Prudential prices $21 billion rights issue at 39% discount

After a delay of a couple of weeks, Prudential plc yesterday announced the details for its upcoming rights offering, saying it is seeking to raise £14.5 billion ($21 billion) by offering shareholders 11 new shares for every two existing shares at 104 pence apiece.

The confirmation of the deal, which will raise part of the money needed to pay the cash component of the UK insurer's $35.5 billion takeover of AIA Group, also puts Prudential's listings in Hong Kong and Singapore back on track. According to the new timetable, Prudential will start trading in these two markets on May 25.

The next key date will be June 7 when Prudential shareholders will vote on whether to approve the AIA acquisition, which will create a pan-Asian life insurer that will be the undisputed market leader with 20 million customers and businesses in 15 countries. The company needs a yes from 75% of the votes cast at annual general meeting, and despite the earlier criticism by some shareholders that the deal was too costly, the Prudential management said yesterday that it is confident that shareholders will approve the transaction, which will create a lot of value and "deliver excellent returns for shareholders".

Prudential is buying AIA from American International Group (AIG), which is selling its profitable Asian life insurance business as it strives to repay the $182.3 billion of bailout money that it received from the US government in 2008. In return AIG will get a 10.9% stake in Prudential.

In a conference call with media yesterday, Prudential CEO Tidjane Thiam noted that even though the benefits of the transaction were outlined when the deal was first announced on March 1, it has been impossible for shareholders to make an informed decision before receiving the detailed financial information that the company was finally able to release yesterday.

"We are very keen to get to this point today when we can finally tell the full story. We were a little bit like a fighter fighting with one arm behind his back, we haven't been able to answer a lot of questions, which was frustrating for our shareholders, quite frankly. But they have been patient and given us the benefit of the doubt and we feel confident that (knowing the full story) they will support the transaction," he said.

"Everything that we have seen since the first of March has confirmed and underlined the quality of the business, the quality of the people and the conservatism in its (AIA's) financials," added Nic Nicandrou, Prudential's chief financial officer.

On paper at least, the numbers seem rather compelling. The combination of the two groups will create annualised revenue synergies of $800 million pre-tax and cost synergies of $370 million during 2013 -- slightly more than the $700 million revenue boost and $340 million cost savings flagged when the deal was first announced on March 1. It is also expected to double the combined group's Asian profit to £2.8 billion by 2013 and to more than double pre-tax operating profit of the group in all markets to £3.26 billion under international financial reporting standards (IFRS) by the same year. Prudential has also set a target to be able to remit at least $1 billion from the AIA Group to the holding company level every year from 2011 onwards.

Thiam referred to the transaction as buying "the right asset at the right time" and noted that AIA is recovering strongly from its lows in 2009, as evident by the 16% growth in new business sales and 32% growth in pre-tax profits in the first quarter this year.

He also argued that when it comes to both growth and profitability, Asia is simply "the most attractive region in world in the insurance industry", supported by a number of key factors. These include a projected eight-fold increase in GDP growth in Asia ex-Japan in the next 10-15 years compared with just under three times for the rest of the world, which means that wealth will increase rapidly. Also, the number of people aged 40 to 65, a group which has big incomes and is preparing for retirement, is set to grow by 200 million individuals in the same period, and the middle class will see its income increase significantly.

"Match this with a low penetration rate and the region is very, very attractive to the insurance industry. Asia also offers much higher margins in addition to higher growth and there is no price competition," Thiam said. He also noted that Prudential believes that there is a "leadership premium in Asia in terms of higher growth and higher returns that will drive shareholder value."

The delay in publishing the details of the rights offering was due to concerns by the Financial Services Authority (the UK regulator for the financial services industry) about the minimum regulatory capital levels at the combined group and the resilience of that capital to withstand market shocks. One banker noted that these concerns were a direct effect of this being the first big financial industry takeover in the UK after the financial crisis. To avoid a potential failure in case of another substantial shock to the financial system, the regulators have stress-tested the transaction at every level and, according to a banker, ended up requiring a more robust capital structure than would have been the case had this deal taken place before the crisis.

To appease the FSA, Prudential has changed its earlier plans to issue about $5 billion of senior debt to make up the difference between the rights issue and the total cash payment of $25 billion and will instead sell junior debt that can more easily be converted into equity. The company said it will raise $5.4 billion of hybrid capital that will consist of a combination of upper tier-2 and lower tier-2 notes. The offering will be backstopped by AIG, which has agreed to buy up to $1.875 billion of the hybrid capital, in case the market fails to absorb the entire deal.

Together with some other measures to ensure its capital structure will remain sound, Prudential's surplus capital after the transaction will now stand at £5.2 billion, which covers the minimum requirement more than two times and by more than 1.5 times even after a significant market shock. The company has earlier announced a capital structure that would result in a surplus capital of £2.6 billion.

The price of the rights shares represents a 39.3% discount to the theoretical ex-rights price (Terp) which works out at 171.5 pence. The discount is in line with most of the other rights issues by UK banks in the past couple of years, which have also been priced at discounts to Terp in the high 30s. The renounceable issue is fully underwritten by Credit Suisse, HSBC and J.P. Morgan and sub-underwritten by just over 30 banks, giving all the major investment banks at least a slice of the fees from this transaction. Prudential will issue approximately 13.96 billion new shares as a result of the deal, which will be the second largest rights issue on record after Royal Bank of Scotland's $24 billion offering in June 2008.

Investors who own Prudential shares on the June 4 record date will all be entitled to rights, including those that hold shares that are listed in Hong Kong or Singapore (who will pay HK$11.78 per new share). There will be trading in the rights on the London Stock Exchange from June 8, while in Singapore and Hong Kong investors can sell their rights in the market from June 9 and 10 respectively. The rights trading period ends on June 23.

According to a banker, the rights are expected to be actively traded, which should help ensure a large take-up of the issue.

As announced earlier, the listing in Hong Kong, which is a dual primary listing, will be through introduction only, meaning Prudential will not issue any new shares. However, the three underwriters of the rights issue will act as liquidity providers to ensure that the demand from Hong Kong investors is met even if not that many existing shareholders chose to transfer their London-listed share to Hong Kong from the start. This will mainly be done by them short-selling the shares to Hong Kong investors during Hong Kong trading hours and then buying them back in London later in the day. Any potential profits or losses made from these transactions will be kept by the liquidity provider.

The fact that this contingency is put in place suggests that the stock exchange is worried that the immediate demand will outweigh the supply to an extent that it might otherwise have pushed the price sharply higher. That happened when Asian Citrus listed through introduction late last year, and prompted the Hong Kong Exchanges and Clearing to call for a system that would ensure orderly trading. J.P. Morgan came up with the liquidity provider facility and used it when Fortune Real Estate Investment Trust listed through introduction in Hong Kong earlier this year. The facility will work slightly differently this time since the shares are not traded in the same time zone (Fortune Reit is also listed in Singapore), so Prudential will be a test of sorts, but the principal is the same.

The incentive for buying the Prudential shares early, is that it will allow Hong Kong investors to participate in the discounted rights issue. And assuming the acquisition goes through as planned in the third quarter, that will give them exposure to AIA. While this is not as direct an investment as buying AIA through an IPO (which was planned before Prudential came along and offered more immediate benefits for AIG through a trade sale) at least it will give them access to the Asian growth story that has got Prudential's Thiam so excited.

One banker says in the short-term, not that big a portion of Prudential's shares is expected to be listed in Hong Kong, but over time it is possible that up to 15% of the stock will be traded here. The listing in Singapore is a secondary listing and is expected to see less trading volume.