6

Disposal of Strategic Stakes

The sale of a strategic stake is not a straightforward matter. Typically the number of shares to be sold represents a large multiple of the stock's average daily volume. Therefore, an immediate and direct sale of the stake onto the market by the investor can have a large negative impact on the stock price, reducing the disposal proceeds. This chapter examines the most common selling strategies.

There is no such thing as the perfect disposal strategy. Each strategy has its strengths and weaknesses. What was the optimal strategy can only be determined “a posteriori”, i.e., once it is possible to see the actual stock price behavior during the relevant period. However, “a priori” it makes sense to determine the objectives of the disposal and then try to design a strategy that could meet these objectives.

6.1 MOST COMMON DISPOSAL STRATEGIES

There are many disposal strategies. In general, the various disposal strategies can be grouped into the following three categories (see Figure 6.1):

• Deterministic disposal strategies. In these transactions, the number of shares to be sold and the selling price are known at the strategy's inception. These strategies include immediate disposal strategies such as accelerated book-building placements and secondary public offerings, and deferred disposal strategies such as the issuance of mandatory exchangeables.
• Enhanced disposal strategies. By implementing these transactions, investors try to sell the stake either at their own entire discretion, at a premium or in a transparent way. In these strategies, the sale price and/or the number of shares to be sold is unknown in advance. These strategies include sale of calls, issuance of exchangeable bonds, execution of range accruals and execution of VWAP-linked instruments.
• Derecognition strategies. The main motivation behind these strategies is not to sell the stake but to derecognize it for accounting and/or tax purposes. These strategies include combinations of equity swaps and calls, and/or combinations of equity forwards and calls.

Next, I will describe these strategies in detail using a case study. These strategies can be combined to better achieve disposal objectives.

6.1.1 Case Study Assumptions

Let us assume that on 1 June 20X0, ABC Corp. owned 40 million shares of XYZ Corp. The shares were trading at EUR 10.00. ABC was looking to sell the stake. XYZ's average daily volume during the last six months was 4 million shares. Other relevant assumptions were:

• The block was worth EUR 400 million.
• The block represented 10% of XYZ's market capitalization.
• The block represented 10 average trading day volumes (ADTV).
• The block represented 15% of XYZ's free float.

6.1.2 Market Dribbling Out or Gradual Sale

One of the most common disposal strategies of a large block is a market dribble-out. This strategy encompasses selling the shares onto the open market in small lots that will not be likely to affect the stock price significantly. As a general rule, a disposal on one day of a number of shares representing more than 20% of the stock's average daily volume is likely to affect the stock price. In our case, ABC decided to not exceed 20% of the daily volume. Because XYZ's average daily volume during the last six months was 4 million shares, under the dribbling-out strategy ABC would be selling approximately 0.8 million (= 4 million × 20%) shares each day. The sale of 40 million shares was then expected to take approximately 50 trading days (i.e., more than two months).

The advantages of this strategy were the following:

• ABC had complete control of the disposal process. If during the execution of the sale XYZ's stock price fell notably, ABC could stop it and resume it later once the market conditions improved.
• ABC could benefit from a future positive behavior of XYZ's stock price.
• There were no fees to be paid to investment banks, other than the usual brokerage commissions.
• There were no discounts to each day's market price of XYZ stock.

The disadvantages of this strategy were the following:

• There was a great uncertainty regarding the disposal price. During 50 trading days, XYZ's stock price could move notably. It could fall and not recover later, making ABC miss attractive price levels.
• ABC needed to devote resources to implement the execution. At least one person was required to follow the stock price and to give the orders to ABC's stockbrokers.
• If the disposal was executed in a weak market environment, the officers making the decision may be subject to criticism from other top management.

6.2 DETERMINISTIC DISPOSAL STRATEGIES

In this section I will cover the main strategies to dispose of a strategic stake. A common thread of these strategies is that ABC will be able to dispose of its stake in its entirety and to know at inception the disposal price. That is why I call these disposal strategies “deterministic”.

6.2.1 ABB – Block Trade

The most common disposal strategy is an accelerated book-building process (ABB). This strategy ensures a full disposal of the stake through a quick execution. The placement usually takes place after the closing of a specific day and before the next day's opening of the stock market. In Chapter 2 the reader can find a detailed description of an ABB. In a nutshell, an ABB is the placement of a block of shares with institutional investors, with the help of an investment bank. If the investment bank guarantees a minimum price, the ABB is called an ABB with backstop. If the block is sold directly to the investment bank at a pre-agreed price, the ABB is called a bought deal or a block trade.

In our case, ABC decided that the best alternative was a block trade. ABC wanted to sell the stock overnight and to agree on a price before the process was implemented. The price was set at a discount to the closing market share price. Therefore, ABC contacted Gigabank, to obtain an indication regarding the discount.

Discount Estimation by Gigabank

Were Gigabank to acquire the XYZ block from ABC at the pre-agreed price, it would need to place the block with institutional investors. Thus, in order to provide ABC with a quote, Gigabank had to estimate what discount to the previous closing price institutional investors would require to buy a large number of shares of XYZ. To assess this discount, Gigabank looked at the discount at which other comparable placements took place:

• The stock market momentum. The stock market was experiencing a mild positive performance. It was expected that this positive momentum could last several days. As a result, Gigabank did not include any negative adjustment to the discount due to the stock market momentum.
• The size of the block relative to XYZ's average daily volume. The block represented 10 trading days. This number was not large compared with other ABBs. Figure 6.2 shows the discounts at which other ABBs were placed during the last 12 months as a function of their number of trading days. It can be seen that blocks representing 10 trading days were placed at a 3% discount.
• The total size of the block. The block was worth EUR 400 million. This size was quite large compared with that of most ABBs placed during the last 12 months. Following a similar analysis to the one followed previously, similar-sized ABBs were placed at a 5% discount.
• The total size of the block relative to the stock free float. The block represented 15% of XYZ's free float. This size was quite modest compared with that of most ABBs placed during the last 12 months. Following a similar analysis to the one followed previously, similar-sized ABBs were placed at a 4.5% discount.
• The total size of the block relative to the market capitalization of the stock. The block represented 10% of XYZ's market capitalization. This number was quite in line with the average size of the other ABBs. Following a similar analysis to the one followed previously, similar-sized ABBs were placed at a 3.8% discount.

