nao report (hc 343 1993/94): sale of the government's debt ......the privatised electricity...

NATIONAL AUDIT OFFICE

REPORTBYTHE COMPTROLLERAND AUDITORGENERAL

Sale of the Government’s Debt in British Telecommunications and the Privatised Electricity Companies

OROEREO BY THE HOUSE OF COMMONS TO BE PRINTED 13 APRIL 1994

LONDON : HMSO 343 f5.45 NET

SALE OF THE GOVERNMENTS DEBT IN BRITISH TELECOMMUNICATIONS AND THE PRIVATISED ELECTRICITY COMPANIES

This report has been prepared under Section 6 of the National Audit Act 1983 for presentation to the House of Commons in accordance with Section 9 of the Act.

John Bourn Comptroller and Auditor General

National Audit Office 6 April 1994

The Comptroller and Auditor General is the head of the National Audit Office employing some 800 staff. He, and the NAO, are totally independent of Government. He certifies the accounts of all Government departments and a wide range of other public sector bodies; and he has statutory

authority to report to Parliament on the economy, efficiency and effectiveness with which departments and other bodies have used their resources.

SALE OF THE GOVERNMENT’S DEBT IN BRITISH TELECOMMUNICATIONS AND THE PRIVATISED ELECTRICITY COMPANIES

Contents

Summary and conclusions

Part 1: Background to the sale

Part 2: Maximising net proceeds

Part 3: Achievement of other objectives

Glossary of terms 16

Appendices

1 Bonds offered for sale

2 Survey of interested parties in the sale

3 Timetable of events

Pages

1

3

4

12

18

19

20


Summary and conclusions

1 In November 1992, the Treasury sold by auction seven of the Government’s holding of 29 issues of debt securities in British Telecommunications plc (BT) and in the privatised electricity companies. The seven issues had a principal value of El,137 million. Gross proceeds totalled El,337 million.

2 The National Audit Office examined how far the Treasury achieved their objectives in the sale. The Treasury aimed to raise target proceeds in 1992-93 of El,250 million by selling part of a portfolio of debt with a combined principal value of E3,i’42 million, and set themselves the following specific objectives: to maximise net proceeds, taking account of any consequential impacts on future tax revenues and to avoid, or minimise, any adverse impacts on sales of gilts, future sales of debt and equity, and to create a perception of success.

3 This sale represented a great measure of success in a novel and complex transaction. In particular:

(a) the competitive structure devised by the Treasury enabled competition between bidders to apply across the whole portfolio of debt and, in terms of cash proceeds in 1992-93, the winning bids represented reasonable to excellent value (Part 2);

(b) the Treasury achieved the other sale objectives (Part 3).

Maximising proceeds

4 The Treasury’s broad approach to the sale was to seek to maximise the impact of competition:

[a) the chief source of competition lay in the fact that the amount the Treasury needed in proceeds (El,250 million) was so much less than the face value of their portfolio (E3,742 million): and BT and the electricity companies could be expected to want to buy back the debt (paragraphs 2.2 to 2.4);

(b) the interest of financial intermediaries in entering bids was encouraged by pre-sale publicity. The Treasury recognised that three separate forms of restructuring the debt prior to the sale could have widened its appeal to third parties. One restructuring was undertaken: the conversion of the debt from domestic to eurobond format. Following consultation with the Inland Revenue, the Treasury decided against interest rate restructuring at end-September 1992, in a process that lasted from July to end November 1992. They considered also that proceeds were more likely to be maximised if prospective buyers were allowed to bid only for full issues of BT debt, while recognising that this did not encourage direct bidding by institutional investors (paragraphs 2.5 to 2.16);

(c) the Inland Revenue’s concerns on restructuring the debt were heightened by the risk that the techniques proposed to be used might serve in other cases to facilitate tax avoidance. This is a particularly sensitive area. The National Audit Office note the careful consideration

1


given by both departments to maximising proceeds by restructuring the debt and the danger to public finances of establishing principles which could be applied in different circumstances. The Treasury had to have full regard to these concerns (paragraphs 2.8 and 2.9):

(d) the Treasury devised a fair means of comparing bids so that third party demand for BT debt could exert competitive tension on BT and on the electricity companies wishing to buy back their own debt (which could not be sold to third parties). This used a novel methodology which was published and which relied upon the use of “baseline prices” specific to each issue of debt and to bids from either issuing companies or from third parties (paragraphs 2.20 to 2.29).

5 The National Audit Office recommend that in a future sale the Treasury should:

(a) continua to work with advisers and the Inland Revenue to explore the scope for appropriate restructuring schemes;

(b) further review the scope for offering the opportunity to bid for parts of issues of BT debt in the light of market conditions and interest rates then prevailing.

6 The timing of the sale during 1992-93 was optimal, and the winning bids represented reasonable to excellent value in cash proceeds (paragraphs 2.30, 2.31 and 2.39 to 2.41 and Figures 4 and 5). The Treasury’s approach necessarily made assumptions about BT’s refinancing costs which affected the baseline price for BT’s bids and evaluation of the consequent tax benefits to the Exchequer of purchase by BT (paragraphs 2.21 and 2.22).

7 The costs of advisers in this sale, excluding VAT, amounted to E451.000, representing 0.034 per cent of gross proceeds (paragraphs 2.43 to 2.45).

Achievement of other objectives

8. The Treasury successfully met their other objectives for the sale:

(a) competition for investors’ funds between debt sold to third parties in the auction and new issues of gilt-edged securities was not discernibly affected by the debt sale, which did not therefore have a material or adverse impact on the sale of gilts (paragraphs 3.2 to 3.6);

(b) the sale was conducted in a way which sought to minimise any adverse

impact on the prospects of a successful future sale of the remaining portfolio of debt held by the Treasury in BT and the electricity generating companies, but the maturity structure of the remaining debt has shortened, making it less attractive to some potential buyers. The Treasury may therefore have to restructure some of the remaining debt to make it more attractive to the issuing companies and third parties in a future sale (paragraphs 3.7 to 3.17);

(c) the sale did not discernibly affect the prospects of a successful future sale of the remaining equity held by the Treasury in BT and the electricity generating companies (paragraphs 3.18-3.20);

(d) the sale was generally well-prepared and managed by the Treasury and created a generally favourable public perception (paragraphs 3.21 to

3.23).

