YANKEE BONDS AND CROSS-BORDER PRIVATE PLACEMENTS: AN UPDATE

Journal of Applied Corporate Finance F A L L 2 0 0 0 V O L U M E 1 3 . 3

Yankee Bonds and Cross-Border Private Placements: An Update by Greg Johnson, Banc of America Securities LLC

80BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

YANKEE BONDS ANDCROSS-BORDER PRIVATEPLACEMENTS: AN UPDATE

by Greg Johnson,Banc of America Securities LLC*

s the year 2000 draws to a close, interna-tional issuers have again demonstratedthe attractiveness of the U.S. long-termdebt markets by setting record issuance

*This article is an updated version of a previously published article by GregJohnson and Thomas Funkhouser, “Yankee Bonds and Cross-Border PrivatePlacements,” Journal of Applied Corporate Finance, Vol. 10. No. 3 (Fall 1997). For

Ato swap U.S. proceeds into other currencies at highlyefficient all-in local currency costs. Add to theanalysis relaxed regulatory reporting requirementsand the prestige of accessing the deepest and longestdebt markets in the world, and it is not hard to seewhy the U.S. bond markets are more and morefrequently the markets of choice for internationalissuers.

Issuers and investors have three primary formsthrough which they can participate in these growinglong-term debt markets: publicly traded, SEC regis-tered bonds (“Yankee” bonds); traditional privateplacements; and underwritten Rule 144A privateplacements. Each of these three financing methodshas distinct benefits and limitations that should bethoroughly evaluated in light of the specific objec-tives of the issuer. The purpose of this article is toprovide a detailed analysis of each type of bondissuance and the related concerns facing a financialofficer trying to determine the most appropriatesource of long-term debt. We explore the back-ground of these issuance methods, analyze recenttrends, examine the legal characteristics, and pro-vide a statistical comparison of the three sectors overthe past several years. The mechanics of issuance ineach market are discussed, including the means ofaddressing investment concerns of U.S. institutionalinvestors, the importance of rating agency involve-ment, and the marketing, distribution, and docu-mentation aspects of each product.

their contributions to this article, the author wishes to thank Arminda Aviles andChase Cairncross, who are Associate and Analyst, respectively, in the YankeeCapital Markets Group at Banc of America Securities.

levels. Growth in the issuance of long-term debt inthe U.S. markets by international issuers is a trendthat began several years ago and shows no signs ofabating. Total cross-border U.S. bond issuance in2000 is expected to exceed $350 billion, easilysurpassing previous issuance levels and almostdouble the levels of just a few years ago.

Privatization of state-owned industries, infra-structure development, and capital investment drivenby economic growth are all contributing to theworldwide demand for long-term capital. Interna-tional issuers have become increasingly familiar withthe benefits and depth of the U.S. bond markets,while U.S. investors have taken seemingly irrevers-ible steps toward global diversification of theirportfolios. More and more investors are learninghow to evaluate country-specific economic, foreignexchange, social, and political risks—investmentskills that should stand them in good stead whenconfronting the higher volatility of cross-borderinvestments.

Although issuers today face credit spreads thatare at or near historic highs, U.S. Treasury yields arenot far from historical lows, resulting in acceptableall-in borrowing rates. Advances in foreign exchangeand interest rate swap structures allow many issuers

81VOLUME 13 NUMBER 3 FALL 2000

MARKET OVERVIEW

Throughout the 1990s, cross-border issuance inthe U.S. long-term debt markets was on a stronggrowth trend. Despite significant market disruptionscaused by the devaluation of the Mexican peso in late1994, the Asian economic crisis of late 1997, and theRussian bond defaults of late 1998, the U.S. debtmarkets have largely remained open and an impor-tant source of debt capital for foreign issuers. The144A market, which only began in 1990, has expe-rienced dramatic growth and is now second inimportance to only the Yankee market. By allowingforeign issuers access to a broad base of U.S.institutional investors without the time and expenseof the SEC registration process, the 144A private hasovercome a major drawback of the Yankee market.

Initially, yield-hungry investors pursued cross-border investments primarily as a means to improvereturns, since such investments offered higher yieldsthan those obtainable on comparably rated domesticissues. Yield premiums for cross-border investmentscontinue to appear under various market conditions(indeed, they were evident when this article wasgoing to press (October 2000)). Nonetheless, inves-tors today seem to more fully appreciate that invest-ments in foreign companies bring a better understand-ing of the intricate workings of our global economy. Asa result, the cross-border premium for issuers hasgenerally declined in recent years, due in part to thehigh credit quality of many of the issuers accessingthese markets. As issuance has increased, so has thenumber of investors with the expertise and authorityto invest in a cross-border deal. Foreign issuance hasgrown to represent over 25% of the public market,roughly one-third of the traditional private market, andover one-third of the underwritten 144A market.

Long Maturities at Attractive Rates

The U.S. bond markets are at their competitivebest when an issuer is most interested in debt witha long average life. The U.S. markets tend to bedeepest at the 10-year maturity, since the broadestrange of investors have investment appetite at thismaturity. Most other debt markets have little or noappetite for 10-year maturities, let alone longer.Maturities of 15, 20, and 30 years account for asignificant portion of overall U.S. cross-border issu-ance, and longer offerings, including 100-year “cen-tury” bonds, have been completed on an opportu-nistic basis. As mentioned earlier, many of theseissues are then swapped by the issuers to their localcurrencies resulting in attractive all-in costs.

