an intelligent, product agnostic approach,” says Goldman’s Ryan. “They can look at a company’s entire capital structure and price the risk of those instruments that lie somewhere between being equity and debt. They are also comfortable holding highly complex instruments that might be unlisted and illiquid.”
Supply Meets Demand
If the hedge funds represent the demand side of the equation, what of the supply? The deals are supplied by capital-hungry Asian corporates and can broadly be separated into two very different categories. The first set of companies is already listed, and the second are privately-owned.
“There are basically two types of situations we most commonly see,” continues Ryan. “There are listed companies with a unique issue or problem that conventional markets won’t serve well. For these companies a more creative package of instruments is required. Then there’s the universe of unlisted growth companies that are looking for capital. They are basically looking for finance to bridge a gap – and tide them over – to an IPO. This leads to pre-IPO financing, such as pre-IPO convertibles.”
It is the latter category that is the fastest-growing segment of the syndicated investing universe. “In the last year I reckon there have been 20-30 of these pre-IPO deals out of China,” says Gokul Laroia, Morgan Stanley’s head of global capital markets for Asia.
An example was JPMorgan’s work with Chinese property company, Greentown. The US bank co-invested with hedge funds in a pre-IPO convertible ahead of the company’s 2006 IPO – which JPMorgan also led.
Why? “In December 2005, Greentown wanted to raise cash knowing it was going to go public in 2006,” says JPMorgan’s Mangla. The company faced a problem specific to its sector, he says. It wanted cash to buy new land for development, but it didn’t want to sell equity based on its 2005 earnings. “Developers in China get cash in pre-sales,” says Mangla. “And Greentown already had a lot of sales booked into 2006. So the company had high earnings visibility for 2006. But no private equity firm was willing to give it cash based on a 2006 valuation.”
That’s where JPMorgan stepped in. It structured a US$150 million pre-IPO convertible, which paid a 10% coupon until the IPO, and at that point offered the holders the potential for equity upside through conversion into stock. From the perspective of the hedge fund buyers there is great value in receiving a guaranteed allocation at the IPO – especially when they expect a China IPO to be ‘hot’. From the company’s point of view it got financing at a valuation that equated to 5x 2006 earnings and used the funds to buy land for future projects.
China’s capital-constrained growth companies have proved the keenest on this type of financing. In the case of Greentown, the company’s stock was entirely held by the chairman, his wife and the general manager. They were very protective of their stock and the pre-IPO convertible offered them the perfect solution.
The logic is easy to understand. If you are a China entrepreneur you don’t want to sell your stock cheaply. You want to jealously hold onto as much of your stock as you can until the IPO. But if you want the value of the IPO to be even higher, you need to invest – in this case in land. This structure allows you to get the money to invest and enhance the value of the company ahead of the IPO. Meanwhile you are not selling any of your equity at today’s lower valuation. Instead the investors in the convertible will receive equity at the time of the IPO, when the valuation is higher. For the controlling shareholder this is the least-dilutive, most wealth-maximising option.
It also explains why the owners are happier to work with the investment banks and hedge funds than private equity firms. “Private equity is expensive and wants board seats,” says one banker. “Hedge funds don’t need a board seat. They also don’t need as high a return as the private equity firm and will also take higher risk.”
The same banker reckons that a private equity firm will want a greater than 30% return from a late-stage pre-IPO investment. Hedge funds are able to live with returns in the 20% plus range – blended across the coupon they are paid and the equity upside potential. This gives hedge funds a pricing advantage when it comes to bidding for such late-stage investments.
The investment banks involvement in the deal also has an additional level of comfort for the hedge fund – quite apart from the co-investment risk the bank is taking. “We have the IPO mandate,” says Mangla. “The hedge fund client wants the IPO to happen – so as to maximise their return. The hedge fund takes comfort that we must be confident the IPO can be done and will be a success.”
China has grabbed most bankers’ attention, but deals are also being done in India, albeit fewer. “We just completed a US$60 million pre-IPO deal for a leading Indian infrastructure company,” says Deutsche’s Cheung. “Right now, the markets in India are relatively expensive. The majority of our recent deals have been in Greater China.”
There is another category of deal that is driving the syndicated investing space: those involving listed companies. By nature – since the companies are already listed – these deals tend to be a lot more public than the pre-IPO financings. They also tend to be a lot more complicated, and often involve some form of special event – such as a leveraged buyout.
