The arithmetic of Lucio Tan

That Lucio Tan cannot evaluate the Black-Scholes formula is disappointing; that he has enough money to buy the Philippine National Bank is enviable; that he knows arithmetic better than the wizards of the Philippine Department of Finance is genius.

The story begins in September 1999 when PNB, the country’s fifth biggest bank, began widening its capital base with a stock rights offering. The Philippine government with its 45.6% equity ownership decided not to exercise its preemptive rights as it would have cost Ps4.3 billion ($93.6 million). Besides, the objective is to privatize the former official depository of the government; so it would have been inconsistent to throw government cash back to PNB.

Brilliant disguise

At this juncture, PNB’s president, Benjamin Palma-Gil, one of the few High Distinction graduates of the most expensive MBA school in the country, came up with an idea: Why not allow the PNB Retirement Fund Inc. (PNBRFI), a non-contributory fund owned by PNB and its employees, to subscribe to the shares being waived by the government?

Brilliant. In this way, the PNB employees who believe in the bank’s future will get to own a piece of the bank. It was to be a dazzling indirect employee stock ownership programme.

The only problem is that PNBRFI is only a retirement fund, meaning it was itself too undercapitalized at Ps1.1 billion for such an aggressive financial battle. Furthermore, because it is the employees’ retirement fund they could not invite outsiders to join the fund.

An equally brilliant solution was derived. Why not get the PNBRFI to create special purpose vehicles (SPVs) and invite investors through the same?

Forthwith, PNBRFI created four SPVs whose names could only have been designed by an investment banker: RF Investments; Witter Webber and Scwabb Investments; Integrion Investments; and Dreyfuss Mutual Investments.

The retirement fund fully subscribed to one SPV to the tune of Ps1.101 billion, while injecting Ps75 million as seed capital into each of the remaining three.

Each of the SPVs has 535,713 shares with par value of Ps140 totaling, Ps75 million.

Mysterious benefactors

The PNBRFI began to scout investors. Since the fund’s managers were confident of their strategy, they sought lenders – not equity partners – and their search came to fruition when they raised a total of Ps3.078 billion equally allocated among the three SPVs. Each SPV now had Ps1.101 billion including the Ps75 million equity.

Each SPV purchased 3.8% of PNB gaining a total of 15.2% of the 324-branch bank. Not a bad deal for the bank’s employees and their hitherto unknown benefactor-lenders.

At Ps137.80, the stock offer that ended on 17 September 1999 was 4.4% more expensive than the prevailing market price of around Ps132. One new share for every two held shares was offered.

The one-year Ps3.078 billion loan agreement they signed carried an interest rate of 14% per annum and called for the acquired PNB shares to be used as security. As such, the voting rights flowed to the lending investors who now controlled 10.59% of PNB by virtue of such rights.

One feature of the loan agreement that enticed the bank’s employees to approve the loan was the option clause.

Under the option clause, the mysterious lending investors may buy the entire stake of the SPVs at Ps140 per share or call the loan at Ps160.23 per share. On the other hand, PNBRFI has a put option, i.e. it can sell SPV shares to the creditors at Ps160.23 per share, 14.45% more valuable than the SPV’s Ps140. The put option had an open window from 14 April to 13 September 13 2000.

Who were the benign lending investors that helped the employees capture 15.2% of PNB? Even by the end of September nobody knew. The PNBRFI simply declared it had acquired about 45% of the rights offered but conveniently forgot to disclose how the tiny retirement fund of one bank raised capital for such a huge acquisition binge.

The companies were: Mabuhay Equities, Starline Investments, and Grande Monde Holdings. The lending investors turned out to be companies that were ultimately owned by – surprise, surprise – Lucio Tan.

El Kapitan

Lucio Tan, who owns around 70% of Philippine Airlines, had quietly acquired the voting rights of 10.59% of the 300,000-depositor bank via PNB’s own employees. Tan does not own these shares but exercises ownership rights due to the assignment.

The beer and tobacco taipan also owns Allied Bank, whose president Peter Favila was previously PNB’s president.

By mid-September 1999 the otherwise somnolent brokers of Manila were in a frenzy of accumulation. ABN Amro Securities, Wealth Securities, and Vickers-Ballas together accumulated close to 14% of PNB’s outstanding capital stock, in a move that was widely suspected as brokering for Lucio Tan.

Other small brokers such as Luys Securities and Mandarin Securities likewise helped Tan acquire PNB from the open market. Both securities houses are related to Tan’s son-in-law. Even a tiny broker such as Panasia Securities gobbled up 38% of PNB’s trades on one day when previously its transactions consisted of only 2%.

By September 24, PNB’s stock had risen to Ps149, about 8.1% over the stock offering, and 12.9% over the market price when the stock rights closed on 17 September.

After the smoke cleared on the trading floors of Makati and Ortigas, and when the brokers began imbibing their San Migs in the bars at El Pueblo and Glorietta, Tan had accumulated 19.22% from the market.