U.S. Treasury yields are currently near historicallows as a result of low inflation and steady economicgrowth. Fears of an end to the economic bliss of thelast decade have nonetheless led to extremely volatilemarket conditions. This volatility has been fueled byearnings warnings, foreign exchange losses, consoli-dation announcements (which constitute “event risk”for bond investors), and a perception of generallydeclining credit quality, resulting in a widening ofcredit spreads globally. In their search for higherreturns, investors in the past have shown a willingnessto invest despite conditions such as these and in sodoing have helped drive credit spreads back to lowerlevels. But, as we open the new Millennium, a newconsideration has moved to the forefront—one that,at least as far as the Yankee and 144A bond marketsare concerned, has overtaken all others in importance.That consideration is liquidity, or lack thereof. Con-cerns about liquidity have led to unprecedented creditspread levels, a condition that shows little sign ofimproving. To understand the impact of limited

TABLE 1ISSUANCE IN THE U.S.LONG-TERM DEBTMARKETS 1996-PRESENT

U.S. Public Market U.S. Private Market U.S. 144A Market

Total “Yankee” % Total For. % Total For. %Year $B Bonds Foreign $B Privates Foreign $B 144A Foreign

1996 545 87 16 48 17 35 103 30 30

1997 749 140 19 57 15 26 211 70 33

1998 1050 211 20 65 16 25 287 75 26

1999 1095 252 23 61 19 31 290 63 22

2000* 990 270 27 50 16 32 200 70 35

*Estimated; 2000 amounts are based on actual SDC levels as of 10/16/2000 for the Public and 144A markets, and on actualSDC levels as of 6/30/2000 for the Private Placement market.Source: Securities Data Corp.

82JOURNAL OF APPLIED CORPORATE FINANCE

Casualty Ins.

Pension Funds 5 to 20 yrs. Moderate Private/Public

Mutual Funds 5 to 15 yrs. Active Public

Bank Trust Depts./ 2 to 10 yrs. Active Public

liquidity on the public-style markets, one needs tobetter understand the investment objectives andcash flow characteristics of each of the primarygroups of institutional investors.

Investor Characteristics

U.S. institutional investors, which are the over-whelming majority of long-term debt buyers, varywidely in size and investment strategy. Nonethe-less, they can be generally grouped into one of fivemain categories: life insurance companies; propertyand casualty insurance companies; public and pri-vate pension funds; mutual funds; and bank trustdepartments and money managers. Investment strat-egies range from a long-term “buy and hold” ap-proach with low portfolio turnover to an activelytraded, “total rate of return” approach, where assetsare continually “marked to market” in order tocalculate value on a real time basis. Portfolio man-agers must select investment categories and indi-vidual bonds based at least in part on their desiredmix of liquid (actively traded, easily tradable) andilliquid (no regular listing of market prices) assets.In this manner, they balance the mix of theirportfolios to reflect the anticipated need to generatecash for portfolio outflows.

Such cash outflows can be very predictable fora life insurance company using actuarial forecasts ofpolicy payments, but very unpredictable for a mutualfund, which may need to convert its holdings to cashat any time. Not surprisingly, the most aggressivebuyers of a liquid Yankee or underwritten 144A bondinclude those investors who need to be able to tradein and out of their holdings. During times of strongcash inflows, mutual funds dominate the public bondmarkets. Those investors with the most stable cashflows—insurance companies and pension funds—dominate the illiquid, traditional private placementmarket. In general, the five main investor groups canbe said to have the investment characteristics outlinedin Table 2.

For a portfolio manager seeking actively to man-ager his or her return, the inability to efficiently trade asecurity is unacceptable. Correctly foreseeing marketdevelopments should lead to appreciation of the valueof the corporate bonds a portfolio manager is holding.Too frequently of late, however, any price appreciationhas been eliminated when a portfolio manager has triedto realize the gain due to wide bid/offer levels in thesecondary bond markets. This has occurred often

enough in these volatile market conditions to drivesome managers out of the corporate bond marketsaltogether. If the portfolio managers cannot achieve theirdesired results with corporate debt, they will use theswap, U.S. Treasury, or other markets perceived to havemore liquidity to pursue their return objectives.

YANKEE BONDS

A Yankee bond is an underwritten, dollar-de-nominated bond that is publicly issued in the U.S. by aforeign entity. Yankee bond offerings are those re-quired to be registered with the SEC under the Se-curities Act of 1933 and are subject to disclosurestandards that are often more stringent than thoserequired in foreign issuers’ domestic markets. Due tothe extensive SEC registration and rating agency re-quirements, a first-time Yankee offering can take any-where from 10 to 14 weeks to complete. Yankeeofferings involve more significant legal, rating, andout-of-pocket expenses than both types of privateplacement.

Yankee bonds can be distributed more widelythan private placements and usually entail the mostextensive roadshow, at least for first-time issuers orvery large transactions. Yankee bonds are marketedvia pre-established documentation that involves nonegotiation with investors, and typically are struc-tured with no financial covenants. The loose covenantstructure reflects the diverse nature of the publicinvestor base. Post-closing negotiations on a widelydistributed issue are extremely difficult, making itimpractical for an issuer to amend or adjust an issueonce it is sold. The investor’s lack of effective controlover the issuer (due to the lack of covenants) ispresumably offset by the liquidity of the publicmarket, and by the ability of an investor to sell theposition if he becomes uncomfortable with companyactions or performance.

TABLE 2 INVESTMENT CHARACTERISTICS OF U.S. LONG-TERM INVESTORS

Money Mgrs.