2

SALE OF THE GOVERNMENT’S DEBT IN BRITISH TELECOMMUNICATIONS AND THE PRIVATlSED ELECTRICITY COMPANIES

Part 1: Background to the sale

1.1 After the privatisation of British Telecommunications plc in 1984 the Government retained a financial stake in the company in the form of holdings of fixed interest debt securities. Similar holdings were also retained in the electricity companies. Details of the debt, the principal (that is, the face value or the amount due to be repaid at maturity) of which totalled E4,879 million, are at Appendix 1.

1.2 The companies issued the debt as part of their initial capital structure at privatisation. It was done to help maximise the Government’s proceeds from the privatisations. The debt was structured in such a way as to give the Government flexibility either to hold it to maturity or to sell it back to the issuing companies or, subject to certain preemption rights in the case of the electricity debt, to third parties in future years.

1.3 In November 1992, following a period of consultation with the companies and on the advice of their financial advisers, Baring Brothers & Co Ltd [Baringsl, the Treasury sold seven of the twenty nine issues of debt which they offered for sale. The issues sold amounted to just under one-quarter of the principal value of the Government’s holdings of debt in the companies. The sale was carried out by auction, raising cash proceeds of El,337 million (Figure 11.

Figure 1: Proceeds from the sale Successful Bidder Issues Sold: Face Amount

Year Of Interest Value of Bid Maturity Rate (%) fM fM

Brifish Telecom Debt :: 2000 2002 12.25 12.25 150 170 ) 375

) Goldman Sachs 2003 12.25 160 221 IJBS Ltd 2006 12.25 229 263

Electricity Debt POWrGtXl 2005 ii.87 150 169 Scottish Hydra-Electric 2001 11.46 116 129 ScottishPower 2005 11.86 142 160

1.4

1.5

1.6

Objectives for the sale

With the aim of contributing to the achievement of a target for privatisation proceeds in 1992-93 of E&O00 million, the Treasury’s objectives for the sale were to:

[al maximise net proceeds, taking account of any consequential impacts on future tax revenues;

[b) avoid, or minimise, any adverse impact on gilt sales;

(c) avoid any adverse impact on the Government’s ability to sell in future years the debt not sold in this exercise;

[d) avoid any adverse impact on the Government’s remaining equity holdings in BT and the electricity generators;

[e] create a public perception of a well- prepared and successful transaction.

The sale was initially required to raise at least El,000 million before 1 April 1993. The target amount was increased to El,250 million just before the sale in case the privatisation of the Northern Ireland electricity industry was postponed beyond 1992-93 (as in the event occurred).

The National Audit Office examined how far the Treasury achieved their objectives for the sale. This Report is based on a review of Treasury papers, discussions with Treasury officials and Barings and the responses to a questionnaire from the National Audit Office to interested parties (Appendix 2). The National Audit Office obtained advice from Hambros Bank Limited. The National Audit Office are grateful for the assistance they have received in carrying out this study and producing their report.

Totals 1.137 1.337

Source: HM Treasurv

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SALE OF THE GOVERNMENT’S DEBT IN BRITlSH TELECOh4M”NICATIONS AND THE PRI”ATlSED ELECTRICITY COMPANIES

2.1

2.2

2.3

Part 2: Maximising net proceeds

This part of the report examines how far the Treasury were successful in achieving their objective to maximise net proceeds, taking account of any consequential impacts on future tax revenue. The National Audit Office examined whether the Treasury:

adopted an appropriate method of sale;

developed a sound means of evaluating bids:

timed the sale well;

generated adequate investor interest;

soundly evaluated bids and maximised proceeds;

effectively controlled the costs of advisers.

Method of sale

The Treasury did not need to sell the whole of the outstanding debt to meet their El,250 million target. This fact was the prime source of competitive tension which the Treasury sought to exploit. There was a strategic choice between, on the one hand, negotiating bilaterally with each issuer to sell the debt back to them, and, on the other hand, introducing competition into the sale by holding an auction. The Treasury thought that an auction would be more likely to maximise proceeds as well as provide the fairest and most transparent method of sale, and be a

basis for selecting which issues to sell.

To maximise competition in the auction, third parties could be given the opportunity of competing with BT to buy the debt. Under the terms on which the electricity companies were privatised their debt could be sold, before January-April 1993, only to the company which issued it. Thereafter, whilst sales to third parties were permitted, the issuing companies would have the right of first refusal to buy the debt at prices determined in advance and expressed as margins above the yields on comparable gilts. The Treasury decided to sell both the BT debt

2.4

2.5

2.6

and the electricity debt simultaneously as a means of bringing competition to bear on the sale of electricity debt.

There were therefore two pools of debt. One pool consisted of BT debt only and was open to bids from BT and third parties. The second pool consisted of electricity company debt, in which only the electricity company concerned could bid for its own debt. The Treasury devised a means of measuring the relative attractiveness of each bid taking into account the estimated effects on future tax revenues of the sale. To do this they calculated a “baseline price” for each issue, and they proposed to measure the attractiveness of each bid by the margin by which the bid exceeded the relevant baseline price.

The Treasury considered that two types of third parties could be expected to bid for BT debt in the salt. First, institutional investors such as pension funds and insurance companies might buy long-term debt intending to hold it to maturity. Second, financial intermediaries such as banks and brokers would also buy the debt for re-sale to institutional investors. Although the Treasury expected that intermediaries might restructure BT debt to make it more attractive to investors and aim to take a profit by so doing this did not imply that sale proceeds would be reduced substantially. The Treasury felt that intermediaries were better placed to search

out opportunities and underwrite the risks involved in re-marketing BT debt. Provided there was competition between intermediaries bidding for BT debt proceeds could actually be increased.