Taking into account all the previous comparisons, Gigabank decided to quote a 4% discount to ABC. Let us assume that ABC found the discount reasonable, and mandated Gigabank to place the block before the opening of the market. Because the closing price of XYZ's stock was EUR 10.00, ABC sold the stake to Gigabank at EUR 9.60 (= 10.00 × 96%). As a result, in three trading days ABC received EUR 384 million (= 40 million × 9.60).

Advantages and Weaknesses of the Block Trade Strategy

The advantages of the block trade strategy were the following:

• The disposal was executed immediately, after the closing and before the opening of a trading day.
• ABC received the disposal proceeds immediately.
• ABC was not exposed to a price fall after the disposal was priced.
• It quickly took advantage of a temporary opportunity in the stock market.

The disadvantages of the block trade strategy were the following:

• The stock was placed at a significant discount to the prevailing market price.
• ABC could not benefit from a future positive behavior of XYZ's stock price.
• Although not relevant in our case, sometimes a placement at a reasonable discount may not be possible if the size of the block is large or if the market environment is weak.
• ABC did not keep the voting rights and did not receive the dividends to the shares after the transaction.

When the block size is a substantial number of trading days it is worth coupling an ABB transaction with a placement with strategic shareholders and other long-term financial investors. Such strategic placement may be a direct sale of shares and/or a sale of put (which is an engagement to buy shares).

6.2.2 Mandatory Exchangeable Bond

Another disposal alternative for ABC was to issue a mandatory exchangeable bond on 40 million XYZ shares. As we saw in Chapter 3, a mandatory exchangeable bond is a bond mandatorily convertible at maturity into a fixed or variable number of shares of the underlying stock. Gigabank proposed ABC the issuance of a 3-year fixed parity exchangeable bond with the following terms:

ABC's Mandatory Exchangeable Bond Terms
Issuer	ABC Corp.
Notional amount	EUR 460 million
Issue date	1-June-20X0
Maturity	1-June-20X3
Underlying stock	XYZ common stock
Issue price	100%
Coupon	7%, semiannual Act/Act
Exchange price	EUR 11.50 (a 15% premium to the EUR 10.00 share price at issue)
Underlying number of shares	40 million
Exchange period	From issue date to maturity date
Dividend protection	Protection for any cash dividend in excess of a threshold amount
Issuer call	None, except a 10% clean-up call and tax call

Advantages and Weaknesses of the Strategy

The advantages of this strategy were the following:

• The disposal pricing was determined at inception.
• ABC received the disposal proceeds immediately.
• ABC kept the voting rights (of the unlent shares) and received the dividends during the life of the exchangeable.
• Upon exchange, the shares were placed at a premium.
• ABC was not exposed to a price fall after the disposal was priced.
• It quickly took advantage of a temporary opportunity in the equity-linked market.

The disadvantages of this strategy were the following:

• ABC had to pay coupon larger than in comparable straight debt.
• ABC could not benefit from a future positive behavior of XYZ's stock price.
• ABC had to lend most of the stake to the exchangeable investors so they could hedge their exposure to XYZ's stock price. ABC did not have the voting rights associated with the lent shares.

6.2.3 Indirect Issue of an Exchangeable Bond

Another way to dispose of a stake is to sell it to an investment bank. The investment bank can issue an exchangeable bond. The feasibility of this strategy is dependent on finding a third party (the “put provider”) willing to sell to the investment bank a put on the underlying shares of the exchangeable (see Figure 6.3). The put is needed so that at maturity, if the exchangeable is not exercised, the investment bank is able to sell its stake to the put provider. The put provider may end up holding the exchangeable bond's underlying shares at its maturity in case of no exchange. Usually, the put provider would be either the issuer of the shares (XYZ in our case) or a core shareholder of XYZ. This strategy was covered in detail in Chapter 4, in a case study on Deutsche Bank's exchangeable into Brisa.

Advantages and Weaknesses of the Strategy

The advantages of this strategy were the following:

• The disposal pricing was determined immediately.
• ABC received the disposal proceeds immediately.
• ABC was not exposed to a price fall after the disposal was priced.
• It quickly took advantage of a temporary opportunity in the equity-linked market.

The disadvantages of this strategy were the following:

• Gigabank had to find a third party willing to sell a put option on the stake.
• ABC could not benefit from a future positive behavior of XYZ's stock price.
• ABC did not keep the voting rights and did not receive the dividends to the shares after the transaction.

6.3 ENHANCED DISPOSAL STRATEGIES

In the previous section I covered the main “deterministic” strategies to dispose of a strategic stake. A common thread of these strategies was that ABC was able to dispose of its stake entirely and was also able to know at inception the disposal price. In this section I will cover disposal strategies that try to enhance a specific feature of the sale. That is why I call these strategies “enhanced” disposal strategies. A majority of the enhanced disposal strategies try to obtain a better disposal price than that of a deterministic strategy, but there could be other enhancement motivations.

6.3.1 Direct Issue of an Exchangeable Bond

A typical way to enhance the disposal price of a sale of a stake is to issue an exchangeable bond. As we saw in Chapter 3, an exchangeable bond gives the holder the right to exchange the bond for a number of shares of the underlying stock. Let us assume that Gigabank contacted ABC to propose a transaction that took advantage of a strong demand for exchangeables. Gigabank proposed ABC the issuance of a 3-year bond exchangeable into 40 million shares of XYZ with a 20% premium. Let us assume that ABC approved the strategy because it allowed it to sell the stake at an attractive premium. The exchangeable had the following main terms:

ABC's Exchangeable Bond Terms
Issuer	ABC Corp.
Notional amount	EUR 480 million
Redemption amount	100% of notional amount
Issue date	1-June-20X0
Maturity	1-June-20X3 (i.e., 3 years)
Underlying stock	XYZ common stock
Issue price	100%
Coupon	3%, semiannual Act/Act
Exchange price	EUR 12.00 (a 20% premium to the EUR 10.00 share price at issue)
Underlying number of shares	40 million
Exchange period	From issue date to maturity date
Dividend protection	Protection for any cash dividend in excess of a threshold amount
Issuer call	None, except a 10% clean-up call and tax call

At maturity, or upon early exchange, there would be two scenarios:

Advantages and Weaknesses of the Strategy

The advantages of this strategy were the following:

• ABC could benefit from a future positive behavior of XYZ's stock price up to the EUR 12.00 exchange price.
• ABC quickly took advantage of a temporary opportunity in the equity-linked market.
• ABC raised EUR 480 million financing at an advantageous cost. The 3% coupon was notably lower than the yield of 3-year straight debt issued by ABC.
• ABC kept the voting rights associated with the unlent shares and received the dividends.

