9

Equity Financings

This chapter provides a detailed understanding of the mechanics of equity financings. Equity financings are indebtedness transactions collateralized by shares. Typically, corporates, financial institutions and high net worth individuals use equity financings to raise cash off the back of their equity stakes as an alternative funding source outside the traditional debt and equity capital markets. There are multiple ways of implementing an equity financing. In the following sections I will cover the most common equity financing structures.

9.1 CASE STUDY: EQUITY COLLATERALIZED BOND

One common way of implementing an equity financing is to issue a bond collateralized by an equity stake. In order to study the different elements of a structured bond collateralized by shares, let us assume a fictional transaction. In 20X1 the ABC Group, one of the Middle East's largest privately owned financial/industrial conglomerates with interests primarily in oil, gas and banking, as well as other investments, approached Gigabank to raise financing secured by part of its stake in XYZ Petroleum (“XYZ”).

ABC Group operated through a series of fully owned holding companies, each with specific industrial focus. One of these holding companies was Oil Holding, which held the oil and gas investments of the ABC Group. Oil Holding owned 30% of XYZ's share capital. XYZ was a publicly quoted company.

On 1 June 20X1, Gigabank arranged a USD 300 million structured equity financing for Oil Holding via the issuance of a bond. The bond was issued by a special purpose entity (see Figure 9.1), Oil SPE, fully owned by Oil Holding. Oil SPE had no assets or activities other than (i) to hold ABC's stake in XYZ and (ii) to provide a loan to its parent Oil Holding. The aim of the financing was to make an intra-group loan to Oil Holding for the purpose of acquiring other oil and gas assets to be retained within the group.

9.1.1 Bond Terms

The bond was secured by XYZ shares, guaranteed by Oil Holding, issued to Gigabank solely and subject to cash margining. The main terms of the bond are outlined in the table below:

Oil SPE's Bond Terms
Issuer	Oil SPE, a wholly owned subsidiary of Oil Holding
Guarantor	Oil Holding
Notional amount	USD 300 million
Redemption amount	100% of notional amount
Issue date	1-June-20X1
Maturity	1-June-20X4 (3 years)
Coupon	USD Libor 3m + spread, paid quarterly Spread: +250 bps
Collateral	46.15 million shares of XYZ (20% of XYZ's share capital). Pledge over the collateral
Collateral value on issue date	USD 461.5 million (i.e., USD 10.00 per share)
Initial LTV	65%
Call right	The issuer has the right to call in whole or in part the bond on or after the 18-month anniversary of the issue, subject to a payment of 1% of the notional prepaid
Trustee	Securities Trust Services
Collateral agent	Gigabank
Cash collateral agent	Gigabank
Escrow agent	Gigabank
Calculation agent	Gigabank
Margining	Cash margining applies (see below)
Early termination events	Deal specific (see below)
Events of default	Customary plus deal specific (see below)

9.1.2 Main Documents of the Financing

The documents that formalize an equity financing transaction vary from one financing to another. In this case, the documents of the Oil SPE transaction were the following.

The cash collateral agreement created a charge in respect of any cash margin pledged pursuant to the collateral agreement and in respect of the account in which it was held. The cash collateral assignment assigned the contents of the cash margin account to the cash collateral agent for the benefit of the bond holders. The parties to the cash collateral agreement were the cash collateral agent and the issuer.

The collateral and pledge agreement allowed the collateral agent to declare collateral events of default in certain circumstances. The agreement also specified the posting of cash margin. The pledgor pledged to the collateral agent a security interest in and to, and a lien upon and right of setoff against, all the pledgor's right, title and interest in and to the collateral. The financing's security was on the XYZ shares in the collateral account. The parties to the collateral agreement were the pledgor, the depositary, the collateral agent and the trustee.

The credit default swaps (CDS) formalized the participation of the lenders other than Gigabank in the financing, being agreed between each lender and Gigabank. The exposure of a lender under the CDS represented a synthetic exposure to the bond.

The escrow agreement served to lock up the issuer's XYZ shares that were not part of the collateral agreement. Remember that Oil Holding had 30% of XYZ, while the financing was backed by 20% of XYZ's share capital. Issuer's XYZ shares in excess of the securities pledged to the collateral account were placed in escrow and held by the escrow agent. This prevented XYZ shares that were not part of the financing collateral from coming onto the market until after the financing collateral had been foreclosed, if required. Any XYZ shares acquired by the issuer after entering into the financing transaction were also placed in escrow for as long as the bond was outstanding. It should be noted that the bond's security was on the shares in the collateral account and the cash in the cash margin account, not on the shares in the escrow account. The escrow agreement was signed by the issuer, the guarantor, the escrow agent and the calculation agent.

The guarantee set out the terms of the parent company Oil Holding's guarantee.

The indenture set out the terms and conditions of the issued bond, including the guarantee from the guarantor. In addition, it set out certain events of default that may lead to the bond becoming immediately due and payable. The indenture also set out certain early termination events that, though not events of default, could lead to the bond becoming due and payable. The parties to the indenture were the issuer, the guarantor, the trustee and the calculation agent.

In our case, the bond was wholly subscribed by Gigabank (the “purchaser”). The subscription agreement set out the issuance of the bond by the issuer and the subscription of the bond by the purchaser. It contained certain conditions precedent to closing. The parties to the purchase agreement were the issuer, the guarantor and the purchaser.

9.1.3 Parties to an Equity Financing

In an equity financing there are several parties involved. In most financings several of the roles are performed by the bank arranging the financing.

The borrower is the entity receiving the proceeds of the financing. In our transaction, Oil SPE was the borrower.

The calculation agent, Gigabank, determined the bond coupons, performed the margin calculations and checked that no early termination events were triggered. The calculation agent was also responsible for computing the outstanding bond notional together with the accrued interest and any other amounts due in respect of the bond upon occurrence of an early termination event or a credit event.

The cash collateral agent retained responsibility for administering all the margin calls payments/releases for the life of the transaction and their related interest payments to the borrower. In our case, the cash collateral agent was Gigabank.

The collateral agent retained responsibility for administering all the movements of shares held in the collateral account. Any movements of these shares required prior consent from the trustee. In our case, the collateral agent was Gigabank.

The escrow agent retained responsibility for administering all the transactions related to the shares held in the escrow account (i.e., the other XYZ shares not pledged for the benefit of the transaction). The escrow agent made sure that any action taken on these shares complied with the provisions set forth in the indenture agreement. Thus, any pledge or transfer of the shares held in the escrow account required prior approval of the escrow agent. In our case, the escrow agent was Gigabank.

The guarantor was the entity that agreed to be legally bound to meet the issuer obligations under the indenture if the issuer did not meet such commitments. Because the issuer was an SPE, the lenders required Oil SPE's parent (Oil Holding) to guarantee the financing. As a result, the bondholders could pursue a claim against Oil Holding if Oil SPE did not meet its obligations under the bond.

The lenders were the entities providing the equity financing. In our transaction, Gigabank was the main lender, facing the borrower directly via the bond. The other lenders did not face the borrower directly, but through credit default swaps.

The pledgor, Oil SPE, pledged to the collateral agent a security interest in and to, and a lien upon and right of setoff against, all the pledgor's right, title and interest in and to the collateral. The pledgor had to warrant and represent good title to the shares which were free from liens and encumbrances or prior pledge with full authority to transfer the shares as collateral security. The pledgor was subject to certain covenants, as we will see later in this section.

During the term thereof and as long as there was no default, the pledgor had full rights to vote the pledged shares and was entitled to all dividends income, except that stock dividends would be pledged. In the event a stock dividend or further issue of stock by the issuer of the XYZ shares, the pledgor had to pledge these shares as additional collateral for the debt. Upon payment of the debt, the pledged shares would be returned to the pledgor and the pledge agreement would be terminated. Upon default the pledgor would pay all reasonable attorneys’ fees and cost of collections.

The trustee held title to the pledged shares for the benefit of the bondholders. The trustee made sure that any action taken on the collateral complied with the provisions set forth in the indenture agreement. Thus, any release or foreclosure of the collateral required prior approval of the trustee. In our case, the trustee was Securities Trust Services. Gigabank could not be the trustee due to conflicts of interest.

9.1.4 Accounts in an Equity Financing

An equity financing requires the opening of several accounts. Some accounts are cash accounts and some accounts are stock custody accounts. In our financing, the main accounts were the following:

The cash margin account held the cash margin posted by the issuer. This account was pledged to the bond holders.

