Late last year, Royal Bank of Canada and the French tire maker Compagnie Financiere Michelin sought access to capital for future contingencies–in the bank’s case, to absorb severe credit losses, and in Michelin’s, to fund future acquisitions or expansions. Rather than access capital from the debt or equity markets, they opted for a new insurance strategy called committed long-term capital solutions, or CLOCS. According to Peter Currie, CFO and a vice chairman of the Toronto-based bank, the move allows the institution “to tap capital in those times when it normally would be difficult and costly to raise it traditionally.”
The policies, marketed by Swiss Re New Markets, a division of Zurich- based Swiss Re Group, are triggered by economic metrics–a fall in a country’s gross domestic product in Michelin’s case, or a reduction in reserves in the Royal Bank of Canada’s. And because CLOCS is insurance, it neatly sidesteps the Catch 22 of customary capital-raising–when you need it most is usually when it’s most expensive. “Unfortunately, you can never guess what the cost of capital will be when the right investment opportunity arises,” says Jacques Tierny, deputy CFO of the E15 billion Michelin Group, based in Clermont Ferrand, France, and Fribourg, Switzerland. “At the same time, you don’t want to raise equity and have it sitting around on your balance sheet.” Nor, he adds, do you always want to issue debt during a recession for acquisition or expansion purposes, since it would increase your risk profile.
Together, the two CLOCS deals, which are both off-balance-sheet, represent an entirely new way of accessing contingent capital. “Essentially, you’re given standby access to money if a certain adverse event happens,” says Carl Groth, managing director of enterprise risk strategies at Willis Risk Solutions, a New Yorkbased alternative risk transfer specialist. “If the economy is doing well and you want to make an acquisition, you can go out and raise capital in the normal way. If it is doing poorly, you can trigger the insurance. And pursuing both strategies [allows] you to diversify your sources of capital.”
The deals also represent the first significant incursion by insurers into a market heretofore owned by the investment banks. In much the same way that banks are offering capital market alternatives to insurance policies, insurers are now offering insurance alternatives to traditional banking strategies. More important, says Currie, is that “CLOCS was a much less expensive option than other insurance structures or more-traditional balance-sheet-mitigation strategies.”
In Michelin’s case, the deal is structured as a 12-year, $1.1 billion subordinated capital facility that is syndicated both to insurance companies, such as Zurich-based Winterthur, and to several European banks, including lead French bank Société Générale. The new capital facility replaces Michelin’s previous 15-year, $1.1 billion junior subordinated credit facility that was arranged in 1990 by J.P. Morgan.
The capital instrument is seen as hybrid equity. It incorporates the long-term subordinated features of equity, but still allows the tax deductibility of debt. Access to it is triggered by a specified drop in GDP growth (a formula that comprises one-third U.S. GDP and two-thirds European GDP). And since Michelin’s earnings are strongly correlated with the growth in both economies, rising as new car sales translate into new tire sales, such a correlation makes sense, says Tierny. “When GDP drops, that means the business for tires will deteriorate, and we might need to draw on additional credit.”