The disadvantages of this strategy were the following:

• ABC had no certainty regarding the sale of the stake. The disposal only took place if XYZ's stock price was above the EUR 12.00 exchange price.
• ABC was exposed to a future price fall of XYZ's stock price. If at maturity XYZ's stock price was below its EUR 10.00 level at inception, XYZ would still own the stake and it would be worth less than its initial EUR 400 million value.
• ABC had to lend part of the stake to the exchangeable investors so they could delta-hedge their position.
• ABC did not have the voting rights associated with the lent shares.

6.3.2 Sale of a Call Option

An alternative available to ABC was to sell a call option on 40 million shares of XYZ. This alternative is similar to the issuance of an exchangeable in that it allows an investor to sell the stake at a premium. Let us assume that the demand for exchangeable bonds was subdued and that ABC liked the idea of selling the stake at a premium.

The main limitation of this strategy is the feasible size. The investment bank acquiring the call usually manages the option risks. The main limitation in terms of size is caused by the hedge of the gamma risk at expiry. Gamma measures the variation of the delta for a 1% change in the stock price. Remember that the delta at expiry is either 100% or zero. If the delta is 100% (i.e., the stock price is above the strike price, the option is in-the-money just prior to expiry), it requires the bank long the call to short 100% of the underlying shares. If the delta is zero (i.e., the option is at-the-money or out-of-the-money just prior to expiry), it requires the bank to not have any position in the underlying stock. Imagine that shortly before expiry the call was out-of-the-money and that the stock price moved, causing the option to suddenly be in-the-money. Rapidly, the bank would need to sell all the underlying shares onto the market. If the number of shares was very substantial, the sale could largely affect the shares’ stock price, causing the bank to sell the shares at a price much lower than expected. As a result, if the number of underlying shares is large relative to the stock's average daily volume, the bank could be incurring a large loss at maturity.

Let us assume that Gigabank was willing to trade options on XYZ a number of shares not exceeding five daily trading days. Because the block represented 10 trading days, Gigabank could only buy call options on 20 million XYZ shares, representing half of the stake. The terms of the call option were:

Physically Settled Call Option – Main Terms
Buyer	Gigabank
Seller	ABC Corp.
Option type	Call
Trade date	1-June-20X0
Expiration date	1-June-20X1 (1 year)
Option style	European
Shares	XYZ common stock
Number of options	20 million
Strike price	EUR 12.00 (120% of the EUR 10.00 stock price on trade date)
Premium	EUR 8 million (4% of the option notional amount)
Notional amount	EUR 200 million (= 20 million × 10.00)
Premium payment date	3-June-20X0
Settlement method	Physical settlement
Settlement date	4-June-20X1

At expiry (i.e., one year after trade date), there would be two scenarios:

Advantages and Weaknesses of the Strategy

The advantages of this strategy were the following:

• ABC could benefit from a future positive behavior of XYZ's stock price up to the EUR 12.00 strike price.
• ABC received a EUR 8 million upfront premium.
• ABC kept the voting rights associated with the unlent shares and received the dividends.

The disadvantages of this strategy were the following:

• ABC had no certainty regarding the sale of the stake. The disposal only took place if XYZ's stock price was above the EUR 12.00 strike price.
• ABC could only implement this strategy for half of its stake (i.e., 20 million shares). ABC needed to put in place another disposal strategy for the other half of the stake.
• ABC was exposed to a future price fall of XYZ's stock price. If at maturity XYZ's stock price was below its EUR 10.00 level at inception, XYZ would still own half of the stake and it would be worth less than its initial EUR 200 million value.
• ABC had to lend part of the stake to Gigabank so it could delta-hedge its position.
• ABC did not have the voting rights associated with the lent shares.

6.3.3 One-speed Range Accrual

In the following subsections, I will cover a popular way to sell a stake at a premium. Range accrual instruments allow the daily sale of shares at a premium to the stock price prevailing at the strategy's inception. There are many versions of this strategy. I will review next the one-speed range accrual instrument.

An alternative available to ABC was to enter into a range accrual with one speed. As an example, let us assume that ABC enters into the following one-speed range accrual:

One-speed Range Accrual – Main Terms
Buyer	Gigabank
Seller	ABC Corp.
Option type	Range accrual
Trade date	1-June-20X0
Start date	7-June-20X0
Maturity date	7-June-20X1 (1 year)
Shares	XYZ common stock
Maximum number of shares	20 million
Initial price	The volume-weighted average sale price per share at which the buyer (Gigabank) puts in place its initial hedge
Strike price	EUR 10.80 (108% of the EUR 10.00 initial price)
Barrier	EUR 9.20 (92% of the EUR 10.00 initial price)
Premium	None
Accrual periods	Each monthly period from, and including, the start date to, and including, the maturity date
Number of shares	For each accrual period: 80,000 × Number of days
Number of days	The number of trading days during the monthly period that the closing price of the shares is greater than, or equal to, the barrier
Settlement method	Physical settlement The buyer shall acquire from the seller the number of shares at a price per share equal to the strike price
Settlement date	Three exchange business days immediately following the end of the corresponding monthly period

The different steps of the transaction during its life are the following (see Figure 6.4):

• On trade date, ABC and Gigabank agreed on the terms of the range accrual. The strike price and the barrier were defined as a percentage, 108% and 92% respectively, of the initial price. Although ABC owned 40 million shares of XYZ, the range accrual could only be done for 20 million shares to make the transaction “risk manageable” to Gigabank. Thus, the transaction could only be implemented for 50% of ABC's stake in XYZ.
• Starting on the trade date (1 June 20X0), Gigabank put in place its initial hedge by selling a number of XYZ shares in the market. Gigabank needed to borrow a number of shares. Because the stock lending market for XYZ stock was too illiquid, ABC lent the corresponding shares to Gigabank so it could implement its initial hedge. Gigabank finished the initial hedge execution on the start date (7 June 20X0). The initial price, EUR 10.00, was the volume-weighted average price at which Gigabank sold the necessary shares to establish its initial hedge. As a result, on trade date the strike price and the barrier were respectively set at EUR 10.80 (108%) and 9.20 (92%).

