With the Australian Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (the “Commission”) being unusually quiet recently following more reactionary and tabloid-friendly beginnings, we thought it might be a good time to consider what impact (currently) planned divestments by the major banks could have on hybrid valuations and risk.
Although not directly prompted by the Commission, the pace and determination of Australia’s major banks to divest underperforming and/or potentially risky businesses that are not aligned to their repurposed domestic alignment has surely been more clearly focused by the inquiry.
The impact that these actions could have on the majors’ hybrid instruments is a little tangential and revolves around the Volume Weighted Average Price (VWAP) that each hybrid is assigned at issuance (Issue Date VWAP) and which is generally based on the daily volume weighted average prices of ordinary shares in the preceding 20 trading days. In the case of CBA’s PERLS X, an Issue Date VWAP of $74.5657 was calculated. This article further explores only this instrument specifically but we note that most Australian bank hybrids will share many of the discussed features.
What is VWAP?
Ordinarily, a hybrid investor would care little about VWAP as it is largely inconsequential for a healthy bank which issues a hybrid instrument at $100, pays periodic distributions and redeems it for $100 on the scheduled call date a certain number of years later.
VWAP becomes much more important for a bank that (for whatever reason) misses its optional call date or is in some distress and close to regulatory action being taken.
Exchange (or Conversion) Formula
In adverse scenarios, the exchange of hybrid instruments for ordinary shares is performed according to the below formula.
- Face Value / (0.99 x VWAP)
The Face Value is generally $100, but, could be less in certain scenarios and the 0.99 represents a small investor-beneficial discount on conversion.
Maximum Exchange (or Conversion) Formula
The exchange to ordinary shares is subject to a maximum as shown below.
- Face Value / (Relevant Percentage x Issue Date VWAP)
The Relevant Percentage in calculating a Maximum Exchange is generally 20%. Depending on the prevailing share price at a conversion event, the relevant exchange formulae prescribes a ceiling on the number of ordinary shares received, which may result in an investor holding significantly less value than the hybrid note subscribed for.
In the case of CBA’s PERLS X, this Maximum Exchange Number is 6.7055, calculated as
- $100 / (0.20 x $74.5657).
Where a bank misses an optional call, a mandatory conversion date exists, typically two years later, where, subject to some conditions which are designed to be protective to investors, conversion will automatically occur at the above formula with a Relevant Percentage of 50% used, such that the formula becomes:
- 100 / (0.50 x $74.5657)
This gives a Maximum Exchange Number under a Mandatory Exchange scenario of 2.6822.
The mandatory conversion conditions are generally threefold:
- Firstly, the VWAP of ordinary shares 25 business days before the Mandatory Exchange Date must be greater than 56% of Issue Date VWAP;
- Secondly, the VWAP of ordinary shares over the 20 business day period before the Mandatory Exchange Date must be greater than 51% of Issue Date VWAP; and
- Thirdly, ordinary shares are listed or admitted to trading on the ASX on the Mandatory Exchange Date.
These conditions are retested every Distribution Payment Date until all are satisfied and then Exchange will occur.
Regulatory Conversion / Automatic Exchange
Automatic Exchange if a Capital Trigger Event or Non-Viability Trigger Event occurs is based on the VWAP 5 business days before the Exchange Date and is subject to the above Maximum Exchange Number.
It is worth pointing out that investors are likely to suffer significant declines in value should Automatic Exchange occur for the above reasons and that the ordinary share price is likely to be so low at that point anyway that the Maximum Exchange Number is easily reached.
Major Bank Divestments
The raft of divestments that have been performed by the major banks in recent years, which are culminating now with the deconsolidation of conglomerate groups, can affect the valuation of hybrids in many ways and particularly through how the various business units are divested by the banks.
Probably the most directly impactful event would be if a bank shed assets such that its core CET1 ratio was altered closer to the Capital Trigger Event line of 5.125% but we think this highly unlikely as they are generally retaining such assets and are strongly pressured by the regulator to maintain high CET1 ratios at all times.
What immediately came to mind for us when we saw the CBA news that it would demerge its wealth management and mortgage broking businesses was how this would affect VWAP (if at all). As mentioned, normally VWAP doesn’t matter for valuations as one expects redemption at call date. Unlike an IPO of a unit, a demerger generally grants shares in the new company to existing equity holders and everything else being equal, the valuation of the former group drops by the valuation of the demerged entity.
A total valuation for CBA’s soon-to-be ex-businesses of $10 billion is probably ~20% too high, but makes for easy maths showing that CBA’s current market capitalization of ~$130 billion would become ~$120 billion, or ~8% lower.
CBA’s current share price of $75.11 is only a little higher than the Issue Date VWAP of $74.57 and, if the demerger were to be effected today, a decline to around ~$69 would not be unreasonable.
Why does this matter? – because in a Mandatory Conversion scenario, the percentage that the new share price has to decline by decreases. 56% (the first condition) of VWAP remains $41.76 but the price fall required to get there is now ~40% ($41.76 / $69) rather than ~45% (41.76 / $75.11). At this price the Maximum Exchange Number would not be reached but this would change should CBA’s ordinary shares be valued at $36.91. Any lower than this and hybrid investors would start to lose value.
In the case of an Automatic Exchange, the Maximum Exchange Number of 6.7055 may optically appear to be better…i.e. an investor can get up to two and a half times as many shares on conversion but one must seriously consider the context. In an Automatic Exchange, either the bank’s core capital has fallen so low or the regulator(s) have no faith in management’s ability or capacity to right the ship that the Exchange occurs. In this scenario, the share price is likely to be very low indeed and investors would probably be exposed to significant loss.
Are There Any Contractual Saviors for Hybrid Investors?
There are change of control provisions which, with some modifiers, operate similarly to the Mandatory Exchange process discussed above.
There are also contractual provisions for capital reconstructions and bonus issues of ordinary shares but in the case of a bank-initiated demerger or IPO, we do not believe that this would meet the criteria for an adjustment (lowering) to VWAP to occur.
Broadly, the reduction of a bank’s earnings streams is credit negative and the divestments completed and being progressed by Australia’s major banks are certainly not positives from this perspective. However, these actions must be balanced by any streamlining benefits and sharper management attention that are afforded, and, not forgetting any possible soothing of adverse outcomes from the Royal Commission.
In summary, the many recent divestments in theory affect hybrid valuations but in reality, in current market conditions with banks that have strong balance sheets, they do not. Credit and equity markets need to get a lot more volatile and risky for detailed VWAP / loss given conversion analysis to become much more relevant.