The bond evidenced a secured claim against the issuer and the guarantor. The collateral account held the shares that were pledged to secure the bonds. At the beginning of the transaction, Oil SPE opened a collateral account with Gigabank, the collateral agent. Once the account was opened, Oil SPE transferred the collateral shares to the account. Oil SPE provided a security charge (i.e., a pledge) over the collateral account and its contents to the trustee representing the bond holders. The collateral account held 46.15 million shares of XYZ, representing 20% of its share capital.

The financing's security was on the shares in the collateral account. The issuer held its remainder XYZ shares in the escrow account, opened in its name. The escrow account mechanism ensured that the issuer's shares in XYZ were locked up and could not come to the market until after foreclosure on the shares in the collateral account. In some equity financings there is no escrow account, giving the borrower absolute freedom to use any unpledged shares.

9.1.5 Credit Enhancement Tools

Security Mechanism

The security mechanism was comprised of the shares collateralizing the transaction and the cash pledged. The bond was secured by 46.15 million shares of XYZ (20% of its share capital). The collateral was held in the collateral account. Under the collateral agreement, the pledgor granted unto the collateral agent a security interest in and to, and a lien upon and right of set-off against, all the pledgor's right, title and interest in and to, the pledged items. The collateral agent acted as agent for the trustee and, inter alia, would realize the pledged shares upon default. The cash pledged pursuant to the cash margin call mechanism (see below) was also part of the bond collateral.

Margin Call Mechanism

The main objective of the margin call mechanism was to preserve the loan to value (LTV) of the financing. On each trading day during the life of the bond, the closing price of XYZ stock was observed and the transaction LTV was calculated.

Loan to Value (LTV)

The loan to value was the ratio, expressed as a percentage, of (i) the drawn amount less the cash collateral, divided by (ii) the market value of the secured collateral.

In some transactions, the issuer is required to post an initial margin. Consequently, any initial margin has to be included in the cash collateral component of the LTV formula. In our transaction, there was no initial collateral and the initial LTV at time of issuance was 65%. The main levels of the cash margining mechanism were:

• LTV margin level: 70%
• LTV reset level: 65%
• LTV release level: 60%

The LTV was computed on each trading day of the stock (the “valuation date”). The market value of the collateral (i.e., the pledged shares) was calculated using the closing price of the stock on the preceding valuation date.

• If, on a valuation day, the LTV was greater than the LTV margin level (70%), the calculation agent gave written notice to the issuer requiring the issuer to post cash in USD as collateral so that the LTV was restored to the LTV reset level (65%). Where this notice was given by 9 a.m. New York time on any valuation day, such cash had to be received by 2 p.m. New York time on the business day immediately succeeding such day.
• Where the LTV was less than, or equal to, the LTV release level (60%) for a period of three consecutive valuation days, the collateral agent would on request by the issuer be required to release cash to the issuer so that the LTV was equal to or less than the LTV reset level (65%). Only cash margin previously posted by the issuer plus interest thereon could be returned.

As an example, let us assume that XYZ's stock price had the following behavior during the first eight valuation days:

In some financings, the borrower is allowed to post additional shares of XYZ up to a certain level. For example, upon the first margin call only, the issuer may post additional shares. Thereafter, margin calls have to be met in cash only. This was not the case in our transaction.

9.1.6 Early Termination Events

An equity financing may include certain early termination events (also called “acceleration events”) that, through not events of default, may lead to the financing becoming due and payable. Upon early termination, the calculation agent would compute the outstanding bond notional together with the accrued interest and any other amounts due in respect of the bond. In this section, I will cover the early termination events most commonly included in equity financings.

Stock Trigger Event

One common early termination event is a “stock trigger event”. This event occurs if the calculation agent determines that an intra-day price per share is equal to or less than a predetermined level (typically 50%) of the initial price at any time during the trading session. The intra-day price per share is defined as “the official price per share quoted on the exchange or, if no such price is available, the price per share as determined by the calculation agent in good faith and in reasonable manner”.

A stock trigger event protects the lenders from a potential situation in which the stock has lost substantial value (e.g., 50%) and it is likely to accelerate its share price fall because the company's fundamentals have been severely and permanently impaired. The borrower up to now has met the margin calls, but a continuing fall may endanger its power to meet additional margin calls. Therefore, besides protecting the lenders, a stock trigger event may provide investment discipline to the borrower, giving it an incentive to exit the investment before it is too late.

LTV Trigger Event

The LTV trigger event tries to protect the lenders from gaps in the stock price. At transaction inception an LTV trigger level is set, for example at 75%. If, at any time – including intra-day prices – the LTV is greater than the LTV trigger level (75%), it constitutes an “early termination event”.

Rating Trigger Event

The lenders may have the right to terminate the transaction early upon occurrence of a rating trigger event. This right can be exercised if the borrower's long-term credit rating is downgraded below a predetermined threshold by one of the major rating agencies – S&P, Moody's or Fitch – or ceases to have a rating. For example, a rating trigger event may occur if:

• The credit rating of the borrower is downgraded to BBB–/Baa3 or below by either Standard & Poor's Rating Services or any successor thereof or Moody's Investors Service or any successor thereof.
• Or, the borrower ceases to have a public credit rating with Standard & Poor's or Moody’s.

Covenants

An early termination event occurs if the calculation agent determines that the issuer failed to observe or perform a specific covenant, if not remedied after a pre-specified number of days from the date of occurrence of such event. Covenants are the part of a financing agreement where lenders give the borrower and/or the guarantor a set of rules explicitly stating what the borrower and/or the guarantor must do or not do as an entity to remain in compliance with the financing agreement. Types of covenant include:

• Financial covenants impose certain financial requirements on the borrower. These typically include measurements of: (a) minimum earnings or cash flow, measured by ratios such as cash flow to interest, debt service and fixed charges; (b) maximum leverage, tested through debt coverage; and/or (c) adequate liquidity, as seen by a current or quick ratio. In addition, the covenants may stipulate a minimum tangible net worth or maximum level of investment in capital expenditures. Financial covenants are sometimes referred to as maintenance covenants originating from the borrower's obligation to maintain these financial levels and ratios.
• Affirmative covenants stipulate actions that the borrower must make, such as pay debt service, pay taxes and maintain insurance.
• Negative covenants prohibit certain actions of the borrower, such as combining with other companies, selling certain assets, making acquisitions, or taking on additional debt.

In our transaction, the bond primarily contained “negative covenants” that limited Oil Holding's (and Oil SPE’s) ability to, among other things: (i) incur additional debt or issue certain preferred shares; (ii) pay dividends on or make other distributions in respect of its capital stock or make other restricted payments; (iii) make certain investments; (iv) sell certain assets; and (v) create or permit to exist dividend and/or payment restrictions affecting its restricted subsidiaries. For example, there was a negative covenant capping debt within the issuer. Under the transaction, the issuer was obliged to not exceed an aggregate outstanding notional amount of indebtedness of USD 500 million, other than permitted subordinated borrowing. Within this cap, the bond used USD 300 million. Therefore, any additional financing (a “permitted financing transaction”) could not exceed USD 200 million.

A permitted financing transaction was one secured by the assets in the escrow account. In our case, there were restrictions in place to protect the position of the bond holders. Any additional indebtedness had to comply with the following requirements:

• It could only be secured by assets in the escrow account.
• It would cross default the bond.
• It was subject to a 30-day standstill upon default. In other words, a third-party pledge in a permitted financing transaction had to agree to not foreclose on the escrow assets within 30 days of an event leading to an early termination of the permitted financing transaction (that would cross default the bond). This standstill allowed a clear market from disposing of the shares in the bond's collateral account.
• It had to involve Gigabank as calculation agent.

Additionally, in our transaction the calculation agent could allow the issuer to raise subordinated debt. A permitted subordinated indebtedness was defined as indebtedness owed by the issuer to the guarantor or any affiliate of the issuer or the guarantor that was contractually subordinated, to the reasonable satisfaction of the calculation agent. The indenture set out several restrictions to the aggregate amount of permitted subordinated indebtedness that could be raised. This amount could not exceed at any time the sum of (1) cash margin at such time, (2) the aggregate of all amounts that became due under the bond at such time, and (3) USD 1 million to be used for the reasonable administration expenses of the issuer. The permitted subordinated indebtedness documentation had to be to the calculation agent's satisfaction.

Upon the issuer's failure to observe or perform these covenants, the trustee would declare the bond immediately due and payable, if not remedied after 90 days from the date of notice of default.

