Yankee Bonds and Cross-Border Private Placements

Journal of Applied Corporate Finance F A L L 1 9 9 7 V O L U M E 1 0 . 3

Yankee Bonds and Cross-Border Private Placements by Greg Johnson and Thomas Funkhouser,

BancAmerica Robertson Stephens

34JOURNAL OF APPLIED CORPORATE FINANCE

YANKEE BONDS ANDCROSS-BORDER PRIVATEPLACEMENTS

by Greg Johnson and Thomas Funkhouser,BancAmerica Robertson Stephens

34BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

nternational issuers have tapped the

U.S. long-term debt markets at an ex-

plosive pace in 1997, a trend that

shows no signs of abating. Total cross-border U.S.

bond issuance in 1997 is expected to top $200

billion, easily surpassing previous issuance levels.

As is necessary for rapid volume growth in any

market, both supply and demand are increasing.

International issuers have become familiar with the

benefits and depth of the U.S. bond markets, while

U.S. investors have taken irreversible steps toward

global diversification of their portfolios. Infrastruc-

ture development, privatization of state-owned

industries, and capital investment driven by boom-

ing economic growth are all contributing to the

worldwide demand for long-term capital. More and

more investors are learning how to evaluate country-

specific economic, foreign exchange, social, and

political risks—investment skills that should stand

them in good stead when confronting the often

higher volatility of cross-border investments. Add to

the analysis credit spreads and U.S. Treasury yields

at or near historical lows, relaxed regulatory report-

ing requirements, and the prestige of accessing the

deepest and longest debt markets in the world, and

it is not hard to see why the U.S. bond markets are

more and more frequently the markets of choice for

international issuers.

I

35VOLUME 10 NUMBER 3 FALL 1997

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

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

1992 852 42 4.9 67 12 17.9 42 11 26.2

1993 1,056 63 5.9 82 27 32.9 91 24 26.3

1994 704 51 7.2 68 20 29.4 66 24 36.3

1995 713 48 6.7 61 14 22.9 71 25 35.2

1996 954 90 9.4 69 21 30.4 132 39 29.5

1H 97 $575 $74 12.9% $32 $10 31.3% $113 $36 31.9%

Source: Securities Data Corp.

TABLE 1ISSUANCE IN THE U.S.LONG-TERM DEBTMARKETS1992-PRESENT

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 issues 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 sectorsover the past several years. The mechanics ofissuance in each market are discussed, including theprimary investment considerations of U.S. institu-tional investors, the rating-agency process, andmarketing, distribution, and documentation aspectsof each product.

MARKET OVERVIEW

Cross-border issuance in the U.S. long-term debtmarkets has been on the rise since early 1995, morethan recovering from the market disruption causedby the devaluation of the Mexican peso in late 1994.The 144A market has grown most dramatically as theconduit for foreign issuers seeking access to a broadbase of U.S. institutional investors without the timeand expense of the SEC registration process. Yield-hungry investors, searching for ways to improvereturns while diversifying their portfolios, havefound value in cross-border investments that offer a

yield premium above comparably rated domesticinvestments. But the good news for would-be issuersis that this premium has declined in recent years inresponse to generally improving economic condi-tions abroad and a growing number of investors withinternational investment expertise. Foreign issuancecurrently represents nearly one third of the traditionaland underwritten 144A private placement markets,and about 13% of the U.S. public bond market.

Long Maturities at Attractive Rates

The U.S. bond markets are at their competitivebest when an issuer places a premium on debt witha long average life. The U.S. markets tend to bedeepest at the ten-year maturity, as the broadestrange of investors have investment appetite at thismaturity. Maturities of 20 and 30 years account fora significant portion of overall issuance, and longerofferings including 100-year “century” bonds arenow being completed on a regular basis.