The one-speed accrual allowed ABC to sell shares of XYZ at EUR 10.80, an 8% premium to the initial price. The maximum number of shares that ABC could end up selling was 20 million. Assuming 250 trading days over the 1-year term of the transaction, each trading day ABC could accrue a maximum of 80,000 shares (= 20 million/250).

The 12-month term of the transaction was divided into 12 monthly periods (the “accrual periods”). On each trading day of the accrual period, the number of shares accruing that day was a function of the closing price of XYZ's stock on that day (see Figure 6.5):

• If the stock closing price was greater than, or equal to, the EUR 9.20 barrier, 80,000 shares accrued that day.
• If the stock closing price was lower than the EUR 9.20 barrier, no shares accrued that day.

Three exchange business days following the end of the monthly accrual period (the “settlement date”), ABC sold to Gigabank the aggregate of the accrued shares (the “number of shares”) during the monthly accrual period. The shares were sold by ABC at EUR 10.80 per share. For example, if during a monthly accrual period, the number of days was 15, the number of shares was 1.2 million (= 15 × 80,000). As a result, ABC sold 1.2 million shares at EUR 10.80 to Gigabank at the end of the monthly accrual period.

At maturity, any outstanding shares borrowed by Gigabank were returned to ABC. ABC still owned any shares not accrued during the life of the range accrual.

In order to highlight the strengths and weaknesses of the strategy, let us assume three different price behaviors of XYZ's stock price during the life of the instrument (see Figure 6.6):

• Under the first scenario, XYZ's stock price experienced a strong rally. Because the stock price always traded above the EUR 9.20 barrier, all the 20 million shares accrued, and therefore sold, over the term of the instrument. However, ABC was not entirely satisfied with the range accrual strategy because it sold the shares at EUR 10.80. It is true that this price was an 8% premium to the initial price. However, without entering into the instrument ABC could have obtained a higher selling price.
• Under the second scenario, XYZ's stock price experienced a movement without an overall bullish or bearish trend. Because the stock price always traded above the EUR 9.20 barrier, all the 20 million shares accrued, and therefore sold, over the term of the instrument. ABC was very satisfied with the range accrual performance because it was able to sell the shares at EUR 10.80, while the stock traded below this level during all the life of the instrument.
• Under the third scenario, XYZ's stock price experienced a strong correction. Excluding the first few months, the stock traded below the EUR 9.20 barrier. As a result only 5 million shares accrued, and therefore sold, over the term of the instrument. ABC was very satisfied with the range accrual performance because it was able to sell the shares at EUR 10.80, while the stock traded well below this level during most of the 12-month term. At the end of the instrument's life ABC still owned the 15 million unaccrued shares.

Advantages and Weaknesses of the Strategy

The advantages of this strategy were the following:

• ABC sold the accrued shares at a premium to the initial price.
• ABC benefited from each day that the stock price traded between the EUR 9.20 barrier and the EUR 10.80 strike price.
• ABC paid no premium to enter into the transaction.
• ABC kept the voting rights associated with the unlent XYZ shares and received the dividends.
• ABC had complete flexibility to pursue other strategies on the unaccrued shares.

The disadvantages of this strategy were the following:

• ABC had no certainty regarding the number of shares to be sold. The disposal only took place if XYZ's stock price was above the EUR 9.20 barrier. XYZ ended up owning all the unaccrued shares.
• ABC could only implement this strategy for half of its stake (i.e., 20 million shares). ABC needed to put in place another disposal strategy for the other half of its stake.
• ABC did not benefit from a stock price above the EUR 10.80 strike price.
• ABC was exposed to a future price fall of XYZ's stock price below the EUR 9.20 barrier.
• ABC had to lend part of the stake to Gigabank so it could delta-hedge its position. ABC did not have the voting rights associated with the lent shares.
• The range accrual was accounted for as a derivative. The instrument needed to be fair valued through the income statement at each reporting date.

Building Blocks

From ABC's viewpoint, the one-speed range accrual was built by combining a purchased knock-out put and a short call. Each trading day over the term of the range accrual, a combination of these two options expired on such day, as follows (see Figure 6.7):

• ABC sold a string of call options with strike price EUR 10.80 on 80,000 XYZ shares. There was a call for each trading day of the 12-month period (i.e., 250 calls). In other words, only one call expired on each day of the 12-month period.
• ABC bought a string of put options with strike price EUR 10.80 on 80,000 XYZ shares. There was a put for each trading day of the 12-month period (i.e., 250 puts). In other words, only one put expired on each day of the 12-month period. Each put ceased to exist if, on its expiry date, XYZ's stock price was below the EUR 9.20 barrier. Therefore, this option was a knock-out put.

6.3.4 Double-speed Range Accrual

A variation available to ABC was to enter into a range accrual with double speed. The first objective was to increase the sale price (i.e., the strike price) from EUR 10.80 to EUR 11.50. Therefore, any shares sold through the range accrual instrument were sold at a 15% premium to the initial price. A second objective was to expand the ranges in which shares accrued. Under the one-speed range accrual, XYZ's stock price had to trade above EUR 9.20 to accrue shares on an observation day. Under the two-speed range accrual, XYZ's stock price had to trade above EUR 8.50 to accrue shares on an observation day. However, these two objectives were achieved in exchange for including a middle range in which just 40,000 shares accrued on a daily basis.

