Kepco pulls off largest Asian convertible in four years

Bonds are backed by shares bought at market price from the government, which has trimmed its stake to 51%.
Korea Electric Power Corp (Kepco) has completed a long-awaited sale of convertible bonds backed by Treasury shares which, at just above $1 billion, ranks as the largest Asian equity-linked deal since 2002.

The rarity of an Asian CB by a single-A credit attracted a large following by top-tier investors and even though the book was open only three hours the final demand for the $824 million base size ended up just shy of $5 billion, according to sources familiar with the sale. The scarcity value was further emphasised by the fact that this was only the second convertible out of Korea this year after Hynix SemiconductorÆs $471 million offer in September.

The strong demand enabled the four bookrunners to exercise the 25% upsize option in full, which pushed the total deal size to $1.03 billion and allowed the company to raise some fresh capital for its own coffers as well. The bulk of the proceeds, or about $792 million, will be used to pay for the shares bought back from the government at market price earlier in the day.

The yield on the two-tranche deal was fixed at the mid-point of the wide 75 basis point marketing range, which was a further testament to the momentum that the leads û ABN AMRO Rothschild, Credit Suisse, Deutsche Bank and JPMorgan - were able to generate in the book. According to people familiar with the bookbuild, there was quite a lot of price sensitivity below the midpoint of the yield ranges, however.

The CB issued by KoreaÆs largest utility company had a typical five-year/three-year put structure with a zero coupon. Unusually though, the issuer chose to do it as a dual currency offering and to use yen and euro rather than dollars - a first in the convertible space in Asia. According to Dealogic, there hasn't been a non-dollar dual currency CB from this region since 1989 when Mitsubishi Trust & Banking completed an offering in Deutschemarks and Swiss francs.

Given that the yen and euro are lower-yielding than the dollar, the company will get away with paying less interest on the bonds. The investor demand was greater for the euro tranche, but there was also quite a bit of order overlap between the two tranches and the company ended up splitting the total size 50-50 between the two. Including the upsize option, this resulted in a deal made up of one Ñ60.81 billion tranche and one Ç401.7 million tranche.

The company retained some flexibility in case the demand for one of the tranches wouldnÆt stack up and launched the deal saying each of the tranches would account for between 45% and 55% of the total size.

Sources say the deal attracted about 120 investors to the euro tranche, which was close to six times covered, and another 90 to the yen tranche, which was about four times subscribed. The momentum was driven primarily by CB specialists, but tier-one hedge funds also featured prominently and, in terms of demand, the split between the two types of investors was fairly even.

Both tranches had the same underlying valuation and both carried a fixed conversion price of W51,000, which translated into a premium of 30.1% over TuesdayÆs (November 21) close of W39,200. Even at first glance that premium seems hefty for a utility company and when considering the low historic volatility and a 10% share price gain in the past two weeks, there is no doubt that Kepco lived up to its reputation as a demanding issuer.

The share price took a 25% tumble from its 2006 high of W45,600 on May 8 to a low of W34,000 two months later, and while it has been edging its way back up since then it is still only up 3.7% year-to-date. To be fair, this is in line with the overall market - the Kospi index up only 3.1% this year.

Another sign of the companyÆs clout is the dividend compensation. This will kick in if the company pays out more than W1,728 per share in 2007, which equates to a dividend yield of about 4.4% at the current price. Being a utility company, Kepco pays relatively large dividends and the company has allowed for a 20% increase in the absolute payout in each of the subsequent years. Given that the share price will fall each time the dividend is paid, the CB investors had to take into account that the conversion premium could effectively be closer to 40% over the three-year life of the bond.

One source notes that when the requests for proposals were sent out the company was looking for a conversion price between W45,000 and W50,000 and as the share price moved higher it decided to go for the top of that range. On the day of the launch it then decided to push it yet one notch higher to W51,000.

ôThe conversion premium was high and the implied volatility was also aggressive, but they got away with it because of the high bond floor (at 96.5%), which meant there is a limited downside even for outright investors,ö says one observer.

Or as another CB banker put it: ôItÆs a pretty safe investment and given the rarity of Korean CBs, there was no compelling reason to miss it.ö

The quality of the credit and the liquid trading in the shares also drew a wide range of investors as it meant the bond component and the equity option were both easy to hedge. Neither of the bookrunners saw the need to provide any asset swaps.

ôAbout 90% of all CB issuers in Asia have a market cap below $5 billion and then once in a while you get a Kepco, which draws investors out of the woodwork,ö notes another banker. Kepco has a market capitalisation of about $26.9 billion.

The euro tranche was priced with a yield of 2.875% after being marketed in a range between 2.5% and 3.25%. The yen tranche was marketed with a yield of -0.2% to 0.55% and priced at 0.175%.

The bonds were issued at par and there is an issuer call after three years, subject to a 120% hurdle.

The underlying assumptions included a credit spread of 30 basis points, which was a little wider than KepcoÆs existing credit default swaps, and a stock borrow cost of 100 basis points.

The implied volatility was set at 22.5%, which compared with a 100-day historic volatility of 19% for the ADR and 14.5% for the locally-listed common shares. The 260-day vol is 28% for the ADR and 23% for the common shares.

In a move to support its share price, Kepco announced in July that it planned to buy back the 18.9 million shares that the government intended to sell to trim its stake to 51% from 54%. It also said it desired to push those shares back into the market through a CB as a way of funding the initial acquisition.

However, it was unwilling to do so under existing Korean regulations which prohibited a company from re-selling shares it has bought back within six months, as it would have meant sitting on a sizeable exposure in case the share price was to fall during that time. In the interest of getting the deal done, the regulations were changed to accommodate a quicker sale. Following that change, Kepco bought the 3% stake from the government after the market closed Tuesday, paying W39.200 per share. The price was equal to the closing price and the same price was then used as the reference for the CB.

ôFor the government this was a good deal because it enabled it to sell its shares at market price rather than at a discount, which would have been necessary if it had done it through a block trade,ö argues one source. ôAnd for Kepco it was a good deal, because it allowed the company to remove the overhang on the share price (resulting from the governmentÆs intention to sell) and also enabled it to send a strong signal about where it expects the share price to go in the next three years,ö

Indeed, the market did take the deal well with the share price trending up 1.28% to W39,700 yesterday. The move was in line with the benchmark Kospi index which added 1.2%. The convertibles also traded higher to about 101 to 101.125 with the euro tranche fractionally higher than the yen tranche.
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