Belgacom Case Study

Belgacom Case

Question 1

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• a) Why did the share price of Belgacom increase following the announcement of the acquisition?
• b) Why did the ratings of Belgacom drop (S&P) or put on a negative watch (Moody’s)?
• c) As Belgacom secured the purchase of the remaining 25% share of Proximus it did not own yet, the share price of the Belgian company increased by 0. 92 % the same day and 9. 8% over the following month. An announcement can lead to pre-event abnormal returns as markets react to this information to get a premium.

Investors will try to assess the increase in expected earnings and dividends. The impact of this assessment will depend on how the merger is done, how the transaction is paid, the sector it concerns, etc. However, according to market efficiency theories, overreaction on stock prices tend to disappear in the long-run and the price reflects the present value of expected returns. That being said, several reasons may explain this jump. First, we can underline the fact that this operation enables Belgacom to collect all the benefits of Proximus. Before the purchase, 25% of the earnings of Proximus were placed in minority interests, these were payable to Vodafone. After the operation, Belgacom owns 100% of the shares and can enter all the cash of its subsidiary in its accounts. It represents an increase in the future cash flow not only for the firm but also for its current shareholders, which will be comforted to receive more in the future or that their shares represent more cash. This is due to the decision of Belgacom to finance its acquisition by debt which doesn’t give ownership rights to the bond owners.

Fig. 1: Evolution of Belgacom Share Price (2005-2008) Second, Belgacom was familiar with the Proximus business as Belgacom (75%) founded the company with Airtouch (25%) in 1994, created by this way the first mobile phone operator in Belgium. Unlike the market, rating agencies did not welcome positively this transaction: Moody’s changed its outlook to negative and Standard&Poors downgraded Belgacom rating to A from A+. Moody’s explained that it keeps Belgacom’s rating unchanged because, according its methodology designed for GRI (Government-Related Issues), there is no change in Belgacom solvability. Moody’s GRI methodology uses three inputs: the rating and the outlook of Belgium, the low level of default dependence, and the medium level of support from the Belgian government. While there is no change in those inputs, there should be no change in the Belgacom rating. That being said, several indicators lead the agency to wonder about the ability of the Belgian company to deal with its creditors.

First, Belgacom announced a bunch of outflows for the months to come: just at the same time, Belgacom decided to sell its 5,8% stake in Neuf Cegestel to SFR: the outcome of the operation was EUR 187 million plus a share buyback (maximum 200 million) and a dividend in 2006 for EUR 100 million. Furthermore, Belgacom's decision to use its current financial stability and therefore weaken its debt ratios. As for Standard&Poors, the agency decided to downgrade the rating of the Belgian firm from A+ to A. S&P said this decision lies in the fact that the Belgacom debt will rise of about EUR 2 billion, making a notably increase the debt/Ebitda ratio from 0,8 to 1,9. Moreover, its business in a competitive and liberalized market, as well as the decline of the fixed lines market make a fear for future results of the company. However, the outlook remains stable, which can be explained by the strong position of the company on the Belgian telecom market and its huge ability to generate cash.

Question 2

• a) Why was the acquisition financed by a bridge loan?
• b) What were the alternative financing sources?
• c) Bridge loans are short-term financial instruments usually used to lock-in a settled price (frequent in Real Estate Market). This practice buys time for the deal maker to sort things out and to better structure its financing scheme. This seems to be the main rationale for Belgacom in this case. The management wanted to lock-in the price agreed on with Vodafone and as the deal was subordinated to the Belgian Authority's approval, it was more cautious to make it happen right away.

Yet there is another way to see a bridge loan as a temporary expensive loan serving the purpose of being intermediate financing means for the company that benefits from it. Later on, this bridge loan is reimbursed with more advantageous types of loans. was in fact a syndicated loan underwritten in order to finance an acquisition. As a matter of fact, the loan was made by several lending institutions called the mandated lead arrangers i. In the case of Belgacom, the company took a bridge loan for several reasons that are detailed below. The bridge loan e. BNP Paribas, Citi, Fortis, ING, and JP Morgan. For the investment banks that underwrite the syndicated loan, the main interest resides in the fact that they gain a fee. In this specific case, the bridge loan was arranged as a revolving credit instrument type. This meant Belgacom had to pay a fee plus interest expenses and can draw-repay-redraw as many times as needed. As said before, the first valid reason would be that the cash was needed quickly (maybe) and bridge loans are arranged more quickly. In any case, it is in the best interest of the company (Belgacom here) to reimburse the bridge loan as quickly as possible because it is very expensive and the interest rate generally increases with maturity. Moreover issuing corporate bonds takes time. In fact, there are four main steps to issue a bond in the bond market. First, there is the pre-mandate phase which aims to determine the funding needs or whether it is the right time to tap the bond market. Additionally, the currency has to be determined, the market as well as the targeted investors.