U.S. Treasury yields are currently near histori-cal lows as a result of benign inflation and steadyeconomic growth. This economic environment hasled to both increased savings (resulting in strongflows into the stock and bond markets) and improv-ing credit quality, causing corporate credit spreadsto decline steadily in recent years and resulting inan extremely attractive environment from an issuer’sperspective. As investors seek higher returns, theyhave shown a willingness not only to invest inlower-quality credits, but to do so for longer periodsof time. While 63% of issuance was rated A or higherin 1995, that ratio has dropped to 38% in the firstthree quarters of 1997. During the same time period,issues of six years or longer have increased from71% of issuance to 82%.


balance the mix of their portfolios to reflect theanticipated need to generate cash for portfoliooutflows.

Such cash outflows can be very predictable fora life insurance company using actuarial forecastsof policy payments, but very unpredictable for amutual fund, which may need to convert its holdingsto cash at any time. Not surprisingly, the mostaggressive buyers of a liquid Yankee or underwrit-ten 144A bond include those investors who need tobe able to trade in and out of their holdings. Duringtimes of strong cash inflows, mutual funds dominatethe public bond markets. Those investors with themost stable cash flows—insurance companies andpension funds—dominate the illiquid traditionalprivate placement market. In general, the five maininvestor groups can be said to have the investmentcharacteristics outlined in Table 2.

Investor Characteristics

U.S. long-term institutional investors vary widelyin size and investment strategy, but can be generallygrouped into one of five main categories: lifeinsurance companies; property and casualty insur-ance companies; public and private pension funds;mutual funds; and bank trust departments andmoney managers. Investment strategies range froma long-term “buy-and-hold” approach with lowportfolio turnover to an actively traded, “total rateof return” approach, where assets are continually“marked to market” in order to calculate value ona real-time basis. Portfolio managers must selectinvestment categories and individual bonds basedat least in part on their desired mix of liquid (activelytraded, easily tradable) and illiquid (no regularlisting of market prices) assets. In this manner, they

FIGURE 1


Yankee Bonds

The State Development Bank of China wasestablished in March 1994 as a policy-oriented finan-cial institution under the direct leadership of theState Council of China. The Bank’s primary purposeis to foster the economic development of Chinathrough the provision of long-term financing forinfrastructure facilities, and for basic and pillar indus-tries. The Bank borrows and lends in both Renminbiand foreign currencies. It extends loans in foreigncurrencies to Chinese borrowers that require foreigncurrency for the purchase of products or servicesfrom non-PRC suppliers.

The Bank was rated at the China “country ceiling”of A3 by Moody’s and BBB+ by S&P at the time of theissue. The Bank entered the Yankee market with aninaugural issue of $300 million with a 10-year matu-rity. The Bank had grown to over $30 billion in assetsat the time of the issue and expected its rapid growthto continue. The 10-year Yankee issue was viewedas an appropriate size and maturity to establish abenchmark in the U.S. bond markets.

Investors reacted very favorably to the issue,which was slightly expanded to $330 million. Sixinvestment banks underwrote the transaction, creat-ing widespread knowledge of the issue and the Bankand encouraging secondary market activity. Theissue created a solid benchmark for the State Devel-opment Bank of China in the Yankee market. Theissue was large enough to allow large individualinvestments by investors, but small enough to createscarcity value. Secondary trading levels now providea reference for future bond issues of the Bank, notonly for the 10-year maturity but for other maturitiesas well.

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

Maturity Trading PrimaryType Preference Activity Bond Type

Life Insurance 5 to 30 yrs. Inactive Private/PublicProperty andCasualty Ins. 5 to 10 yrs. Inactive PublicPension Funds 5 to 20 yrs. Moderate Private/PublicMutual Funds 5 to 15 yrs. Active PublicBank Trust Depts./Money Mgrs. 2 to 10 yrs. Active Public

Mechanics of Issuance

Issuance of Yankee bonds requires the hiringof one or more lead managers and typically two ormore additional co-managers to market and distrib-ute the bonds. The selection and number ofunderwriters in the syndicate will depend on thesize of the issue and the desired breadth ofdistribution. The lead manager is responsible forstructuring the financing and overseeing docu-mentation of the issue as well as managing theunderwriting syndicate and ensuring successful

YANKEE BONDS

A Yankee bond is an underwritten, dollar-denominated bond that is publicly issued in theU.S. by a foreign entity. Yankee bond offeringsare required to be registered with the SEC underthe Securities Act of 1933, and are subject todisclosure standards that are often more stringentthan those required in foreign issuers’ domesticmarkets. Due to the extensive SEC registrationand rating agency requirements, a first-timeYankee offering can take anywhere from ten to14 weeks to complete. Yankee offerings involvemore significant legal, rating, and out-of-pocketexpenses than both types of private placement.