Method of sale: debt restructuring

The Treasury needed to consider whether the debt to be offered to third parties was in a form likely to appeal to them. Although, at the time of BT’s privatisation, the debt had been structured to facilitate sale to third parties, by 1992 two changes had occurred which made it necessary to consider restructuring:

4


Figure 2: Market interest rates and the market price of debt 1 The fixed capons applying to the debt ranged from 11.437 per cent to 12.958 per cent a year. Market interest rates at the time of the

auction were around 9 per cent a year. AS a consequence the market price of the debt was at a significant premium to face value. for example:

a) assume flO0 of debt was issued for 10 years with a fixed capon of 15 per cent a year (ie a fixed interest payment of El5 a year); if the interest rate in the market was also 15 per cent then the price of the debt would be equal to its face value (flO0) and the yield would amount to 15 per cent (ie f15 divided by f100);

b) if the market interest rate fell from 15 per cent to 10 per cent investors would be attracted to debt paying a fixed coupon of f15 a year and the market price would rise;

C) if the market price stabilises at. say, f3i the debt would now yield only 10 per cent a year. the same as the market interest rate.

2 In the example above, the f31 above the face value of El00 is known as a premium. Redemption ot premium-priced debt by an issuing company would lead to a capital loss equal to the premium. Under current tax legislation such a loss would not be allowable against an issuing company’s profits liable to corporation tax. In addition, the capital loss would have to be included in an issuing company’s profit and loss account for the year the debt was redeemed. This could result in a material fall in reported profits and earnings per share for the y&W.

Source: National Audit Office

. the development of the eurobond market 2.9 and with it a relatively standardised form of tradable corporate debt. This differed from the form of the BT debt;

. a fall in market interest rates below the coupon payable on the debt, implying that the market price of the debt would substantially exceed its face value. This premium could create tax difficulties for potential buyers, including the issuer itself (Figure 21. This point also applied to the electricity debt.

2.7 The Treasury and their advisers devoted considerable efforts to questions of restructuring the debt to make it more attractive to the market. It was also necessary to consider whether to sell full issues of the debt or whether to permit bids for parts of issues.

(a] creating debt with coupons at current rates 2.10 of interest

2.8 It was technically possible for the debt to be restructured to create issues carrying current rates of interest. Such a restructuring would have increased the principal value of the government’s holdings and overcome the tax problems associated with selling debt at substantial premia to face value. If the restructuring could be done in advance of the sale, a wider third party market could be addressed. Barings advised the Treasury that 2.11 restructuring might have yielded up to an additional G!o million in sale proceeds. Restructuring schemes were put forward by two of the issuing companies.

The Inland Revenue were concerned that the Treasury should be on their guard against schemes that appeared to them to be motivated by a desire to avoid tax or which might imply endorsement of such schemes. In the view of the Inland Revenue, the use and implicit endorsement by the Treasury of such schemes could have led to large scale avoidance by other taxpayers, wiping out any possible financial gain to the Exchequer from their use in the sale of BT debt. The Inland Revenue were also concerned the Treasury should know if proposed schemes did not, on examination, seem to work as desired. The schemes put forward by the issuers were all judged by the Inland Revenue to have suffered one or other of these disadvantages. The Treasury therefore decided not to restructure the debt in this way in advance of the sale.

(bJ offering certain full issues of BT debt in smallerpackoges The Treasury decided that all of the debt should be sold in full issues. This decision meant that many potential buyers would not be able to buy the debt directly in the auction because a single issue would be too large for them. Competition in the sale would be likely to be limited therefore to the issuers and to intermediaries. In reaching this decision, the Treasury had to judge whether such a limitation would increase or reduce proceeds.

The Treasury’s main concern about selling parts of issues was that potential bidders would fear that such an auction might result in an illiquid secondary market for particular issues, either dominated by one large purchaser or where the Treasury themselves had to retain a large part of an issue. The fear of such an outcome could deter third party

5


bidders and lead to lower bids, offsetting any gain apparently derived from addressing directly the wider market. The Treasury were also concerned that the willingness of intermediaries to bid aggressively might be reduced if they believed they would be competing directly with the same final investors to whom they would remarket the debt.

2.12 In a future sale it will again be necessary for the Treasury to assess the balance of advantage in selling debt in full issues.

2.13 Replies to a National Audit Office survey of interested parties in the sale (Appendix 2) indicated that institutions may be strongly attracted to a future sale in which the restriction to bid only for full issues was lifted. Twenty-two out of a total of 27 institutions who responded to the questionnaire highlighted the restriction on bids as a factor which influenced them not to bid and 18 stated they would consider bidding in a future auction if the restriction were lifted.

2.14 In deciding not to restructure the debt, the Treasury recognised that financial intermediaries would be presented with an opportunity to purchase and restructure BT debt into a form that would be more attractive to institutional investors. Intermediaries could restructure the debt along similar lines to those considered by the Treasury (ie creating debt with coupons at current rates of interest or by w-offering certain issues in smaller packages]. In addition, intermediaries could also split the debt into its component parts and market the cashflows of interest and principal separately or bundled together in a particular way to meet specific investor requirements. The Treasury sought to promote competition between intermediaries by highlighting in the specialist financial press prior to the sale the opportunities for restructuring the debt. Intermediaries were, however, precluded by the terms and conditions of the sale from m-offering to BT any debt they purchased.

[cl changing from domestic loan stock to eurobond format

2.15 The Treasury, having checked with the Inland Revenue that there would be no unforeseen tax implications, agreed with BT to change the debt from domestic loan stock (ie registered debt paying interest net of tax) into modern

2.16

2.17

2.18

eurobond format (ie non-registered debt paying interest gross), while keeping the coupon unchanged. This was intended to add to the market value of the debt at no cost to the Exchequer by widening the market to include those investors who traditionally prefer eurobonds to domestic loan stock.

All the BT debt held by the Treasury was subject to covenants which were nmre onerous than BT would expect to have to offer investors at the time of the sale. BT were unwilling to agree to change the debt to eurobond format unless the covenants were relaxed on all the debt, even that still to be held by the Treasury. The Treasury resisted this, believing that the covenants might give BT an incentive to bid aggressively to buy back the debt and were unwilling to extend the concession to debt not sold to third parties. Following discussions with BT, however, the Treasury agreed to relax the cwenants on BT’s entire portfolio of Government debt, in return for an underwriting commitment from BT to bid for not materially less than f750 million cash value of its bonds at no less than baseline prices calculated by the Treasury. The Treasury saw this as an important contributor to competitive tension in the auction.

