The capital markets arena is a key focus of many City firms. The top spots in Chambers UK rankings are taken up the magic and silver circle firms, as well as a number of US firms. For them, capital markets and capital markets transactions are central areas of business activity. They are also increasingly important to larger commercial firms in the regions.
But what precisely are the capital markets? And why do lawyers get involved in transactions? The Student Guide thought it would be helpful for you to better understand the current state of this important area of the economy.
What are capital markets?
During our many interviews with senior sources at top City firms, we asked for a simple layman’s definition of capital markets. This is one of the responses: “The term capital market covers anything related to either the public or private sale of interests in some product – a corporation, a partnership or a loan – and the selling of interests in that product.” So, capital markets are an arena – an arena in which businesses that need an injection of cash seek out investors. Investors, meanwhile, are on the lookout for profitable businesses in which they can grow their investment. There are many ways in which this investor-lender relationship can be organised, and many ways to make money out of the process.
“The term capital market covers anything related to either the public or private sale of interests in some product – a corporation, a partnership or a loan – and the selling of interests in that product.”
The equity capital markets are the easiest to understand. They’re the world’s stock markets. Private companies raise money by listing themselves on a stock market and then selling shares in their domestic market and often internationally as well. This is known as a flotation or IPO (Initial Public Offering) and means that the company’s stock can be bought and sold by investors.
An IPO is a transformational event for a company – it changes from a private affair, run by a small group of shareholders to a public company, subject to significant regulation and to the will of its shareholders. For example, after floating Virgin, Richard Branson found having to run ‘his’ company in a way that pleased his new institutional shareholders incompatible with his entrepreneurial style of management, so he bought back the company, returning it to private status.
Following an IPO, a company and/or its shareholders can offer further stock in subsequent share offerings. For the investor, the profit on shares consists of any dividends they receive and any increase in market value of the shares. Shares pay dividends when the company is profitable – the level of the dividend being determined by directors and shareholders. Share values are not repayable by the company unless it is being wound up or operating a buyback of shares, but investors can realise their asset by selling in the market.
On the debt capital markets, borrowers/issuers – which can be companies, banks or governments – raise money by selling debt obligations (tradeable loans) to investors. These are called bonds and the investor becomes the owner of the bond. At predetermined intervals, the owner of the bond receives interest payments from the company, which can be at a fixed or floating rate, depending on the terms of the bond. The perceived credit risk of the bond (which is based broadly on the credit of the issuer, the maturity of the bond, the currency of the bond and any particular features of the bond) determines the interest rate. When the bond matures (when the duration of the loan expires), the bond owner receives back the bond’s initial value, unless the issuer has gone bankrupt or defaulted in some way. For the investor, the profit on bonds consists of the interest payments they receive and any increase in market value of the bond. If the creditworthiness of the issuer improves, the bonds will typically trade at a price of more than 100% of the issue price. Unless the issuer of the bond has defaulted, or there are specified events in the terms of the bonds, bonds are not usually payable before maturity. However, an investor can realise his asset by selling in the market (provided of course there are purchasers interested in buying the bond!). Unlike shares, bonds therefore have a secure yield. Furthermore, bonds guarantee to pay back the initial value of the loan unless the company or government runs out of money. On an insolvency of the issuer, bondholders are paid with other creditors. Shareholders only receive their share of what (if anything) is left after all other creditors are paid. With shares there is everything to play for – much to gain, but also much to lose. In normal markets, bonds are less volatile – this was not the case for many bonds during the credit crisis.
Bonds and stocks both carry with them an element of uncertainty. This uncertainty creates a desire to offset the dangers of future losses and the opportunity to place ‘bets’ on future market performance.
Bonds and stocks both carry with them an element of uncertainty. This uncertainty creates a desire to offset the dangers of future losses and the opportunity to place ‘bets’ on future market performance. Capital markets have created numerous instruments that allow investors and borrowers to protect and insure themselves against uncertain developments. Two of the most noteworthy developments on the debt capital markets since the 1980s are the use of collateralised debt obligations and the rise of the derivatives market. We’ll define derivatives shortly.