Yankee bonds can be distributed more widelythan private placements and usually entail themost extensive roadshow. Yankee bonds aremarketed via pre-established documentation thatinvolves no negotiation with investors, and typi-cally are structured with no financial covenants.The loose covenant structure reflects the natureof the public market; issuer/investor negotiationsin a widely distributed issue are extremelydifficult, making it impractical for an issuer toamend or adjust an issue once it is sold. Theinvestor’s lack of effective control over the issueris offset by the liquidity of the public market, andby the ability of an investor to sell the position ifhe becomes uncomfortable with company actionsor performance.

In general, individual Yankee bond offeringsrange in size from $100 million to $1 billion, withmost issues in the $200 to $500 million range.Individual offerings are often completed in mul-tiple tranches of $100 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.

Foreign issuance currently represents nearly one third of the traditional andunderwritten 144A private placement markets, and about 13% of the U.S. public bond

market. The 144A market has grown most dramatically as the conduit for foreignissuers seeking access to a broad base of U.S. institutional investors without the time

and expense of the SEC registration process.


distribution of the issue. The lead and co-managersare expected to provide after-market trading andresearch support. The lead underwriter is oftenchosen based on a strong fixed-income researchdepartment (one capable of aiding investors intheir investment decisions) and a strong fixed-income trading desk (capable of maintaining aliquid secondary market in the bonds). The leadunderwriter is also responsible for guiding theissuer through the rating-agency process.

Despite industry standards, fees charged bythe underwriters will vary based on the expectedlevel of complexity of the above responsibilities.The credit quality, industry, country of domicile,and market conditions will all affect the “grossspread” charged by underwriters (that is, thedifference between the price received from inves-tors and the proceeds to the issuer). The grossspread for an investment-grade issuer typicallyranges from 50 basis points for a five-year bond to90 basis points or more for a 30-year or longerbond, and is significantly higher for lower-ratedissuers.

The gross spread on an investment gradetransaction is divided into three components. Amanagement fee, which is paid to lead and co-managers for managing the issue, is usually 20%of the gross spread. An underwriting fee is paidto the lead and co-managers—and to any addi-tional firms hired to underwrite the issue—forassuming the underwriting risk and various costsassociated with the offering. The underwritingfee is also usually 20% of the gross spread. The“selling concession” is paid pro rata directly tothose firms that actually sell the bonds. Theselling concession typically represents 60% ofthe gross spread and, in most cases, goes dispro-portionately to the lead underwriter by virtue ofits control of the “pot” bonds. Pot bonds areusually 50% of an issue and, as a result, underwrit-ers only retain 50% of their legal underwritingcommitment for direct sale to investors. Knowingthat the lead manager controls these pot bonds aswell as its own proportional retention, investorswill often direct orders to the lead manager toassure themselves a generous allocation. Theresult is that the lead underwriter typically getsthe lion’s share of the fees, despite balanced legalunderwriting commitments.

Fee splits for non-investment grade (highyield) bonds are more straightforward. Fees for

these deals are usually predetermined and aredirectly in proportion to the legal underwritingcommitment of each underwriter, regardless ofwho is actually responsible for selling the bonds.There is much greater market risk associated withnon-investment grade transactions, more than theunderwriters are willing to assume in most situa-tions. High yield bonds are therefore completely“pre-sold” before a transaction is priced. The fee-split arrangement closely aligns compensationwith the legal underwriting risk of the transaction,as distinguished from the marketing or sales risk.

