Allens Arthur Robinson: Publication: In the money: December 2001 - Feature article

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Allens Arthur Robinson

Feature article

There are many types of securities and funds which make up the capital markets universe. This issue of "In The Money" provides a helicopter overview of the range of these securities and fund types. AAR has over 130 people who cover this broad field, in depth, through focussed teams which study not only the legal and tax issues but also market practice and key market developments.

Security types

Shares in dual listed companies (DLCs)

AAR has acted on the 2 recent Australian DLCs: representing Brambles on the Brambles/ GKN DLC and representing BHP on the BHP/Billiton DLC. The shares in each DLC entity are generally speaking normal ordinary shares but the DLC arrangement requires immensely complex structures to be put in place which have the result that

shareholders in the two DLC entities do not sell their securities or buy any securities in order to form the DLC;
the DLC entities do not dispose of assets to each other in order to form the DLC;
the DLC entities enter into arrangements to equalise in agreed proportions the distributions on the securities which each has on issue;
each DLC entity retains its own legal entity status, but the DLC companies are run as part of one economic unit;
there is some sort of capital reconstruction, such as a bonus issue, in relation to one of the DLCs so that the proportionality of value between them and their shares is correct.

Exchangeable shares

These are securities which are exchangeable for other securities by a different issuer in particular circumstances. The initial security may, for example, be a share in a New Zealand company which in particular circumstances can be put to an Australian company which in return issues shares in the listed Australian company. There may be regulatory reasons for capital to be needed in a particular company in a particular jurisdiction on a temporary basis and it may make more sense for an entity in that jurisdiction to raise the capital, but to enhance liquidity and certainty for investors, investors may require the ability to "flip" the security into a more liquid parent security upon the happening of various circumstances eg, a takeover for the parent. One of the challenges with this type of structure is to give investors the ability to influence the casting of the same number of votes as they would have been able to vote had they held shares in the listed parent company from day 1. There are also other complex issues relating to dividend support and taxation.

Westpac's NZ Class Shares issued by a Westpac entity in New Zealand is an example. AAR acted for Westpac.

Preferred and hybrid securities

This category comprises preferred equity, redeemable preferred equity, convertible preferred equity and converting preferred equity. Each has the characteristics as described below.

Preferred equity

Preference shares or preference units are like debt instruments in a commercial sense in that they carry a fixed dividend (payable only to the extent there are profits). In a winding up the preferred equity ranks ahead of ordinary equity as regards return of capital.

Redeemable preferred equity

Preference shares or units can be made redeemable (but redemption of preference shares may only occur out of profits or out of the proceeds of a fresh issue of shares for the purpose of funding redemption). A redemption right makes this type of security more like a loan. Redeemable preference shares used to be a very popular financing technique.

Convertible preferred equity

This is preferred equity which converts into ordinary equity at the option of the investor (ie typically convertible preference shares). This gives the investor the comfort of a quasi-subordinated debt ranking with some equity upside.

Converting preferred equity

This is preferred equity which converts into ordinary equity sooner or later whether the investor wants to or not (ie typically converting preference shares). Often the conversion formula protects the investor from share price drops to some extent.

Hybrid securities are popular when the outlook for "ordinary" shares is just that, rather ordinary. This means now, since the economic climate is less than robust in many key economies. Profit growth is on the cards for only a few lucky or extremely well managed companies.

AAR has worked on many innovative deals such as:

advising Burns, Philp on its renounceable rights offering of 355 million converting preference shares;
St.George Bank's innovative $300 million offering of non-cumulative, resetting, non-redeemable convertible preference shares (known as PRYMES);
Amcor's $400 million offering of perpetual resetting convertible notes (called PACRS); and
QBE's offering of US$172.5 million mandatory converting securities (known as FELINE PRIDES).