The mechanics of the double-speed range accrual are similar to the one-speed range accrual. The only difference lies in the daily accrual mechanism. As we saw earlier, the 12-month term of the transaction was divided into 12 monthly periods (the “accrual periods”). On each trading day of the accrual period, the number of shares accruing that day was a function of the closing price of XYZ's stock on such day (see Figure 6.8):

• If the stock closing price was greater than the EUR 11.50 strike price, 80,000 shares accrued that day.
• If the stock closing price was greater than, or equal to, the EUR 8.50 barrier and lower than, or equal to, the EUR 11.50 strike price, 40,000 shares accrued that day.
• If the stock closing price was lower than the EUR 8.50 barrier, no shares accrued that day.

At the end of each monthly period, the accrued shares were sold by ABC to Gigabank at EUR 11.50 (i.e., the strike price).

Comparison with the One-speed Range Accrual

If we compare the two-speed range accrual with the one-speed range accrual, the performance of one strategy relative to the other depends on XYZ's stock price behavior:

• In a strong stock market from the start, the two-speed range accrual is likely to outperform. Although a similar number of shares would be sold through both instruments, the accrued shares under the two-speed range accrual would be sold at EUR 11.50 instead of at EUR 10.80.
• In moderately positive, or moderately negative, stock market behaviors, the one-speed range accrual is likely to outperform. A much larger number of shares is likely to accrue under the one-speed range accrual. The fact that the shares are sold at a lower price than in the two-speed version will be more than compensated by the larger number of shares sold.
• In a notably weak market from the beginning, the two-speed range accrual is likely to outperform as it will take longer to reach the barrier level.

Building Blocks

From ABC's viewpoint, the two-speed range accrual was built by combining, on a daily basis, a purchased knock-out put and a short call. Each trading day over the term of the range accrual, a combination expired on such day, as follows (see Figure 6.9):

• ABC sold a string of call options with strike price EUR 11.50 on 80,000 XYZ shares. There was a call for each trading day of the 12-month period (i.e., 250 calls). In other words, only one call expired on each day of the 12-month period.
• ABC bought a string of put options with strike EUR 11.50 on 40,000 XYZ shares. There was a put for each trading day of the 12-month period (i.e., 250 puts). In other words, only one put expired on each day of the 12-month period. Each put ceased to exist if on its expiry date, XYZ's stock price was below the EUR 8.50 barrier. Therefore, this option was a knock-out put.

6.3.5 Double-speed Range Accrual with Final Call

Another popular version of the range accrual instrument is a range accrual with a final call. Let us take the previous section's two-speed range accrual. This range accrual had a barrier set at EUR 8.50 and a strike price at EUR 11.50 (a 15% premium to the initial price). By including the sale of a call and maintaining the barrier unchanged, the strike price could be set at EUR 11.80 (an 18% premium to the initial price). The call gave Gigabank the right, but not the obligation, to buy at maturity at the strike price all the unaccrued (and thus unsold) shares during the 12-month tenor of the instrument.

As an example, let us assume that out of the maximum 20 million shares, ABC sold 8 million shares through the accrual process during its 12-month duration. At maturity, Gigabank had the right to buy 12 million (= 20 million – 8 million) shares at EUR 11.80. Therefore:

• If at maturity XYZ's stock price was greater than EUR 11.80, Gigabank would exercise the call and ABC would sell to the bank 12 million shares at EUR 11.80. ABC would then have sold all its 20 million XYZ shares.
• If at maturity XYZ's stock price was lower than, or equal to, EUR 11.80, Gigabank would not exercise the call. Then, ABC would still own 12 million XYZ shares.

The improvement in the strike price caused by the inclusion of the call, from a 15% premium to an 18% premium, was not very large. Why didn't it result in a larger strike price? This was because a stock price at maturity well above the EUR 11.80 strike price would likely mean that the daily accrual mechanism accrued 80,000 shares for many days. Therefore, if the call was exercised at maturity, the number of unaccrued shares would likely be low.

The improvement in the strike price was not for free. By selling the final call option, ABC lost the flexibility of selling the unaccrued shares during the life of the instrument. ABC had to wait until maturity to know if it would be left with any unsold shares.

6.3.6 Double-speed Range Accrual with Deduction

Another popular version of the range accrual instrument is a range accrual with a deduction feature. Let us take the two-speed range accrual. This range accrual had a barrier set at EUR 8.50 and a strike price at EUR 11.50 (a 15% premium to the initial price). Better terms can be achieved if already accrued shares can be “unaccrued” again. The following two-speed accrual improves the strike price to EUR 11.80 (i.e., an 18% premium to the initial price). As we saw earlier, the 12-month term of the transaction was divided into 12 monthly periods (the “accrual periods”). On each trading day of the accrual period, the number of shares accruing that day was a function of the closing price of XYZ's stock on such day (see Figure 6.10):

• If the stock closing price was greater than the EUR 11.80 strike price, 80,000 shares accrued that day.
• If the stock closing price was greater than, or equal to, the EUR 8.50 barrier and lower than, or equal to, the EUR 11.80 strike price, 40,000 shares accrued that day.
• If the stock closing price was lower than the EUR 8.50 barrier, no shares accrued that day. A maximum of 80,000 shares will be deducted from the month-to-date total number of accrued shares.

At the end of each monthly period, the accrued shares were sold by ABC to Gigabank at EUR 11.80 (i.e., the strike price). This alternative is notably speculative, as a drop during a month can wipe out the already month-to-date accrued shares.