Life Insurance 5 to 30 yrs. Inactive Private/Public

Property and 5 to 10 yrs. Inactive Public

Maturity Trading PrimaryType Preference Activity Bond Type


In general, individual Yankee bond offeringsrange in size from $200 million to $1 billion, withmost issues in the $300 to $500 million range.Individual offerings are often completed in mul-tiple tranches of $200 million or more, with mostfirst-time issuers offering a benchmark 10-yeartranche as the largest portion and with smalleramounts in the shorter and/or longer tranches. Asconcerns over liquidity have increased, more andmore issues have been sized to assure diversemarket interest and holding. Billion dollar issues,a rarity only a few years ago, have becomecommonplace, with 15 such “jumbo” issues al-ready completed this year.

Mechanics of Issuance

Issuance of Yankee bonds requires the hiring ofone or more lead managers and typically two ormore additional co-managers to market and distrib-ute the bonds. The selection and number of under-writers in the syndicate will depend on the size of theissue and the desired breadth of distribution. Thelead managers are responsible for structuring thefinancing and overseeing documentation of theissue as well as managing the underwriting syndicateand ensuring successful distribution of the issue. Thelead managers and co-managers are expected toprovide after-market trading and research support.

The lead managers are often chosen based on astrong fixed-income research department (one ca-pable of aiding investors in their investment deci-sions) and a strong fixed-income trading desk (ca-pable of maintaining a liquid secondary market inthe bonds). A lead manager is also usually respon-sible for guiding a first-time issuer through the ratingagency and SEC processes.

Despite industry standards, fees charged by theunderwriters will vary based on the expected levelof complexity of the above responsibilities. Thecredit quality, industry, country of domicile, andmarket conditions will all affect the “gross spread”charged by underwriters (that is, the differencebetween the price received from investors and theproceeds to the issuer). The gross spread for aninvestment-grade issuer typically ranges from 50basis points for a five-year bond to 87.5 basis pointsor more for a 10-year or longer bond, and issignificantly higher for lower rated issuers.

Syndicate and resulting fee structures have beenaffected by investors’ liquidity concerns and havechanged dramatically in the last couple of years. Tobegin with, two lead managers are nearly the normon large deals (and are the norm if one excludes self-issuance). The arguments for two or more leadmanagers are many, but the strongest is based in thecurrent demand for liquidity. Use of a single leadmanager limits the competitiveness of secondary

YANKEE BONDS

Abitibi-Consolidated Inc. is the world’s largest manufacturerof newsprint and of paper used by the publishing industry.Following the acquisition of Donohue Inc. in early 2000, thecompany has roughly 32% of the North America newsprintmarket and 15% of the global newsprint market. In addition,the company has operations in value-added papers(principally uncoated groundwood), lumber, and pulp. Thecompany has expanded into Asia through a major jointventure and now operates a total of 29 paper mills, 24sawmills, and 1 pulp mill.

After the acquisition of Donohue, the company waslooking to refinance bank debt with longer-maturityobligations. The company was already a seasoned issuerin the Yankee markets and was widely expected to enterthe markets for $1 billion or more in debt. Marketconditions for low investment-grade issues were less thanoptimal in the early spring, and the company held offissuing. As a Baa3/BBB- issuer, the company did not want

Despite significant market disruptions caused by the devaluation of the Mexican pesoin late 1994, the Asian economic crisis of late 1997, and the Russian bond defaults oflate 1998, U.S. debt markets have remained an important source of debt for foreign

issuers. Foreign issuance has grown to represent over 25% of the public market, androughly one-third of the traditional private and underwritten 144A markets.

the market to conclude that the company had to issueregardless of market conditions.

Newsprint prices increased through the spring andadded to the perception that the company might notissue long-term debt at all. But, when issuance slowedsignificantly as the July 4 holiday approached, thecompany took advantage of the light forward calendar.Three tranches of debt were issued, including the largestamount of 30-year bonds for a low investment-gradeissuer that year.

Abitibi-Consolidated issued $450 million of 5-yeardebt, $500 million of a benchmark 10-year issue, and$450 million of 30-year bonds for a total of $1.4 billion inproceeds. The transaction pricing was tightened duringthe marketing process to the point that the yield was lowerthan the secondary trading levels that existed on thecompany’s outstanding debt prior to the announcement ofthe deal.


market quotes, especially for infrequent issuers.With investment banks consolidating at a rapid clip,two lead managers hardly guarantee competitionwill exist in the secondary market over the life of a10-year bond. In another major change, the splittingof fees in investment-grade transactions is now beingpredetermined and set in direct proportion to thelegal underwriting commitment of each underwriter,regardless of who actually ends up selling the bonds.This pre-agreed fee, or “100% pot,” arrangement, hasbeen a common practice in the high yield marketsince its inception. There is much greater market riskassociated with non-investment-grade transactions,more than the underwriters are willing to assume innearly all situations. High yield bonds are thereforecompletely “pre-sold” before a transaction is priced.The pre-agreed, 100% pot fee split arrangementclosely aligns compensation with the legal under-writing risk of the transaction, as distinguished fromthe sales performance or market risk.

The traditional gross spread structure, seldomused these days even on an investment-grade trans-action, had three components. A “management fee,”which was paid to lead and co-managers for manag-ing the issue, was usually 20% of the gross spread.An “underwriting fee,” paid to the lead and co-managers for assuming the underwriting risk andvarious costs associated with the offering, was alsousually 20% of the gross spread. And the “sellingconcession,” paid pro rata directly to those firms thatactually sold the bonds, typically represented 60% ofthe gross spread. In most cases, the selling concessionwent disproportionately to the lead underwriter byvirtue of its control of the “pot” bonds. Pot bonds wereusually 50% of an issue and, as a result, underwritersonly retained 50% of their legal underwriting commit-ment for direct sale to investors. Knowing that the leadmanager controlled the pot bonds as well as its ownproportional retention, investors often directed or-ders to the lead manager to assure themselves agenerous allocation. The result was that the leadunderwriter typically got the lion’s share of the fees,despite balanced legal underwriting commitmentsand incentives for each firm to sell the bonds.