Other Early Termination Events

A transaction may include other early termination events to protect the bond holders. For example, an early termination of the bond may occur on:

• The ADTV (Average Daily Trading Volume) of the pledged shares, tested over a specific number of days, falling below a certain threshold level. In our transaction, the collateral represented 30 full ADTVs. A sharp fall in XYZ's ADTV would imply a larger than expected period to sell the collateral, upon default, increasing the risk of losses.
• Nationalization of XYZ.
• Delisting of XYZ shares.
• Cross default or cross acceleration to the issuer's or the guarantor's indebtedness or event of default, subject to a USD 10 million threshold and a cure period of 20 business days.
• Any legal proceeding instituted or other event occurred that called into question the binding effect of the issuer under the indenture or collateral agreement.
• Any legal proceeding resulted in a final judgment to dispose of the shares held in the escrow account.
• The guarantee held in a judicial proceeding to be unenforceable or not in full force or effect.
• A final judgment against the issuer or the guarantor unsatisfied for 20 business days, but, with respect to the guarantor only, only where the amount is lower than USD 10 million.
• An early termination of any permitted financing transaction.
• Involuntary and voluntary bankruptcy or insolvency of the issuer or the guarantor.
• A stock market disruption for more than a pre-specified number of consecutive days.
• A mandatory bid triggered in relation to the XYZ shares. In our case, Oil Holding owned 30% of XYZ. If Oil Holding exceeded a 30% ownership it would be obliged to make an offer for 100% of the XYZ. An offer for the remaining shares could significantly affect the risk profile of the transaction.

Grace or Cure Periods

Some of the early termination events have a cure period, also called a “grace period”. A grace period is a period during which the issuer and/or guarantor are given the chance to remedy an early termination event, before triggering an early termination of the indebtedness. Commonly, there is a 20 business day cure period for early termination events, although some cure periods are longer and other events do not have a cure period. Furthermore, in certain circumstances the cure period runs until the event becomes effective.

Make-whole Amount

In some financings, the amount due and payable by the issuer upon occurrence of an early termination event includes a make-whole amount. The make-whole amount is the present value of the aggregate of all payments representing the financing spread that would have been paid by the issuer as per the scheduled terms of the bond from the date of default to its scheduled maturity. In our case, the financing spread was 250 basis points.

9.1.7 Events of Default

Our indenture contained several events of default. Upon occurrence of an event of default, the trustee would be required to declare the bond immediately due. Usually, there is a grace period (a “cure period”) during which the borrower can remedy the situation. If the default continues beyond the cured period, the trustee would declare the event of default.

Failure to Comply with Payment of Interest and Principal

In our transaction an event of default would occur if the issuer defaulted in payment of the bond's interest or principal.

Failure to Comply with Margin Calls

In our case, an event of default would occur if adequate cash was not provided as margin on its due date, unless the failure to pay was caused by administrative or technical error or the banking system experienced difficulties and the issuer had already provided a SWIFT confirmation from the issuer's correspondent bank for USD to confirm the sending of funds, and payment was received within three business days of its due date.

Failure to Comply with Collateral Requirements

Under the collateral agreement, the collateral agent would declare an event of default upon the occurrence of:

• Failure of the collateral account to contain at least 46.15 million shares of XYZ.
• Or, failure at any time of the security interests to constitute valid and perfected security interests in all of the collateral.

Liquidation Procedure

Upon occurrence of an event of default, the trustee would be required to declare the bond immediately due and payable. The following process, as defined in the indenture agreement, would then be executed:

• The calculation agent, Gigabank, would compute the outstanding bond notional together with the accrued interest and any other amounts due in respect of the bond.
• Following the trustee's approval, the collateral agent (Gigabank) would foreclose the 46.15 million shares of XYZ held in the collateral account. In some cases the shares in the collateral account exceed the threshold amount above which a mandatory bid would be triggered. Upon enforcement, Gigabank would own the pledged shares. The enforcement mechanism has to be designed to avoid a mandatory bid requirement for Gigabank.
• The collateral agent would be appointed as disposal agent and would liquidate the collateral selling it onto the market. Gigabank would probably seek to sell it quickly through an ABB.
• The cash collateral agent, Gigabank, would deliver any funds in the cash margin account to the collateral agent, also Gigabank in our case.

The proceeds of the liquidation of the collateral would be applied by the collateral agent in the following order of priorities (see Figure 9.2):

• First, the payment to the collateral agent and the cash collateral agent of the expenses of such sale or other realization, including reasonable compensation to each of the collateral agent and the cash collateral agent and its agents and counsel, and all expenses, liabilities and advances incurred or made by the collateral agent and the cash collateral agent in connection therewith, including brokerage fees in connection with the sale by the collateral agent of any pledged item (other than break funding costs).
• Second, the payment to the trustee of any costs and expenses incurred in connection with the event of default and such sale or other realization, including reasonable compensation to the trustee and its agents and counsel, and all documented expenses, liabilities and advances incurred or made by the trustee in connection therewith.
• Third, the payment to the trustee for distribution in accordance with the terms of the indenture, including for pro rata distribution to the bond holders of an amount equal to the principal, interest due and payable under the bond, and any make-whole amount due. The make-whole amount included the present value of the bond spread that would have been paid by the issuer as per the scheduled terms of the bond from the date of default.
• Finally, if all the obligations of the pledgor under the indenture have been fully discharged or sufficient funds have been set aside by the collateral agent at the request of the pledgor for the discharge thereof, any remaining proceeds would be released to the pledgor.

In the event of an under-recovery in respect to the bond following enforcement, the collateral agent could try to dispose of the shares held in the escrow account not securing any permitted financing transactions, to satisfy a residual claim under the bond. However, under certain securities laws it is unlikely that these shares could be sold without restrictions, unlike the shares in the collateral account.

In the event of an under-recovery in respect of the bond following enforcement, the bond holders could pursue a claim against the issuer and the guarantor. The bond ranked pari passu with claims of other unsecured and unsubordinated creditors. Under the CDS, Gigabank would deliver the corresponding part of the bond to each CDS counterparty. The CDS counterparty would pay the bond notional amount minus the cash margin posted by the issuer minus the recovery amount realized from the liquidation of the share collateral.

9.1.8 Syndicating the Equity Financing with a Credit Default Swap

Once Oil Holding mandated Gigabank for the bond issuance, the bank tried to place part of the transaction with other lenders, primarily banks. This process is called syndication. Gigabank took the risk of taking a larger than expected participation in the financing, if other lenders lacked appetite for participating in the financing.

Other lenders could participate in the financing by either (i) acquiring part of the bond from Gigabank or (ii) entering into credit default swaps (CDSs) with Gigabank. In our transaction, Gigabank preferred the latter solution. Let us assume that another bank called Megabank was interested in participating in the financing. The main differences between syndicating a transaction via a bond or via a CDS were the following:

• Gigabank was the only entity facing Oil SPE. It gave the bank better visibility vis-à-vis the borrower. It also gave Gigabank more control to enforce the borrower obligations under the bond (e.g., the covenants).
• Gigabank did not need to list the bond.
• Megabank did not have to fund the transaction, as in a CDS there is no exchange of principals, unless Gigabank required cash collateral to be posted by Megabank to credit enhance the CDS.
• With the CDS, the contractual arrangement was between Megabank and Gigabank. Thus, Megabank was exposed not only to the default risk of Oil SPE and Oil Holding, but also to the ability of Gigabank to make good under the CDS. Therefore, a CDS increased Megabank's counterparty risk under the transaction. Similarly, if no collateral was posted by Megabank at the beginning of the transaction, Gigabank had a large counterparty risk exposure to Megabank if a credit event occurred.
• The sale of the risk by Megabank to a third party would be a bit more complicated through a CDS. Instead, if Megabank acquired part of the bond directly, it would be easier to sell it to third parties.