Method of sale: strategic approach

The main events in the sale are shown in Appendix 3. Also shown are changes in market interest rates for gilts and a commentary on their impact on the sale. The Treasury announced their broad approach to the sale prior to discussions and negotiations with issuers. The intended auction process was explained in a press release, on 20 August 1992, which announced a consultation period

with the issuers, prior to finalising the detailed sale arrangements. The sale was of a kind never previously attempted, and the principles involved in the proposed auction were new both to the Treasury and potential bidders.

The Treasury’s main purpose in the consultation period was to persuade the issuers that the chosen approach was genuinely intended to promote competition and pricing tension, that it would work, and that it would be fair as between the different issuers and third party bidders. Because the consultation period led to a great deal of discussion of various restructuring schemes

6

SALE OF THE GOVERNMENT’S DEBT IN BRITISH TELECOMMUNICATIONS AN!, THE PRIVATISED ELECTRICITY COMPANIES

(see paragraphs 2.6-2.16 above), it took a little longer to complete than the Treasury had planned, but the result of the consultation process left the strategic approach to the sale largely unchanged.

2.19 In summary, the strategic approach to the sale was as follows:

(4

Cd

Cdl

(e)

an auction, relying for competitive tension on the large excess of debt available for sale over the amount needed to be sold by the Treasury;

a fair method, known in advance to bidders, for comparing different bids for different stocks:

enhanced tension created by the BT underwriting commitment;

encouragement to intermediaries rather than third party final investors to bid;

baseline prices for each issue announced to the issuer and, in the case of the BT issues, to pre-registered third parties.

Evaluating bids

Baseline Prices: introduction

2.20 The prime purpose of baseline prices was to provide the Treasury with a consistent means of comparing different bids for different issues made by the companies and third parties in the auction. The methodology for calculating baseline prices was made public, and they were announced to the bidders.

2.21 There were two types of baseline price. For all issues offered for sale an estimate was made of the price obtainable in the secondary market. This was the baseline adopted for third party bids for BT debt. A second baseline price was calculated for the issuing companies. This took account of the beneficial effects for the Exchequer of redemption and cancellation of debt by issuing companies. It assumed that an issuing company would finance the purchase, at a lower rate of interest, in the fixed-interest sterling bond market. As a result the continuing stream of tax deductions allowable for interest payments on the new debt would be lower than the tax deductions claimed on the original debt which was redeemed and cancelled. The Treasury’s baseline price for sale to BT was therefore lower in each case than for sale to third parties. The difference in each case between BT’s two baseline prices

2.22

2.23

2.24

2.25

2.26

was an estimate of the gain to the Exchequer of BT claiming lower tax relief on the financing costs of buying back their own debt.

The assumption that all the issuing companies would finance any purchase in the fixed- interest sterling bond market enabled the Treasury to estimate the differential impact on all bids of tax effects. In the event none of the issuing companies financed their purchases in that market, using cash reserves instead. Therefore, the eventual gain to the Exchequer from reduced tax relief to those companies may not be as assumed.

The methodology for calculating the baseline prices and their use in comparing bids was technically correct and, subject to the inevitable uncertainties surrounding the way in which companies would choose to finance their purchases, it provided a sound basis for the Treasury to select the bids which maximised value for money from the sale.

Baselines as yardsticks of value

The Treasury and their advisers saw the baseline price for each issue as a yardstick based on an estimate of fair market value rather than a reserve price. It was important that bidders should not regard the baseline prices as reserve prices, because if they did there would be the risk that they might focus on what was the minimum excess they would need to bid, rather than on the maximum they could afford.

The baselines were intended to act as yardsticks for the Treasury’s evaluation of bids for different issues and as a guide for bidders, providing an implicit floor in price terms which would increase competitive tension in the auction. The Treasury also considered that, as well as this yardstick function, the baseline prices could have a quantitative impact on bidding in the auction. If set too low, they could lead to low bidding. If set too high, they could discourage bidding and undermine the competitive process at the heart of the sale.

In the formal instructions to potential bidders the Treasury emphasised the fact that the baseline price for each issue was not a reserve price but was rather a yardstick against which bids would be measured.

7

SALE OF THE GOVERNMENT’S DEBT IN BRITISH TELECOMM”NICATIONS AND THE PRIVATISED ELECTRICITY COMPANIES

2.27

2.28

2.29

In the view of the Treasury, the participants’ acceptance of the fairness of the process required both the methodology to be established well in advance and actual baseline prices to be calculated and announced prior to bidding on the day of the auction (the baseline prices for each issue moved in response to prices in the gilts market because they were calculated as a margin above the relevant gilt). The Treasury saw this aspect of their approach as a means of encouraging highly competitive bidding by participants.

Link with the BT underwriting commitment

In negotiation with the Treasury on the underwriting commitment (paragraph 2.16), BT argued that they could not commit themselves to any bid which could be shown not to give good value to their shareholders. The Treasury therefore calculated their own estimates of BT’s maximum price, making assumptions about BT’s refinancing costs. Although these estimates showed the existence of a margin above the Treasury’s baseline and below BT’s maximum price, that margin was narrowed, during the course of the negotiation, by downward movements in market interest rates. Because the underwriting commitment would have to be given several weeks before the auction, BT argued that the commitment should be renegotiated if BT’s maximum price, calculated in the way proposed by the Treasury, should fall below the Treasury baseline price.

Competition enhancement

Because the Treasury believed that the absolute level of the baselines would affect the bidders’ psychology, and because they thought that falling market interest rates would have narrowed the margins between the issuers’ break-even prices and the Treasury’s, they accepted Barings advice that the baseline prices should be reduced slightly to enhance competition. They considered that since they expected bids well above the baseline prices such a reduction would not reduce proceeds but rather could increase them by promoting a greater degree of competition in the auction. It is impossible to assess the effect on proceeds of this adjustment to baseline prices. All the bids accepted exceeded the baseline price by more than this reduction.