SEC Registration

The 1933 Act requires issuers of publiclyoffered securities to file with the SEC a registrationstatement and to maintain regular ongoing disclo-sure of prescribed business and financial informa-tion. (First-time foreign issuers generally file theregistration statement on form F-1.) The filing mustinclude a prospectus that contains strictly defined,detailed descriptions of, among other items, theissuer’s operations, product lines, geographic re-gions, financial condition, and potential risk factorsthat could have a material effect on operations oron the value of the offering. Issuer’s legal counselwill draft the SEC registration statement withassistance from the issuer and the underwriters.Issuers, underwriters, and their respective counselcan be held legally responsible for the accuracy ofmaterial furnished to the public in connection witha public offering.

The purpose of the strict standards set by the1933 Act was to shift the burden of verifying theaccuracy of relevant information onto the sellers ofthe securities for the benefit of the buyers. Inaddition, the bond issue will contain provisions thatrequire the issuer to continue to file periodicfinancial information with the SEC for as long as theissue is outstanding.

Credit Ratings

Buyers of public bonds rely heavily on ratingagencies to conduct credit analysis, so much so thattwo ratings is the market standard for public bonds.Moody’s and Standard & Poor’s ratings are usuallyrecommended, if not required, as a result of theirlong-standing market presence and establishedtrack record. Rating agencies follow an intensive


and methodical process in examining all relevantaspects of an issuer’s operations, management,industry position, and financial condition.

Rating methodologies used are published bymost rating agencies and readily available uponrequest. Rating agencies typically charge between$25,000 and $125,000 for each individual corpo-rate credit rating, with issues over $500 millionincurring additional fees.

Timing

The preparation for a Yankee bond offeringinvolves multiple drafting sessions in which rep-resentatives from the issuer, issuer’s legal counsel,and the underwriters conduct a review of allmaterial required for the SEC filing. At about themid-point in the 10- to 14-week process, a firstdraft of the registration statement is confidentiallysubmitted to the SEC for review, and rating-agencypresentations are conducted by the issuer and thelead manager. Rating agencies may conduct in-depth, on-site due diligence following the initialpresentations.

An indication from rating agencies and com-ments from the SEC are typically received one tothree weeks later and drafting of a revised regis-tration statement commences. Near the end of theprocess, preliminary ratings are released and theregistration statement is publicly filed, at whichtime the transaction is announced to the market anda preliminary “red herring” prospectus is distrib-uted. An extensive roadshow will usually begin assoon as the preliminary prospectus is distributed,and the issue is typically priced immediatelyfollowing the roadshow schedule. Financial clos-ing on public bonds typically occurs within threebusiness days of pricing.

Documentation

The binding legal document for public issuesis an indenture that requires a bond trustee toadminister payments and take other actions onbehalf of the investors. In addition to the indenture,additional important documentation requirementsinclude a 10(b)-5 opinion by legal counsel statingthat no knowledge of any material misstatement oromission exists, and an accountants’ comfort letterstating that the most recent financial information iscorrect.

TRADITIONAL PRIVATE PLACEMENTS

A traditional private placement is a transac-tion that qualifies for exemption from registra-tion requirements under either Section 4(2) orRegulation D of the 1933 Act. As a consequenceof the exemption, limitations are placed on thetype and number of investors who can partici-pate in an offering, and there are also restrictionson resale. A traditional private placement is thedirect sale of debt or other securities by an issuerto one or more “accredited investors.” As de-fined in Regulation D, accredited investors in-clude banks, insurance companies, registeredand small business investment companies, cer-tain employee benefit plans, organizations withtotal assets in excess of $5 million, and certainwealthy individuals.

The traditional private placement market his-torically has offered issuers quick, discreet accessto a broad base of long-term U.S. institutionalinvestors, primarily life insurance companies andpublic and private pension funds. Private place-ment investors usually hold bonds to maturity andare frequently repeat investors in new debt ofissuers with which they have relationships.

Disclosure standards in the traditional pri-vate placement market are unregulated andsignificantly less well-defined than those in theYankee bond market. Transactions are typicallycompleted on a negotiated basis, transferring tothe investors much of the risk of assuring that allrelevant information is available and has beenconsidered. Investors often require financialcovenants in addition to numerous representa-tions and warranties in order to protect the valueof what they expect will be a very long-termholding. The need for credit ratings variesdepending on the issue, but the majority ofissues are completed with one or no rating. Atraditional private placement for a first-timeissuer can typically be completed in six to tenweeks.