6.3.7 Double-speed Range Accrual with Knock-out

Another version of the range accrual instrument is a range accrual with a knock-out feature. Let us take the two-speed range accrual. This range accrual had a barrier set at EUR 8.50 and a strike price at EUR 11.50 (a 15% premium to the initial price). Better terms can be achieved if the range accrual terminates early when a barrier is reached. The following two-speed accrual improves the strike price to EUR 11.60 (i.e., a 16% premium to the initial price), but includes a knock-out barrier at EUR 8.00. If, on any observation day, XYZ stock is trading at or below EUR 8.00, the range accrual terminates and the accrued shares are sold. As we saw earlier, the 12-month term of the transaction was divided into 12 monthly periods (the “accrual periods”). On each trading day of the accrual period, the number of shares accruing that day was a function of the closing price of XYZ's stock on such day (see Figure 6.11):

• If the stock closing price was greater than the EUR 11.60 strike price, 80,000 shares accrued that day.
• If the stock closing price was greater than, or equal to, the EUR 8.50 barrier and lower than, or equal to, the EUR 11.60 strike price, 40,000 shares accrued that day.
• If the stock closing price was lower than the EUR 8.50 barrier and greater than the EUR 8.00 knock-out barrier, no shares accrued that day.
• If the stock closing price was lower than, or equal to, the EUR 8.00 knock-out barrier, no shares accrued that day and the instrument terminated early.

At the end of each monthly period, the accrued shares were sold by ABC to Gigabank at EUR 11.60 (i.e., the strike price). Upon early termination, the accrued shares would be settled.

6.4 DERECOGNITION STRATEGIES

In this section I will cover the main strategies to immediately derecognize a strategic stake. A company might be interested in accelerating derecognition of a strategic stake for many different reasons, such as:

• The company is obliged to sell the stake for legal reasons. The company has just merged with another company, a competitor of XYZ, and the competition authorities have required the disposal of the strategic stake.
• The company holds substantial unrealized capital gains on a strategic stake, and is willing to recognize these capital gains immediately to improve reported earnings.
• The company wants to disclose to the market that it has sold a stake, but wants to keep its participation in the stake's performance.
• The company already sold part of a strategic stake, claiming a special capital tax treatment. Any additional disposals of the stake not implemented during the same tax year cannot be subject to the same capital gains tax advantageous treatment.

6.4.1 Sale + Cash-settled Equity Swap

A popular strategy to accelerate the disposal of a stake while maintaining its economic exposure is to combine the sale with a cash-settled equity swap. Let us assume that ABC holds 40 million shares of XYZ, and that the shares are trading at EUR 10.00. ABC is obliged to sell the stake to meet the requirements set by the antitrust authorities, but believes that the current EUR 10.00 stock price is too low. ABC decides to sell the stake and enter into a cash-settled equity swap in which ABC would be the equity amount receiver. The maturity of the equity swap is one year.

Flows of the Transaction

The flows of the transaction on the trade date are as follows (see Figure 6.12):

• ABC and Gigabank enter into the cash-settled total return equity swap on 40 million shares of XYZ. The initial price is set at EUR 10.00.
• ABC sells the 40 million XYZ shares to Gigabank, so the bank initially hedges its position. Thus, ABC receives EUR 400 million.
• ABC and Gigabank disclose the sale and purchase of the stake, respectively. ABC meets the requirements of the antitrust authorities.

The flows of the transaction during the life of the equity swap are as follows (see Figure 6.13):

• ABC pays an interest, the floating amount, to Gigabank based on the EUR 400 million equity swap notional.
• Gigabank pays to ABC an amount, the dividend amount, equivalent to the dividends distributed to the underlying XYZ shares. This amount is paid on the same date the dividends are paid by XYZ to its shareholders.

The flows of the transaction at maturity (i.e., on the settlement date of the equity swap) are as follows (see Figure 6.14):

• Gigabank unwinds its hedge by selling 40 million shares of XYZ onto the market.
• ABC and Gigabank settle the equity swap after calculating the settlement amount.

Before approaching maturity, ABC would assess if XYZ's stock price was attractive enough. If the price was still unattractive, most probably ABC would request the extension of the equity swap maturity, probably for another year.

At maturity (i.e., on the equity swap valuation date), the settlement amount would be calculated as:

The settlement price is the price at which Gigabank unwinds its hedge position (i.e., the sale price of the 40 million XYZ shares onto the market) at maturity.

• If the settlement amount was positive, the equity amount payer – Gigabank – would pay to the equity amount receiver – ABC – the settlement amount. For example, if the settlement price was EUR 13.00, ABC would receive from Gigabank EUR 120 million [= 40 million × (13.00 – 10.00)].
• If the settlement amount was negative, the equity amount receiver – ABC – would pay to the equity amount payer – Gigabank – the absolute value of the settlement amount. For example, if the settlement price was EUR 8.00, Gigabank would receive from ABC EUR 80 million [= Absolute value of 40 million × (8.00 – 10.00)].

Advantages and Weaknesses of the Strategy

The advantages of this strategy were the following:

• The transaction could be implemented very quickly, without a need to find third-party investors. Therefore, it allowed immediate disposal and a subsequent search/negotiation with potentially interested investors.
• The transaction could be implemented for a large size. Thus, ABC could dispose of the whole stake in one shot.
• ABC could benefit from a rising stock price during the equity swap term. ABC could dispose of the stake in a weak stock market environment, but benefit from a potential rebound later on.
• ABC still received the dividends distributed to the underlying shares.
• ABC paid no premium to enter into the transaction.

The disadvantages of this strategy were the following:

• ABC remained exposed to a falling stock price during the equity swap term.
• ABC did not have the voting rights associated with the underlying shares.
• Derecognition was not achieved. I will comment on this subject next.

Final Comments

The main objective of the transaction was for ABC to end the ownership of the voting rights associated with the strategic stake. The sale of the stake to Gigabank at inception meant that Gigabank was the owner of the voting rights pertaining to the stake from that date. The terms of the transaction had to be carefully designed in order to avoid any suspicion of ABC and Gigabank acting in concert. In Chapter 7, there is a case (Telefonica's offer to Portugal Telecom) that covers this subject.

The equity swap transaction did not try to achieve any specific accounting treatment. The way it was designed most probably could not achieve derecognition because ABC kept all the economic benefits and costs associated with an ownership of the stake. Usually derecognition is achieved by stopping to receive (pay) one of the benefits (costs). For example, Gigabank could keep the dividend instead of passing it through to ABC. A common shortcoming when derecognition is achieved is that the equity swap could thereafter be treated as a purely speculative instrument, being fair valued at each balance sheet date with changes in fair value reported in the income statement. In this case, the equity swap could cause ABC to report a more volatile income statement.