2.30

2.31

2.32

2.33

2.34

Timing of the sale

The Treasury planned to complete the sale by October 1992. Because consultation with the issuers and especially negotiation with BT about the underwriting commitment ran on beyond mid-September 1992, the sale took place in November 1992. This was probably the most favourable time in 1992 to hold the sale. Since the suspension of the United Kingdom’s membership of the European Exchange Rate Mechanism on 16 September 1992, interest rates had fallen by one per cent in each of the consecutive months of September, October and November 1992. This increased the value of the existing high fixed interest debt in the auction.

The Treasury had, in fact, little scope to vary the timing of the sale. Following ministerial approval in May 1992 to prepare for the sale, they appointed their advisers in July 1992. This meant that the earliest date to complete the sale was in the Autumn. Delaying the sale until the first quarter of 1993 was also unattractive. Any unforeseen delay in a sale to be held in the first quarter of 1993, may have put at risk the aim of completing the sale before the end of the 1992-93 financial year.

Generation of interest in the sale

The sale received widespread press coverage and generated considerable interest [Figure 3). All 13 issuers and 34 third parties pre- registered for the sale. These third parties comprised: 11 UK banks and brokers: five UK institutional investors; eight North American banks; six European banks, and four Japanese banks.

This pattern of interest reflects the way the sale was structured, particularly around the sale of full tranrhes of debt. Figure 3 indicates the strength of preregistration against the potential for issuers and third parties. The strongest third party interest was shown by UK banks and brokers, North American banks and Japanese banks.

The main conclusions to be drawn from this analysis are:

. the high interest from UK banks and brokers indicates that the market thought that BT debt could offer value to UK institutional investors;

8


Fiaure 3: Generation of interest in the sale Numbers of registrants 100

90 -

80 -

70 -

UK banks UK inve?Sors European banks N American banks Japanese banks

= actual numbers registered

= potential numbers of registrants (see note)

numbers if debt restructured prior to sale (see note)

Source: National Audit Office Note: Estimates provided by Hambros Bank Limited

This figure suggests that larger numbers of prospective bidders may have been attracted to the auction if the bonds had been restructured prior to the sale. bv creatina bonds with cowons at current rates of interest or allowina bids for wt tranches of BT bonds.

l the structure of the sale was not, in reality, directly attractive to UK institutional investors (which is consistent with the Treasury’s decision to encourage maximum interest from intermediaries as a means of maximising proceeds);

. the high interest shown by North American and Japanese banks indicates that third party investors were attracted by repackaging and remarketing opportunities;

. the low interest shown by European banks, traditional placers of debt with private investors, indicates that the sale was not attractive to private investors.

Evaluation and outcome

2.35 The National Audit Office examined the way in which the Treasury evaluated the bids against their objective of maximising proceeds, taking account of any consequential impacts on future tax revenues. The Treasury fixed the baseline prices against which they would judge bids at discounts below the prices of relevant benchmark gilts at 9.30 am

on 20 November 1992 and announced winning bids later that day in accordance with the terms and conditions of the auction.

2.36 In total 30 bids, worth sane g5,800 million, were submitted by 13 bidders. BT submitted bids for each issue of their debt in the auction. Six financial intermediaries bid for BT debt and six of the electricity companies bid for their debt.

Proceeds

2.37 The cash value of the top six bids was El,050 million, which fell short of the Treasury’s El,250 million proceeds target. The Treasury then chose the next best bid enabling them to meet (and slightly exceed) their target. The winning bids raised proceeds totalling f1,337 million.

2.38 Two financial intermediaries were successful with their bids for BT debt (Figure 1). Goldman Sachs International Limited split the issue they purchased into its component parts and remarketed the cashflows of interest and principal separately to meet specific investor requirements. UBS Limited remarketed their issue in its original form but in smaller packages to institutional investors. In July

9


1993, UBS Limited restructured the remaining SlOO million into its component parts for sale in international markets and have since maintained an active market for the debt in its restructured as well as original form. The debt purchased by the issuing companies was cancelled in accordance with the terms of the auction.

2.39 All the bids accepted by the Treasury offered a premium over baseline prices. The prices of the relevant benchmark gilts set an implicit ceiling. In practice, bidders would expect to pay less for corporate debt, as in this sale, to reflect the greater risk than that attaching to gilts. In addition, the fact that the debt was valued at a premium to face value (see paragraph 2.6) could be expected to lead to a further discount. Finally, the baseline included a small allowance to enhance competitive bidding (see paragraph 2.291. This analysis provides three price bands in which the actual bids were expected to lie (Figure 4).

Figure 4: Value obtained from winning bids in the auction Price range Value from bids Number of Amount of

within price winning winning raanoe bids bids ffMl

Benchmark oilt 1 price

- t

Excellent 2 390 Less: allowance for issuing companies’ credit ratings (A) J

(A) less allowance Reasonable 5 947 for premium

,-.

price (6) (paragraph 2.6)

(8) less allowance 1 to enhance competition (C) (paragraph 2.29)

Acceptable 0 0

7 - 1~337


2.40 All the successful bids fell comfortably within the gilt price less the allowances for credit rating (A) and premium price CBI, indicating reasonable value. Two bids fell short of A by less than the allowance to enhance

Fioure 5: Bids received comoared with baseline orices

Number of bids

15

10

5

Number of bids below baseline m

3 -

t”*

2 4 ‘h% more than

cl Number of bids above baseline

Source: Final evaluation and ranking of bids prepared by &rings

This figure shows that of the 30 bids received, 23 were above baseline prices. Of these 23 bids, 13 were within 0.5 per cent above baseline prices

10


2.41

2.42

competition (Cl, the smallest of the three adjustments, indicating an outcome close to excellent. Two bids were a little above A, indicating excellent value. In terms of cash proceeds in 1992-93, the winning bids represented reasonable to excellent value. (This analysis does not take into account the tax consequences of the outcome of the auction.]