Private placements can be completed in anyamount, but are usually most cost-effective above$25 million and below $250 million. Total issu-ance costs for a private placement can be muchless than those paid for an underwritten transac-tion, since placement and legal fees can be aslittle as half those paid for an underwritteninvestment-grade issue.

The loose covenant structure of Yankee bonds reflects the nature of the public market.The investor’s lack of effective control over the issuer is offset by the liquidity of the

public market, and by the ability of an investor to sell the position if he becomesuncomfortable with company actions or performance.


Traditional Private Placement

CAE Inc. is a world leader in the design andmanufacture of commercial and military flight simula-tors, control systems for the marine and powerindustries, and industrial technologies for the forestproducts, railroad, automotive, and food processingindustries. As a Canadian company with significantinternational sales, CAE sought U.S. long-term debt inits capital structure, in part to hedge some of its U.S.dollar revenue exposure.

CAE, which does not have a current rating fromeither Moody’s or S & P, believed that the U.S. privateplacement market would view the company in atleast as favorable a light as the rating agencies. CAEentered the market for $100 million and had theflexibility to accept offers in a variety of maturities,including 8, 10, 12, and 15 years.

Investors viewed the company as a strong invest-ment-grade credit and expressions of interest ex-ceeded $500 million. Pricing was consistent with thelevels one would expect for a company with thehighest NAIC rating level. The negotiated nature ofthe private placement market allowed the companyto accept only the most aggressive bids in eachmaturity. The resulting financing of $108 million wasmade up of $15 million for 10 years, $60 million for12 years, and $33 million for 15 years. An additionalC$20 million of Canadian dollar bonds were placedwith one investor for eight years.


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 offering andthe issuer. The time required for preparation of aprivate offering memorandum is usually shorter thanthat required in a public transaction, mainly becausethe issuer has greater latitude in describing thecompany and its activities. While the informationpresented in a private placement memorandumtends to be quite similar to that required by the SECfor a public filing, there are no formal standards orrequirements. Because private investors often con-duct their own due diligence review, the issuergenerally has more freedom in discussing the merits,

drawbacks, and prospects of its company than ispossible in 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 towardlonger meetings with individual investors. Pricingoccurs at the end of the roadshow or marketing period(if there is no roadshow), and is followed by investordue diligence and the finalizing of documentation.

Credit Ratings

Ratings from a wider range of recognizedrating agencies are acceptable in the traditionalprivate placement market, and “private” ratingscan be obtained that are not published or publiclydisseminated. Fees charged by these alternativeagencies, which include Duff & Phelps and FitchInvestors Service, are similar to or slightly lowerthan Moody’s and S&P. Since all investmentspurchased by insurance companies are ultimatelyrated by the Securities Valuation Office of theNational Association of Insurance Commissioners(“NAIC”), a rating by one agency is sometimesrecommended as a preemptive strategy.

Documentation

Traditional private placements were histori-cally marketed via a term sheet, with documenta-tion undertaken after the general provisions of thetransaction had been accepted. Over the lastseveral years, however, industry efforts to stan-dardize documentation have been very successful,resulting in many if not most transactions beingcompleted on a “pre-documented” basis. In a pre-documented deal, legal counsel is engaged to draftthe note purchase agreement (the binding legaldocument between the issuer and investors) priorto going to market.

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 have a slightly longer leadtime but can be closed in as little as one to two


Underwritten Rule 144A Private Placement

Dayabumi Salak Pratama, Ltd. (“DSPL”) is a specialpurpose company formed to build and operate a 165megawatt geothermal power plant near Jakarta, Indo-nesia. The power plant’s sponsors are Unocal Corpora-tion, an integrated energy resources company and oneof the leading operators of geothermal resources in theworld, and PT Nusamba Geothermal, an Indonesiancorporation established to develop the geothermalresource. Electricity generated by the power plant willbe sold to PLN, the Indonesian state-owned electricitycompany, under a 15-year energy sales contract.

Construction had begun and the sponsors wereseeking long term debt to finance the power plant andcreate a capital structure which would match the longlife nature of the asset. The power plant’s credit-worthiness was based in large part on a dollardenominated 15-year off-take agreement with PLN.