After that, comes the book building process which is one of the most important tasks that consists of taking the orders from the investors. Then, a range for the coupon rate has to be determined and the amounts have to be allocated to the investors. Those steps could typically take weeks. Helping companies with short term funding is thus a major need for the client. Another reason may be that it gives Belgacom time to wait for more favorable economic conditions for issuing the bonds. Depending on investor’s appetite, timing is in fact crucial in such deals. Now, from the investment bank’s perspective, there is possibly a conflict of interest as the investment bank is at the same time creditor (through the bridge loan) and the entity that prices the securities that will be used to reimburse this loan. One could argue the investment bank could lack objectivity. However, this constitutes an additional incentive for the book runners to successfully carry the deal to its end. Additionally, four of the five banks that granted the bridge loan became the joint book runners. To that extent, there are clear business interests that are involved.

This can be interesting for the investment bank in order to get closer to the client. Moreover, this form of short term financing is more expensive for the company because it bears higher risks. Alternatively, it means that it is more lucrative for the investment bank as well. To sum up, bridge loans seem to be a lucrative source of profits for investment banks. First, they place themselves in a comfortable position to issue bonds for the company later on. Second, they can diversify their revenues and be a good candidate for bond issuance. As a matter of fact, four of the five banks providing the bridge loan took care of bond issuance.  Alternatives to bridge loans were traditionally letters of comfort written by the investment bank stating that the bank was ‘highly confident’ that the additional financing needed by the company could be obtained. This implies no bridge funding at all. Hence the alternative would be to wait for the bonds to be issued. The risk here however would consist of being too late for acquiring the target. Another alternative would be to use your own capital to fund the acquisition in the short run. This depends, of course, on the ability of Belgacom to generate such a large amount of cash. Yet another option would have been to raise more capital by issuing shares with the agreement of its existing shareholders. However, this option could have been detrimental to existing shareholders: the Belgian state which had a major stake in Belgacom with 50. 1% of the shares.

Here is a summary of all the plausible alternatives: Pay with retained cash: Belgacom could put 2Bn€ on the table for Vodafone’s stake (assuming that the amount was available at the time). Although, this is known as the worst-case scenario for current shareholders. Putting the cash in acquisition would also have constrained Belgacom to lower (even cancel) its expansion investments. Go straight to the Market: Belgacom could issue the bonds without taking the bridge loan but since the company had no prior bonds outstanding in the secondary market, the pricing would have been necessary anyway and it takes time and money to process it. The risk, in that case, is the agreement with Vodafone; other players could profit from the info and buy the stake in order to sell it back to Belgacom at a premium.

Question 3

Assuming the 5-year swap rate was 3. 922% and the 10-year swap rate was 3. 977% at the time of pricing the deal (primary market), could you calculate:

• a) The yield for investors The yield is composed of the risk-free interest rate and the risk premium. The risk-free rate is usually defined as the rate of a government bond or the interbank rates (ex: Euribor) for the same maturity. However, the swap rate is used for maturities beyond 12 months. Here, the explanatory statement assumes that the 5-year and the 10-year swap rate were respectively 3,922% and 3,977%. The credit spread or risk premium depends on the maturity and the quality of the issuer. After comparing the coupon offered by companies with the same risk profile from the telecom peer group in the secondary market, the explanatory note explains banks’ position which suggested to issue the 5Y bond and the 10 Y bond with
• b) The coupon rate. The coupon rate is the amount of interest payable on the bond. It is important to keep in mind that the market practices want the yield to vary by steps of 0,125%. Therefore, according to table 1, the yield for the investor varies between 4,125 and 4,250 for a 5-year maturity bond and 4,5% and 4,625% for a 10-year maturity bond.
• c) The issue price is the price at which investors buy bonds in the primary market. The bond issue price is the present value of the bond’s cash flow. To obtain this price, we have to use the coupon rate, the face value, and the yield for the investor as described in this formula:

Issue Price = Coupon 1(1+y)+ Coupon 2(1+y)? +… +Coupon n1+yn+ Face value1+yn

At issuance, the subscriber will pay Min. 99,57%, Max 99,90% for the maturity of 5-year. Min. 99,39%, Max 99,98% for the maturity of 10-year. The cost for Belgacom The cost to maturity for the issuer y is defined as Issue Price – Fees of the bookrunners = Coupon 1(1+y)+ Coupon 2(1+y)? +… +Coupon n1+yn+ Face value1+yn The rate y solving (cost to maturity) this equation is: Min. 4,256%, Max 4,306% for a maturity of 5-year. Min. 4,609%, Max 4,659% for maturity of 10-year. Cash Flows Here are the cash flows for the issuer. For a maturity of 5 years: At inception (time 0), the issuer receives (99,57%-0,15%)=99,42% multiplied by the total face value. Every year for 5 years, the issuer pays the coupons of 4,125%

Question 4

Consider an outstanding corporate bond in the secondary market (issued a few months ago). All else being equal, the market suddenly perceives a more important credit risk associated with the considered issuer. What impact should it have on:

• a) The credit spread The credit risk is the risk that the issuer may default and not pay back the full amount he owes to bondholders (the total face value of the bonds). The credit spread translates the uncertainty about potential future stock price movements”. If the market suddenly perceives more important credit risk associated with the issuer, the credit spread will widen as the market is perceived has been relatively safer. The payoff associated with extra credit risk is a higher yield. Therefore, the credit spread represents a bonus for investors when supporting extra risks. Fig 2: Yield curves Source: CFA
• b) The yield There are two components in the yield: the risk-free rate and the credit spread. All else being equal, if the credit spread widens, the yield increases.
• c) The price Investors want to pay less for a risky bond having the same pay-offs as a risk-free bond. By taking more risk, the final amount the investor expects to receive may be less than what he will get us there is a credit default risk. The variable on which the market has a direct influence in order to adjust for a higher yield is the market price. Due to the negative relation between the yield and the price and if the coupon payments and the principal repayment remain unchanged, the price must decrease in order to translate the surge in the yield.