In cash terms the successful bids averaged 1.2 per cent above the baselines. The lowest winning bid was 0.9 per cent over the baseline and the highest 1.6 per cent over. Twenty three of the 30 bids were above baseline prices, including 13 bids at margins above the baselines of less than 0.5 per cent (Figure 5).

Value of debt if held to maturity

In October 1992, the Treasury advised ministers that if they sold around fl,OOO million of debt at baseline prices, the Exchequer would suffer a loss of up to f10-12 million as compared with holding the debt to maturity. Ministers approved the sale on this basis. In the event, the bids accepted were higher than baseline prices and the National Audit Office estimate the loss at around S5-6 million. This loss measures the cost to the Exchequer of the decision to sell the debt rather than holding it to maturity. As a result of the auction process, the debt issues which were sold are those where bids came closest to the value of holding the debt to maturity. In a future sale it is likely that the loss from selling at baseline prices will be proportionately higher.

2.43

2.44

2.45

Control of costs ’

Appointment of advisers

The Treasury employed three principal advisers for the sale:

Baring Brothers & Co Ltd (financial advisers]

Allen & Overy Dewe Rogerson

(legal advisers) (public relations advice]

The appointments were based primarily on the Treasury’s assessment of the quality of service offered, having regard to price. One of the advisers was not appointed on a competitive basis as they agreed to work on the terms and conditions of an existing contract (relating to the sale of the second tranche of BT shares) with the Treasury which had been awarded to them following competition.

costs of sale

The costs of advisers on the sale, excluding VAT, amounted to ?Z451,000. This represents 0.034 per cent of gross proceeds. Although the final amount paid to advisers exceeded the Treasury’s internal budget for the sale by just Over 10 per cent, costs were satisfactorily controlled. The main cost overrun was on legal fees. The Treasury attributed the additional legal costs to unforeseen complexities in the sale process, including the tax issues arising out of proposals for debt restructuring made by a number of prospective bidders.

11

SALE OF THE GOVERNMENT? DEBT IN BRITISH TELECOMMUNICATIONS AND THE PRIVATISED ELECTRICITY COMPANIES

3.1

3.2

3.3

3.4

3.5

Part 3: Achievement of other objectives

In addition to maximising net proceeds from the sale, the Treasury set themselves four further objectives. The National Audit Office have considered the extent to which each of these objectives was achieved.

Avoid or minimise any adverse impact on gilt sales

Although the capacity of the sterling bond markets is huge, the amount of funds available for investment is still finite and there is considerable competition among borrowers. The debt auction was seen by the Treasury as complementary to the wider process of funding the Public Sector Borrowing Requirement, primarily by the issue of gilt- edged securities. The Treasury’s main concern under this objective was to minimise competition for investors’ funds between debt sold to third parties in the auction and new issues of gilts.

The National Audit Office analysed influences on the market in gilts during 1992-93 to see whether the performance of new issues was dictated by external influences or whether the auction of debt had a material impact.

The National Audit Office found that:

Cal

(bl

(cl

the performance of new issues of gilts in the period August 1992 to March 1993

reflected general economic conditions: the amount of BT debt bought by third parties amounted to no more than about 18 per cent of average monthly issues of gilts in the period July to December 1992:

the volume of trading in gilts during November and December 1992 maintained general trends and there is nothing to suggest that bids for BT debt led to any degree of non-participation in the gilt market by third parties.

The National Audit Office asked the companies and third parties who had registered an interest in the auction whether they had changed their short-term position in

the gilts market as a result. All but one of the twenty companies and third parties who responded stated that the auction had not resulted in a change. The National Audit Office also asked whether the companies and third parties thought the auction had an impact on the gilts market. Out of a total of 40 respondents, 33 stated there had been no impact. Of the seven who thought there had been an impact, two viewed it as positive while five thought there may have been a negative impact.

3.6 During 1992-93 the sterling markets were undergoing a period of exceptional volatility and associated interest rate and exchange rate tensions. These factors, along with the timing and size of new issues, determined the trading performance of the gilts market.

Avoid any adverse impact on the Government’s ability to sell in future years the debt not sold in this exercise

3.7 In planning and executing the sale, the Treasury sought to take into account possible impacts on their negotiating position in a future sale. Their objective was to avoid a ccaurse of action which would make a future sale difficult to complete successfully. In examining the achievement of this objective,

the National Audit Office considered:

[al whether the debt was sold with any conditions which might limit the future negotiating position of the Treasury;

(b) the characteristics of the unsold debt:

(c) the views of the companies and third parties.

Conditions of sale

3.8 The main condition attached to the sale required the companies who redeemed their debt to cancel it immediately. This condition was designed to prevent tax planning arrangements being put in place after the auction which would reduce future tax

12


3.9

3.10

3.11

revenues. It had no effect on any future sale. The Treasury did not accept any conditions restricting their ability to make the sale.

BT negotiated a relaxation of the covenants on all of the Treasury’s portfolio of BT debt (paragraph 2.16). In agreeing to this, as part of the negotiation of BT’s underwriting commitment, the Treasury recognised that they would not have the potential lever of financial covenants on BT debt in a future sale.

Characteristics of the debt

Four of the seven tranches of debt sold were for BT. The other three tranches were redeemed by PowerGen, Scottish Hydro- Electric and ScottishPower. None of the regional electricity companies redeemed their debt. In a future sale the Treasury will be able to offer tranches of electricity debt to third parties, as long as the companies do not exercise their preemption options.

Figure 6 shows how the debt can be classified. The most easily re-marketable debt is the high quality, long-dated debt (10 years or more] which are in issues of more than ~70 million. Prior to the auction, E979 million (58 per cent) of the Treasury’s marketable portfolio was made up of this type of debt (the electricity companies’ debt has not been included as it could not be sold to third party investors). Assuming that none of the pre-emption options are exercised, the proportion of the Treasury’s portfolio which comprises long- dated debt available to be sold in future auctions is now f822 million (32%) (s400 million, or 15%, assuming full exercise of preemption rights).