DSPL sought to take advantage of favorable mar-ket conditions through an underwritten Rule 144Aprivate placement. The DSPL offering was rated Baa3by Moody’s and BBB by S&P, equivalent to the“country ceiling” ratings for Indonesia at the time ofissue. The financing was structured as a 14.5-year finalmaturity, 11-year average life offering.

The 144A approach focused the marketing efforts onsophisticated institutional investors with the resourcesnecessary to analyze the complex risks associated withthe power plant, including geothermal power production,facility completion risk, single purpose aspect of theunderlying assets, and Indonesia risk in general, amongother factors. The financing was oversubscribed andplaced with 12 qualified institutional investors (QIB’s).

weeks following circle. It may take significantlylonger to close a transaction after circle if the dealis based on a summary term sheet and draftingtakes place during the investor due diligencestage.

144A PRIVATE PLACEMENTS

Rule 144A was adopted in April 1990 as ameans to facilitate the resale of privately placedsecurities and thus increase secondary tradingamong institutional investors of otherwise illiquidinvestments. Rule 144A permits resale of privatelyplaced securities to “qualified institutional buy-ers,” or “QIBs,” which include institutions that ownat least $100 million of eligible securities anddealers that own at least $10 million of suchsecurities. When Rule 144A was first initiated,issues that were otherwise being executed astraditional private placements had a Rule 144Aprovision built into the documentation to makesecondary trades easier. But Rule 144A had littleimpact in this market because most investors whopurchased such illiquid investments were lookingto hold such investments to maturity anyway.Investment banks soon discovered, however, thatthe Rule 144A provision could be used to developa quasi-public issue.

In an underwritten 144A issue, an investmentbank becomes the initial purchaser of a privateplacement and then resells the bonds to institu-tional investors under a Rule 144A exemption. Anew market quickly evolved around this process,and today it closely resembles the SEC-registeredmarket in terms of underwriting practices, includ-ing marketing, distribution, disclosure, documen-tation, and credit-rating requirements. Foreignissuers were particularly pleased with the devel-opment of this market since it allowed them to selllarge issues to U.S. institutions without complyingwith, among other things, the intrusive executivepay disclosure requirements of the SEC.

Transaction size range for 144A transactions issimilar to that of public bonds, with transactions inthe $150 to $300 million range most common. Thelower threshold is around $100 million. Issuancefees, including underwriting fees, are comparableto, and structured in the same manner as, fees onYankee bonds. Because of the lack of registrationrequirements, 144A transactions can typically becompleted in eight to 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, invest-ment-grade Rule 144A offerings are often indistin-guishable from SEC-registered transactions in termsof process 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

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.


information as a public prospectus. Syndicationgroups are formed with the same eye towardresearch and secondary market-making capabilitiesthat one would expect for an SEC-registered issue.

Currently, the Rule 144A market is undergoingyet another transformation that is propelling issu-ance to even higher levels. Nearly two thirds of theRule 144A transactions during the first half of 1997were completed with registration rights, a provisionthat requires the issue to be registered with the SECwithin a prescribed time period after issuance(usually six months). This registration requirementeffectively converts the 144A into a public bond,thus conferring on the buyer the benefits of regis-tration, including disclosure requirements and li-quidity, while still allowing the issuer to come tomarket quickly and deal with the SEC registrationprocess afterward. An issuer’s failure to register thesecurity in such an offering results in additionalpenalty interest on top of the coupon rate.

Credit Ratings

Two credit ratings are generally required by144A buyers, although one alternative agencyrating coupled with an S&P or Moody’s rating issometimes acceptable, depending on the nature ofthe transaction. Rating agency fees are consistentwith those required for a Yankee issue, and theprocess is virtually the same.

