Riding the M&A wave

South African companies have become popular targets for private equity investors. The wave of activity has generated new business for dealers as vanilla and more exotic forms of hedging begin to catch on. Mark Pengelly reports

South Africa is undergoing a buyout boom. In September the market witnessed the creation of the largest private equity fund on the continent. Johannesburg-based Pamodzi Investment Holdings launched its $1.3 billion Pamodzi Resources Fund 1, which will focus on opportunities in the mining and natural resources sector in sub-Saharan Africa. Ndaba Ntsele, Pamodzi's chief executive, claimed the fund had more than 20 deals in the pipeline, as of September 5.

And, while Pamodzi has grand plans for its new fund, big deals have already been on show in 2007. Johannesburg-based hospitality and gaming company Peermont Global, for instance, was successfully bought out by a consortium led by local black economic empowerment firm Mineworkers Investment Company for R7.3 billion ($1 billion) in May. This came hot on the heels of the country's largest-ever leveraged buyout (LBO), a R25 billion acquisition of Johannesburg-based retailer Edgar's Consolidated Stores (Edcon) by US private equity firm Bain Capital.

Given that South African corporates have historically issued relatively little debt, it is little wonder that the country is proving an attractive hunting ground for private equity investors. Their average net debt/equity ratio stood at 7% at the start of the second quarter of 2007, compared with 32% and 45% in the US and Europe, respectively, according to research by Merrill Lynch.

Giles Heeger, director for sales and structuring interest rate derivatives at Standard Bank in Johannesburg, says this is largely the cause of buyout activity. "Quite a few South African corporates were under-geared relative to international standards, and that obviously creates quite a nice opportunity for buyout firms to do some sort of leveraged take-out."

Throw in strong earnings growth, which can translate into a higher exit value for an LBO when a target company is refloated - and the fact that stock market valuations are widely regarded as accurately reflecting value based on fundamentals - and the country begins to resemble private equity nirvana. Assets under management by such funds grew by 32% to R56.2 billion in 2006, according to a survey by auditors KPMG and the South African Venture Capital & Private Equity Association.

So far, the suspicions of analysts that quivering global credit markets may halt South African LBO activity appear to have been overly pessimistic. Rising delinquencies on US subprime mortgages have scared investors elsewhere, including Europe. Between June 1 and July 30, the iTraxx Crossover Index of European sub-investment-grade credit default swaps (CDSs) leapt from 189bp to 471bp. Spreads on the index were at 311bp on September 18. This betrays a dearth of liquidity in Europe's high-yield bond markets, where much of South Africa's buyout activity is often financed. But on September 4, Ethos Private Equity announced a planned R11.4 billion LBO of Johannesburg casino operator Gold Reef Resorts, with a consortium of banks including Goldman Sachs and Nedbank. If it goes ahead, it would be the country's biggest after April's Edcon takeover by Bain.

Investment banks have always turned a tidy profit during such waves of merger and acquisition (M&A) activity through advisory fees and income related to associated capital-raising. But during this most recent wave, South Africa's domestic banks are facing increased competition from overseas financial institutions. "The South African market has always gone through phases where international banks have been more or less involved," says Standard's Heeger. With these international players back in a big way over the past few years, he argues, the market is seeing non-domestic firms pushing innovation in M&A derivatives.

Deal-contingent hedges, for example, are an emergent product. These instruments allow firms to hedge the interest rate or foreign exchange exposure arising from an acquisition. A deal-contingent swap terminates if an acquisition falls through, either because of a regulatory veto or failure to win shareholder approval, for instance.

This structural feature allows acquirers to obviate the risk of carrying naked hedges on their book if a proposed deal does not close. While these products seem ideal for companies seeking to mitigate exposure to M&A deals, they are troublesome for dealers themselves to hedge (Risk November 2006, pages 54-56).

Detailed analysis of underlying deals and a large portfolio of deal-contingent trades are both vital. As a result, it's larger global investment banks, such as JP Morgan, that have been the most active in offering these products - although some domestic players have been active too. Dealer estimates on the amount of deal-contingent trades executed during the current M&A boom vary hugely; a total notional of less than R10 billion is deemed a reasonable estimate of market size by several dealers.

Traditional activity

More traditional market risk M&A hedging activity has been in evidence too. When buyout companies and their targets look to finance large acquisitions, they largely end up looking to the international market, especially Europe, for funding. These sizeable bond issues will usually be denominated in euros, creating a requirement for firms to arrange swaps to hedge their euro-denominated liabilities against rand-denominated incomes. Dealers say the sheer size of these cross-currency swaps from large international bond issues have had a palpable impact on the market.