Tracking shares (also called Letterstock)

These are shares which are issued by a company which owns more than one business and where the terms of issue of the tracking shares are such that their capital and distribution rights relate to the performance of one or more of those businesses, but not all of them. In other words, the shares "track" the performance of the relevant business or businesses. Such tracking shares are intended to facilitate capital raising by a company which owns one or more businesses which are not attractive to the market at that time. A number of problems with this type of share make it rare in Australia. For example, if the "tracked" businesses are profitable and would normally permit dividend distributions on the tracking shares, the legal ability to make such distributions may be impaired by losses made in the other "unattractive" businesses. Spin offs achieve the same objective but result in a loss of control of the business spun off.

Tier one capital instruments

Tier one is a hybrid of debt and equity which counts as capital for bank capital purposes, but preferably is treated as debt for tax purposes.

Recent tax changes will put pressure on some existing hybrids, but will also clarify the ground rules for new issues under different structures. Expect some new issues in the New Year.

Stapled securities

This is where securities of different types are linked together such that the linked securities cannot be traded or transferred alone but only together. A common combination is a unit in a trust combined with a share in a company. This type of structure is usually in part intended to facilitate a sensible taxation outcome. For example, in some cases it is best for a trust to own real property and for any active property related business to be carried out by a company. In this way the totality of the relevant business is owned between the trust and the company and all profits/losses are distributed through the company and the trust to investors. Those investors do not need to concern themselves with the precise allocation of assets between the two entities as the investor holds a security in each entity.

In some cases, a merger of entities is carried out using a stapled security structure. This generally avoids crystallising taxable gains by the holders of securities in the entities which are to merge. If you are security holder in Entity 1 which is to merge with Entity 2, then instead of selling your securities in Entity 1, you are issued securities in Entity 2. Security holders in Entity 2 are likewise issued securities in Entity 1. A number of mergers in the property trust sector have occurred using this mechanism.

AAR has acted for the lead managers on many capital raisings by issuers of such stapled securities.

Retail debentures

There is renewed interest in debentures aimed at the retail market now that many retail investors are more interested in yield than capital growth. Traditionally the market for debt instruments has been mostly a wholesale one but signs are that this may change. Retail marketing of course requires a lodged prospectus.

AAR acted on a recent debenture issue targeted to retail investors, with an attractive yield.

Convertible debt securities

These are debt securities which convert to equity at the option of the investor (typically convertible notes). Convertible debt securities typically have a fixed coupon thereby providing yield certainty and give the holder the right to participate in share price growth through a mechanism which allows the debt/ investment to be converted to ordinary shares.

Convertible notes are part of a growing section of the corporate securities market described as hybrids. In the last 2 or 3 years, there has been a growing demand for fixed and floating income investments from the retail market, especially as share-market uncertainty has focussed investors on yields.

The key legal issues to be considered include the tax aspects of both domestic and cross-border convertible debt securities and accounting issues eg: whether the convertibles will be treated as equity or as debt? New tax legislation makes it reasonably clear which hybrid structures will be classified as debt and which will be counted as equity for taxation purposes so they should continue to be a popular capital management tool.

AAR has advised on a number of large issues of convertible debt.

Perpetual (income) securities

These are debt securities which are not repayable or are only repayable in very limited circumstances or only if a particular regulator does not object. In and around 1999 a great deal of capital was raised by a number of issuers issuing this type of security. However, many of these securities are now trading at a discount to their issue price and tax changes have made them less attractive. They aim to provide tax deductible interest and superior capital rating with banking authorities.

AAR acted for the lead managers in the first such issue in Australia.

Pure debt securities

This are debt instruments issued by corporates, some of which may be traded in the stock market or over the counter (OTC). Among the more common forms of instruments are:

medium term notes (MTNs)
Kangaroo bonds
commercial paper
Eurobonds
CPI indexed debt securities

The basic features of all these instruments is an obligation to repay together with periodic interest (if any). The major differences between the securities relate to the term of maturity, whether any interest is payable and if so how it is calculated, and the offer structure used to issue and distribute the securities.