Figure 6: Analysis of Government holdings of debt by maturity

Before the sale After the sale Nominal Number Nominal Number value Of value Of

tranches tranches fm fm

BT Debt Long (loyrs or more) 979 5 400 2 Medium (<lOyrs) 710 5 560 4

Electricity Debt Long 714 6 422 4 Medium 1,055 7 939 6 Tranches cfmtl 284 6 284 6

3,742 29 2,605 22

Source: Nataf,onal Audit Office

3.12

3.13

3.14

3.15

3.16

Of the remaining debt, +Z560 million (21 per cent) carries maturities of less than 10 years. Such debt is usually purchased by a mix of institutions and private investors, many of whom are domiciled outside the UK, rather than UK institutional investors. International private investors tend to buy only current coupon debt priced at around face value, which pays gross interest annually. Finally, individual issues smaller than f70 million (f284 million in total or 11 per cent) are unlikely to provide the market with adequate liquidity. It is likely, therefore, to be necessary to re-structure these issues, through amalgamation, to make them marketable.

A further consideration is the credit rating of the Treasury’s portfolio. Prior to the auction, 57 per cent of the portfolio was composed of top quality “AAA” credits. This has now fallen marginally to 54 per cent.

The portfolio of debt remaining with the Treasury and available for a future sale is not likely to be as attractive to third parties as before, due mainly to the change in maturity structure and to further reductions in interest rates. The amount of debt which could be sold to third party investors at similarly competitive prices and in a manner similar to the original auction has fallen from 58% to 15-31% of the Treasury’s portfolio.

Views of the companies and third parties

The National Audit Office asked the issuing companies and third parties if they would bid in a future sale structured in the same manner. Of the 36 responses received 23 stated they would not bid. The highest level of resistance to participation in a future auction came from third parties [just wer two-thirds of respondents stated they would not bid). Three of the seven issuers who responded stated they would not bid. The companies’ main ccmcern centred on the premium price and consequent tax and accounting implications. All the issuers who responded stated they would bid in a future auction if the premium on redemption was removed.

In response to a question to a sample of potential bidders on the reasms for not registering an interest in the auction, six of the 13 respondents stated that the maturity structure of issues on offer was a major factor and a further six cited the same reason as a minor factor for their decision. Seven out of

13

SALE OF THE GOVERNMENT’S DEBT IN BRlTlSH TELECOMMUNICATIONS AND THE PRIVATISED ELECTRICITY COMPANIES

Figure 7: Movements in BT share price during 1992-93

Share price in pence

425 425 - - Date Date of of Sale: Sale: 20 20 November November 1992 1992

400 400 - -

MV APT May JUl JUI Aw SeP act NW IJec JW Feb MX

I- BTShares ---- FTAII-Share 1

Source: Published stock market prices at end of each month

This figure shows that the BT share price generally outperformed the Financial Times All-Share Index in 1992-93, there was no discernible effect on the trend of the share price as a result of the sale.

eight third parties who responded to a further question also stated that a change in the maturity structure of the debt would cause them to consider bidding in a future sale.

3.17 The outcome of the survey shows that most of the issuing companies would again be willing to take part in a future sale.

Avoid any adverse impact on the Government’s remaining equity holdings in BT and the electricity generators

3.18 Until July 1993 the Treasury held a residual equity stake in BT and currently hold around 40 per cent of the issued share capital of PowerGen and National Power. The National Audit Office examined the trading performance of the shares of the companies on the stock market to ascertain whether the debt sale had an impact on their market value.

3.19 Because of the strength of the companies as defensive investments the shares tend to outperform the all-share index in times of

recession. The pattern is evident in the trading performance of BT shares in 1992-93 [Figure 7) and corresponds closely to performance by the electricity companies and other comparator utilities. The auction had no discernible impact on the value of the shares.

3.20 The National Audit Office asked the issuing companies and third parties whether they thought the sale might affect the Treasury’s ability to sell their remaining equity holdings in the companies. Of the 34 responses received, 28 thought the auction had no impact and five of the remaining six respondents viewed the impact as positive rather than negative.

Create a public perception of a well prepared and successful sale

3.21 Media coverage in the United Kingdom was generally favourable but mixed. The main criticisms were mainly about the complexity of the auction structure. The auction attracted little publicity overseas.

14

SALE OF THE GOVERNMENT5 DEBT IN BRITISH TELECOMMUNICATIONS AND THE PRIVATlSED ELECTRICITY COMPANIES

3.22 Barings concluded after the sale that media understanding of a future sale involving an auction would benefit from a greater emphasis on written material in addition to formal press RlWISeS.

3.23 The National Audit Office asked the companies, third parties who registered an interest in the sale, and a sample of third parties who did not register, a series of questions to establish how well the auction was administered and whether a public perception of success had been created. The results (Figure 8) are mainly positive.

Figure 8: Views of interested parties on the management of the sale

Numbers of resoondents who answered:

YES NO

Do you think that information relating to the auction was released in sufficient time to allow investors to analyse the offer? 44 0

Do you think that press releases clearly explained the terms of the auction? 39 3

Were any questions asked by you answered promptly and to your satisfaction? 33 2

Do you think the information released to pre-registrants clearly defined the terms and conditions of the auction? 24 5

Totals (per cent) 140 (93%) 10(7%)

Do you think the auction was perceived as successful in the market? 34 6


15

SALE OF THE GO”ERNMENT’S DEBT IN BRITISH TEI.ECOMMLlNlCATIONS AND THE PRIVATISED ELECTRKXTY COMPANIES

Glossary of terms

Bond

coupon

Cove”ants

Eurobond

A negotiable debt instrument. The issuer promises to pay an amount of principal in the future and a regular series of interest payments in the period until then.

Annual rate of interest payable on a bond, expressed as a percentage of its principal value.

Restrictions imposed on borrowers (eg companies) limiting their ability to take actions which might put the security of the amount borrowed at risk [eg further borrowing beyond a specified limit]. Covenants were included in the BT and electricity debt at the time of privatisation and it was within the Treasury’s power to lift the covenants if they wished to do so.