The equity swap could also be structured to optimize the timing of the disposal from a tax standpoint. Usually, the tax treatment follows the accounting treatment. Therefore, the taxation of a disposal commonly takes place when derecognition is achieved from an accounting standpoint.

6.4.2 Physically Settled Equity Swap + Call Option

A popular strategy to accelerate the disposal of a stake while maintaining the economic exposure to a strategic stake is to combine a physically settled equity swap with a cash-settled call option. The main advantage of this alternative is that it may achieve derecognition while maintaining the ownership of the stake.

Let us assume that ABC holds 40 million shares of XYZ, and that the shares are trading at EUR 10.00. ABC is looking to derecognize the stake to be able to immediately recognize a capital gain, but believes that the current EUR 10.00 stock price is too low. Also ABC wants to retain the stake's voting rights. To achieve these objectives, ABC enters into the following transaction: (i) ABC keeps the stake; (ii) ABC enters into a physically settled equity swap with Gigabank, in which ABC would be the equity amount payer; and (iii) ABC buys a cash-settled deep-in-the-money call from Gigabank. The maturity of the equity swap and the call is one year.

Flows of the Transaction

The flows of the transaction on trade date are as follows:

• ABC and Gigabank enter into a physically settled total return equity swap on 40 million shares of XYZ with Gigabank. The initial price is set at EUR 10.00. The maturity of the swap is 1 year. At maturity, Gigabank will sell 40 million shares of XYZ to Gigabank at EUR 10.00 per share. ABC will pay to Gigabank the dividends distributed to the underlying shares. Gigabank will pay a quarterly interest to ABC.
• ABC buys from Gigabank a cash-settled call on 40 million XYZ shares with a strike of EUR 6.00 (i.e., a 60% strike). The expiry of the call is 1 year. ABC pays a EUR 172 million (i.e., EUR 4.30 per share) premium. The initial delta of the option is 85%, or 34 million shares (= 85% × 40 million).
• Gigabank borrows from ABC 6 million XYZ shares (to be explained next), so the bank initially hedges its position.

Let us take a look at Gigabank's initial delta position (see Chapter 1 for a description of the delta concept). Under the equity swap, Gigabank had to sell 40 million shares as its delta was –100%. Under the call, Gigabank had to buy 34 million (= 85% × 40 million) shares, as its delta was 85%. As a result, Gigabank had to sell 6 million shares (40 million – 34 million). In order to sell these shares, Gigabank had to borrow the same number of shares from ABC (or from the market).

The flows of the transaction during the life of the equity swap and the call are as follows:

• Gigabank pays an interest, the floating amount, to ABC based on the EUR 400 million equity swap notional.
• ABC pays to Gigabank an amount, the dividend amount, equivalent to the dividends distributed to the underlying 40 million XYZ shares. This amount is paid on the same date the dividends are paid by XYZ to its shareholders.
• Gigabank pays to ABC the dividends and a borrowing fee on the borrowed 6 million shares.

The flows of the transaction at maturity of the equity swap (or at expiry of the call) are as follows:

• Under the equity swap, ABC delivers 40 million XYZ shares to Gigabank and receives EUR 400 million.
• ABC exercises the call if XYZ's stock price is greater than the EUR 6.00 strike, receiving the settlement amount. If XYZ's stock price is lower than, or equal to, the EUR 6.00 strike, the call expires worthless. The settlement amount is calculated as 40 million × Max[(settlement price – strike price), 0].

Gigabank's Position under the Transaction

Let us analyze Gigabank's position under the transaction, ignoring the equity swap's interest and dividend flows:

• Under the equity swap, Gigabank had a long position in the 40 million underlying shares at EUR 10.00 (the equity swap initial price). Therefore, it benefited from XYZ's stock price being above EUR 10.00 and was exposed to a stock price below EUR 10.00.
• Under the call, Gigabank was exposed to a share price above the call strike (EUR 6.00). Gigabank received a EUR 4.3 per share premium.

As a result, Gigabank was short a put with strike EUR 6.00 (see Figure 6.15). It received a EUR 0.3 premium.

Advantages and Weaknesses of the Strategy

The advantages of this strategy were the following:

• The transaction allowed immediate derecognition of the stake. Some auditors may question the accounting derecognition because the combination of the equity swap and the call option was similar to owning the shares for a stock price above EUR 6.00. In such a situation, the strike of the call may need to be higher (e.g., at EUR 8.00) to make it less similar to a long position in the underlying shares.
• The transaction could be implemented for a large size. In our case, ABC could derecognize the whole stake in one shot. This is not always true. Under the transaction, Gigabank was, in effect, short a put, limiting the potential size it could trade.
• ABC could benefit from a rising stock price during the transaction term. ABC could derecognize the stake in a weak stock market environment, but benefit from a potential rebound later on.
• ABC was not exposed to a share price below the strike of the call.
• ABC kept the voting rights associated with the underlying unlent shares.

The disadvantages of this strategy were the following:

• ABC did not keep the dividends distributed to the underlying shares.
• ABC paid a substantial premium to acquire the call. ABC probably needed to raise financing.
• ABC remained exposed to a falling stock price, up to the call strike.

6.5 COMBINATION OF ABB AND A CALL OPTION/EXCHANGEABLE

The combination of an accelerated book-building and a call option (or an exchangeable bond) enables investors to partially dispose of a strategic stake, minimizing the negative impact on the stock price caused by the disposal. In a real case, I will cover the technicalities of such a strategy.

6.5.1 Case Study: Germany's Disposal of Fraport with JP Morgan's Collaboration

This transaction shows a real-life example of a transaction in which an investor sold its strategic stake via an accelerated book-building (ABB) trade and the sale of a call. The sale of a call was mirrored by the issuance of an exchangeable bond.

Background Information

In 2005, Germany's finances were under strain as near-record unemployment boosted welfare payments and weak domestic growth saddled tax income. The budget deficit as a proportion of gross domestic product exceeded the European Union's 3% limit every year during the last three years. The large deficit forced the German government to sell assets to cut debt and reduce interest payments. The objectives were to quickly reduce its budget deficit, which the Bundesbank described as “extraordinarily critical”, and to safeguard its AAA rating. S&P, the credit rating agency, threatened to cut Germany's AAA rating unless Germany improved its public finances. Germany had the highest debt levels, as a percentage of GDP, among the sovereigns – holding an AAA credit rating.