AAR has a very substantial track record in this area.

CMBS

CMBS is short for Commercial Mortgage Backed Securities. It takes 2 forms, with the most common form not really being a true securitisation, but rather a structured form of property finance.

The first form involves a financial institution selling its interests in commercial property based loans and mortgages. Another form involves a substantial corporation leasing its properties, and then sub-leasing them back. The sub-lease payments are then securitised. These deals are like an MBS deal, which involves the securitisation of residential mortgages. They may be called a "true securitisation". Not many of these have been done, primarily because of the cost of the credit enhancement.

The second form involves a financial institution, often a listed property trust, issuing notes that are backed by mortgages over commercial properties. This form draws on AAR's experiences both in property finance and securitisation.

AAR has acted on many CMBS deals.

Structured Notes

These are debt securities with lots of bells and whistles, which vary from one type to another.

Under one structure, notes are issued as 'Structured Notes' and remain as Structured Notes until a particular Conversion Date (which has a discretionary element, allowing either party to nominate a conversion date once an initial period expires). At the Conversion Date, the Structured Notes convert into normal floating rate notes. The general purpose of Structured Notes is to allow the holders of such notes, for so long as they are structured notes, to match returns on the notes to the performance of a nominated index or pool of bonds (especially government bonds).

Credit wrapped securities

Credit wrapped capital markets issues involve the issue by highly rated financial organisations of a financial guarantee in respect of note issues or other capital markets products. In a standard credit wrapped MTN deal, the financial guarantee covers the payment of scheduled principal and interest on the notes and certain amounts in respect of some withholdings. Rating agencies rate the notes (or other product) on the basis of the credit rating of the financial guarantor, resulting in a AAA rating for the note issue where the financial guarantor is AAA.

AAR's experience in credit wrapped capital markets issues is second to none in Australia. We represent both MBIA Insurance Corporation and AMBAC Assurance Corporation here and have acted on 10 of the credit wrapped note issues so far sold into the primary market here.

Early credit wrapped transactions in Australia focussed on refinancings - particularly of privatisation debt in the utilities and infrastructure sectors. Likely future developments of the credit wrapped product include kangaroo bond issues (such as the Scottish power deal), securitisations (for example the recent Samsung transaction), PFIs, credit default swaps and other derivatives. Credit wrapped issues are likely to be used more in initial financings, rather than just refinancings, as has been the case in the UK.

Credit linked notes

This is a true synthetic securitisation. It involves a financial institution identifying a pool of financial assets and entering into a credit risk swap or obtaining a financial guarantee from a special purpose trust. The swap or guarantee covers the financial institution against agreed losses on the underlying pool of assets. The special purpose trust then issues some notes (eg 15%-20% of the nominal amount of the credit swap or financial guarantee) to investors. The proceeds of those notes are then placed on deposit and form the first source of funds if a claim is made under the credit swap or financial guarantee.

The second form of support is a back up credit swap or financial guarantee from a highly rated party (eg, an OECD bank).

The main issue to deal with in these type of structures is whether the credit swap or so called financial guarantee constitutes insurance for any of the Insurance Act, GST, tax or stamp duty.

Warrants

Warrants are at the most simple level, derivative option contracts. They are traded on ASX, and are governed by a combination of the Corporations Law and the ASX Business Rules. However, warrants differ from traditional exchange traded options in that they trade on the ASX equities board (not the derivatives exchange) and are far more of a retail product than ETOs. It is the retail focus of warrants that make them particularly popular. This focus has resulted in significant growth in the number of players in the market in the last 2-3 years.

As derivatives, warrants are listed "over" certain instruments, such as shares, currencies, stock market indices or commodities. Warrants range from simple "vanilla" product listed over Australian listed companies to highly structured "instalment warrants" that involve funding for investors and trust structures that offer advantageous tax positions.

AAR acts for many of the warrant issuers in the Australian market.