Eurobonds are long-term debt issued outside the country of the currency in which the debt is denominated and which are intended for sale in various countries. Eurobonds are therefore loans raised by international companies or other institutions in several countries at the same time. Eurobonds are issued in bearer form [ie no register is kept by the issuing company of who owns the bonds, ownership is dependent on physical possession of the bond certificate). Interest is usually paid gross rather than net of basic rate tax.

Financial intermediaries Banks and other investment houses trading in equity and debt. They link borrowers and lenders in international markets and ensure both parties can raise or invest capital quickly and easily.

Gilts

Institutional investors

Bonds issued by the UK Government

Institutions such as pension funds and life assurance companies who would buy long-term debt to finance future obligations (eg pension payments) and as an investment. Many institutional investors are exempt from UK income and capital gains taxes.

Issuers/Issuing companies The companies whose debt was offered for sale.

Market (secondary Most issues of gilts and company debt can be traded on the London and market] International Stock Exchanges. These are known as secondary markets (as opposed

to the primary market when debt is first issued and placed by a sponsoring bank with investors or intermediaries).

Principal value/Face value The amount of capital on which interest is paid over the term of the borrowing and repaid to the lender at a future date.

Restructuring An agreement between the issuer and holder of debt to vary the terms on which the debt was originally issued. For example. BT proposed that the interest rate on its debt could be reduced to then current market levels, removing the premium price and the balance of interest payments replaced by a new debt security issued to the Treasury.

Third parties Financial intermediaries and institutional investors who registered or who might have registered an interest in bidding for BT debt in the auction.

Yield Return on an investment expressed as an annual percentage rate.

16

SALE OF THE GOVERNMENT’S DEBT IN BRITISH TELECOMMUNICATIONS AN!, THE PRIVATISED ELECTRICITY COMPANIES

Yield curve A term used to describe how current interest rates vary according to the term to maturity of the debt security. When longer-term interest rates are higher than shorter-term rates, the yield curve is upward sloping (or normal, or positive). When longer-term interest rates are below shorter-term rates, the yield curve is inverse or negative. These interest rate comparisons can be shown on a graph, hence the term yield curve.

17


Appendix 1 Bonds offered for sale

Issuer Principal f million

pd Interest Maturity 0 Date

British Telecommunications

Total: British Telecommunications

National Grid

National Power PowerGen

150 150 150 350 150

Total: Electricity Generators 950

Eastern

London Manweb

Northern Norweb

Seeboard South Western

Total: Regional Electricity Companies

ScottishPOwer

Scottish Hydra-Electric

Total: Scottish Electricity Companies 516

Total Bonds Offered 3742 Pre ,997 Bonds (see note) 1137

Total Bonds Outstanding 4879

130 130 140 150 160 170 180 190 210 229

1689

59 59 70 20 37 55 77 76 54 80

567

142 142 116 116

12.50 Mar 97 12.50 Mar 96 12.50 Mar 99 12.25 Mar 00 12.25 Mar 01 12.25 Mar 02 12.25 Mar 03 12.25 Mar 04 12.25 Mar 05 12.25 Mar 06

12.958 Mar 97 12.859 Mar 01 11.437 Mar 08 12.035 Mar 98 Ii ,669 Mar 05

12.661 Sep 99 12.365 sep 08 12.661 sep 99 12.661 Sep 99 12.365 sep 08 12.661 Sep 99 12.661 sep 99 12.365 Sep 08 12.365 Sep 08 12.365 Sep 08

11.457 Mar 01 ii.856 Mar 05 il.457 Mar 01 il.856 Mar 05

Note: Further Bonds totalling f497 million in BT and f640 million in the regional electricity companies, maturing between March 1993 and March 1997, were not offered for sale as Treasury forward budgeting assumed they would be held to maturity.

18


Appendix 2 Survey of interested parties in the sale

Background 1 The National Audit Office undertook a survey of all the issuing companies, third parties who registered an interest in bidding and a sample of third parties who did not register an interest. The purpose was to:

a) assess how successfully the sale was managed by the Treasury and their advisers;

b) identify reasons for bidding, not bidding or not registering an interest;

c) obtain overall perceptions of the sale (for example, whether the auction was perceived as successful in the market].

Key results are included in parts 2 and 3 of this report

2 Following consultations with the Treasury and Hambros Bank Ltd, questionnaires were sent to all the issuing companies and 71 third parties. The overall response rate was 52 per cent. All but one of the issuing companies and 3’2 third parties responded.

19


Appendix 3 Timetable of events

Key Event Changes in Yield Curve

rune 1992

Treasury Ministers give go-ahead for sale preparations.

Short-term interest rates higher than medium and longer-term rates. Redemption of bonds by issuing companies in June 1992. financed by a new issue of fixed-interest bonds with a matching maturity date, would be less costly then using cash.

August 1992

Sale strategy agreed by Treasury. Companies given details and offered opportunity to consult Barings.

Interest rates largely unchanged from ,une 1992.

September/October 1992

September: suspension of United Kingdom’s membership of ERM (16th). Consultation period with companies completed on 18th but negotiations continue on restructuring proposals.

October: negotiations with companies finalised. Treasury Ministers approve execution phase of sale, potential bidders invited to pre- register.

Interest rates largely unchanged in immediate aftermath of suspension of ERM membership,

November 1992

Baseline prices released to companies and third parties (5th). Baseline prices recalculated and released to bidders 119th).

20th November: DAY OF AUCTION.

Successive reductions in short-term interest rates end consequent. but less marked, falls in medium and longer-term rates (since mid- September] provided incentive to issuing companies to finance redemption from cash.

December 1992

Sale proceeds received [l%h].

Interest rates largely unchanged since day of auction.

Yield At 1 June 1992

Yield I

At 10 August 1992

zj, “,,,

0 3 5 7 10 16

Yield

10% \

At 21 September 1992

7% “ears

0 3 5 7 10 16

Yield I

At 23 November 1992

‘iii dTC 0 3 5 7 10 16

I 0 3 5 7 10 16

Yield At 1.5 December 1992 I I

0 3 5 7 10 16

20

nao report (hc 343 1993/94): sale of the government's debt ......the privatised electricity...

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