Bonds and shares are both types of securities. However, the term securitisation is most often used for the process by which loans are bundled up into a collateralised debt obligation. The most commonly securitised types of loans are mortgages. The volume of mortgage-backed securities in the US grew from $200m in 1980 to $4 trillion in 2007. Essentially, bundles of mortgage loans were sold on to other players on the capital market. The sale of these bundles of loans provided liquidity to lenders, since they received money for loans that had not yet been repaid by the original borrowers of the money. In addition, the sale of the loans freed up capital for banks. Why? Because regulators require banks to ‘post capital’ i.e. to hold cash or its equivalents equal to a percentage of all the loans it has made. This capital is expensive for banks – traditionally they make money by taking deposits and then lending this money at a higher interest rate, not by keeping money on their books. By selling the loans they were able to free up capital.
Why would an investor buy an interest in a bundle of mortgages? Because it allows them to invest in mortgage loans, which many institutional investors could not previously do because they did not have the relevant licences or did not want the hassle of dealing with individual lenders. In addition, the loans were repackaged in a way that makes them more attractive to institutional investors. By bundling the loans, the issuer could split them into ‘strips’ (called tranches) with different risk levels and pay-out dates attached to each strip.
At present, the world derivatives market is worth in excess of $500 trillion, which is over ten times the size of the entire world economy.
A derivative is a financial instrument that allows its buyer or seller to ‘bet’ on positive or insure against negative price movements of an underlying asset. Assets range from potatoes to gold to currencies. At present, the world derivatives market is worth in excess of $500 trillion, which is over ten times the size of the entire world economy. Derivatives provide businesses with opportunities to protect (hedge) themselves against future market developments. Futures, forwards, options and swaps are all types of derivates.
- Forwards are the most simple: they are bilateral agreements between two parties that one will buy a certain product from the other for a fixed price at a fixed date in the future. These can be very useful for a company that has revenues in one currency at one time of the year and has to pay for goods or services in another currency later in the year. A simple illustration is a UK ski holiday company – it typically has income in pounds sterling but costs in euros. If the value of the pound falls between the time it agrees a price for its costs and the date when holidays are booked, it can significantly affect profitability. If the company can buy a forward, it can ‘fix’ the exchange rate at the initial rate, making its business more stable.
- Futures are standardised forwards: they can be traded on the futures market.
- An option is an optional future: a buyer has the right but not the obligation to purchase or sell a certain quantity of a certain good for a certain price at a certain date in the future. Options that anticipate a rise in the price of the underlying asset are called 'call options', whereas options that anticipate a price decrease are called 'put options'.
- A swap is when two parties agree to exchange assets – at a fixed rate. Typically, swaps cover interest rate payments or currencies. This allows investors to protect themselves from fluctuations in interest rates or currency exchange rate, and more speculative investors to ‘bet’ on rates. A credit default swap (CDS) is a contract in which the buyer purchases protection against a default on a loan issued by a third party. The buyer makes a series of payments to the seller and the seller pays out if a default occurs.
“There are lots of laws which regulate the trading of loans and debts,” explained our senior City source, “like whether they are public or privately traded. Lawyers also get involved in creating the product: the packaging of loans and selling of the interests in them.”
Lawyers are key players in the transactional processes which permeate the world of capital markets. They advise debt and equity issuers and the investment banks which structures and sells the financial instruments. The role of lawyers includes advising on legal and regulatory matters, drafting documents, negotiating contracts, and working with bankers to obtain approval from various external parties such as regulators, listing agencies and rating agencies. Some transactions are straightforward (‘cookie cutter’) deals because some parties are frequently active in the market and use standard documents. Some transactions are bespoke and more complex. Junior lawyers cut their teeth on cookie-cutter deals, but as lawyers gain more experience they (hopefully) work on more specialised deals.