Asia Aluminum is a very good example of just such a situation. This was a deal that saw majority shareholder and chairman, Kwong Wui-chun, raise US$500 million to de-list the metals firm – a feat that looked all the more gravity-defying when you consider the market capitalisation of Asia Aluminum was only US$350 million and it had US$450 million worth of debt.
Merrill Lynch, which was advising Kwong and co-investing with a small group of hedge funds, came up with a solution that financed the buyout of the public shareholders. The rationale for the whole transaction was Kwong’s own massively bullish view on the company’s prospects and his belief that the public markets were not valuing the firm fairly due to the stock’s low liquidity and poor analyst coverage. Meanwhile, both Merrill and the hedge fund investor group have financed the debt – which includes covenants to align theirs and Kwong’s interests – and retain warrants on any future equity upside.
“This was a cheap company which the market had fallen out of love with,” says one observer. “The chairman was very bullish, and if you are smart you can see why. So you finance him and take equity upside.”
This sort of deal has very much entered Merrill’s DNA, especially since Sheldon Trainor arrived from Morgan Stanley to run investment banking in May 2005.
“The first structured deal we did was for Medco in Indonesia,” says Soofian Zuberi, Merrill’s co-head of Asia equity capital markets. “We started work on this on 24 December 2004. There was no overall strategy at the outset. It was a leading tycoon in Indonesia who needed to raise money rapidly. He had lost management control during the crisis and had to raise US$468 million in four weeks (to buy the stake off PTT E&P and a distressed debt investor). That was the challenge. And that was to raise the money for him, not the company. We approached this from an ECM point of view and thought there should be an equity component as part of the fundraising. So we created a structure that gave a double-digit yield and contained synthetic equity optionality.”
After the deal, tycoon Hilmi Panigoro’s stake went from 40% to 85%. With a stronger management team in place, a clearer shareholding structure and rising oil prices, the stock quickly doubled. “We did a GDR to help pay down the debt,” says Zuberi. “Hilmi now owned a 52% stake, but his stock is also now worth twice as much as before.”
Merrill had put some of its money into the deal, and says Zuberi: “After we did Medco, we extended this strategy to other companies in Southeast Asia and North Asia.’”
Subsequent deals included a successful transaction last year for Berau Coal and most recently a deal for Neptune Marine that closed in April.
Merrill runs its syndicated investing out of investment banking and its team includes – aside from Zuberi – Jason Cox (co-head of Asia ECM) and Andrew Cooper (head of Pacific Rim equity-linked origination); as well as Alex Woodthorpe, the overall Pacific Rim ECM head.
The Path to Riches
The firms that have entered the ‘syndicated investing’ space have all got there partly because of their risk cultures and partly because of their history. At Goldman it grew out of the phenomenal successes achieved by its special situations group (known in Asia as ASSG).
At Credit Suisse it dates back to the financial crisis itself, and the firm’s lending exposures in Indonesia. It was through working these out that the investment bank gained an expertise in distressed debt valuation and trading. It is this which evolved, for Credit Suisse, into the current hybrid, which sees both it and its hedge fund clients take strong credit views, but attach an equity component.
At Morgan Stanley it has grown out of the firm’s real estate investment franchise. Over the past few years this has been one of the firm’s most profitable platforms, and has certainly been the area where its proprietary risk appetite has appeared strongest.
“For Morgan Stanley, our initial foray into this was through the real estate business,” says Morgan Stanley’s Laroia. “Last year we did a privately-placed CB of US$100 million for Shanghai Real Estate.”
Morgan Stanley has just hired a team of five professionals to focus on structured lending and syndicated investing and Laroia estimates the number could rise to ten by the end of the year. “This is a significant opportunity,” he says.
The firm’s focus is on pre-IPO deals from China and India. This is an area where Morgan Stanley reckons it has a competitive advantage in sourcing deals.
“We’ll do 30-40 China private sector IPOs this year,” says Laroia. “Access to deals comes from your footprint and the quality of your franchise and track record. Often it’s our existing clients, private entrepreneurs and CEOs who have the best insights and contacts in terms of future leads. It’s a powerful network.”
In fact, sourcing these deals goes to the heart of the investment bank’s role in syndicated investing. The hedge funds have plenty of capital but they don’t necessarily have the manpower to go trawling round China to find opportunities in places like Anhui province.
These transactions come from more diverse sources than traditional investment banking deals. For example, good leads come from private bankers. “Our private bank works very closely with the investment bank,” notes Credit Suisse’s Sorensen. “They bring deals to the product guys. The private bank speaks to a lot of the relevant individuals.”