Fund types

Exchange traded funds

Exchange traded funds (or ETFs) are pooled investment products. So, in essence, it is a fund (trust) which issues units and those units are traded on the Stock Exchange. But beyond this, true ETFs are usually index-linked ie, they invest in stocks included in a particular stock market index in the proportions in which they are included in that index so that the performance of the fund replicates the performance of the index eg the top ASX 50 industrials or top 100 etc.

ETFs combine characteristics of unlisted managed funds and shares - they are structured as open-ended trusts which are divided into units and have a responsible entity (trustee) but have additional liquidity because they are traded on a stock exchange like shares. ETFs generally have lower management fees than other managed funds because administration costs are lower. This is, in part, because ETFs typically track a market index or a pre-determined portfolio of shares and therefore have none of the usual costs associated with active investment. Traditional ETFs have two simultaneous markets:

a primary market in which the creation and redemption of units occurs; and
a secondary market in which existing units are actively traded.

The primary market consists of professional investors for whom large parcels of units in the fund are created or redeemed; transactions are settled in kind, rather than in cash. The secondary market is cash-settled, takes place on a stock exchange and makes the units available to retail investors. ETFs are required to be registered as managed investment schemes under the Corporations Act 2001 (Cth). Because they are traded on the ASX, ETFs are also required to comply with the relevant ASX Listing Rules.

In the US, the SEC is seeking public views on actively managed ETFs. To read more about this see our summary.

Hedge funds

Hedge funds are usually structured as trusts or companies. What distinguishes hedge funds is not their legal form but the investment strategy and the risk profile attaching to such strategy. Now that the returns on ordinary shares are much less attractive than during the bull market, those investors with an appetite for continuing to receive higher returns, are attracted to hedge funds where the hoped for returns are high. Hedge funds often cater to wealthier individuals who have substantial amounts to invest, but are now being marketed more widely.

Hedge fund investments in the US and Europe have grown to now exceed US$500 billion. Some funds are, "merger-arbitrage" funds which seek to make money out of changes in share prices of companies the subject of takeover announcements. Many hedge funds are "long-short equity" funds which seek to bet on rising or falling share prices.

Few hedge funds are listed on stock exchanges. Attempts to establish hedge fund indices as benchmarks have met with difficulties as it would be most relevant to compare one hedge fund with a particular investment strategy with other hedge funds having a similar strategy, but the strategies are so varied that such comparisons are difficult.

Private Equity

Private Equity is a general term that is used to describe a variety of different types and stages of equity investments in rapidly growing companies. Expressions such as venture capital, angel investments, seed capital, development capital, mezzanine investments and many others can be categorised as Private Equity. The common theme is that the funds for such investments come from "private" sources rather than from public fundraising sourced from stock exchange based equity capital markets. The entities involved in providing this funding are as many and varied as the types of investment they make. They include pure venture capitalists, high net worth individuals, private equity funds or divisions within investment banks, high-tech or other research concerns seeking to reinvest in new technology and super funds with a private equity focus.

While the concept of Private Equity is not new, it is an expression that has gained profile as a result of the massive growth in emerging technologies in the last 10-15 years, especially in the United States. Venture capital has been a key driver in the development of Silicon Valley high tech and biotech start-up companies and is a strong and expanding industry within Australia.

Private Equity is regarded as a high risk, high return investment strategy and investors seek to protect their investment with certain control rights. By way of example, a venture capitalist may seek a board seat and actively partner an emerging company, helping it to grow, with a view to exiting from the investment (for instance, via a trade sale or initial public offering). The timing of such an exit can be anywhere from 3 to 10 years from the date of investment. In contrast, a high net worth individual (often referred to as an "angel investor") may simply take a stake in a company (anywhere between $50,000 and $500,000) without too many rights of control and where the company may have little more than an idea and a business plan. At the other end of the spectrum, private equity investors may provide development capital to established but expanding businesses or seek to fund a management team in a management buyout (MBO) of an existing business and would seek board representation and veto rights.