Legal and regulatory advice: we looked at equity capital markets above and noted that an IPO is transformatory for a company. It requires hours of lawyers’ time to ensure the company is ready to list on an exchange and take the company’s board through every step in the process. A first-time borrower in the debt capital markets also requires a lot of lawyer time to prepare it for the new transaction. Much of this type of activity is cross-border, which means considerable time needs to be spent working out how various regulations fit together and liaising with local lawyers. For example, it is not unusual for a UK firm to lead on the IPO of a Kazakh company, listed in the EU, with offerings in other jurisdictions, including in the USA. And there’s nothing cookie-cutter about all that.
When it comes to drafting documents, there are key clauses to get right, and in many cases huge volumes of documents to prepare and amend. While swap confirmations and other derivatives contracts are often short (although complex), the majority of capital markets transactions are just the opposite. The selling document for securities (a prospectus) can range from 15 pages to more than 500, and the contractual documents are not far behind. Securitisation probably tops the charts for most documentation – and therefore worst hours! At university, the longer the essay the more likely you were to stay up all night – nothing much changes when you get to a law firm.
The selling document for securities (a prospectus) can range from 15 pages to more than 500, and the contractual documents are not far behind.
Negotiating contracts is a big part of the job. There are a lot of contracts which need to be signed off by a lot of parties – and every contract is of great importance to every party. As such, negotiations can be protracted. Issuers want the best terms; investment banks need the clauses to be acceptable to their internal credit committees, and in the case of securities, they want terms that make the product optimal for selling. Investors are usually not involved in the negotiations; however, if they don’t like the way the instruments are structured, they won't buy them!
Regulatory and other approvals are a necessary step. They range from simple listing approvals for frequent bond issuers, to more time-consuming activities like a first listing approval of a securitisation of Russian credit card loans on the London Stock Exchange. Ratings agencies (like Moody's, Standard & Poor's and Fitch) also require legal advice when determining a product’s rating.
Long hours, complex contracts, demanding clients – what is the attraction? The opportunity to work with a client on a huge transaction; the sense of teamwork involved when grafting alongside people from banks, client companies and other law firms; the fun of negotiation and the buzz of finally creating a transaction that complies with all the different laws and regulations and which an investor will still want to buy.
The credit crunch
It is generally accepted that the credit crunch that precipitated the global economic slowdown was caused by the huge market for repacking (collaterisatising) American sub-prime mortgages. These bundles of mortgages were sold between banks. Because they were easy to repackage and sell, lenders could keep selling more and more of them – they seemed not to care whether the original home-owner borrowers could actually meet their monthly mortgage repayments. When it transpired that the mortgages could not actually be repaid, the assets’ worth collapsed. The re-bundled mortgages became a burden (known as toxic assets) that affected banks’ balance sheets. Banks were less able and willing to lend money as the asset side of their balance sheets had shrunk, thus leading to a liquidity crisis.
Although the crisis originates in the US, capital markets are such a global phenomenon that what followed was a true domino effect. Within weeks of the old Wall Street bank Lehman Brothers collapsing, Iceland declared bankruptcy and scores of other countries looked set to follow. The Eurozone was hardest hit, with Greece, Ireland and Portugal all receiving bail-outs from the European Central Bank. There are continuing fears of debt rates in Spain, Italy and even France. Unprecedented events have seen the US credit rating downgraded by Standard & Poor's and the future of the euro threatened, in what is now being called a 'North Atlantic debt crisis'.
This crisis clearly shows that doing business on the capital markets entails risk. Just look at the worldwide stock market slump in 2011, with exchanges seeing a 5% one-day drop, because of fears of a double-dip global recession. But this is nothing compared to the period between October 2007 and 2008, when the FTSE 100 index dropped 45% – an event which sparked the subsequent global recession. This went hand in hand with a sharp drop in new listings, especially on the Alternative Investment Market (AIM).
The global bond market grew by 5% in 2010 (making it worth $95 trillion) and the total value of bond deals that year was $6.05 trillion (an increase of nearly 40% from 2008). This is good news both for law firms advising on such deals and the economy more generally, as it means lending and borrowing on the up. This recovery is important as it shows investors have increasing confidence in corporate bonds. When that confidence evaporated in 2008-09, investors rushed to buy-up in government bonds. But since then big concerns about countries' ability to finance their debt has come to the forefront.