Given the volatile market conditions of late, itseems unlikely that we will be returning to partial potand traditional fee structures anytime soon. It seemsmore likely that, when conditions stabilize, we will seegreater use of hybrid structures that try to compensateunderwriters not only for their legal risk but also fortheir actual contribution to the sales effort.

SEC Registration

The Securities Act of 1933 requires issuers ofpublicly offered securities to file a registrationstatement with the SEC and to maintain regularongoing disclosure of prescribed business andfinancial information. (First-time foreign issuersgenerally file the registration statement on formF-1.) The filing must include a prospectus thatcontains strictly defined, detailed descriptionsof, among other items, the issuer’s operations,product lines, geographic regions, financial con-dition, and potential risk factors that could havea material effect on operations or on the value ofthe offering. Issuer’s legal counsel will draft theSEC registration statement with assistance fromthe issuer and the underwriters. Issuers, under-writers, and their respective counsel can be heldlegally responsible for the accuracy of materialfurnished to the public in connection with apublic offering.

The purpose of the strict standards set by the1933 Act was to shift the burden of verifying theaccuracy of relevant information to the sellers of thesecurities for the benefit of the buyers. In addition,the bond issue contains provisions that require theissuer to continue to file periodic financial informa-tion with the SEC for as long as the issue isoutstanding.

Credit Ratings

Buyers of public bonds rely heavily on rat-ing agencies to conduct credit analysis, so muchso that two ratings are the market standard forpublic bonds. Moody’s and Standard & Poor’sratings are usually recommended, if not required,as a result of their longstanding market presenceand established track record. Rating agenciesfollow an intensive and methodical process inexamining all relevant aspects of an issuer’soperations, management, industry position, andfinancial condition.

Rating methodologies are published by mostrating agencies and readily available upon request.Rating agencies typically charge upfront fees ofbetween $25,000 and $125,000 for each individualcorporate credit rating, with issues over $500 millionincurring additional up-front fees. Annual monitor-ing fees are also charged by the agencies as long asthe issue is outstanding.


Timing

The preparation for a Yankee bond offering in-volves multiple drafting sessions in which representa-tives from the issuer, issuer’s legal counsel, and theunderwriters conduct a review of all material requiredfor the SEC filing. At about the midpoint in the roughly12-week process, a first draft of the registration statementis confidentially submitted to the SEC for review, andrating agency presentations are conducted by the issuerand its rating agency advisor, usually a lead manager.Rating agencies may conduct in-depth, onsite duediligence following the initial presentations.

An indication from rating agencies and com-ments from the SEC are typically received one to threeweeks later and drafting of a revised registrationstatement commences. Near the end of the process,preliminary ratings are released and the registrationstatement is publicly filed, at which time the transac-tion is announced to the market and a preliminary “redherring” prospectus is distributed. An extensiveroadshow will usually begin as soon as the prelimi-nary prospectus is distributed, and the issue is typi-cally priced within a day or two after completion ofthe roadshow. The financial closing of a public bondoffering typically occurs within three business days ofpricing, but can be longer on complex issues.

Documentation

The binding legal document for public issues isan indenture that requires a bond trustee to admin-ister payments and take other actions on behalf of theinvestors. In addition to the indenture, additionalimportant documentation requirements include a10(b)-5 opinion by legal counsel stating that noknowledge of any material misstatement or omissionexists, and an accountants’ comfort letter stating thatthe most recent financial information is correct.

TRADITIONAL PRIVATE PLACEMENTS

A traditional private placement is a transactionthat qualifies for exemption from SEC registrationrequirements under either Section 4(2) or RegulationD of the 1933 Act. As a consequence of the exemption,limitations are placed on the type and number ofinvestors who can participate in an offering, and thereare also restrictions on resale. A traditional privateplacement is the direct sale of debt or other securitiesby an issuer to one or more “accredited investors.” As

defined in Regulation D, accredited investors includebanks, insurance companies, registered and smallbusiness investment companies, certain employeebenefit plans, organizations with total assets in excessof $5 million, and certain wealthy individuals.

The traditional private placement market his-torically has offered issuers quick, discreet access toa broad base of long-term U.S. institutional investors,primarily life insurance companies and public andprivate pension funds. Private placement investorsusually hold bonds to maturity and are frequentlyrepeat investors in new debt of issuers with whichthey have relationships.

Disclosure standards in the traditional privateplacement market are unregulated and significantlyless well defined than those in the Yankee bondmarket. Transactions are typically completed on anegotiated basis, transferring to the investors muchof the risk of assuring that all relevant information isavailable and has been considered. Investors nearlyalways require financial covenants in addition tonumerous representations and warranties in order toprotect the value of what they expect will be a verylong-term holding. The need for credit ratings variesdepending on the issue, but the majority of issues arecompleted with one or no rating. A traditional privateplacement for a first-time issuer can typically becompleted in six to twelve weeks.

Private placements can be completed in anyamount, but are usually most cost effective above$50 million and below $500 million. Most issuesare in the $100 to $200 million range. Totalissuance costs for a private placement can bemuch less than those paid for an underwrittentransaction, since placement and legal fees can beas little as half those paid for an underwritteninvestment-grade issue.


