With multilateral development banks under pressure to boost their lending firepower, one of the tools being explored is hybrid capital. While this product is commonly used by banks and corporates, MDBs present a completely different proposition for its use.
MDB hybrid capital was explored at the Global sovereign debt forum, hosted by OMFIF’s Sovereign Debt Institute last month. As well as leading MDBs, this new flagship event brought together some of the most prominent asset managers, debt management offices and other emerging market participants for a series of high-level discussions.
Commenting on the African Development Bank’s inaugural public hybrid capital deal from earlier in the year, a funding official from an MDB said one of the concerns with the deal was ‘the large array of spreads’ that the AfDB received during the price discovery process. From its leads, AfDB said it received spreads ranging from 125 basis points all the way to 250bp over its senior curve, but said it eventually priced the deal at around 130bp.
A disparity in pricing is normal for a new asset class, but this was exacerbated by the fact there was and still is no clear and obvious investor base for MDB hybrid capital. This is because much of the traditional investor base for MDBs and public sector borrowers, such as bank treasuries, central banks and official institutions, do not buy perpetual securities.
Finding the right investor base
Marketing the product to credit investors like a generic hybrid security might seem like the most obvious solution, but MDBs are nothing like corporates or banks. For example, subordinated debt for an MDB is very different to additional tier 1 debt by banks in terms of credit ratings and structure. How investors treat MDB hybrid capital needs to be very different to how they treat hybrid and subordinated debt from other types of issuers, and this needs to be reflected in the price.
For AfDB, it was a case of testing the waters and seeing who would buy the product when it came to the market in January. In the end, hedge funds took more than half of the final allocation of the $750m perpetual non-call 10.5-year sustainable deal. Some market participants have been critical of this as hedge funds are not long-term investors and their vast allocation has been attributed to the poor performance of the deal in the secondary market. However, AfDB’s response is that hedge funds were helpful in building momentum in the book while also being transparent on where they wanted the deal to be priced.
Insurance and pension funds were said to have asked for wider spreads while the more opportunistic buyers in the form of hedge funds came at the tighter end. But relying on hedge funds to be the core investor base for MDB hybrids is not a feasible solution. Hedge funds are not the core investor base for hybrid securities by corporates, banks or any sort of products by public sector borrowers. MDBs will have to continue to educate and reach out to more investors to develop a reliable and core investor base. However, it is unclear what that will look like and what implications that will lead to in terms of the price MDBs end up paying for public hybrid deals.
A solution could be to restructure hybrid securities to make them appeal to the existing investor base for MDBs. This could be to make the securities dated without a perpetual maturity but this would mean not receiving the full capital treatment by the credit rating agencies. Another solution to ensure they do get full capital treatment is to issue a perpetual security into a special purpose vehicle and then issue dated debt off the SPV. ‘That may make it easier to find a price that is more consistent with where we need to be priced,’ said a funding official at an MDB.
There are other solutions too, such as bypassing the capital markets and offering hybrid securities directly to shareholders and partners as a private placement. Issuing in this way would keep funding costs contained and would make them attractive to shareholders as they would receive a coupon for their investment, which they do not get for a regular capital increase. But unlike a capital increase, they would not get voting rights. Plus, for MDBs that have recently completed a capital increase, or are about to, it may not be possible to stretch the support of their shareholders.
The bottom line is that it will take time to carve out a model and investor base that makes hybrid capital work for MDBs. It is not a one-size-fits-all solution.
Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.