Major movements on the debt or equity markets are not usually felt immediately by businesses or consumers, but after a short period they can have a major effect on everything from public spending and household income to M&A deals and redundancy rates.
In a credit crisis, liquidity (the availability of money) dries up. Borrowers cannot attract new capital. This effectively stopped most new investments and hit businesses relying on short-term borrowing to finance ongoing activities. Investors also faced problems since many of their investments went down in value or became very difficult to value. Many institutional investors, such as hedge funds and pension funds, have faced their own crises.
The challenges of the credit crisis provided new business opportunities for law firms. Financial institutions, corporates and even governments needed to restructure their balance sheets, pay back governments (or other banks) and sell off business assets. Investors needed to understand the contractual terms of all the securities and derivatives they were holding. They too had to restructure. Regulatory bodies were active and their requests had to be met. Litigation ensued. All this activity has required a lot of lawyer involvement. Some of their key activities have included:
- Restructuring – this has been the lifeblood of capital markets lawyers in the wake of the crunch. All investors are acutely aware of the need for alternative ways to raise capital and the significant credit risks that they may be exposed to. Unprofitable loans, derivatives and securities need to be dropped and profitable ones picked up.
- Reorganisation of debt – this has also required significant legal advice. For example, Dubai-based developer Nakheel was in difficulty after the Dubai property market collapse. It was forced to reorganise $10.5bn worth of debt, a large part of which took the form of Islamic bonds.
- Lawyers have also been assisting companies with recapitalisations. Leveraged recapitalisations involve a company issuing bonds and using the money raised to buy back company stock.
- Market volatility leads investors to seek out new ways to shore up good returns on their investments. An increase in credit default swaps (explained above) has been one consequence.
- Another development is creativity. With the help of their lawyers, investment banks are developing novel financial instruments, many of which were pioneered in the USA. For example, catastrophe (CAT) bonds are derivatives that offer investors insurance against natural disasters, while high-yield debt (also known as junk bonds) offers high interest rates but carries a high risk of default. Allen & Overy has been involved with the development of crossover bonds, which have features of both investment-grade and junk bonds. William Hill and Stagecoach are among the companies that have issued such bonds.
- City firms also advise government institutions, such as HM Treasury and the Bank of England, on market regulation and transparency legislation. Lawyers also help investors and borrowers bring their activities in line with new regulations.
- Lenders and borrowers also want to understand what went wrong in the past. A trainee at a regional UK firm described advising a major high street bank during the financial crisis: “The bank had previously had a very loose lending policy, so we ended up having to look at every securities deal we had done for them to see if there were issues with how sensible the deal had been.”
- Lawyers have also been kept busy with rights issues. These are sales of shares to existing shareholders for a specified price within a specified time. The price offered to shareholders is typically lower than the market price, sometimes by a considerable about if the market is bad. A large number of banks have been using rights issues to raise capital – often a last resort in an industry where there should be myriad other ways of raising capital. Hence many of these issues are termed ‘rescue rights issues’.
- Disputes over defaulted loans, securities and shareholder dividends are increasingly common. Some of the most iconic cases of the recession were related to Norway’s Terra Securities scandal. This saw Norwegian municipalities lose their savings as a result of mortgage defaults in the USA. Who to blame? The Norwegian municipalities decided to blame their banks. A spate of litigation followed, some involving UK firms. Two municipalities sued their Irish bank while seven other towns sued Citigroup.
The economic crisis brought great challenges to the law firms that operate in the capital markets arena. Their key clients – the financial institutions – were hit hard. And yet the collapse of the credit bubble also provided opportunities for law firms. It a truthful cliché that those opportunities increasing lie in emerging markets rather rather than struggling Western economies. This means lawyers with a good understanding of the markets, an innovative approach and an global outlook can have a key part to play in the shaping of the new financial landscape.
This feature was first published in December 2011.