Traditional private placements are executed ona best efforts basis, usually by one lead agent. Thefirst step is typically a due diligence review by thelead agent, who then assists in the preparation of anoffering memorandum that describes the offeringand the issuer. The time required for preparation ofa private offering memorandum is usually shorterthan that required in a public transaction, mainlybecause the issuer has greater latitude in describingthe company and its activities. While the informationpresented in a private placement memorandum

Yankee bonds are expected to account for roughly 76% of the $356 billion ofU.S. cross-border issuance by volume in 2000, and make up an estimated

73% of the market when measured by the number of transactions.


tends to be quite similar to that required by the SEC fora public filing, there are no formal standards orrequirements. Because private investors usually con-duct their own due diligence review, the issuer gener-ally has more freedom in discussing the merits, draw-backs, and prospects of its company than is possiblein a public or 144A document.

Investors in a private placement recognize theyhave fewer protections than those afforded byregulations for public securities. Accordingly, theirinvestigations into the merits of a particular offeringcan be extremely detailed. A roadshow is advisablein many instances, although it will be directed tofewer investors and will usually be oriented towardmore in-depth meetings. Pricing occurs at the end ofthe roadshow or marketing period (if there is noroadshow), and is followed by investor due dili-gence and the finalizing of documentation.

Credit Ratings

Ratings from a wider range of recognized ratingagencies are acceptable in the traditional private

Cookson Group Plc is a diversified industrial materialsgroup with three major operating divisions. The company’sElectronics Division is a world leader in the supply ofmaterials and equipment used in the manufacture of printedcircuit boards and other electronic goods. The company’sCeramics Division is a world leader in the production ofceramic refractory products and systems that control, protect,and monitor liquid iron and steel. The company’s PreciousMetals Division is the North American leader in fabricatedprecious metals for the jewelry and electronics industries.

The different activities of the three divisions do notnaturally lend themselves to strong synergies. Nonetheless,the company’s market share and technological leadershipin each of its targeted markets make for a compellingcredit story. The company is best understood by analyzingeach of the businesses on a stand-alone basis and byknowing management’s capabilities well enough to becomfortable with their ability to profitably oversee anddirect such diverse activities.

Cookson had an existing private placement of $170million outstanding with a rating from Fitch of BBB+ anda corresponding NAIC rating of 2. Recent acquisitions andpending disposals had Cookson interested in additionallong-term debt, but they wanted to avoid additional fixed

rate exposure. The U.S. private placement market coupledwith interest rate swaps appeared to be the most efficientmeans of raising long-term floating rate debt. Privateplacement investors were also believed to be willing to dothe analysis necessary to get comfortable not only withthree separate businesses but with the significantrestructuring activities that were not yet finalized.

The company undertook an extensive roadshowgiving private placement investors the opportunity toanalyze in depth each of the company’s divisions andmanagement. Cookson entered the market for $200million and found more than enough investor interest tocomplete a much larger financing. The negotiated natureof the private placement market allowed the company toaccept only the most aggressive bids in each maturity. Thecompany raised a total of $400 million in four maturities—5, 7, 10, and 12 years. The allocations were heavilyweighted toward the longer maturities, resulting in afinancing with an average life exceeding 10 years. Usinginterest rate swaps, this 10-year fixed rate debt was thenconverted into floating rate financing with a very attractiverate.

UNDERWRITTEN RULE 144A PRIVATE

placement market, and “private” ratings can beobtained that are not published or publicly dissemi-nated. Fees charged by alternative agencies such asFitch are similar to or slightly lower than Moody’s andS&P. Since all investments purchased by insurancecompanies are ultimately rated by the SecuritiesValuation Office of the National Association of Insur-ance Commissioners (“NAIC”), a rating by one agencyis sometimes recommended as a preemptive strategy.

Documentation

Traditional private placements were historicallymarketed via a term sheet, with documentation under-taken after the general provisions of the transaction hadbeen accepted. Over the last several years, however,industry efforts to standardize documentation havebeen very successful, resulting in most, if not all,investment-grade transactions being completed on a“pre-documented” basis. In a pre-documented deal,legal counsel is engaged to draft the note purchaseagreement (the binding legal document between theissuer and investors) prior to going to market.

TRADITIONAL PRIVATE PLACEMENT


If the deal is not pre-documented, drafting ofthe note purchase agreement is conducted afterinvestors have “circled” the deal, during theinvestor due diligence stage. An “acceptance ofcircle” occurs when all major terms are finalized.Pre-documented deals take slightly longer to getto market but can be closed in as little as one totwo weeks following circle. It may take signifi-cantly longer to close a transaction after circle ifthe deal is based on a summary term sheet anddrafting takes place during the investor due dili-gence stage.

144A PRIVATE PLACEMENTS

Rule 144A was adopted in April 1990 as a meansto facilitate the resale of privately placed securitiesand thus increase secondary trading among institu-tional investors of otherwise illiquid investments.Rule 144A permits resale of privately placed securi-ties to “qualified institutional buyers,” or “QIB’s,”which include institutions that own at least $100million of eligible securities and dealers that own atleast $10 million of such securities. When Rule 144Awas first initiated, issues that were otherwise beingexecuted as traditional private placements had aRule 144A provision built into the documentation tomake secondary trades easier. But Rule 144A hadlittle impact in this market because most investorswho purchased such illiquid investments were look-ing to hold such investments to maturity anyway.Investment banks soon discovered, however, thatthe Rule 144A provision could be used to develop aquasi-public issue.

