For France Télécom, a Bitter Sweetener

Contingent value rights could cost the French telco nearly $2 billion in its acquisition of Equant.
Ian RowleyOctober 24, 2001

No one ever said publicity was cheap. But France Télécom could end up spending a small fortune on a PR exercise that was used to sweeten a recent deal.

The saga began in November last year, when the $30.3 billion (E34 billion) telecommunications company announced that it was taking a majority stake in Equant, a $1.4 billion (E1.6 billion )Dutch business which provides Internet and data services for multinational businesses. In June, the transaction was completed. Under the terms of the deal, France Télécom sold — or rather merged — its Global One data business to Equant in return for 80.6 million newly issued shares in the Dutch company. It also bought 68 million shares in Equant from the SITA Foundation, a privately held provider of communications services for airlines.

On top of that, France Télécom agreed to invest $1 billion (E1.1 billion) of cash in Equant in return for 10 million new convertible preference shares. Those shares carry voting rights and convert automatically into common shares of Equant in five years. All in, France Télécom ended up owning 54.3 percent of the new Equant group.

When the transaction was first announced, analysts were bullish about its prospects. HSBC Securities, for example, upgraded Equant’s stock from “add” to “buy” and raised its target share price from E45 to E60.

Double Whammy

One year later, however, things aren’t looking so rosy. In line with many other companies in troubled high-tech sectors, Equant’s share price has fallen to E13.

As if a two-thirds decline in Equant’s value isn’t bad enough for France Télécom, there could be worse to come: on the three-year anniversary of the deal, the French telco could face a charge of $1.8 billion (E2 billion). That’s because, as part of the deal, France Télécom sweetened its offer by issuing contingent value rights (CVRs).

The CVRs, one per outstanding common share in Equant — excluding those still held by the SITA Foundation — entitle their owners to receive, in three years, cash equal to the difference, if negative, between the average price of Equant’s shares prior to that time and E60. The amount payable on each CVR is limited to a maximum of E15, but could still stretch to a nearly $2 billion payout in June 2004.

“It’s easy to say with hindsight, but there’s a good chance they will have to pay out on the CVRs,” says one London-based telecoms analyst who declined to be named. “I think the company made a mistake.”

Experts agree that the CVRs weren’t strictly necessary. So why did France Télécom issue them? While France Télécom declined to be interviewed for this article, the answer, say outside observers, was primarily because the French telco was keen to avoid bad publicity.

Although it wanted to take a controlling stake in Equant, France Télécom was also keen to keep Equant’s independent stock listing, which meant maintaining a large free float. Under Dutch law, that was perfectly possible — although France Télécom was buying more than 50 percent of Equant, it wasn’t legally required to make a bid for the whole company as it would have been in many other European countries such as Germany or the U.K. Nonetheless, that still left plenty of minority Equant investors who could well have felt that they were being ignored, or treated badly by the Gallic Goliath. The CVRs were designed to placate them.

CVR Résumé

Luce Gendry, an investment banker at Rothschild, which advised France Télécom on its deal with Equant, says that it was important to maintain a good reputation among institutional investors — something it wouldn’t have achieved if it had ridden roughshod over Equant’s minority investors. “When you are a group like France Télécom, it’s important to take care of minority shareholders,” she says.

If France Télécom is forced to pay out a large sum on its CVRs, it won’t be the first. For example, CVRs were used in the late 1980s in the merger that created Marion Merrell Dow. That deal ultimately cost Dow Chemical, the company’s parent, more than $1 billion in 1991 when the CVRs were redeemed.

Nonetheless, while CVRs can be costly, several companies — including Allianz, BNP, and Diageo — have used the securities in recent years. France, in particular, briefly became a hotbed of CVR issuance in the late 1990s. “[CVRs] became flavor of the month and investors began to expect them,” says Mike Stevens, vice chairman of corporate finance at KPMG Consulting.

Rothschild’s Gendry notes that companies have issued CVRs for a range of reasons. Initially, she says, they were meant to encourage shareholders to exchange their shares in a target company for shares in an acquiring one, with the CVRs used to reduce the risk investors faced with the deal.

BNP, for example, offered CVRs linked to its own stock when the French bank launched a bid for Paribas in 1997. KPMG’s Stevens notes that BNP was concerned that Paribas’ shareholders would turn down their offer. “The Paribas board were saying the BNP share price wouldn’t do well in the future,” he says. “So BNP used CVRs to guarantee it.”

Another use of CVRs was demonstrated by a deal between General Mills, a U.S. food company, and Diageo, a British food and drinks group. They used CVRs in July 2000 when managers at the two companies couldn’t reach a mutually acceptable price for The Pillsbury Co., which General Mills wanted to buy from Diageo. Under the terms of the transaction, which is still — over a year later — awaiting regulatory approval in the U.S., General Mills eventually agreed to pay Diageo $10.5 billion in stock.

Included within that $10.5 billion, however, is a $642 million payment tied to a CVR. If one year after the deal’s completion, General Mills’ share price is lower than $38 — the price at the time of the deal — Diageo can keep the $642 million. But if the share price is higher, Diageo is compelled to pay back all or part of the payment depending on how much General Mills’ share price has increased.

Because of the CVR, General Mills was able to claim that it paid just $10 billion for Pillsbury, while Diageo could inform its shareholders with equal confidence that it stood to gain $10.5 billion.

“We genuinely believe that this is a way in which they could have their cake and we could eat it too,” James Lawrence, CFO at General Mills told The Wall Street Journal at the time of the deal’s announcement. “There’s no question in my mind that [without] this instrument we wouldn’t have been able to reach a deal.”

As of press time, General Mills shares are trading at $45. If the share price stays at that level, Diageo would have to refund the full $642 million.

Bankers add that another type of CVR emerged in the late 1990s. At that time, acquiring companies used CVRs to persuade investors to retain their shares. Allianz, the German insurer, for instance, offered CVRs to investors as an alternative to a cash offer in its friendly takeover of Assurances Générales de France (AGF), a French insurer, in 1997. Under French law, Allianz was legally bound to bid for all the outstanding shareholdings in AGF. Because Allianz management wanted to maintain a sizable free float, it used the CVR as an alternative to its cash offer to induce investors to keep their shares.

Not for Everyone

Nonetheless, while CVRs have proved to be a useful tool for many companies, experts agree that Europe is unlikely to see a rash of deals that use them. For one, shareholders rarely expect CVRs. Rothschild’s Gendry notes that one reason for that is because not all investors are allowed to hold them. “To a large extent, CVRs will be held by arbitrageurs or institutions that specialize in holding options instruments,” she says. “But often retail investors and some institutions are not allowed to own CVRs.”

For another, few managers — nor shareholders — are confident enough in their company’s stock performance to issue CVRs on the expectation that the share price will go up. Given what’s happened to Equant’s share price in the last year, that worry seems to be spot on.

For more in-depth coverage of financings and deals on the continent, visit CFO Europe