The sourcing of deals is one area where the banks have a distinct role. The other area where the banks add value is in their due diligence and structuring skills. A third and related area, relates to the reputational risk they expose themselves to. The big firms cannot afford to back a dud company, or worse, a fraudulent one. This gives hedge funds – particularly the smaller ones – a degree of comfort when they invest.
“It’s critical to spend time figuring out which businesses you want to sponsor,” says Laroia. “You need to be careful and selective and remember that your franchise is always at stake.”
The fact the banks are putting their money into the deals also adds a further layer of comfort. And as previously stated, so does the fact the bank has the IPO mandate – and thereby feels confident it can bring the company public. (Conversely, this is also one of the neat synergies for the banks; when they get involved in the pre-IPO deal, they also lock in a further fee-paying piece of business, the IPO, at some point in the future. This also makes the whole process very beneficial for the banks’ IPO pipelines.)
One challenge for the investment banks, is sharing these deals among the growing band of hedge funds. This is exacerbated by the structure of the deals which – by design – tend to be syndicated to only around 3-5 firms. That’s partly a function of their size, and partly to the chunky amounts that each hedge fund wants to invest (if they spend the time on the deal analysis, they want to commit serious sums). It is also a function of the fact that if anything goes wrong, the hedge funds want to be part of a compact group that can act quickly and in concert.
Bankers say that this leads to a selection problem: which hedge funds to invite and which to leave out. It also forces the bank to evaluate what is the ‘right’ size for its own investment. If it takes 50%, then that leaves a much smaller pie for the hedge funds; if it takes 5% that might be viewed as too small a commitment.
So what is the hedge fund perspective on this? “It is important that bankers maintain close dialogue with the hedge funds that are most established in this space – so as to ensure that pricing, structuring and analysis remain ‘on market’. It is disappointing when banks say they are taking half the deal, and take it or leave it,” says Edds of Stark, one of the biggest movers and shakers in this space. “I think that can lead to the mis-pricing and mis-structuring of transactions. My experience has been that the sweet spot is when the bank takes 20% of a deal. That is where the pricing is fairest and the incentives seem to be in the right balance between the institutional clients, corporate clients and proprietary interests.”
Industry experts also observe that a bifurcation is occurring between the hedge funds themselves. The distribution of the best deals – with the best returns – is increasingly hogged by four to five ‘gorilla’ funds. These ‘gorillas’ – such as Citadel and Stark – are nearly always the first to see transactions. They are constantly in reverse-enquiry dialogues with the investment banks – in other words they’re telling the banks the sorts of deals they want. In some cases, they even identify companies for themselves, and merely ask the banks to find a couple of other funds to come in as well.
“This is a specialised area of investing that requires capital, brand credibility and staff with strong legal, structuring and analytical skills that have been seasoned in Asia. It is becoming more and more a game of size,” says Stark’s Edds.
But will it continue to be a game of success for all involved? So far, most deals have paid off handsomely – but that is partly thanks to rising markets. These cannot last forever. A bear market would shut the IPO window, and that would damage financial returns.
“So far this has been a bull market trend,” says JPMorgan’s Mangla. “No one has tested how it will last when the markets go down. For the time being, it is great for issuers.”
Goldman’s Ryan notes: “This product works in a bull or a bear market, because in the latter there are more companies that have lost access to the markets and structured placements work well.” But he qualifies this remark: “The exception to this is probably in those transition windows where markets go from a bull to a bear phase. That’s when some hedge funds could be underperforming and their risk appetite lessens.”
“We have been doing this for nine years,” says Credit Suisse’s Sorensen, “and there have been plenty of hiccups along the way. We find hiccups provide opportunities, but at the moment we are benefiting from a bit of a bull market phenomenon. However, all the hedge funds and banks are now interested in this asset class. It is here to stay.”
In fact, this asset class could represent a new chapter for Asian finance. “It is transforming the capital market for newer, growth companies,” says Deutsche’s Cheung. “This is a very positive trend for Asian growth.”
And he is bullish on the trend. “It will keep evolving and growing,” he adds. “You have the most sophisticated players and the most sophisticated firms working on this.”
In fact, the only people who should perhaps be worried are the staff of global private equity firms in the region. This new alliance of investment banks and hedge funds is hoovering up deals – particularly in the region’s fastest-growing economy, China. And unlike private equity firms they are not demanding politically-sensitive controlling stakes.
Asian entrepreneurs evidently like this aspect of syndicated investing. And it is for this very reason that some bankers suspect syndicated investing could be more successful in Asia than private equity.
This article first appeared in FinanceAsia, April 2007.