In an underwritten Rule 144A issue, an invest-ment bank becomes the initial purchaser of a privateplacement and then resells the bonds to institutionalinvestors under a Rule 144A exemption. A newmarket quickly evolved around this process, andtoday it closely resembles the SEC-registered marketin terms of underwriting practices, including market-ing, distribution, disclosure, documentation, andcredit rating requirements. Foreign issuers wereparticularly pleased with the development of thismarket since it allowed them to sell large issues toU.S. institutions without complying with, amongother things, the intrusive executive pay disclosurerequirements of the SEC.

Transaction size range for 144A transactions issimilar to that of public bonds, with transactions inthe $200 to $500 million range most common.

Transactions such as Vodafone’s $5.2 billion inbonds clearly demonstrate there is no technical limitto the size of a 144A issue. Issuance fees, includingunderwriting fees, are comparable to, and structuredin the same manner as, fees on Yankee bonds.Because of the lack of registration requirements,144A transactions can typically be completed in eightto twelve weeks.


While some complex 144A transactions are stillexecuted as traditional private placements, the vastmajority of 144A private placements are underwrit-ten and executed by a public style syndicate similarto that required for a Yankee issue. For bothunderwriters and institutional investors, investment-grade Rule 144A offerings are often indistinguish-able from SEC-registered transactions in terms ofprocess and acceptance. The offering circular isprepared by issuer’s counsel. Although not legallysubject to the same liability standards as a publicbond, it generally contains the same type of informa-tion as a public prospectus. Syndication groups areformed with the same eye toward research andsecondary market liquidity that one would expect foran SEC-registered issue.

The Rule 144A market underwent yet anothertransformation in recent years that helped propelissuance to even higher levels. Many first-time cross-border, and nearly all first-time high yield issuers, nowuse the Rule 144A structure with registration rights, aprovision that requires the issue to be registered withthe SEC within a prescribed time period after issuance(usually six months). This registration requirementeffectively converts the 144A into a public bond, thusconferring on the buyer the benefits of registration,including disclosure requirements and liquidity, whilestill allowing the issuer to come to market quickly anddeal with the SEC registration process afterward. Anissuer’s failure to register the security in such anoffering results in additional penalty interest on top ofthe coupon rate.

Credit Ratings

Two credit ratings are generally required by144A buyers, although one alternative agency ratingcoupled with an S&P or Moody’s rating is sometimesacceptable, depending on the nature of the transac-tion. Rating agency fees are consistent with those

The traditional private placement market historically has offered issuers quick,discreet access to a broad base of long-term U.S. institutional investors, primarily life

insurance companies and public and private pension funds.


SELECTING THE MOST EFFICIENT MARKET

Yankee bonds are expected to account forroughly 76% of the $356 billion of U.S. cross-borderissuance by volume in 2000, and make up anestimated 73% of the market when measured by thenumber of transactions. Given that Yankee bondsare generally utilized by the largest and most-frequent issuers, their dominance is not surprising.The importance of the 144A and traditional privateplacement markets is more evident if one focusessolely on corporate issuers, as opposed to all issuingentities. Sovereign, quasi-sovereign, and short-termfinancial institution (i.e., commercial bank) financingsall inflate Yankee issuance levels compared tostraight long-term corporate bond issuance.

Generalizations are dangerous in the capitalmarkets, but for an international entity rated byMoody’s and S&P, an SEC-registered bond willnearly always be the most efficient form of long-termfinancing available. Exceptions to this “rule” includedeals that are small (under $250 million) or veryunusual in structure, or which have a particularlycumbersome amortization schedule, or any of anumber of other possible quirks. Traditional privateplacement and underwritten 144A investors are

Companhia Vale do Rio Doce (“CVRD”) is the world’slargest producer of iron ore and iron ore pellets. CVRDis also a major force in the production of aluminum andwoodpulp and in the mining of copper, gold, and otherminerals. Based in Brazil, the company is constrained bythe sovereign debt ceiling to a non-investment-graderating of its straight corporate debt.

The company operates two railroad networks thatare linked to port facilities from which they ship their ironore products to steel companies around the world. Ironore is an essential element in the production of steel, andCVRD has very longstanding relationships with most ofthe world’s steel producers. Price and volume stabilitycoupled with the strength of CVRD’s relationships withits steel customers were strong arguments for a financingbased on the securitization of the company’s exportreceivables. The structure captures payments made bycertain steel companies in an offshore trust, from whichinterest and principal payments are made to investorsbefore excess flows make their way back to the company.The structure allowed the company to secure investment-

required for a Yankee issue, and the process isvirtually the same.

Documentation

The binding document in a 144A private place-ment is usually a purchase agreement negotiated be-tween the issuer and the underwriter group (initialpurchasers), which then resells the securities. BecauseRule 144A bonds are distributed in a manner similarto public bonds, their covenants resemble those ofpublic bonds; that is, they are virtually non-existent.It is very difficult to negotiate amendments or adjust-ments once a transaction is sold even if the investorgroup cannot include individuals. Covenants arefound more frequently in lower credit quality transac-tions, although they typically carry compliance levelsthat a company should be able to meet in all but themost dire of circumstances. In addition to limited orno financial covenants, 144A purchase agreementstypically do not require expansive representationsand warranties of the issuer or provide inspectionrights to the investor, as is usually the case in atraditional private placement. The same legal opin-ions and accountants’ comfort letter required for apublic offering are also generally required.

grade ratings for the transaction from all three of themajor rating agencies.

