The phone call sometimes comes around 2 p.m.
That’s when a large stock seller-either a corporation or, more likely, a private equity firm-will confirm to major Wall Street investment banks that it wants to effect a large overnight block trade. The possibility of such a trade may have been informally discussed within the banks’ private banking sides for a few days. Some limited due diligence has been done, but now the deal is happening.
The vehicle: a secondary offering of stock in a public company such as hospital operating company HCA Holdings or car rental outfit Hertz Global Holdings. The seller typically wants to move $1 billion or more worth of shares in such a well-known company, listed on a national exchange, after the market’s close. The seller also wants Wall Street banks to bid on the shares, in a transaction known as an overnight block trade.
Immediately, the investment banks’ syndication desks, due diligence groups and risk professionals scramble in the scant few hours remaining in the trading day.
The syndication desk will try to get a feel for which institutional investors would be potential buyers of the stock-a delicate dance, because the desk doesn’t want to tip its hand that a large block of this particular stock is coming to market. The due diligence squads will again swarm over reconnaissance material, making sure there is nothing unknown about the seller, the stock or the trade.
Now armed with full details of the size and market price of the trade, the risk pros will distill dozens of factors-everything from the size of the block compared to the stock’s outstanding float, to how close the sale is the to company’s next earnings announcement. They mix the minutiae into a brew that determines a single number: How much will a bank-or group of banks-pay the seller for the entire block?
For the banks, the trick is to keep their heads and know the fundamentals. “When you’re bidding on a block trade, you have to, one, know the story; and two, know the price levels where buyers care and you can move the stock,” said John Paci, head of cash and ETF trading for the Americas at Morgan Stanley, who has been through this drill many, many times.
A too-high bid, after all, may leave a bank with unwanted holdings. Because the bank doesn’t intend to hold onto the stock. Instead, it instantly turns around and sells the block in pieces to mutual funds and other institutional investors, usually before the market opens the next morning.
By 4:15 p.m.-just 135 minutes after the banks are given their opportunity to bid for the block-the dust is settled. Bids are in, and the issuer of the block announces which banks will get to do the deal, often pairing up rival banks that came in with similar bids. The winning banks’ trading areas then become a mecca of frenzied phone-calling, texting and emailing as traders break off pieces of the large block to resell to investors. The bank will cut the investors a slight discount on the stock’s closing price, but it will be a slightly higher price than the bank paid the issuer for the block.
By the time public markets open at 9:30 a.m. the next day, the initial block is moved, as are the resale of its pieces to asset managers.
Such is the rapid-fire buying-and-reselling of billion-dollar blocks of stock when markets are closed. Overnight block trading has surged on Wall Street, reaching almost $60 billion in the last 12 months, nearly two and a half times the amount totaled in the year-earlier period of $24.3 billion, according to data from Thomson Reuters.
For banks, profits can run around 2.3 percent of the value of each block, which range from $250 million to more than $1.5 billion each, said Jay R. Ritter, professor of finance at the University of Florida. Although this quick profit-$23 million on a $1 billion deal-is about half of what an investment bank would make by taking the issuer on the traditional path of marketing a stock offering through a weeks-long road show and book-building, it is the issuer that is driving the surge in overnight block deals.
Overnight trading is also expanding the role investment banks play in providing liquidity to these issuers. These overnight block deals have the investment banks bridging the issuers’ need for cash and the markets themselves, which might have difficulty digesting such a large block of stock if it were sold on the open market. The largest investment banks do this because they can and because it is profitable, even as it heightens the chances that an investment bank or two might get caught in the middle, if buyers cannot be lined up for the repurchase of slices of the block, or if a market event or company event happens overnight and sours investor interest.
“The overnight block trading business really exploded in early 2012, and it’s sustained itself into early 2013,” said Kevin Russell, global head of cash equity trading at Citigroup. “And it’s a trend that we think is a secular change in how both financial sponsors and corporations are going to issue equity.”
Building Blocks
While called overnight block “trades,” the practice is actually an overnight pricing of a secondary or follow-on sale of stock, in which public shares are sold by either the issuing company itself or by a large shareholder, such as a private equity firm that may have been involved in taking the company public and still owns a large piece of equity.
In February, for example, Bain Capital and KKR & Co. sold a $1.8 billion stake in hospital operating company HCA Holdings via an overnight block trade. The deal was handled through Citigroup and Barclays-the two industry leaders in terms of volume of block trades underwritten.
In another February deal, Apollo Global Management sold $1.5 billion worth of stock in LyondellBasell Industries, a chemical company, through Goldman Sachs & Co.
The current surge in overnight block trading, which tends to run in cycles, is being strongly underpinned by several market trends, including low volatility, a dearth of liquidity in the general equity market and a need on the part of both sellers and buyers to do these trades, according to several trading desk pros at the big Wall Street firms. In fact, many said they have observed that more institutional investors are making informal “reverse inquiries”-a buyers’ informal process of sniffing out any possible large block trades in the pipeline-and expressing a willingness to buy into the next transaction.
