Equity derivative products are playing an important role in the restructuring of European companies and investment institutions. Goldman Sachs is better at selling them than any other firm

At the beginning of last year, Jaime Llorens Coello, head of accounting at the Caja Madrid savings bank, was handed a €1.25 billion risk management problem by his board. Back in April 1997, the bank had taken a large strategic stake in Telefonica, the Spanish telecommunications company. The stake had doubled in value, and the Caja board wanted to hedge the downside risk and lock in unrealised gains. A costless equity collar, with put options financed by the sale of call options to an investment bank counterparty, seemed a straightforward solution. But who would provide it?

“We spoke to three investment banks,” says Coello. “But my feeling was that Goldman Sachs was the right choice. The other two banks indicated that the size of the position involved would give them problems in terms of their own risk capital.” Time and again though the course of the 1990s, one got the sense that Goldman Sachs was willing to sell its global equity capital markets business harder than any other firm. Take the explosion of privatisation business, for example. Goldman’s track record made it simply impossible for civil servants from Bonn to Beijing to leave it out of the largest share sales.

The question coming into 1999, however, was whether the driven men of Goldman would slow down when the partnership went public. The Telefonica trade was the largest of 45 collar-based private transactions Goldman Sachs executed for European companies, a track record that demonstrates not only how successful the firm has been in fully integrating equity derivatives into its equity capital markets business, but also how that unified approach has maintained Goldman’s ability to eyeball risk and take it on.

There is a limit to how complex an equity derivative can be. Stock markets, and individual stocks, are often illiquid. This was certainly the case with Caja de Madrid’s Telefonica deal. The challenge for Goldman Sachs was to hedge its position without impacting the market price for the shares – no easy task in the relatively small and close-knit Spanish stock market.

In total, it took 25 trading days, from the middle of last February to the end of last March, to hedge the book; short-selling Telefonica shares borrowed from Caja de Madrid on the basis of a zero-interest cash collateral deposit. On some days, Goldman Sachs sales were equivalent to as much as 24% of the rest of the market’s volume in Telefonica stock, but at the completion of the hedge, Telefonica’s share price had only marginally underperformed the broad IBEX market index.

In addition to hedging its exposure to Telefonica without paying a premium, Caja de Madrid was able to defer capital gains tax until the maturity of the collar, which runs from three years from this month.

More and more European companies are turning to collars to manage their cross-holdings in the face of mounting pressure from institutional shareholders to realise returns from what are often long-held positions. As far as equity derivatives are concerned, most CFOs don’t want complex products, they want simple solutions to simple problems.

Perhaps more than any of its rivals, Goldman Sachs has succeeded in integrating its equity derivatives desk, headed by James Ziperski, within its equity capital markets (ECM) division, headed by Antoine Schwartz. The trading side of that business is headed by Gary Williams, who has honed Goldman Sachs as one of the leading firms in block trading of European shares over recent years. Rivals may place more emphasis on the Chinese walls between the corporate finance and trading sides of their business but, coupled, with Goldman Sachs’ appetite for risk, it’s a team that clients say has the ability to move faster on a deal than anyone else.

The ECM team is proud of the fact that its sales pitch can be over and done in 60 seconds. There are two options, they tell a CFO. Either you can do this privately with us and buy a collar – simply a form of insurance, paid for with cash or by giving us a call, which means you forego a return above a certain level. What Goldman Sachs needs to have to do the deal is enough liquidity in the stock, and the ability to borrow it.

The second option is to do the securitised version of a collar, a publicly issued mandatory convertible bond issue that guarantees the shares are sold at a certain date and also allows the bond issuer to raise cash. Often, the mandatory convertible issue has the added tax advantage that, while they hold on to their shares, their coupon payments to bondholders are tax deductible.

Another important side of the European restructuring story is what is happening at pension funds and asset managers. Girish Reddy, the Goldman partner in charge of marketing equity derivatives to institutional investors, has had as successful a year as his colleagues in the ECM division. Last year, according to Reddy, Goldman Sachs executed 23 programme trades larger than €500
million for European investment clients seeking to restructure equity portfolios, one as large as €4 billion. Derivative structures, again often involving collars, were involved in each case.

Goldman’s ability to sell equity derivative products is helped by its strength and penetration in listed options and warrants in local markets. This year, its rivals will closely follow its e-trading initiative. Six months ago Goldman Sachs bought Chicago-based Hull Group for $531m, and this looks like the sharpest bet on electronic equity trading laid by a major investment bank. Hull is a leading market-maker of exchange-traded equity derivatives as well as a market-maker in the cash equity markets.

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