Megabank participated in the financing via a credit default swap where the reference obligation was the indenture for the bond and the reference entity was Oil SPE. Thus, the investors faced Gigabank, and Gigabank faced Oil SPE. Gigabank handled all the operational issues. Let us assume that Megabank took a USD 60 million risk piece. The main terms of the CDS with Megabank were:

Physically Settled Credit Default Swap
Trade date	1-June-20X1
Floating rate payer (“Seller”)	Megabank
Fixed rate payer (“Buyer”)	Gigabank
Scheduled termination date	The earlier of: (i) The redemption date for the reference obligation, if the reference entity or the buyer exercises its right to terminate the reference obligation early, or (ii) 1-June-20X4
Reference obligation	The bond with notional amount USD 300 million issued by Oil SPE on 1 June 20X1 and guaranteed by Oil Holding
Reference obligation notional	USD 300 million, subject to reduction with effect from each day on which any payment of principal is made to the holders of the reference obligation in respect of the reference obligation (as a result of accelerated amortization, acceleration of payment obligations, redemption or otherwise)
Reference entity	Oil SPE
Reference price	100%
Calculation amount	20% multiplied by the reference obligation notional (representing USD 60 million of the reference obligation)
Fixed payments
Fixed payments payer	Buyer (Gigabank)
Fixed payments	250 bps per annum Act/360, paid on a quarterly basis. Fixed amounts shall be payable in respect of the period from the last fixed rate payment date immediately preceding an event of default under the terms of the reference obligation to the date on which such event of default occurs
Floating payments
Floating payments payer	Seller (Megabank)
Conditions to settlement	Credit event notice. Notifying party: the buyer. Notice of publicly available information: inapplicable
Credit events	(i) Failure to pay (grace period extension: applicable, payment required: USD 1) (ii) Obligation event of default (default requirement: USD 1)
Obligations	Obligation category: reference obligation only
Settlement terms
Settlement method	Physical settlement
Amount payable by Seller	Calculation amount plus any accrued but unpaid interest up to and including the termination date on calculation amount minus the pro rata cash margin posted in respect of the reference obligation minus the pro rata recovery amount under the liquidation of the reference obligation's collateral
Delivery obligations	Delivery obligation category: reference obligation only
Calculation agent	Gigabank

Under the CDS, two scenarios could take place during its life:

• If no credit event occurred, i.e., no events of default have occurred under the bond, the buyer of the protection (Gigabank) would pay to the seller (Megabank) a regular premium of 250 basis points on a quarterly basis (see Figure 9.3). This amount is called the fixed payment amount.
• Following a credit event, i.e., an event of default has occurred under the bond, the protection buyer (Gigabank) would provide the seller (Megabank) 20% of the bond in return for a cash payment amounting to its corresponding notional amount (i.e., USD 60 million) minus the corresponding cash margin posted by the bond issuer minus the recovery amount under the liquidation of the collateral (see Figure 9.4). The protection buyer (Gigabank) would then stop paying the fixed amount. As a result, the seller (Megabank) would end up directly owning its corresponding part of the bond.

9.1.9 Recourse vs. Non-recourse Equity Financings

The case just covered was a recourse equity financing. In general there are two types of equity financing: recourse and non-recourse equity:

• Upon default in a recourse financing, the lenders would seize the pledged collateral to meet the borrower obligations under the financing. If the realized value of the foreclosed collateral is lower than the amounts due under the financing, the lenders may pursue a claim against the borrower. Thus, the under-recovered amount would be claimed in conjunction with all other pari passu ranked claims against the borrower.
• Upon default in a non-recourse financing, the lenders would seize the pledged collateral to meet the borrower obligations under the financing. If the realized value of the foreclosed collateral is lower than the amounts due under the financing, the lenders may not pursue a claim against the borrower, thus realizing a loss. Therefore, the financing spread of a non-recourse financing is, in general, notably larger than that of a comparable recourse financing to compensate for the higher risk assumed by the lenders.

9.2 SALE + EQUITY SWAP

9.2.1 Transaction Description

One way to structure an equity financing is by combining a sale of stock and an equity swap. By entering into an equity swap, the borrower retains the stock dividends and its exposure to the stock price. The equity financing transaction is structured as follows:

9.2.1 Equity Swap Terms

Let us assume the same inputs as in the previous case, primarily:

• On 1 June 20X1, Gigabank arranged a USD 300 million structured equity financing for a special purpose entity, Oil SPE, fully owned by Oil Holding. The term of the financing was 3 years. The spread of the financing was 250 basis points.
• The financing was secured by 46.15 million shares of XYZ, representing 20% of its share capital.
• The financing was guaranteed by Oil Holding.
• The initial LTV of the financing was 65%, based on a USD 10.00 per XYZ share at the beginning of the transaction.
• A margining mechanism (see previous case in this chapter).
• Early termination events and events of default (see previous case in this chapter).

The counterparties to the equity swap were Oil SPE and Gigabank. Although the maturity of the equity swap was 3 years, Oil SPE could terminate it early, either totally or partially, at any time. The main terms of the equity swap are shown in the following table (the parts not detailed will be covered later):

Total Return Equity Swap Terms
Party A	Oil SPE, guaranteed by Oil Holding
Party B	Gigabank
Trade date	29-May-20X1
Effective date	1-June-20X1
Final termination date	1-June-20X4 (i.e., 3 years after the effective date)
Termination date	A date occurring on the earlier of (i) the final termination date, (ii) the final early unwind date and (iii) the early termination date
Early unwind	Party A (Oil SPE) may terminate this transaction in full or in part on any exchange business day prior to the termination date, subject to a prepayment fee by giving four exchange business days’ notice in writing to Party B (Gigabank) of the number of shares subject to such early unwind. Party A (Oil SPE) shall also specify to Party B (Gigabank) a new initial valuation date in respect of this early unwind If an early unwind occurs in respect of less than all of the number of shares, the terms of the transaction shall be adjusted accordingly If, following an early unwind, the number of shares becomes zero, the valuation date for such early unwind becomes the early unwind date
Underlying currency	USD
Initial exchange part	To be covered later
Equity amount part	To be covered later
Floating amount part	To be covered later
Dividend amount part	To be covered later
Interim exchange part	To be covered later
Other	To be covered later

Initial Exchange Part

The initial exchange part of the equity swap contained the sale by Oil SPE of 30 million XYZ shares to Gigabank in exchange for USD 300 million, the financing amount. The sale was settled on 1 June 20X1:

Total Return Equity Swap Terms – Initial Exchange Part
Initial exchange
Initial exchange	On the effective date, Party A (Oil SPE) shall deliver to Party B (Gigabank) 30 million XYZ shares and Party B (Gigabank) shall pay to Party A (Oil SPE) an amount in USD equal to 300 million

Floating Amount Part

The floating amount part of the equity swap contained the interest to be paid periodically by Oil SPE during the life of the equity swap. This part represented the interest to be paid on the loaned USD 300 million. Oil SPE paid quarterly USD Libor 3-month plus 250 basis points, calculated initially on the USD 300 million notional. Every time a partial termination of the equity swap took place, Oil SPE paid interest thereafter on the outstanding notional amount:

Total Return Equity Swap Terms – Floating Amount Part
Floating amount part
Floating amount payer	Party A (Oil SPE)
Notional amount	The time-weighted average equity notional amount from, and including, the previous floating amount payment date to, and excluding, the floating amount payment date
Payment dates	At the end of each quarter The last payment day is the later of (i) the last physical settlement payment date and (ii) the last cash settlement payment date
Floating rate option	USD Libor fixed on the second local business day preceding the last floating amount payment date. The floating rate for the initial period would be determined two local business days prior to the effective date
Designated maturity	3 months
Spread	Plus 250 bps (2.50%)
Floating rate day count fraction	Actual/360

The dividend part

Remember that Oil SPE sold 30 million XYZ shares at the beginning. The shares were acquired by Gigabank. Consequently, Gigabank received directly from XYZ any dividends distributed to the 30 million XYZ shares. Under the equity swap dividend part, Gigabank passed the received dividends to Oil SPE. These dividends are called “manufactured dividends”. Thus, the dividend part of the equity swap allowed Oil SPE to retain the dividends distributed to the equity swap underlying shares. The dividends paid were net of any withholding and other taxes levied at source. Therefore, if Oil SPE benefited from a more advantageous tax treatment than Gigabank in relation to XYZ dividends, this advantage was likely to be lost through the equity swap:

Total Return Equity Swap Terms – Dividend Part
Dividend amount part
Dividend amount	The result of (i) multiplied by (ii) (i) The dividend per share paid by the issuer to holders of record of a share, net of withholding or taxes at the source by or on behalf of any applicable authority having power to tax such a dividend and shall exclude any imputation or other credits, refunds or deductions granted by any applicable authority having power to tax in respect of such dividend and any taxes, credits, refunds or benefits imposed, withheld, assessed or levied thereon, in relation to which the date (the record date) by reference to which registered holders are identified as being entitled to a cash dividend payable in relation to such shares occurs during the dividend period (ii) The number of shares on such record date
Dividend payer	Party B (Gigabank)
Dividend receiver	Party A (Oil SPE)
Dividend period	The period commencing on, and including, the third scheduled trading day preceding the effective date and ending on, and including, the termination date
Dividend payment date	Two currency business days after the date of the payment of the dividend by the issuer of the shares to the holders of the shares in the market
Reinvestment of dividends	Not applicable

