Mega's market migraine?

Echoes of summer 2002 as a convertible for Mega Financial Holdings needs to be priced below par to clear the market.

Joint leads Lehman Brothers, Morgan Stanley and Barits Securities completed a $600 million convertible for Mega Financial Holdings late Wednesday night Asian time after re-pricing the deal to make sure it could withstand secondary market trading.

The decision clearly paid off after the transaction traded up in the secondary market the next day and the deal came good. However, its passage to market provides yet another example of what happens when investment banks get boxed into a corner because of the competitive bidding process for deals, which forces virtually everyone to bait unfeasible terms and then try and switch them.

Where Taiwan is concerned, it is all highly reminiscent of the problems encountered last summer, when the convertible market was overloaded with too many large sized bank deals, which had been won on exceptionally tight terms, which investors would not accept and the borrower would not change. In particular, Goldman Sachs ran into problems with a $700 million convertible for Cathay Financial Holdings, which set the Asian precedent of pricing below par, but still stands as the largest CB on record from Taiwan.

Like Cathay, Mega was also proposing an extremely large deal size, now the second largest on record. And likewise, bankers were proposing terms many believed unworkable even back at the height of a bidding frenzy for deals in July when it was mandated.

Goldman, for example, is considered a house bank of Mega, but is said to have refused to bid because it thought the terms unattainable. A second bank is said to have matched the winning terms, only to pull out three days later after getting cold feet.

Since then, rising Treasury yields have made it difficult to execute all deals won at that time. In this instance, the borrower allow the bond floor to be lifted by about three to four points, but it was still not quite enough to let the deal comfortably clear the market.

Mega is said to have had three clear objectives. Firstly it wanted a negative yield structure. Secondly, it wanted a large issue size because the transaction is designed to rid the bank of its unwanted Treasury shares. And thirdly it wanted to achieve a conversion price of NT$21.08.

What it came up against was an investor base wary of being swamped, particularly after a relatively large deal for China Development Financial Holding Company (CDFHC) only one week ago. Adding to the problem, CDFHC's $310 million deal is also trading fractionally below issue price.

As one observer puts it, "I think experience shows that once deal sizes get over $400 million in Taiwan, it gets more challenging to find orders."

On an issue price of par, the leads are said to have built an order book for Mega that closed 1.2 times covered. At this level, investors would have received a complete fill and the deal would have almost certainly collapsed in the secondary market.

Instead, they went out with a second term sheet re-offering the deal at 99.625%. On fees of 90bp, this would have meant losing about $2.5 million of the $6.21 million fee pool available (including the greenshoe).

Non syndicate bankers describe it as a "responsible" compromise. "They did the right thing by taking the hit themselves rather than pass it back to the issuer, or try and push it onto investors," says one. "It keeps the market sweet and the pipeline open for other deals to follow."

Final terms comprise an issue price of par, re-offer price of 99.625% and redemption price of 99.80%. The zero coupon deal has a two-year maturity and there is a put option after 18 months at a price of 99.85%. At the issue price of par, this equates to a negative yield-to-put of 0.10. But given the deal was offered to investors below par, it represents a positive yield of 0.15%.

The conversion premium was set at a 22.56% premium to the stock's NT$17.2 close. There is also a call option after one year subject to a 130% hurdle and a re-set on the 45th day prior to the first and secondary anniversaries subject to an 80% floor and at the issuer's discretion. There is a $90 million greenshoe.

Underlying assumptions comprise a bond floor of 96.2%, theoretical value of 101.7% and implied volatility of 19.7%. This is based on a credit spread of 95bp over Libor, zero stock borrow, zero dividends and 24% volatility assumption.

"These terms are fair to the market," says one CB specialist. "A bond floor above 96% works. The original proposals around the 92% to 93% level were simply mad."

As a result of re-pricing the deal, the leads were able to re-build the momentum and ended the process with an order just over 1.5 times covered. Just over 80 accounts participated, with a geographical breakdown, which saw 40% placed into Europe, 35% into Asia and 25% in the US.

By the middle of Asia's trading day Thursday, about half the deal was felt to have been asset swapped. Like CDFHC, Mega has a very high triple B rating (Baa1), which attracts a lot of credit demand. The rating is based on a degree of government ownership (26%), and the strong corporate franchises of its banking subsidiaries - Chiao Tung Bank (A3 rating) and International Commercial Bank of China (A2).

"Its subsidiaries individually have strong market positions and offer significant synergies that should allow Mega to provide integrated financial services across a broad spectrum of corporate requirements," the agency said in its ratings review.