The term ‘groundbreaking’ is often overused in capital markets. But the African Development Bank’s hybrid capital deal in January 2024 was just that – or at least that is the hope. In the works for three years, it is the first such transaction in the public sector bond market, opening the door for other multilateral development banks to lend more to emerging markets for sustainable development.
Talk of hybrid capital has been gathering pace over the last few years. It came into sharp focus in 2022 after an independent review of MDBs’ capital adequacy frameworks by the G20. The review recommended that, as hybrid securities are treated as equity by credit rating agencies, MDBs should use this product to lend more without impacting their credit ratings. But while the objective was simple, structuring the deal was far from it.
Finding the right price
Pricing the deal proved challenging. While corporates and financial institutions issue hybrid capital, MDBs or public sector borrowers had not done so before. There was no benchmark for what the spread would be for a public sector borrower’s senior to subordinated curve.
‘With regards to pricing, we had intense discussions internally with the banks about the best way to work this out,’ said Hassatou N’Sele, vice president and chief financial officer at the AfDB. ‘While this is not a 10-year bond – it is equity – a fair starting point to build the price was a 10-year senior unsecured bond. The pricing had to make sense for us and for investors, but it was difficult to benchmark as there were no real comparable deals.’
During an extensive roadshow conducted over three weeks across the UK, US and Europe in September 2023 – where the AfDB met with over 150 investors – discussions around pricing were at the forefront.
‘The price discovery process was at the centre of our discussions with investors,’ said Benjamin de Forton, head of debt capital markets at BNP Paribas, one of the joint structuring banks and leads on the transaction. ‘We explained the structure to investors, got feedback on what was working for them and not working for them. It was very much an open exchange between us.’
Creating an investor base from scratch
The challenge was accentuated by the fact that the leads were explaining a novel product by an MDB to an undefined investor base. ‘We had to educate both the traditional sovereign, supranational and agency investor base that don’t buy perpetual products and credit investors that don’t buy MDB bonds,’ said de Forton.
For the AfDB and its leads, this meant building an investor base from scratch, with the banks using their SSA, financial and corporate DCM desks to reach out to as broad an investor base as possible.
As hybrid capital is subordinated in the capital structure, the worry was that the AfDB would pay a significant amount for the deal over its senior curve. During the roadshow, investors were asking for a spread of around 150-200 basis points over the issuer’s senior or conventional curve. While this spread aligns with what corporates and banks would typically pay for hybrid capital, it raises concerns for public sector borrowers as cost efficiency is crucial to funding and issuance.
‘For the price discovery process, one aspect was to look at the best in class in this market,’ said de Forton. ‘That was the starting point. But it was difficult as this deal is rated AA, which no other hybrid security has. Another difficulty was that there was no outstanding 10-year point on AfDB’s curve, but assuming a new 10-year might come at [US] Treasuries plus 23-25bp, that gave a spread to the issuer’s senior curve of around 130bp.’
Strong result on price and demand
Achieving a spread of 130bp over the AfDB’s senior curve was a great result, although some DCM bankers away from the deal saw the spread as closer to 150bp. Either way, it came in tighter than anticipated. ‘We were able to structure this in a way that worked out for all of us,’ said N’Sele.
Some market participants away from the deal said the delay of the transaction from the September 2023 roadshow to execution in January 2024 was due to frictions between investors and the issuer on the price. But, according to N’Sele, the delay was more about finding the right window. ‘The delay to the transaction was not due to issues around the pricing, but volatility in the market towards the end of last year,’ she said. ‘We worked for three years on this transaction, and this maiden sustainable hybrid capital transaction deserved to be launched in a conducive market.’
As well as achieving a great result on pricing, the demand for the deal was impressive. The order book peaked at over $6bn, allowing the issuer to comfortably issue $750m for the perpetual non-call 10.5-year sustainable hybrid capital deal. There were over 275 investors in-book, with over 190 allocated to the trade. Hedge funds and specialised funds took the bulk of the allocation (54.8%), followed by asset managers (27.8%), central banks and official institutions (6.7%) and insurance and pension funds (6.6%).
Will other MDBs follow?
For this transaction to really make an impact, other MDBs will have to follow. Whether they will is the crucial question that market participants seem split on.
‘It looked like a good outcome in all regards,’ said a head of an SSA syndicate away from the AfDB’s deal. ‘But the question is: does it make economic sense versus borrowing direct from shareholders? My feeling is that the premium that the World Bank will pay versus their senior curve with their private placement to Germany will be less than what AfDB paid with this transaction.’
In September 2023, Germany became the first country to subscribe hybrid capital through a €305m private placement for the World Bank. A private placement allows MDBs to bypass the capital markets and issue directly to their shareholders. By issuing in this way, funding costs are contained as there is only one investor and shareholders receive a coupon for the investment, which they do not get with a regular capital raise.
According to N’Sele, the AfDB is looking at this method too. ‘Our sustainable hybrid capital project has two flavours: one designed to be placed with shareholders and another one through capital markets,’ she said. ‘We are pursuing our discussions with shareholders and foundations for a hybrid capital placement.’
There are other innovative ways for MDBs to unlock more lending. These include shifting part of their portfolios and transferring the risk to the private sector through synthetic securitisations, which is also an area where the AfDB has taken a leading role. But hybrid capital seems poised to gain traction – especially after such fundamental groundwork has been laid.
Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.