At one time, Jardine Fleming Exchange Capital accounted for 65% of PNB’s daily trade. It is owned by the group of Luis Juan Virata, who was previously president of Philippine Airlines – another Tan-controlled company.

By November 4, PNB had hit Ps150.

At this stage, Tan had acquired 19.22% plus 10.59% or a total of 29.81% of Philippine National Bank. Total cash outlay so far: Ps9.3 billion or about 3.6 times the budget of the office of President Estrada.

The privatization of PNB started in May 1989 when Arsenio Bartolome III, the founder of the now-defunct UrbanBank, supervised the sale of 30% through an IPO. In October 1991, the government offloaded a further 19%.

Now Lucio Tan had become a strategic shareholder, and his group controlled four seats in the 11-seat board. Templeton Asset Management with its Asia Pacific headquarters in Hong Kong controls a seat for its 12.9% stake.

Forced exit

Fast forward to the year 2000. The government wanted to dispose of its remaining 30.39% stake in PNB to fully privatize the bank. Incidentally, the IMF and World Bank had set this as a condition for releasing a $100 million loan for banking reforms.

Lucio Tan’s acquisition of PNB raised outcry in Manila, with some claiming that cronyism was back. On the other hand, Tan was quoted in the newspapers are saying that he should be declared a hero for saving PNB.

After much public pressure, the government persuaded Lucio Tan to sell his stake at the same time as it did. Rumored to be 46%, a figure that includes proxies that he exercises for unknown principals, Tan reluctantly agreed to set his block up for sale.

By this time, Feliciano Miranda Jr., a former deputy governor at the Central Bank had replaced Palma-Gil as PNB’s president.

In the week prior to the bidding, PNB’s stock hovered around Ps70. Since Lucio Tan acquired the shares during the September 1999 stock rights offering at Ps137.80, and even at around Ps140 from the open market, this meant he had lost close to half of his holding’s value. The loan he granted to the three SPVs of PNBRFI totaled over Ps3 billion with PNB shares as ultimate security. This meant his loan’s value was effectively reduced by almost Ps1.5 billion. Not a small amount of money in paper losses.

The Department of Finance was effectively requesting that Lucio Tan suffer a real loss by conducting this sale. The government was forcing Tan’s exit from PNB, and given his strong support for the Estrada regime, it seems he was willing to take the pain.
 
The bidding was set for 9 June 2000. The local universal bank Rizal Commercial Banking Corp (RCBC) owned by the Yuchengco family was one entrant.

Among the other interested parties was Loida Nicolas-Lewis of TLC Beatrice in the US, who feels her family owes gratitude to PNB for supporting their family business years back. She formed a consortium with Templeton called LNL-Templeton but was still looking for a bank partner as required by the government’s bidding rules.

A group linked to Indonesian mining firm Lebung Tandai was also rumored to be another interested bidder.

The two crucial conditions of the bidding were: There must be more than one bidder and the bidder must have experience in running a bank.

Friday 9 June came. The only bid on the table was from Yuchengco-linked RCBC. Nicolas-Lewis was not able to find a banking partner.

Consequently, the bidding was declared a failure because there was only one bid.

In the next few days, the IMF and World Bank granted the government a reprieve of one year during which to dispose of the government’s 30.39% stake.

Like PAL, like PNB

In the meantime, Lucio Tan had changed his mind. He no longer wanted to lose about Ps1.5 billion by selling his block. This meant the government was facing a quandary.

The government had already been criticized for waiving its preemptive rights in September 1999. Yet, the government simply had no funds with which to exercise those rights. In fact, the IMF-approved year 2000 budget deficit of Ps62.5 billion was going to be breached soon unless the government raised funds. The government tried to issue euro-denominated bonds but that was scuttled due of lack of investor interest. The only viable source of funds was the privatization effort.

The government made a unilateral decision. It would sell its 30.39% without Lucio Tan’s block. It finally settled on the date as well: 19 July.

During this time, the government was likewise saddled with finding a buyer for UrbanBank, the biggest Manila bank to fail due to investor withdrawals from the latter’s investment arm. Thus the PNB privatization had a competing event – the sale of UrbanBank, one of the most admired universal banks in the country. (For a full account of UrbanBank’s failure read “The Baptism of the Liquidator” FinanceAsia July 2000).

The 19 July bidding rules had two major concessions. According to the Committee on Privatization executive director Crisanta Legaspi, the more-than-one-bidder rule was removed; and the banking experience rule was similarly removed.

That begs the question, if those rules could be waived in July, why didn’t the government waive them in the first instance, during the 9 June bidding?

The seller is the buyer

The day arrived. Aside from the two rules that have been waived, another thing differentiates this bidding from the 9 June bidding: Lucio Tan’s shares are no longer for sale. This means that whoever bids for the government’s 30.39% block, will be forced into bed with Lucio Tan’s allegedly 46% block.

A few days before, Loida Nicolas-Lewis of TLC Beatrice in the US, who was supposed to have teamed up with JP Morgan, phoned Finance Secretary Pardo indicating an interest to bid. But she did not come.