“I think that the institutional buyside-the mutual funds and hedge funds-have become much more comfortable with doing bought transactions and as being looked upon to be the other side of these trades,” said Scott Bacigalupo, head of Americas cash sales and trading at Bank of America Merrill Lynch. These are “bought” transactions because the Wall Street investment bank essentially “buys” the block first from the issuer before lining up buyers to sell it to.
This growing comfort with these deals among banks, issuers and institutional buyers, coupled with weak volume during regular trading hours, has created a perfect environment for these overnight block trades, Bacigalupo explained. “All these things led to a much more robust bought-registered type of transaction.”
In the six-month period that ended April 30, 77 block trades totaling $33.5 billion were done, more than any other six-month period in the past five years, according to Thomson Reuters. Indeed, block trading activity has grown steadily since the six-month period that ended Oct. 31, 2011, when $10.1 billion was moved in 25 block trades.
The pricing of a secondary offering of stock via the overnight, out-for-bid type of block trade also has become more popular, representing about 25 percent of all secondary offerings in 2012, up from 15 percent in 2011, according to analysis from Ipreo, a market data firm. So far this year, at least anecdotally, several block traders said they are seeing at least a third of all secondaries being done on the overnight block market.
Even though overnight bought deals have a much thinner spread, especially compared with a traditional marketed deal, there are good economic and competitive reasons for an investment bank to be pursuing this lower-margin business. “To be honest, I’d rather have 100 percent of a 1 percent spread on $1 billion deal, than a 4 percent spread on a marketed deal I have to split with six other banks,” said one block trading professional, requesting anonymity. “Plus, then I’m also not sharing the league-table credit.”
The strong market for overnight block trades has really helped the issuer class, especially the private equity firms, which are continuing to sell down holdings as the broader markets have improved, said Michael Kim, an analyst who covers the asset management industry for Sandler O’Neill. “It has helped [private equity firms] that the markets have provided this exit strategy, and as the markets continue to rally, the secondary window is going to open a lot more.”
Indeed, private equity firms were responsible for more than half the dollar value of all secondary offerings in the first quarter of this year-the highest quarterly percentage on record, according to Dealogic. Besides Bain Capital, Apollo Group and KKR, other big private equity firms tapping the overnight block trading market include Carlyle Group and Clayton, Dubilier & Rice.
Citigroup’s Russell said this current market environment is conducive to overnight block trades, leading seasoned issuers to move away from the slower-paced traditional book-building deal format whenever a block trade is feasible. “It’s a tough argument to convince sellers to take both depreciation and market risk when banks are willing to purchase the block at risk,” said Russell.
The risk, of course, comes when outside events or just market whims move against the price of the stock after the Wall Street firm has purchased it. Then, if the stock cannot be successfully placed, the Wall Street firm may end up holding it, a factor that could spell trouble for the bank’s balance sheet. For example, Barclays was left with a 12.7 percent stake in Ziggo, a Dutch cable company, in March, after the bank failed to find enough buyers for its purchased block of stock.
Despite these risks, or perhaps because of them, many trading chiefs at the top Wall Street firms said there is definitely an appetite for the potential profits that block trading brings. “There’s a willingness to do large block transactions as well as traditional marketed deals,” said Scott Lynch, managing director and head of cash trading at Credit Suisse. “But I do think the pricing of some of these blocks has gotten too narrow for the magnitude of some of these trades.”
It’s a situation that has bred cutthroat competition among the banks for a business that, despite its big numbers and heightened risks, is really a very simple practice among a known group of financiers, corporations and investors. “If it’s a private equity firm selling down another 15 percent of a stock that it has done on a regular schedule, then to Wall Street, it’s just a piece of meat to be priced,” said one big firm trader, who requested anonymity. “So, you basically have nine dogs fighting over this piece of meat, and the winner is sometimes not the winner.”
Morgan Stanley’s Paci agreed banks had to be careful when pricing the block. “If the buyside does not like the discount that you’re willing to sell it to them at, you could get stuck with a significant chunk of stock,” he said.
Tight Trades
Spreads are not always as wafer-thin as seen in some recent deals
But generally they have tightened as overnight block trading becomes more common. “Most are not that tight, but some are,” said one desk chief, who asked for anonymity. “We might bid down 5 percent, and then turn and sell it down 41/2 percent or 4 percent to buyers. Or sometimes, if it’s an illiquid stock, we could go down 9 percent, and resell it at between 5 percent and 7 percent.”
The spread in the Hertz deal that took place in March was on the low end, but still in the ballpark of other recent overnight block trades, indicating how spreads continue to narrow on these big deals. In February’s sale of HCA Holdings by Bain Capital and KKR, the discount spread was 1.8 percent; on Apollo Global’s block sale of LyondellBasell Industries, it was 1.3 percent.
And how do overnight block traders keep cool as spreads tighten and competition heats up? Discipline and doing the math, several of them said.