The Equity Amount Part

Oil SPE had the right to partially or totally unwind the transaction. On each early unwind, Oil SPE had to pay to Gigabank a 1% prepayment fee calculated on the unwind amount. The equity amount part of the equity swap contained the settlement process at each early unwind and at maturity of the transaction. Oil SPE could elect between cash and physical settlement. Generally, Oil SPE would elect physical settlement because this would imply recovering the 30 million shares (or the portion applicable to the early unwind) sold at inception and repaying the debt. However, were Oil SPE not interested in retaining the stake, it could elect cash settlement. Under a cash settlement, the shares underlying the unwind would be sold onto the market by Gigabank, and any excess (deficit) over the unwound amount would be paid by Gigabank (Oil SPE) to Oil SPE (Gigabank) in the form of a settlement amount:

Total Return Equity Swap Terms – Equity Amount Part
Equity amount part
Equity amount payer	Party B (Gigabank)
Equity amount receiver	Party A (Oil SPE)
Shares	XYZ common shares
Number of shares	30 million. The number of shares shall be reduced on each day during the unwind period by the number of shares that Party B has unwound its hedge position in respect of this transaction on such day
Initial price	USD 10.00
Equity notional amount	Number of shares × Initial price Initially USD 300 million
Final initial valuation date	The maturity date
Settlement method election	Applicable Electing party: Party A (Oil SPE) Settlement method election date: the day that is two exchange business days prior to the initial valuation date Default settlement method: cash settlement
Physical settlement	Applicable
Physical settlement payment date	The date that falls one settlement cycle following the initial valuation date
Cash settlement	Applicable
Settlement currency	USD
Final price	In respect of each valuation date, the volume-weighted average price per share (net of taxes and commissions) at which Party B (Gigabank) unwinds its hedge positions with respect to this transaction during the unwind period on such valuation date
Unwind period	A period commencing on, and including, the initial valuation date and consisting of the number of consecutive exchange business days that Party B (Gigabank) in consultation with Party A (Oil SPE) determines to be necessary to unwind its hedge position on a best effort basis with respect to this transaction Each day of the unwind period is deemed to be a valuation date
Cash settlement payment date	The date that falls one settlement cycle following the valuation date
Prepayment fee	An amount in USD calculated by the calculation agent (Gigabank) following the formula below: 1% × Early unwind amount Early unwind amount is the product of (a) the number of shares subject to such early unwind and (b) the initial price The prepayment fee shall be payable by Party A (Oil SPE) to Party B (Gigabank) on the physical settlement date or the last cash settlement payment date relating to the early unwind

Interim Exchange Part

The interim exchange part of the equity swap contained the margin call mechanism. Remember that the objective of this credit enhancement tool was to preserve the LTV of the equity financing. The functioning of the margin call mechanism was explained in the previous case study of this chapter. The interim exchange part also contained the additional 16.15 million XYZ shares that Oil SPE posted as collateral to the transaction, so the initial LTV was 65%:

Total Return Equity Swap Terms – Interim Exchange Part
Interim exchange
Party A interim exchange amount	If, on a collateral valuation date, the LTV ratio is greater than the LTV margin level (70%), Party A (Oil SPE) shall pay to Party B (Gigabank), on the first business day following such date, the required cash margin amount
Party B interim exchange amount	If, during three consecutive collateral valuation dates, the LTV ratio is lower than the LTV release level (65%), Party B (Gigabank) shall pay to Party A (Oil SPE), on the first business day following such date, the absolute value of the required cash margin amount
LTV ratio	In respect of each collateral valuation date, the number expressed as a percentage equal to (i) divided by (ii), with: (i) the result of (a) the equity notional amount minus (b) the cash collateral amount (ii) the market value of the shares
Required cash margin amount	In respect of each collateral valuation date, an amount in USD equal to: (i) the equity notional amount minus (ii) the cash collateral amount minus (iii) (a) the LTV reset level multiplied by (b) the market value of the shares
LTV margin level	70%
LTV reset level	65%
LTV release level	60%
Market value of the shares	In respect of each collateral valuation date, (i) multiplied by (ii), with: (i) the sum of (a) the number of shares and (b) the number of additional shares (ii) the closing price per share on the exchange on the exchange business day immediately preceding such collateral valuation date, as determined by the calculation agent
Exchange	New York Stock Exchange
Additional share collateral	On the effective date, Party A (Oil SPE) shall post 16.15 million shares (the “number of additional shares”) of XYZ as collateral in favor of Party B (Gigabank) The additional share collateral would be released in accordance with the reduction in the number of shares
Collateral valuation dates	Each exchange business day from, and including, the effective date to, and including, the final initial valuation date
Cash collateral amount	From the effective date, an amount in USD equal to the aggregate Party A interim exchange amounts minus the aggregate Party B interim exchange amounts

Final Exchange

The final exchange part of the equity swap made sure that Gigabank returned to Oil SPE the cash margin posted at the end of the life of the transaction:

Total Return Equity Swap Terms – Final Exchange Part
Final exchange
Party B final exchange amount	On the physical settlement date or cash settlement date relating to the final initial valuation date, as appropriate, Party B (Gigabank) shall pay to Party A (Oil SPE) a USD amount equal to the cash collateral amount

Other Parts of the Equity Swap

The equity swap also included, among other terms, the early termination events and events of default that were described in the previous case study of this chapter. I have avoided repeating them for simplicity:

Total Return Equity Swap Terms – Other Parts
Other
Calculation agent	Gigabank
Early termination events	Deal specific (same as in the previous case)
Events of default	Customary plus deal specific (same as in the previous case)

9.2.3 Equity Swap Flows

At inception of the transaction the following steps took place simultaneously (see Figure 9.5):

During the life of the equity swap, the following flows were exchanged (see Figure 9.6):

At maturity and at each early unwind, Oil SPE could choose between physical and cash settlement. If Oil SPE was willing to buy back the shares, it would elect physical settlement. Conversely, if Oil SPE was unwilling to continue participating in XYZ's stock price behavior, it would elect cash settlement.

In case Oil SPE chose physical settlement, assuming for simplicity no early unwinds over the term of the transaction, the flows were the following (see Figure 9.7):

Alternatively, in case Oil SPE chose cash settlement, assuming no early unwinds over the term of the transaction, the flows were the following (see Figure 9.8):

9.2.4 Advantages and Weaknesses

There are several advantages of the “sale plus equity swap” strategy:

There are several weaknesses of the “sale plus equity swap” strategy:

9.3 PREPAID FORWARD + EQUITY SWAP + PLEDGE

9.3.1 Product Description

One way to raise cash without selling the shares is to combine several derivatives into a transaction that mirrors the flows of a loan as follows:

9.3.2 Equity Derivatives Terms

Let us assume the same inputs as in the previous case, primarily:

• On 1 June 20X1, Gigabank arranged a USD 300 million structured equity financing for a special purpose entity, Oil SPE, fully owned by Oil Holding. The term of the financing was 3 years. The spread of the financing was 250 basis points.
• The financing was secured by 46.15 million shares of XYZ, representing 20% of its share capital.
• The financing was guaranteed by Oil Holding.
• The initial LTV of the financing was 65%, based on a USD 10.00 per XYZ share at the beginning of the transaction.
• A margining mechanism (see first case in this chapter).
• Early termination events and events of default (see first case in this chapter).

The counterparties to the prepaid forward and the equity swap were Oil SPE and Gigabank. Although the maturity of both equity derivatives was 3 years, Oil SPE could terminate them early, either totally or partially, at any time. Also, the transaction would terminate early upon occurrence of an early termination event. The main terms of the equity derivatives transactions are shown in the following table (the parts not detailed will be covered later):

Prepaid Forward and Equity Swap – Common Terms
Common terms
Party A	Oil SPE, guaranteed by Oil Holding
Party B	Gigabank
Trade date	29-May-20X1
Effective date	1-June-20X1
Final termination date	1-June-20X4 (i.e., 3 years after the effective date)
Termination date	A date occurring on the earlier of (i) the final termination date, (ii) the final early unwind date and (iii) the early termination date
Early unwind	Party A (Oil SPE) may terminate this transaction in full or in part on any exchange business day prior to the termination date, subject to a prepayment fee by giving four exchange business days’ notice in writing to Party B (Gigabank) of the number of shares subject to such early unwind. Party A (Oil SPE) shall also specify to Party B (Gigabank) a valuation date in respect of this early unwind. If an early unwind occurs in respect of less than all of the number of shares, the terms of the transaction shall be adjusted accordingly If, following an early unwind, the number of shares becomes zero, the valuation date for such early unwind becomes the final early unwind date
Shares	XYZ common shares
Exchange	New York Stock Exchange
Number of shares	30 million. The number of shares shall be reduced on each forward cash settlement date by the number of shares in respect of such early unwind
Initial price	USD 10.00
Underlying currency	USD
Calculation agent	Party B (Gigabank)
Prepaid forward part	To be covered later
Equity swap part	To be covered later
Other	To be covered later