AAR has a substantial track record in working in the private equity sector in all its forms. Our Private Equity team is also able to leverage off our knowledge and experience in the biotechnology and information technology practice areas and more generally, our broad equity/ hybrid/ debt capital markets experience. The recent announcement of the first "public to private" private equity transaction and the proposed implementation of a favourable taxation regime for Venture Capital Limited Partnerships show that Private Equity in Australia is a strong industry sector.

Sector funds

Sector funds are managed investment schemes which specialise in investing within a particular asset class, such as direct property, property securities, international equities, Australian equities, bonds, cash and so on.

Subject to any restrictions contained in its constitution and to its risk/return profile, this type of fund will typically invest in a range of securities which are available within the sector in which it specialises. Depending on the sector in question, this may include shares, units in other managed funds, derivatives and fixed income securities. These funds may be leveraged through borrowing. The fund will typically be structured so that its performance can be assessed against a relevant benchmark index. Depending on the underlying investments, the fund may provide tax-free or tax-deferred income. They are available to wholesale and retail investors.

Infrastructure investment funds

Infrastructure funds are commonly established as unit trusts although other structures such as company structures may be used. They may be retail or wholesale and listed or unlisted. Infrastructure funds often involve investment in an asset which operates in a low competition environment such as a tunnel or toll way.

AAR recently acted in the establishment of a Bermudan based airports infrastructure fund. It took the form of an open ended mutual fund company.

Superannuation funds

Superannuation funds are required to comply with the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS) in order that they are able to accept compulsory superannuation contributions (SG), receive concessional tax treatment on their income, and provide benefits that are concessionally taxed. Superannuation funds are subject to various statutory restrictions in relation to investments under the SIS Act (they generally cannot borrow, trustees cannot grant a charge over fund assets, trustees cannot acquire assets from fund members or their associates and the in-house asset rules limit investments in the employer sponsor and other associates).

AAR has a team of superannuation experts who can provide advice on all aspects of superannuation law. This includes working with trustees and fund managers on fund offer documentation. We also advise superannuation fund trustees as to their obligations under the SIS Act in relation to fund investments.

Superannuation fund trustees are increasing in maturity and sophistication and there is a gradual increase in their willingness to be more adventurous in the investments they might consider. Recently, ethical investments and venture capital funds are focussing on superannuation funds as potential investors.

Investor Directed Portfolio Services (IDPS)

IDPS are essentially services for acquiring and holding investments. They are becoming increasingly popular with investors because of the centralised reporting and administration they provide. There will generally be a menu of investment options associated with an IDPS. A crucial feature of an IDPS is that the investor makes all the investment decisions (although some of these investment decisions may involve investment into particular managed funds). Arrangements marketed as master trusts or wrap accounts are normally IDPS. In January of last year ASIC issued a new policy statement on IDPS which required existing IDPS to transition to a new regime.

AAR acted for one of the first fund managers to transition a master trust to the new IDPS regime mid way through last year.

Property trusts

These are well known and well established vehicles investing in real property (office buildings and/ or shopping centres and/ or industrial sites). They are sometimes called REITS (Real Estate Investment Trusts). Some listed property trusts have moved into issuing medium term notes as an alternative to traditional bank borrowings. This trend should continue after the current economic uncertainties have subsided. Recently we have seen more activity in wholesale closed end funds and property syndicates. We anticipate that this will continue with heightened interest in suburban office buildings.

Lease renegotiations possibly affecting income streams will start to loom as a significant issue depending on the lease expiry profile if the economy enters a downturn.

AAR has a dedicated national property funds management group with experience ranging from major listed property trusts to single property wholesale funds. We can provide a comprehensive service including helping with property acquisition, establishing the fund and fundraising (both debt and equity).

Envirocredits funds

This is an emerging sector. It involves the transformation of environment credits (eg carbon credits or water rights) into property rights, the vesting of those rights in a fund vehicle and the creation of tradeable securities in that vehicle.