“We have a very, very disciplined and robust committee [that looks at potential overnight block trades],” said BofA’s Bacigalupo. “We have not only people who pontificate on the risk of doing a bought transaction, but also the due diligence around a particular transaction.”
These professionals make sure that BofA thinks about what the market looks like and the liquidity profile of the name, as well as understanding the reasons the transaction is going to take place. “So, our philosophy is to try to price things accordingly and distribute to our institutional client base,” he said.
Turning the League Tables
Often on the minds of many traders is his or her bank’s position in the block trading league tables.
As with many equity underwriting endeavors-whether IPOs, traditional secondary offerings or overnight block trades-a lot of weight is placed on the banks’ position in the rankings of those institutions that do those types of transactions. It becomes a virtuous cycle-the more business a bank does, the more attention it receives for it, and the more business that comes in the door because of that.
“If you’re at the top of it, then, guess what? It’s important,” one trader quipped.
The current league tables for block trading shows that, like many other types of business on Wall Street, it is dominated by a top coterie of investment banks, with the concentration of market share climbing, the higher you go in the rankings.
Over the trailing 12-month period that ended on April 30, Barclays and Citigroup duked it out for supremacy, with Barclays holding a slight edge, underwriting $12.4 billion worth of block trades and amassing a market share of 20.7 percent among the top 10 firms.
“Barclays is seeing quite a bit of business,” said Brian Reilly, U.S. head of equity capital markets for the firm. “We recognized several years ago that block trades would become an increasingly important way for many of our larger corporate and private equity clients to raise capital and monetize positions, so we set ourselves up internally to capitalize on that trend.”
And block trading in not a new thing for Barclays, he added, saying that blocks have been being done since the early 2000s. In 2005, Reilly explained, Lehman Brothers recognized the growing trend and moved its head of cash equity to the syndication desk to better identify coming block trades and react more quickly. “Lehman was really ahead of the game on this.”
Citigroup, in second place, has done $12.1 billion in block trading deals, and holds a 20.2 percent share of the market. The two banks, in fact, are separated by a dollar amount that would be equal to a single, small overnight block trade.
Bank of America, Goldman Sachs and Morgan Stanley round out the top five banks in block trading, with market shares of 12.8 percent, 12.5 percent and 11 percent, respectively. Based on market share, the top five banks underwrite about three-fourths of all block trades done by the top 10 banks. (Goldman Sachs declined to make anyone available for interviews for this story.)
A lot of investment banks still very much pay attention to the league tables, and if an investment bank falls off in the rankings dramatically, the bank will usually set aside a certain amount of revenue to go after league table business and get back into contention, according to several traders. This also increases the completion and the tightness of spreads in this type of transaction, because bankers have been given a mandate to get back into the game, they said.
The competition can create a risk that the banks will be exposed overnight or during the next trading day–and this risk can increase when the push to get atop the league table comes into play.
“I’ve noticed that some of the deals with the terms most attractive to the stock seller are those that get done near the end of a quarter, when the issuer can take advantage of those banks that want to buy market share,” the University of Florida’s Ritter explained.
Traders are more explicit. “Some competitors take even money just to buy league table credit,” one said, requesting anonymity.
There have been blowups-deals where the bank miscalculated the price range that large investors would be willing to pay for the stock it had purchased the night before. Or, perhaps impactful events turned sentiment against the stock or against the markets in general at the wrong time.
In Barclays’s Ziggo block deal, the miscalculation left the bank with an unwanted 12.7 percent stake in the company. The bank was bailed out of the trade days later-and spared further embarrassment and possible regulatory problems-when cable giant Liberty Global bought the stake from Barclays. A Barclays spokeswoman declined to comment on the trade.
In another example, Citigroup was reportedly was stuck with a substantial stake in Edenred, a European prepaid services company, after the bank underwrote a block trade for selling shareholder Eurazeo, a French private equity firm, according to press reports. After pricing the deal at 2.5 percent discount to Edenred’s closing price on March 5, the stock tumbled almost 5 percent the next day, leaving Citi with a stake that some ECM pros estimated at one-fourth of the block, or roughly $235 million. A Citigroup spokesman had no comment on the Edenred block trade.
“The bidding process is not an exact science, but you better be on your game,” said one block trading specialist who requested anonymity. “Because if the Street gets wind that you’re holding a position, then there’s some friendly fire out there that can come and shoot against you.”
Other blips have occurred, mostly in Europe or Asia, inadvertently fanning fears that bank overconfidence could bring a high-profile block trade disaster to U.S. shores. “Mostly these problems have been in Europe,” said the block trader. “I think the stronger equity market in the U.S., especially for large chunks of seasoned names, has bailed out some banks from some potentially bad deals.”
While obviously, no major Wall Street bank has been forced into the poorhouse by a blowup, the overnight block trading game is not for everybody.
“There are some global banks that can be in this business, and there are some that probably can’t be in this business,” said Bacigalupo, adding that it depends on risk appetites, on successes and failures, and on how you want to be perceived in the marketplace. “Eventually, the market will bear out who can and can’t be doing this type of business.”
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