Prepaid Forward Part

The prepaid forward carried out the payment of the USD 300 million financing amount to Oil SPE. This payment was defined in the “prepayment amount” term of the forward and paid on the effective date. The prepaid forward could only be cash settled. Every time that Oil SPE decided to unwind the transaction early, it had to provide a valuation date on which the early unwind became effective. At maturity, or at each early unwinding, Oil SPE partially or totally repaid the borrowed amount via the “forward cash settlement amount”. This amount was the market value of the underlying shares at the exchange closing on the valuation date. The terms of the prepaid forward are shown in the following table:

Prepaid Forward Plus Equity Swap Terms – Prepaid Forward Part
General terms
Buyer	Party B (Gigabank)
Seller	Party A (Oil SPE)
Forward price	Initial price (i.e., EUR 10.00)
Prepayment	Applicable
Prepayment amount	USD 300 million
Prepayment amount payer	Party B (Gigabank)
Prepayment date	The effective date
Equity notional amount	Number of shares × Initial price Initially USD 300 million
Cash settlement	Applicable
Settlement currency	USD
Final price	In respect of each valuation date, the price per share at the valuation time
Final valuation date	The maturity date
Valuation time	The closing time on the exchange for its regular trading session
Forward cash settlement amount	Number of shares × Final price
Forward cash settlement amount payment date	The date that falls one settlement cycle following the valuation date
Forward cash settlement amount payer	Party A (Oil SPE)

In the prepaid forward plus equity swap strategy, unlike in the sale plus equity swap strategy, there is no need to define an unwind period because Gigabank does not have to dispose of any shares following an early unwind notice.

Equity Swap Part

Let us assume that Oil SPE did not unwind the transaction early and that at maturity the shares closed at USD 17.00. According to the terms of the prepaid forward, Oil SPE had to pay USD 510 million (= 30 million shares × 17.00), the “forward cash settlement amount”. In contrast, Oil SPE only received USD 300 million at inception, the prepayment amount. Aiming to offset the difference between these two amounts of the prepaid forward, an equity swap was also part of the transaction. Let us review next each section of the equity swap part.

The Equity Amount Section of the Equity Swap

Oil SPE had the right to partially or totally unwind the transaction early, specifying in the early termination notice a valuation date on which the early unwind became effective. The equity amount part of the equity swap contained the equity swap settlement process at each early unwind, at an early termination and at the final termination of the transaction. Similarly to the prepaid forward part, at each valuation date the final price was calculated as the market value of the underlying shares at the exchange closing on the valuation date. At each early unwind, Oil SPE had to pay a 1% unwind fee calculated on the amount unwound. The terms of the equity amount section of the equity swap are shown in the following table:

Prepaid Forward Plus Equity Swap Terms – Equity Amount Section of the Equity Swap Part
Equity amount part
Equity amount payer	Party B (Gigabank)
Equity amount receiver	Party A (Oil SPE)
Equity notional amount	Number of shares × Initial price Initially USD 300 million
Settlement method election	Not applicable
Cash settlement	Applicable
Settlement currency	USD
Final price	In respect of each valuation date, the price per share at the valuation time
Final valuation date	The maturity date
Valuation time	The closing time on the exchange for its regular trading session
Cash settlement payment date	The date that falls one settlement cycle following the valuation date
Prepayment fee	An amount in USD calculated by the calculation agent (Gigabank) following the formula below: 1% × Early unwind amount The early unwind amount is the product of (a) the number of shares subject to such early unwind and (b) the initial price The prepayment fee shall be payable by Party A (Oil SPE) to Party B (Gigabank) on the cash settlement payment date relating to the early unwind

Floating Amount Part

The floating amount part of the equity swap contained the interest to be paid periodically by Oil SPE during the life of the equity swap. This part represented the interest to be paid on the loaned USD 300 million. Oil SPE paid quarterly USD Libor 3-month plus 250 basis points, calculated initially on the USD 300 million notional. After a partial termination of the equity swap took place, Oil SPE paid interest on the outstanding notional amount only:

Prepaid Forward Plus Equity Swap Terms – Floating Amount Section of the Equity Swap Part
Floating amount part
Floating amount payer	Party A (Oil SPE)
Notional amount	The time-weighted average equity notional amount from, and including, the previous floating amount payment date to, and excluding, the floating amount payment date
Payment dates	At the end of each quarter The last payment day is the day that falls one settlement cycle following the final valuation date
Floating rate option	USD Libor fixed on the second local business day preceding the last floating amount payment date. The floating rate for the initial period would be determined two local business days prior to the effective date
Designated maturity	3 months
Spread	Plus 250 bps (2.50%)
Floating rate day count fraction	Actual/360

The Dividend Part

In contrast with the “sale plus equity swap” strategy, under the “prepaid forward plus equity swap plus pledge” strategy Oil SPE remained the owner of the underlying shares. Therefore, the equity swap did not have a dividend part as Oil SPE received directly the dividends distributed to the shares.

Interim Exchange Part

The interim exchange part of the equity swap contained the margin call mechanism. Remember that the objective of this credit enhancement tool was to preserve the LTV of the equity financing. The functioning of the margin call mechanism was explained in the first case study of this chapter. The terms of the interim exchange part of the equity swap were almost identical to that of the previous “sale plus equity swap” strategy:

Prepaid Forward Plus Equity Swap Terms – Interim Exchange Section of the Equity Swap Part
Interim exchange
Party A interim exchange amount	If, on a collateral valuation date, the LTV ratio is greater than the LTV margin level (70%), Party A (Oil SPE) shall pay to Party B (Gigabank), on the first business day following such date, the required cash margin amount
Party B interim exchange amount	If, during three consecutive collateral valuation dates, the LTV ratio is lower than the LTV release level (65%), Party B (Gigabank) shall pay to Party A (Oil SPE), on the first business day following such date, the absolute value of the required cash margin amount
LTV ratio	In respect of each collateral valuation date, the number expressed as a percentage equal to (i) divided by (ii), with: (i) (a) the equity notional amount minus (b) the cash collateral amount (ii) the market value of the pledged shares
Required cash margin amount	In respect of each collateral valuation date, an amount in USD equal to: (i) the equity notional amount minus (ii) the cash collateral amount minus (iii) (a) the LTV reset level multiplied by (b) the market value of the shares
LTV margin level	70%
LTV reset level	65%
LTV release level	60%
Market value of the shares	In respect of each collateral valuation date, (i) multiplied by (ii): (i) the number of pledged shares (ii) the closing price per share on the exchange on the exchange business day immediately preceding such collateral valuation date, as determined by the calculation agent
Exchange	New York Stock Exchange
Share collateral	On the effective date, Party A (Oil SPE) shall pledge 46.15 million shares (the “number of pledged shares”) of XYZ in favor of Party B (Gigabank) The share collateral would be released in accordance with the reduction in the number of shares
Collateral valuation dates	Each exchange business day from, and including, the effective date to, and including, the termination date
Cash collateral amount	From the effective date, an amount in USD equal to the aggregate Party A interim exchange amounts minus the aggregate Party B interim exchange amounts

Final Exchange

The final exchange part of the equity swap made sure that Gigabank would return to Oil SPE at maturity of the transaction the cash margin posted. The terms of the interim exchange part of the equity swap were very similar to those of the previous “sale plus equity swap” strategy:

Prepaid Forward Plus Equity Swap Terms – Final Exchange Section of the Equity Swap Part
Final exchange
Party B final exchange amount	On the termination date, Party B (Gigabank) shall pay to Party A (Oil SPE) a USD amount equal to the cash collateral amount

Other Parts

The equity swap also included, among other terms, the early termination events and events of default that were described in the first case study of this chapter. I have avoided repeating them for simplicity:

Total Return Equity Swap Terms – Other Parts
Other
Early termination events	Deal specific (same as in the “equity collateralized bond” case). The date that the early termination event is triggered becomes the early termination date
Events of default	Customary plus deal specific (same as in the “equity collateralized bond” case)

9.3.3 Transaction Flows

At inception of the transaction the following steps took place simultaneously (see Figure 9.9):

During the life of the equity swap, the following flows were exchanged (see Figure 9.10):

At maturity of the prepaid forward and the equity swap the following flows took place, assuming that no early unwinds took place during the life of the transaction (see Figure 9.11):

As an example, let us assume that there were no early terminations and that at maturity XYZ's share price, the final price, was USD 8.00. Remember that the initial price of the shares was USD 10.00 and the initial number of shares was 30 million:

• Under the prepaid forward, the forward cash settlement amount was USD 240 million (= 30 million × 8.00), to be paid by Oil SPE to Gigabank.
• Under the equity swap, the absolute value of the cash settlement amount was USD 60 million [= 30 million × (10.00 – 8.00)], to be paid by Oil SPE to Gigabank.
• Therefore, the net amount paid by Oil SPE to Gigabank at maturity was USD 300 million (= 240 million + 60 million), the financing amount.