The financing was sold in three separate tranches,including a 7-year final $25 million tranche, a 10-yearfinal $150 million tranche, and a 7-year final MBIA-guaranteed $125 million tranche. The $300 milliontransaction was the largest and longest-maturity Brazilianexport receivables transaction ever completed.

The underwritten 144A approach focused themarketing efforts on sophisticated institutional investorswith the resources necessary to analyze the complexnature of the transaction on their own, much as onewould expect with a traditional private placement. Theunderwritten 144A approach also allowed simultaneousmarketing of the MBIA-guaranteed portion to morepublic style AAA investors. The company was able toconsider all of its options before expanding the size ofthe oversubscribed $200 million transaction originallytaken to market. Nearly 30 qualified institutional investors(QIB’s) participated in the transaction.

PLACEMENT


looking for a premium over the yield of a comparablepublic issue to compensate them for the reducedliquidity of their investment, however unlikely theyare to resell the securities. Accordingly, a Yankeebond should be the lowest-cost issuance method forrated issuers of any credit quality.

Why don’t all issuers head to the Yankeemarket instead of using the underwritten 144A ortraditional private placement markets? As men-tioned above, the efficiency of the Yankee marketis greatest for larger transactions due to the highup-front costs. Other reasons include the desirenot to report to the SEC on an ongoing basis, toprotect the confidentiality of results or companyinformation, and to avoid the ongoing and con-tinuous scrutiny of the rating agencies.

The Rule 144A structure is often used forcomplex structures requiring heavy rating agencyinvolvement, such as future financial flow transac-tions and project financings. While the traditionalprivate placement market has long accommodatedsuch esoteric structures, the 144A market providesaccess to a wider investor base and has thus becomean alternative market for issues large enough tojustify the additional issuance costs. The 144Amarket is generally preferred over the Yankeemarket for this type of issue, in part because SECregistration will not notably increase the numberof investors who are able or willing to analyzesuch credits.

Ratings Plays

If a company does not yet have ratings from thetwo top agencies, the choice of which market is mostcost efficient will require more thought. In the simplestterms, a ratings play is the ability of an issuer to positionitself with investors as a higher quality credit than theissuer would be if a formal rating from Moody’s andS&P were obtained. For a company with one or moredebt ratings that have been made public, there is littleopportunity to identify a ratings play. Nevertheless,ratings plays occur in the global debt markets on aregular basis. While one can argue that the significantfunding cost differences among markets (after adjust-ing for differences in risk and liquidity) should beeliminated over time, in practice investors deal withimperfect market information and incomplete knowl-edge of rating agency opinions. For investors confidentin their own investment analysis, this is often seen asmuch as an opportunity as a hindrance.

Institutional investors that purchase privateplacements are perhaps the most willing of allinvestor groups to help identify opportunities forratings plays. To be sure, ratings are still importantto these investors. Insurance companies, the larg-est sector of private placement investors, aresubject to NAIC ratings on all of their investments,which in turn determine their reserve require-ments. While issuers that are rated by one of themajor rating agencies are nearly universally ac-cepted by the NAIC on a comparable basis, theNAIC has on rare occasion challenged the accu-racy of ratings from a rating agency. A lower ratingfrom the NAIC will translate into higher reservecosts for the investor and much higher issuancecosts for an issuer’s future transactions.

Opportunities for ratings plays exist on sev-eral levels. An example is the possibility—somewould say the likelihood—that one of the threeprimary U.S. rating agencies (or an agency in theissuer’s home country or region) will provide ahigher rating than both Moody’s and S&P canagree upon. The reasons for a more favorablecredit perspective, which are as varied as theissuers themselves, can be related to differinglegal, industry, or economic outlooks, or be asbasic as differences in credit philosophy.

While not anxious to encourage the phe-nomenon, institutions buying private placementsare sophisticated investors and are aware of theincentive of an issuer to hire the rating agencythat is likely to treat the issuer in the mostpositive light. Indeed, private investors oftenbelieve that, with sufficient covenant protection,an investment may be of higher value than aMoody’s or S&P rating might suggest. Value tothe investor can be measured not only in terms ofthe probability of timely payment of principaland interest (the overriding focus of the majorrating agencies), but also in terms of covenantprotection against significant events and the prob-ability of ultimate recovery of principal and inter-est in the event of default.

These investors are also aware that they have tocompete with alternative sources of funds that areunaware of or indifferent to U.S. rating agencyviewpoints, and which may lend at very aggressivelevels. Institutional investors with a more positiveoutlook than the major rating agencies for a givencredit, industry, or country will be strong advocatesfor a higher NAIC rating.

The Rule 144A structure is often used for complex structures requiring heavy ratingagency involvement, such as future financial flow transactions and project

financings. Foreign issuers were particularly pleased with the development of the144A market since it allowed them to sell large issues to U.S. institutions without

complying with the executive pay disclosure requirements of the SEC.


Underwritten or Bought

“Cost efficient,” “highly liquid,” and “very long”are all appropriate characterizations of the U.S. debtmarkets. If the inaugural bond issue of an interna-tional issuer is completed in an appropriate manner,the company will have the ability to return to themarket for additional, and often longer-term, moneyon an expedited basis. For a first time issuer,however, the market may seem to have an unusualset of requirements and conventions.

