Why customised equity derivatives make more possible
Flourishing innovation in customised equity derivatives is providing corporates with more sophisticated financing opportunities.
The world’s equity markets have changed hugely compared with 20 years ago. Looking back to 2000, if a company wanted to raise $1 billion in equity finance the only place to do so was the public equity markets. Today, this capital can also be raised in the private markets, which are growing far more quickly than mainstream stock markets.
Yet this is not the only illustration of equity finance’s greater possibilities. An outbreak of innovation, especially in derivatives, has given tech entrepreneurs, large corporates, private equity firms and hedge funds far more flexibility than ever before.
Equity derivatives have adapted to an economy characterised by the tech boom, low interest rates and economic uncertainty, finding creative ways for raising finance and hedging risk. Typically, the concept behind the derivatives transactions is fairly simple – clients want to monetise or to hedge large strategic equity stakes. But today’s sophistication means that this can be done in a nuanced way that is customised to highly specific sets of circumstances, often on better terms than might otherwise be the case.
Think of a large corporation looking to hedge stock options risk. Or a private equity firm wanting to borrow against its holding in a mid-stage business to invest in another business. Or an entrepreneur wanting to hedge the remaining equity stake in a partly exited business. These are just a few of the possibilities.
“Corporate equity derivatives has always been a solutions-driven business,” explains Raymond Ko, Head of Societe Generale’s Strategic Transactions Group Americas. “What we are seeing today is a period when there is a lot of innovation similar to the 2000s. This business has always been about coming up with good ideas that address client needs with better trade-offs. We have been as smart as anyone else in coming up with ideas.”
Equity derivatives tailored to specific needs
Societe Generale has recently experienced a substantial growth in interest among clients looking to exploit the flexibility of the derivatives markets to raise finance or hedge risk in the most attractive way. Given today’s prevailing low-interest rate environment, for example, a company might look to raise funds as cost effectively as possible by issuing a convertible bond with a call spread overlay set at a level designed to minimise the chances of dilution.
For the most part, transactions are quietly executed in private. But Tesla’s May 2019 convertible bond is a rare public example. The electric car maker raised $2.70 billion through a dual equity ($0.86 billion) and convertible bond ($1.84 billion) offering to fund development of its new models. It also entered into a convertible call spread to raise the convertible bond’s conversion premium from 27.5% to 150%. Societe Generale was a manager for the equity and convertible issues, as well as the lead call spread counterparty.
How did this structure help Tesla? Through the convertible bond’s higher equity conversion price, the company kept as much of the equity’s future upside as possible. Also, the bond’s keen pricing meant that Tesla got the most capital possible to develop its electric cars. “We were able to find a sweet spot,” says Ko. “I think we gave the transaction more time and thought more about the dynamics out there.”
Also arising from today’s macro-economic environment is the desire to hedge large strategic equity holdings against a fall in equity prices. Equity markets are close to all-time highs despite the ageing economic cycle and signs of stress in some economic indicators. It would not be the first time that equities have gone on rising, ignoring the evidence until finally correcting sharply. Consequently, some holders of strategic equity stakes are seeking to hedge them against a correction in markets.
Any holder of a large strategic equity stake might consider such a hedge. Examples would include a private equity fund holding a stake in a mid-sized business that it is not yet ready to exit, or an activist hedge fund with a 10-20% stake in a publicly-listed business, or even an entrepreneur with a residual holding in a business.
Sophistication and scale
Achieving the best results in terms of creativity and pricing takes a combination of sophistication and global scale that few banks can offer. Societe Generale’s position as a leader in global equity derivatives is recognised by awards such as Global Finance’s “Global Best Equity Derivatives House 2019” and the Risk Award 2019 of “Structured Product House of the Year”.
“We leverage the global equity derivative platform that gives us a liquidity pool of option risk to put into trades,” notes James Masserio, Societe Generale’s Co-Head of Equities & Equity Derivatives, Americas. “There are a lot of ways that we can leverage the platform to be more competitive on trades. Only one or two other firms have the footprint and sophistication do this.”
Over the past 10 years, customising solutions for the corporate market has become an important part of the equity derivatives business, as flow transactions have become less profitable. Is this sustainable even if there is a change in the economic environment? The answer is yes. “This is a business that creates different opportunities depending on the economic environment,” says Masserio. “So, if you do have a recession there are other opportunities. Equally, if the economy keeps going we will continue to be busy.”