Now, let us assume that at maturity XYZ's share price, the final price, was USD 14.00. Remember that the initial price of the shares was USD 10.00 and the number of shares was 30 million:

• Under the prepaid forward, the forward cash settlement amount was USD 420 million (= 30 million × 14.00), to be paid by Oil SPE to Gigabank.
• Under the equity swap, the cash settlement amount was USD 120 million [= 30 million × (14.00 – 8.00)], to be paid by Gigabank to Oil SPE.
• Therefore, the net amount paid by Oil SPE to Gigabank at maturity was USD 300 million (= 420 million – 120 million), the financing amount.

9.3.4 Advantages and Weaknesses

There are several advantages of the prepaid forward + equity swap solution:

There are several weaknesses of the prepaid forward + equity swap solution:

9.4 REPO FINANCING

9.4.1 Product Description

One way to implement an equity financing is to enter into a repo financing. A repo is not a derivative because it is not treated as an independent asset whose value is derived from another asset. The repo financing structure allows the lender to buy the shares, having title to them, allowing its possession in the event of default. Thus, this solution circumvents issues surrounding enforcement of the pledge.

In our case the transaction would be implemented as follows:

One of the consequences of the transfer of title of the XYZ shares is that the voting rights attached to the shares are passed to Gigabank. Thus, the repo agreement should provide that Gigabank must exercise these voting rights in accordance with Oil SPE's directions.

One of the main advantages of the “repo” financing relative to other types of financing is that Gigabank can lend the shares in the stock lending market, obtaining an extra yield. Gigabank can share the lending fee with Oil SPE, resulting in a lower spread.

9.5 STOCK LOAN FINANCING

9.5.1 Product Description

One way to implement an equity financing is to enter into a stock loan agreement. The structure of a stock loan is very similar to that of a repo financing. A stock loan is a transaction in which securities are transferred by one party to another in return for an undertaking to redeliver equivalent securities (i.e., the same number of shares of the same issuer) at a future date. A stock loan is not a derivative because it is not treated as an independent asset whose value is derived from another asset. The mechanism is unlike a pledge, where title does not pass and further, under which the lender therefore has no right to borrow the shares. The stock lending structure allows the lender therefore:

In our case the transaction would be implemented as follows:

One of the consequences of the transfer of title of the XYZ shares is that the voting rights attached to the shares are passed to Gigabank. Thus, the stock loan agreement should provide that Gigabank must exercise these voting rights in accordance with Oil SPE's directions.

One of the main advantages of the “stock loan” financing relative to other types of financing is that Gigabank can lend the shares in the stock lending market, obtaining an extra yield. Gigabank can share the lending fee with Oil SPE, resulting in a lower spread.

9.6 PUT FINANCING

A risk-controlled way of raising financing on the back of an equity stake is for an investor to purchase a put option and, on the back of the put option, raise financing from a bank. The major weakness of both the previously covered equity financing strategies is the margin call mechanism. As the stock price drops, the borrower is required to post collateral commonly in cash. Another weakness of these equity financing strategies is that the LTV cannot be very high, to protect the lender. Because under a put financing the bank's financing is fully, or almost fully, protected, the amount of the loan can be set close to the strike of the put option, allowing a higher LTV than other strategies. Also, this strategy requires no cash margining. The main problem of the put financing strategy is that the borrower has to acquire the put, which can be very costly if the volatility of the underlying stock is high and/or the term of the financing is long.

9.6.1 Product Description

In order to describe the mechanics of a put financing, let us take our previous example in which Oil SPE was looking to raise financing collateralized by a pledge of 46.15 million XYZ shares, which were worth USD 461.50 million. Levels of 3-year European puts on XYZ shares were the following, assuming the 3-year USD swap rate at 4% and a dividend yield of 3%:

Let us assume that due to the almost full mitigation of the counterparty credit risk, the put financing spread was 120 basis points (instead of the 250 basis points spread in our previous cases). If Oil SPE would be paying the interest quarterly, and Gigabank believed that the highest level that USD Libor 3-month could reach was 10% during the next 3 years, the maximum exposure to Oil SPE due to the interest payments was 2.8% [= (10% + 1.2%)/4]. Thus, Gigabank was willing to finance Oil SPE at a level equal to the strike of the put minus 2.8%.

Let us assume further that Oil SPE was willing to buy the 90% put, paying USD 50.8 million. Gigabank would then be willing to provide financing for 87.2% (= 90% – 2.8%) of the value of the stock. Thus, Oil SPE raised USD 402.4 million (= 87.2% × 461.50 million). Because Oil SPE had to pay the put premium, the net amount raised was USD 351.6 million (= 402.4 million – 50.8 million).

The flows at inception were the following:

The flows during the life of the transaction were the following:

At maturity, if XYZ's share price was greater than, or equal to, the USD 9.00 strike price, Oil SPE would not exercise the put. Oil SPE would repay the USD 402.4 million loan. To repay this amount, Oil SPE could sell a part of its XYZ shares onto the open market.

At maturity, if XYZ's share price was below the USD 9.00 strike price, the put would be exercised. Oil SPE could choose between physical and cash settlement:

• If Oil SPE chose physical settlement, Oil SPE would deliver to Gigabank the pledged 46.15 million XYZ shares, receiving the USD 415.4 million (= 46.15 million × 9.00) strike amount. Oil SPE would repay the USD 402.4 million loan. Gigabank would net the strike amount and the loan redemption amount, paying USD 13 million (= 415.4 million – 402.4 million) to Oil SPE.
• If Oil SPE chose cash settlement, Gigabank would sell the underlying shares onto the market, at an average share price (the final price). Oil SPE would receive the put cash settlement amount [i.e., 46.15 million shares × (9.00 – final price)]. Oil SPE would repay the USD 402.4 million loan. The put cash settlement amount would be netted with the loan redemption amount.

9.6.2 Advantages and Weaknesses

There are several advantages of the put financing strategy:

There are several weaknesses of the put financing strategy:

9.7 COLLARED FINANCING

The major weakness of the put financing is the substantial premium to be paid to purchase the put option. An alternative is to simultaneously sell a call option to reduce the overall premium. A financing that includes a call and a put is called a collared financing. The inclusion of the call limits the upside participation in the underlying equity stake. Nonetheless, the investment could still earn an attractive return due to the potential high leverage of the strategy. This strategy is particularly attractive to investors that are looking to put in place a highly leveraged investment in a stock with a high dividend yield.

9.7.1 Product Description

Let us assume that Oil SPE entered into an 80%/119% collared financing. Following the reasoning described in the previous “put financing” strategy, Gigabank was willing to provide a 3-year loan with an amount up to the put strike minus 2.8%. Therefore, the notional amount of the loan was USD 356.3 million [= 461.5 million × (80% – 2.8%)].

The flows at inception were the following:

The flows during the life of the transaction were the following:

At maturity, Oil SPE could choose between physical and cash settlement upon exercise of any of the two options. If Oil SPE elected physical settlement:

• If XYZ's share price was greater than the USD 11.90 call strike price, Oil SPE would deliver 46.15 million XYZ shares in exchange for USD 549.2 million (= 46.15 million × 11.90). Oil SPE would repay the USD 356.3 million loan. Both amounts would be netted, realizing Oil SPE a profit of USD 192.9 million (= 549.2 million – 356.3 million). Gigabank would return the borrowed XYZ shares.
• If XYZ's share was lower than the USD 8.00 put strike price, Oil SPE would deliver to Gigabank the pledged 46.15 million XYZ shares, receiving USD 369.2 million (= 46.15 million × 8.00) strike amount. Oil SPE would repay the USD 356.3 million loan. Gigabank would net the strike amount and the loan redemption amount, paying USD 12.9 million (= 369.2 million – 356.3 million) to Oil SPE. Gigabank would return the borrowed XYZ shares.