The only bid was from a company called Starbuck Equities, Inc. And guess what? Starbuck is owned by Lucio Tan.

About 10 minutes before the 11am deadline, Tan paid a Ps600 million deposit for to purchase the 62.7 millions shares of PNB at Ps100 each, through his representative Jaime Bautista. Tan paid with a cheque drawn against, what else, Allied Bank, which he owns.

Where was RCBC, the lone bidder in the 9 June bidding? The Yuchengcos of RCBC were not interested in acquiring PNB unless it was the majority owner. But the government’s 30.39% was a smaller stake than Lucio Tan’s 46%.

Thus instead of selling his entire stake in the 9 June bidding, Lucio Tan subsequently controlled 69.19% of Philippine National Bank after the 19 July bidding. The seller had become the buyer.

Barely two days later, the PNB stockholders approved raising its capital stock to Ps50 billion of which Ps10 billion stock rights were to be offered by September 2000. Since Lucio Tan had agreed to infuse Ps10 billion into the bank, practically all the rights would pass to him.

Why did Lucio Tan expand his hold over PNB when hardly anybody came for the 9 June party? Even market players in Manila were at a loss for logic. With the same amount of money, anybody could seize large chunks of any top 10 Manila bank.

Lucio Tan must know something the public doesn’t. PAL is one of PNB’s big borrowers. PAL of course is 70% owned by Tan. It does make sense to own the bank that lends to the flag carrier that one owns.

Another of PNB’s biggest creditors is the recently closed down National Steel Corporation. PNB is close to taking over National Steel. In such as case, another Lucio SPV could rise from the mists and purchase it from PNB for a song.

Another scenario is the inevitable merger of PNB and Allied Bank that should strengthen Tan’s image as a bank tycoon.

Indeed, cocktail gossip in Manila is that Tan wants to transform his “vice taipan” image (referring to his vice-leaning products beer and tobacco) into a more dignified banking tycoon image.

Nevertheless, Lucio Tan has a proven track record as a turnaround artist.

Lucio Tan usually comes to the party in large waves – biggest airline, the biggest government bank, or the biggest piggery – and arrives when the company in question is in dire straits.

“There is money in problems,” Tan is wont to say. Well, he has the cash, so he is king.

As of June 2000, PNB’s asset quality worsened to an NPL ratio of 35% second only to Singapore-owned United Overseas Bank whose bad loans topped 53%.

Surprise

The rights issue was designed to raise PNB’s capital adequacy ratio beyond the BIS minimum standards. With Lucio Tan’s capital, PNB, which controls 30% of the dollar remittances from overseas Filipino workers, was set to regain it dominant position in the banking sector.

However, on Monday, 18 September 2000, Lucio Tan caught the government by surprise when instead of presenting a standby letter of credit for the full payment of the 19 July purchase of the government’s 30.39% share in PNB, his representatives instead presented a letter that basically said Tan could not make the payment.

Tan gave two reasons. First, he could not obtain the necessary letter of credit due to adverse publicity generated by the Ps25.6 billion tax evasion case that he won on 30 August at the Court of Appeals. Until decided by the Supreme Court in a process that could take two more years, the tax overhang will haunt Lucio Tan. It was alleged the local banks were charging a “Lucio Tan premium” of 3% more than normal.

Second, the newly promulgated Securities Regulation Code’s tender offer rule constrains him to make the offer to other existing shareholders and that could cost him an extra Ps1.5 billion.

Who needs who?

But was Lucio Tan worried over losing the Ps600 million down payment? It seems the government was more worried about this unexpected scenario. Who will buy the government’s share when in fact they have had two failed biddings? Where will PNB source the Ps10 billion that Tan promised as forthcoming in September 2000? It would appear the government needs Lucio Tan more than Lucio Tan needs the government.

The Department of Finance issued a demand letter to Lucio Tan asking him to pay at an extended deadline of Friday, 22 September. Lucio Tan was said to have asked for different terms if he is to pay up.

Whatever happens, Lucio Tan remains in control of the Philippine National Bank.

Unmentioned genius

A quick glance through the numbers shows there is more genius in Tan’s move than anything else.

As seen above, while he foregoing his Ps600 million deposit, Lucio Tan has the theoretical potential to save Ps3.2 billion, if he bought the same shares in the open market. If.

But wait. If Lucio Tan backs out, the government may never find any other block buyer, and the only option left on the horizon is for the government to sell the shares in the Philippine Stock Exchange at Ps39 instead of Ps100. The government’s hand has been forced. That would be the time for Lucio Tan to execute his brilliant arithmetic.

In the end, the wizards of the Philippine government may have been surprised by the non-payment of Lucio Tan – given that the latter had gone through the bidding process in July. Yet once they inquired into the possible reasons, they finally saw the genius of Lucio Tan’s tactic.

It was not the Black-Scholes formula, it was not the Ross-Roll arbitrage pricing theory. It was simply arithmetic. After all, Lucio Tan is a pragmatic chemical engineer by profession. Why buy at Ps100 when you can buy at Ps39? This could be the arithmetic of Lucio Tan.