This is particularly relevant when the issuer is the target of a leveraged buyout, which, in most cases, is leveraged by the issuance of new bonds. The increased debt used in order to make such financial actions often decrease the totality of the bonds of the issuer to a status of « junk bonds ».

Question 5

How would you assess Belgacom’s position with regard to the qualitative factors enumerated to assess the pricing?  Issue premia for the recent transaction, First of all, this is the first bond offering issued by Belgacom. Therefore, it cannot be referred to as a previous premium offered in its own recent transactions. Therefore, the reference will be the telecom peer group having the same risk profile. Aftermarket performance of recently launched deals The issue premia have widened for two main reasons. First, a trend towards more acquisition in the Telecom sector since 2005. Second, the Telecom sector suffers from the fact its services are more and more commoditized which in turn may hurt the profitability of a Telecom company. At the time it was expected the bond could be split into three types. Moreover, there were strong liberalization policies pushed by the EC and investors were afraid that the Belgian state would disinvest in Belgacom after the following elections. The Belgian state had already to divest, keeping 50,1% of the share. Therefore, investors wanted insurance against a change of control in case the Belgian State sold his participation but also to cover the risk against an LBO. As Belgacom could not introduce a step-up language, it could have had an impact on the credit spread by increasing it. Credit Spread volatility Credit spread rose significantly more for telecom companies in 2005-2006.

This was due to the fact the telecom companies ventured more in acquisition activities during that period. 5-year and 10-year credit spread for A-rated telecom companies respectively rose 10bp and 20bp during that period. Saturation effect in investors' portfolios? Are investors sick of telecom bond issuances? In principle, investors were not sick of telecom bond issuances as the one of Belgacom would add diversification to their portfolio. What is more, Belgacom was seen as a safe and relatively liquid company as they were previously weakly leveraged.  Amount raised in the past. As far as Belgacom is concerned, the company has never issued any bond. Hence this was a premiere for the company. If we look at the issue amount of comparable transactions in the peer group of the same year, telecom issuers have issued in 2006 from three to 5 times with an issue amount from 500 million. For example, Telefonica issued in 2006 a total of 11. 750 million € * Credit quality of issuer and peers In terms of credit quality, Belgacom is better than most competitors. This is mostly due to the fact that Belgacom was weakly leveraged before the issuance.

For instance, EBITDA/Interest expenses of France Telecom, Telecom Italia, and KPN were between 2. 4x and 7. 2% while Belgacom’s was 93x. However, Belgacom wasn’t the best according to credit rating agencies. The considered peer group is made of France Telecom, Telecom Italia, KPN, and Belgacom. Moreover, Moody’s seems to give to Belgacom a better rating than Fitch. Therefore, we may suppose that Belgacom’s cost of issuance may be slightly lower than those of his peer group.

Question 6

What is a change of control put provision? How would it have protected investors?

Why did some investors think the step-up language would not be useful? Looking at the step-up language, what would be the coupon rate if the rating of Belgacom was downgraded a) to BBB- (S&P)/Ba1 (Moody's)? b) to BB+ (S;P)/Ba1 (Moody's)? A change of control put a provision is an option given to the bondholder to get its bond repaid before maturity at par or above, in the event of a change of control followed by a rating downgrade (e. g. after an LBO). Companies may be reluctant to issue bonds including this clause because it can place more constraints on their finances as investors have the power to control repayments.

Besides, it protects investors so they can have the opportunity to change their investment decision strategy if the issuer would happen to change its ownership. In the case of an LBO, for example, the ownership of the company is transferred by using debt relying on the future cash flows of the company. According to (Rosenbaum et al. , 2007), “a target only represents an attractive LBO opportunity if it can be purchased at a price and utilizing a financing structure that provides sufficient returns with a viable exit strategy. In such a case, a former bondholder would see the credit risk he faces considerably increase, given the amount of additional debt supported by the company. This clause should then enable a bond investor to exit his position without bearing that increased risk because firstly, the change of control was likely since the Belgian government was seeking to sell its stake in Belgacom and secondly because some argued that the inclusion of a step-up language taking the form of a +50bp in interest payment per downgrade below investment grade would be far from compensating the additional risk they would be born. In the case of Belgacom, there were some concerns about this possible withdrawal of the Belgian state from its majority stake, intensified by the fact that the company could also be the target of a potential LBO operation as explained above. In order to reassure prospective investors and consequently lower interest rates for long term bonds (10 years), it has been considered to include such a clause in the deal. Therefore, Belgacom finally decided to add a step-up language despite the concerns emitted by some investors.

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