Documentation

The binding document in 144A private place-ments is usually a purchase agreement negotiatedbetween the issuer and the underwriter group,which then resells the securities. Because Rule144A bonds are distributed in a similar manner aspublic bonds, their covenants resemble those ofpublic bonds; it is very difficult to negotiate amend-ments or adjustments once a transaction is sold evenif the investor group cannot include individuals.Covenants are found more frequently in lowercredit quality transactions, although they typicallycarry compliance levels that a company should beable to meet in all but the most dire of circumstances.In addition to limited or no financial covenants,144A purchase agreements typically do not requireexpansive representations and warranties of theissuer or provide inspection rights to the investor,as is usually the case in a traditional private

placement. The same legal opinions and accoun-tants’ comfort letter required for a public offering arealso generally required.

SELECTING THE MOST EFFICIENT MARKET

While Yankee bonds accounted for 60% of the$150 billion of cross-border issuance by volume in1996, Yankees made up only 37% of the marketwhen measured by the number of transactions.Given that Yankee bonds are generally the largestissues, their dominance by volume is not surprising.The importance of the 144A market to internationalissuers is evident, however, when viewing themarket by number of deals. In fact, 144A issues nowrepresent the largest segment, accounting for 38%of all transactions. Traditional privates make up 25%of the total number of transactions, underscoringtheir importance as an issuance method and theoverall balance among these three markets.

Generalizations are nowhere more dangerousthan in the capital markets, but for an internationalentity rated by Moody’s and S&P, an SEC-registeredbond will always be the most efficient form of long-term financing. Exceptions to this “rule” include dealsthat are small (under $150 million) or very unusualin structure, or which have a particularly cumber-some amortization schedule or any of a number ofother possible quirks. Traditional private placementand underwritten 144A investors are looking for apremium over the yield of a comparable public issueto compensate them for the reduced liquidity of theirinvestment, however unlikely they are to resell thesecurities. Accordingly, a Yankee bond should be thelowest-cost issuance method for rated issuers of anycredit 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 best for larger transactions due to the high up-frontcosts. Other reasons include the desire not to reportto the SEC on an ongoing basis, the desire forconfidentiality of results or company information,and the desire not to live with the ongoing andcontinuous scrutiny of the rating agencies. If acompany does not yet have ratings from the two topagencies, the choice of which market is best willrequire more thought.

The Rule 144A structure is often used forcomplex structures requiring heavy rating-agency


involvement, 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 to justifythe additional issuance costs. The 144A market isgenerally preferred over the public market for thistype of issue, in part because SEC registration will notnotably increase the number of investors who arecapable of or willing to analyze such credits.

Ratings Plays

In the simplest terms, a ratings play is the abilityfor an issuer to position itself with investors as ahigher-quality credit than the issuer would be if aformal rating from Moody’s and S&P were obtained.For a company with one or more debt ratings thathave been made public, there is little opportunityto identify a ratings play. Nevertheless, ratings playsoccur in the global debt markets on a regular basis.While one can argue that the significant funding-cost differences among markets (after adjusting fordifferences in risk and liquidity) should be elimi-nated over time, in practice investors deal withimperfect market information and incomplete knowl-edge of rating-agency opinions. For investors con-fident in their own investment analysis, this is oftenseen as much as an opportunity as a hindrance.

Institutional investors that purchase private place-ments are perhaps the most willing of all investorgroups to help identify opportunities for ratingsplays. To be sure, ratings are still important to theseinvestors; insurance companies, the largest sector ofprivate placement investors, are subject to NAICratings on all of their investments, which in turndetermine their reserve requirements. While issuers

that are rated by one of the major rating agencies areusually accepted by the NAIC on a comparable basis,the NAIC has on occasion challenged the accuracyof ratings from lesser-known rating agencies. A lowerrating from the NAIC will translate into higher reservecosts for the investor and much higher issuance costsfor an issuer’s future transactions.

Nonetheless, opportunities for ratings playsexist on several levels. An example is the possibil-ity—some would say the likelihood—that one of thefour primary U.S. rating agencies (or an agency in theissuer’s home country or region) will provide a higherrating than both Moody’s and S&P can agree upon.The reasons for a more favorable credit perspective,which are as varied as the issuers themselves, can berelated to differing legal, industry or economicoutlooks, or be as basic as differences in creditphilosophy.