"When we saw the Edcon transaction earlier this year, where there was about EUR1.5 billion of hedging done, it certainly had a dramatic impact on the basis swap market," says Craig Williamson, who covers sales and structuring at Rand Merchant Bank's (RMB) debt capital markets division in Johannesburg.

Since January, there has been a flurry of European high-yield offerings. These included a EUR520 million offering by Peermont Global in April, lead-managed by Citi, and a EUR1.18 billion offering by Edcon following its takeover by Bain, which was jointly arranged by Barclays Capital, Credit Suisse and Deutsche Bank.

Such transactions, which are usually hedged via the more liquid dollar market, helped push the five-year zero-coupon rand-dollar basis swap curve up to as high as 52bp by August 2, from 6bp on January 2 (see figure 1). This has increased the cost of hedging such issue in the future. By September 10, spreads on five-year zero-coupon rand-dollar basis swaps were at 33bp.

But for RMB's Williamson, the most pressing hedging need that buyout activity presents to South Africa's banks is not market-related, but credit risk. While the credit ratings of target companies do not usually fall outright, the perception of credit risk usually increases with the expectation that the company's balance sheet will become more highly leveraged. "Interest rate and cross-currency swaps are still pretty generic products from a market risk perspective. The challenge is all around managing the credit risks associated with those products."

In the past, South Africa's banks would have requested such counterparties to post additional collateral or have cash-margining arrangements in order to deal with this heightened credit risk. But with buyout firms reluctant to tie up cash under such facilities, this becomes difficult to do. Instead, domestic banks have been employing more innovative ways of mitigating the credit risk associated with foreign exchange and interest rate financing-related (and indeed, non-financing-related) hedges. Contingent credit default swaps (CCDSs), a relatively new product, are beginning to be employed (Risk June 2007, pages 28-30).

CCDSs are similar to traditional CDSs in that, upon the occurrence of a credit event related to the reference entity (in this case, the South African company requiring the financing), the protection buyer delivers to the seller a debt obligation of an amount equal to the CDS contract's notional value, in exchange for payment at par.

However, the reference notional in a CCDS contract is variable and equal to the value of an underlying OTC derivatives trade, such as an interest rate or cross-currency swap. This makes the CCDS a more appropriate hedge for counterparty credit risk, as its change in value tends to closely offset changes in the underlying over-the-counter derivatives trade's credit risk premium.

Dealers tell Risk South Africa that CCDSs are being traded in the interbank market, although the efficiency of CCDSs as a hedge has been held back somewhat by the lack of a fully liquid and transparent South African high-yield credit market. Typically, the spread at which companies' bonds are trading in the local market helps dealers determine pricing for CCDS deals.

And it's not just those directly involved in M&A transactions that have been affected by the buyout activity's knock-on effect on the derivatives market. With LBO funds gravitating towards corporate South Africa, corporate treasury groups elsewhere are feeling an impact too: namely, a notable increase in the use of derivatives to ensure balance sheets are used more optimally (see box). As one local banker puts it: "There's no place for lazy balance sheets anymore."

RISK, RAND, REWARD

Alongside the emergence of exotic deal-contingent trades associated with M&A activity, more traditional corporate hedging activity has also blossomed in South Africa.

On August 29, the country's main year-on-year inflation rate was announced at 6.5%, outside of the Reserve Bank of South Africa's target of 3-6%. This has reinforced fears of an imminent hike in interest rates.

With the financing season approaching, many corporate risk managers are currently considering flexible and forward hedging strategies, according to dealers. "There's a big demand for forward-starting interest rate protection - because a lot of corporate funding programmes will be coming through in four to six months' time," says Craig Williamson, who covers sales and structuring at Rand Merchant Bank's debt capital markets division in Johannesburg.

Callable fixed-rate loans are also proving popular. These structures give corporate clients a call option to terminate fixed interest rate loans after a specified period, in return for paying a spread over the vanilla fixed interest rate. The attraction for corporates that are willing to pay the extra cost is that they can potentially refinance to take advantage of lower rates if and when they become available.

"There is probably a broader understanding now of structured hedges and derivatives products among corporates than there was three years ago," says Chris Paizis, Johannesburg-based head of corporate risk advisory at Absa Capital.

Paizis believes that, regardless of buyout activity, the evolution of South Africa's corporate banking sector will continue apace with derivatives at the fore.