If Oil SPE elected cash settlement:

• If XYZ's share price was greater than the USD 11.90 call strike price, Oil SPE would pay to Gigabank the appreciation of the XYZ shares above the USD 11.90 call strike price. For example, if XYZ's stock price was USD 13.00, Oil SPE would pay to Gigabank USD 50.8 million [= 46.15 million × (13.00 – 11.90)]. Also, Oil SPE would repay the USD 356.3 million loan. Gigabank would return the borrowed XYZ shares.
• If XYZ's share was lower than the USD 8.00 put strike price, Oil SPE would receive from Gigabank the depreciation of XYZ shares below the USD 8.00 put strike price. For example, if XYZ's stock price was USD 6.00, Oil SPE would receive from Gigabank USD 92.3 million [= 46.15 million × (8.00 – 6.00)]. Also, Oil SPE would repay the USD 356.2 million loan. These two amounts would be netted. Gigabank would return the borrowed XYZ shares.

If no option were exercised because XYZ's share was lower than, or equal to, the USD 11.90 call strike price and greater than, or equal to, the USD 8.00 put strike price, Oil SPE would repay the USD 356.2 million loan. In theory, the delta of the collar in this scenario would be zero, so Gigabank already returned any borrowed XYZ shares.

9.7.2 Advantages and Weaknesses

There are several advantages of the collared financing strategy:

There are several weaknesses of the collared financing strategy:

9.8 REVOLVING MARGIN LOAN FACILITIES

The most common equity financing strategy is a margin loan, also called a Lombard loan. In this section I will walk through a margin loan. All the cases we covered previously in this chapter included term financings. In a term financing, the borrower draws down the full amount of the financing immediately and repays the loan at maturity (or at an early unwind). In our previous cases, Oil SPE already had the XYZ shares and drew the total financing amount at inception.

If an investor is looking to quickly benefit from a sudden and sharp fall of a stock, a term loan may not be the best solution as it typically takes several weeks to put in place, especially if it needs to be syndicated. An investor may prefer instead to have an available financing so he/she can quickly acquire a block of shares. This type of financing is called a revolving credit facility. In a revolving credit facility, the borrower can draw from the facility up to the full amount of the facility and, once the borrower repays, the limit is reset (hence the term revolving).

9.8.1 Case Study: Oil SPE's Revolving Margin Loan Facility

Let us assume that Oil SPE signed with Gigabank a revolving facility to finance up to USD 1 billion acquisitions in listed oil companies in Europe and the USA. The facility had a maturity of three years and could be drawn in multiple drawdowns of USD 10 million, with a minimum amount of USD 100 million per drawdown. The terms of the loan facility were as follows:

Oil SPE's Revolving Margin Loan Facility Terms
Borrower	Oil SPE, a wholly owned subsidiary of Oil Holding
Guarantor	Oil Holding
Lender	Gigabank
Facility type	Secured revolving loan facility
Facility amount	USD 1 billion
Signing date	1-June-20X1
Ranking	The facility is a senior secured obligation of the borrower and the guarantor
Availability period	The period from and including the signing date to and excluding the final maturity
Final maturity	1-June-20X4 (i.e., 3 years from the signing date)
Revolving facility	Any part of the facility which is repaid is available to be re-borrowed during the availability period
Drawdowns	The borrower may draw down the facility amount in multiple drawdowns, subject to a minimum amount of USD 100 million per drawing, to be drawn in multiples of USD 10 million
Final repayment	Bullet repayment at the final maturity
Facility agent	Gigabank
Other terms	To be covered below

Let us take a look at the interest and fees to be paid by Oil SPE under the facility. The fees were the following:

• An upfront fee calculated on the facility amount. The upfront fee is commonly payable at funding and its size depends on the size and complexity of the deal. If the deal is syndicated, the distribution of the upfront fee is by tier in the syndicate. Allocation of the fee is a function of size of commitment, with the bookrunners receiving a larger proportion. In our case the upfront fee was 0.80% of the USD 1 billion facility amount.
• An interest of USD Libor 3-month plus 250 basis points, calculated on the drawn amount at the start of the quarterly interest period. Any drawdowns taking place during the quarterly period also accrued interest calculated using the interpolated USD Libor rate from the drawdown date to the end of the quarterly period plus the 250 basis points spread. Therefore, any amounts returned during the quarterly period were not deducted from the interest calculation.
• A commitment fee of 1% calculated on the unused portion of the facility during the quarterly period. To be consistent with the calculation of the interest, any drawdowns taking place during the quarterly period were also deducted from the calculation of the commitment fee from the drawdown date to the end of the quarterly interest period.
• In other financings there might also be an administrative agent fee, which is a predetermined annual fee paid to the administrative agent or the bank that has the role of administering all of the interest and principal payments, and monitoring the loan post-issue.
• Also in other financings there might be a structuring fee, paid to the lead bank for structuring a complex facility.

Oil SPE's Revolving Margin Loan Facility Terms (Continuation)
Upfront fee	0.80% of the facility amount, to be paid on the signing date
Interest	USD Libor 3m + spread, paid quarterly, and calculated on the drawn amount at the beginning of the interest period Spread: + 250 bps In the event of any further drawing that occurs during an ongoing interest period, the interest period for such additional drawing shall be the period from such drawing to the end of such interest period and its interest rate shall be the relevant interpolated USD Libor rate
Commitment fee	An annual 1%, paid quarterly, calculated on the unutilized portion of the facility at the beginning of the interest period In the event of any further drawing that occurs during an ongoing interest period, the commitment fee for such additional drawing from the drawing date to the end of such interest period shall be deducted from the calculation of the commitment fee

Next, let us take a look at the facility's collateral. This was the most complex part of the financing terms. The transaction was secured by a combination of cash and common shares (the “secured collateral”). The borrower could change the composition of the secured collateral up to six times per quarter. Upon borrower default, the lender will seize the secured collateral and immediately liquidate it. The lender imposed some requirements on the composition of the collateral to facilitate its orderly and quick disposal. In our financing, limitations were set on any stock added to the secured collateral:

• Market capitalization: the stock had to have a market capitalization of at least USD 10 billion.
• Membership of a major stock index: the stock had to be a member of a major stock index.
• Diversification: the stock could not represent more than 20% of the collateral.
• Liquidity: the stock added could not represent more than three daily trading days.

In this financing, any stock added to the secured collateral had to comply with all the requirements. However, it allowed the added stock to miss either the diversification or the liquidity requirements.

Other financings may include other requirements, for example a maximum percentage of the share capital of the stock, to preclude an obligation to launch a public offer. Other restrictions may set a maximum percentage of the free float of the stock.

Oil SPE's Revolving Margin Loan Facility Terms (Continuation)
Reshuffle	The borrower has the right to change the composition (a “reshuffle”) of the secured collateral at any time during the availability period, by providing a reshuffle notice to the facility agent. Any common shares added to the secured collateral shall take the form of eligible collateral The borrower cannot execute more than six reshuffles per interest period
Secured collateral	Secured collateral shall take the form of common shares as well as any cash collateral posted by the borrower, and must at all times be sufficient to meet the covenants and the margin requirements set out herein
	Secured collateral shall be subject to legally enforceable security for the benefit of and in a form satisfactory to the facility agent and shall be held in a secured account with the custodian in a jurisdiction acceptable to the facility agent
Eligible collateral	Eligible collateral shall mean any common shares subject to the following requirements: (i) each issuer of the common shares should have a market capitalization of at least USD 10 billion equivalent on the day immediately preceding the date such equity security is added to the secured collateral; and (ii) each issuer of the common shares should be a member of the Bloomberg World Energy Index (Bloomberg code BWENRS) and of one of the following indices on the date such security is added to the secured collateral: Dow Jones EuroStoxx50 Index S&P 500 Index FTSE 100 Index Nikkei 225 Index Hang Seng Index and (iii) either the conditions (a) or (b): (a) the market value of the common shares of the same issuer shall not constitute more than 20% of the market value of the secured collateral on the date such security is added to the secured collateral (b) the number of shares of the same issuer shall not constitute more than three times the average daily trading volume of the shares, as determined by the facility agent, during the 90 exchange trading days preceding the date such security is added to the secured collateral.

A major problem with this financing was the requirement of any stock in the collateral to be in the oil and gas industry. This requirement could result in a high correlation between the stocks in the collateral pool. If one of the stocks had a very poor performance, it was likely that other stocks in the collateral pool also showed a weak performance, increasing the risk to the lender under the transaction. This requirement was included by the borrower to comply with its articles of association.

The transaction also had margining mechanisms and covenants. I am not going to repeat these protection mechanisms as their functioning was already covered in detail in this chapter's first case study.