While not anxious to encourage the phenom-enon, institutions buying private placements aresophisticated investors and are aware of the incentiveof an issuer to hire the rating agency that is likely totreat the issuer in the most positive light. Indeed,private investors often believe that with covenantprotection an investment may be of higher value thana Moody’s or S&P rating might suggest. Value to theinvestor can be measured not only in terms of theprobability of timely payment of principal andinterest (the overriding focus of the major ratingagencies), but also in terms of covenant protectionagainst significant events and the probability ofultimate recovery of principal and interest in theevent of default.

These investors are also aware that they haveto compete 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 positive

FIGURE 2

Foreign issuers were particularly pleased with the development of the Rule 144 Amarket since it allowed them to sell large issues to U.S. institutions withoutcomplying with, among other things, the intrusive executive pay disclosure

requirements of the SEC.


outlook than the major rating agencies for a givencredit, industry, or country will be strong advocatesfor a higher NAIC rating.

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 ten-year issue, the present-value impact on the under-writers of a bought deal is much more significant thanthe impact on a three-year Eurobond transaction ofthe same amount. In addition to the greater pricevolatility of longer maturity issues, the time necessaryto prepare for market is often longer than in othermarkets for reasons including the SEC review period,the rating-agency review periods, and the prepara-tion of legal opinions and documentation. The longerthe lead time required to market an issue, the higherthe 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 road-show 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 portion

of 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 inprice, and those investors who were most bullish onthe company (the investors who liked the companyenough to buy their bonds through the appropriatemarket level) suffer a loss on their new investment,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 secondary tradinglevel and sold to unresponsive investors. Boughtdeals make sense for issuers with billions of dollarsalready outstanding, for which a new issue can beviewed as little more than a large secondary trade.But few international issuers fit the proper profile ofa competitive bid issuer.

DOCUMENTATION CONCERNS

The private placement market was its ownworst enemy 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 andYankee bond markets were appropriately pre-ferred by international issuers and investment banksalike. The relatively recent development of themodel-note agreement—and its increased use byintermediaries to offer deals to investors on a take-it-or-leave-it basis—has helped focus issuer andinvestor alike on the more important aspects ofdocumentation. Nonetheless, as issuance of lower-quality credits continues to grow and now includesissues with covenants, more Yankee and Rule 144Aissuers face the troubling possibility of a default onan issue—and the nearly impossible job of amend-ments from unknown 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 profitable


Public “Yankee” Offering

Usually three or more underwriters,depending on deal

$150 million - $1 billion

For investment-grade or non-invest-ment grade issuers

Marketed via pre-establisheddocumentation

Most extensive roadshow

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 neededbefore accessing the market

Loosest covenant structure

Traditional Private Placement

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

$25-$250 million

For investment-grade and some non-investment grade issuers

Marketed via term sheet or pre-established documentation

Limited roadshow, if any

Unless using pre-establisheddocumentation, negotiation controlledvia extensive term sheet

Credit rating may be required + widerange of options available

Limited 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

products for many investment banks than traditionalprivate placements. Other issuers will have precon-ceived notions about the difficulty of meeting ongo-ing SEC registration requirements, or of dealing withrating agencies, or of documenting a traditionalprivate placement. The reality is that each productneeds to be considered in the total context of theissuer’s long-term financial strategy, as well as withregard to the issuer’s short-term tactical needs. Theproduct that is the right solution for one financing

need of an issuer may not be the right solution foranother 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 products andthat careful consideration needs to be given to theseissues when choosing a financing solution. After all,a financial officer is going to live with the character-istics of whichever product is chosen for a very longtime indeed.

GREG JOHNSON

is Senior Managing Director and head of the InternationalCapital Raising Group at BancAmerica Robertson Stephens.

THOMAS FUNKHOUSER

is an Associate in the International Capital Raising Group atBancAmerica Robertson Stephens.

Rule 144A Offering

Usually three or more underwriters,depending on deal

$100-$500 million

For investment-grade and some non-investment grade issuers

Marketed via pre-establisheddocumentation

Extensive roadshow

Little or no negotiation of terms withinvestors

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 neededbefore accessing the market

Covenants similar to those required for apublic issue

SUMMARY OF U.S. MARKET ALTERNATIVES

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