The subtleties of the underwriting commitmentan investor receives is one such issue and, indeed,a common cause of confusion among first-timeissuers. Yankee or underwritten Rule 144A transac-tions are nearly always completed on a negotiatedbasis, not as competitive bids, or “bought” deals.Many international issuers approaching the U.S.markets for the first time assume “underwritten”means that the underwriters will be assuming marketrisk. This is not the case for a variety of reasons. Oneis that most U.S. deals are of relatively long maturity,as compared to debt issues in other world markets.If the bond market moves 10 basis points on a 10-year issue, the present value impact on the under-writers of a bought deal is much more significantthan the impact on a 3-year Eurobond transaction ofthe same amount. In addition to the greater pricevolatility of longer-maturity issues, the time neces-sary to prepare for market is often longer than inother markets for reasons including the SEC reviewperiod, the rating agency review periods, and thepreparation of legal opinions and documentation.The longer the lead time required to get an issue tomarket, the higher the market risk.

Nonetheless, bought deals do occur, albeitrarely. The downside to such transactions is notnecessarily seen by an issuer immediately. Considerthe progress of such a deal if market conditions moveagainst the lead manager after it has committed to amaximum credit spread. The issue progresses as itotherwise would through the SEC, rating agencies,and roadshow process. Investor interest is deter-mined and a book of orders is built. But because themarket has moved, investor interest at the originalcredit spread is insufficient to sell all of the bonds andthe lead manager is left holding a significant portionof the issue. After the syndicate closes and secondarytrading gets underway, the lead manager will likelydump the unsold bonds to clear its balance sheet forthe next issue. As a result, the bonds will trade off in

price, and those investors who were most bullish onthe company (the investors who liked the companyenough to buy their bonds through the appropriatemarket-clearing level) suffer a loss on their newinvestment, at least on paper.

The end result is that the deal is viewed asperforming badly, and the issuer is seen as havinglittle regard for fair treatment of those investors whowere most willing to support the issue. The outcomeof the company’s next trip to the market is likely tobe a deal priced off an unfavorable secondarytrading level and sold to unresponsive investors.Bought deals make sense for issuers with billions ofdollars already outstanding, for which a new issue canbe viewed as little more than a large secondary trade.Only a few international issuers fit the proper profileof a competitive bid issuer in the U.S. debt markets.

Documentation Concerns

The private placement market was its own worstenemy over the last decade, often fighting forprovisions in documents that issuers found moreinsulting than onerous in practice. The pre-docu-mented aspects of the underwritten 144A and Yan-kee bond markets were appropriately preferred byinternational issuers and investment banks alike.The relatively recent development of the model noteagreement—and its increased use by intermediariesto offer deals to investors on a take-it-or-leave-itbasis—has helped focus issuer and investor alike onthe more important aspects of documentation. None-theless, as issuance of lower quality credits continuesto grow and now includes issues with covenants,more Yankee and Rule 144A issuers face the trou-bling possibility of a default on an issue—and thenearly impossible job of amendments from un-known and widely diverse investors.

IN CLOSING

The tradeoffs between issuance methods forany company considering the U.S. long-term debtmarkets are considerable. One product certainlydoes not fit all clients. Many issuers hear strongarguments only for a Yankee or underwritten 144Aissue, in part because these tend to be more profit-able products for many investment banks thantraditional private placements. Other issuers willhave preconceived notions about the difficulty ofmeeting ongoing SEC registration requirements, or


of dealing with rating agencies, or of documentinga traditional private placement. The reality is thateach product needs to be considered in the totalcontext of the issuer’s long-term financial strategy, aswell as with regard to the issuer’s short-term tacticalneeds. The product that is the right solution for onefinancing need of an issuer may not be the rightsolution for another financing need of the same issuer.

We hope that this article has conveyed themessage that there are significant differences in thebenefits and limitations of each of these productsand that careful consideration needs to be given tothese issues when choosing a financing solution.After all, a financial officer is going to live with thecharacteristics of whichever product is chosen for avery long time.

SUMMARY OF U.S. MARKET ALTERNATIVES

Traditional Private Placement

Usually arranged by one agent, oroccasionally two agents on larger deals

$50-$500 million

For investment-grade and a very fewnon-investment-grade issuers

Marketed via pre-establisheddocumentation

Limited and/or electronic roadshow, ifany

Little or no negotiation of terms withinvestors

Credit rating may be required + widerange of options available

Lowest up-front documentation costs

Transaction costs generally lowest

Usually highest credit spread

Best efforts transaction

Quick market access (interest rate canbe set in a matter of days)

Covenants looser than for a bank deal;tighter than for a public or 144A deal

Rule 144A Offering

Usually three or more underwriters,depending on deal

$250-$1000 million

For investment-grade and some non-investment-grade issuers


More extensive and/or electronicroadshow

No negotiation of terms with investors

Two long-term credit ratings generallyrequired

Considerable up-front documentationcosts

Higher transaction costs

Credit spread usually slightly higherthan public

Underwritten transaction—priced after“Book” is filled

Longer preparation time needed beforeaccessing the market

Covenants similar to those required fora public issue

Public “Yankee” Offering

Usually three or more underwriters,depending on deal

$250 million-$10 billion

For investment-grade or non-investment-grade issuers


Most extensive and/or electronicroadshow

No negotiation of terms with investors

Two long-term credit ratings arerequired

Considerable up-front documentationcosts

Highest transaction costs

Lowest credit spread

Underwritten transaction—priced after“Book” is filled

Longest preparation time needed beforeaccessing the market

Loosest covenant structure

GREG JOHNSON

is Senior Managing Director and head of the Yankee CapitalMarkets Group at Banc of America Securities.

If the inaugural bond issue of an international issuer is completed in an appropriatemanner, the company will have the ability to return to the market for additional, and

often longer-term, money on an expedited basis.

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Documents

YANKEE BONDS AND CROSS-BORDER PRIVATE PLACEMENTS: AN UPDATE