In October 2005, the German government was planning the privatization of its remaining 18.25% stake, or 16.6 million shares, in Fraport A.G., the operator of the Frankfurt Airport. Frankfurt Airport was Europe's second busiest airport after London's Heathrow Airport. Fraport A.G. had a market cap of approximately EUR 3.5 billion. Therefore, the 18.25% stake was worth approximately EUR 640 million.

The objectives of the German government were:

• To dispose of the whole stake in one transaction.
• To maximize the disposal price.
• To quickly execute the transaction.
• To minimize the downward pressure on Fraport's stock price.

The easiest and quickest way to sell the stake was through an accelerated book-building placement (an “ABB”). However, the stake represented a large number of Fraport's average daily volume. An ABB for the whole size required such a large discount that it became unattractive.

To achieve most of these objectives, the German government decided that the best solution was to dispose of the stake via the combination of two transactions, to be executed simultaneously:

• An ABB.
• An issuance of an exchangeable bond.

However, because the German government was not allowed to issue the exchangeable bond directly for Maastricht budgetary reasons, it had to rely on a third party – JP Morgan – to issue an exchangeable. As a result, instead of issuing an exchangeable directly, the German government sold a call option to JP Morgan. In turn, JP Morgan then used the call option to issue an exchangeable bond. Figure 6.16 depicts the strategy building blocks:

The Accelerated Book-build

The German government's first step was the disposal of 64% of the total stake (i.e., 11.7% of Fraport's share capital) in an ABB with institutional investors and with Lufthansa. JP Morgan and Morgan Stanley managed the direct sale of stock. The 10.6 million shares of Fraport were sold at EUR 38.40 price per share, a 4% discount to prior-day Fraport's closing stock price. Therefore, Germany raised a total of EUR 407 million.

A large portion of the ABB was placed with Deutsche Lufthansa A.G. (“Lufthansa”), Europe's second largest airline at that time. Lufthansa acquired 4.95% of Fraport, or 4.5 million shares. Lufthansa spent EUR 173 million. The airline bought the holding to take a seat on Fraport's supervisory board, in order to play a role in the airport's decision-making. Fraport planned to expand Frankfurt's airport with a new terminal and a new runaway. About 60% of Lufthansa's passengers flew through Frankfurt, and the airport accounted for roughly half of its take-offs and landings.

The sale left the German state of Hesse and the city of Frankfurt as the largest shareholders in Fraport, owning 50% of the company. At that time Hesse and Frankfurt had no plan to buy or sell shares in Fraport because of a 10-year lock-up they agreed to at Fraport's IPO in June 2001.

The Sale of a Call

The German government sold a call with a 113% strike on 6.6% of Fraport's share capital. The overall premium received by the German government was not disclosed, but I assume it was 5% of the notional, or EUR 12 million. The option had a 17-month expiry, and allowed for physical settlement only. The following table summarizes the call main terms:

Physically Settled Call Option – Main Terms
Buyer	JP Morgan
Seller	The German government
Option type	Call
Trade date	26-October-2005
Expiration date	7-March-2007 (i.e., 17 months)
Option style	American. Option could be exercised from 1-March-2007 up to expiration date
Shares	Fraport A.G.
Number of options	6 million
Strike price	EUR 45.25 (113% of the EUR 40.04 stock's closing price on previous day
Premium	EUR 12 million (5% of the option notional amount)
Notional amount	EUR 240.2 million (= 6 million × 40.04)
Premium payment date	28-October-2005
Settlement method	Physical settlement
Settlement date	Three exchange business days from 26-October-2005

The Exchangeable Bond

Concurrently with the previous two transactions, JP Morgan issued a zero-coupon bond exchangeable for Fraport stock. JP Morgan issued the exchangeable bond in order to hedge its exposure to Fraport's stock price under the call option it bought from the German government. The exchangeable had a 17-month maturity, a notional amount of EUR 271.5 million and an exchange price of EUR 45.25, or 13% above the closing price on the day prior to its issuance. The following table summarizes the exchangeable main terms:

JP Morgan's Exchangeable Bond Terms
Issuer	JP Morgan Bank Luxembourg S.A.
Notional amount	EUR 271.5 million
Redemption amount	100% of notional amount
Issue date	26-October-2005
Maturity	12-March-2007
Underlying stock	Fraport A.G.
Issue price	100.15%
Coupon	Zero
Exchange price	EUR 45.25
Underlying number of shares	6 million (= 271.5 million/45.25)
Exchange premium	13% above the stock closing price on previous trading day (the share price)
Closing stock price on previous trading day	EUR 40.04
Exchange period	From 1-March-2007 to 7-March-2007
Issuer call	None, except clean-up call and tax call

Scenarios at Maturity

At maturity of the exchangeable bond (to be precise, during the last week of the exchangeable's life), there were two scenarios:

The low conversion premium – 13% – allowed for a high probability of conversion. The bond had a zero-coupon feature, to perfectly mirror the call option terms. In other words, the bond paid a zero coupon to make sure that if the call was exercised, the exchangeable would in theory be exercised too. The call 5% premium was in theory the present value of the yield of straight bonds issued by JP Morgan with the same tenor.

Advantages and Weaknesses of the Transaction

The advantages of the transaction to the German government were:

• The whole transaction was executed simultaneously.
• The ABB discount price was lower compared with a sole ABB.
• The call option allowed for a potential future disposal at a premium.
• It kept the voting rights and received the dividends on the shares underlying the call option.
• It diversified the investor base by targeting both cash equity and equity-linked investors with limited overlap.
• It took advantage of a strong demand in the cash equity and equity-linked markets.
• It benefited from an attractive price of Fraport stock.

The weaknesses of the transaction to the German government were:

• There was no certainty regarding the disposal of the shares underlying the call option.
• There was a negative impact on Fraport's stock price. However, it was significantly less negative than in a sole ABB transaction.