What you need to know about bank preference shares

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South Africa’s adoption of the Basel III regulatory framework has presented an interesting conundrum for holders of bank preference shares.

Not only do these shares differ from ordinary preference shares, they are also being phased out under the new framework.

“The preference shares that the banks issued are unique,” Greg Saffy, founder of Cast Iron Capital, told CNBCafrica.com.

“It sits somewhere between equity and debt, it is what’s commonly known as a hybrid instrument. What makes [them] fairly special is that they were historically counted as a bank’s capital – that’s under the old Basel regime.”

The uniqueness of this type of share also comes from the fact that it is a floating rate instrument and has loss-absorbing features, thus qualifying it as hard equity.

“The importance of understanding that within a bank is that you can take that equity – preference share capital that you raised – and you can make loans against it,” Saffy explained.

“For every rand, very simply, that they raised in qualifying core tier 1 (CT1) preference shares, they’ve written advances, for example mortgages, 10 to 12 times on that – that’s the unique nature of it.”

This, however, changed when, South Africa came out with the Capital Accord – the South African bank regulators’ reaction to Basel III.

“Under there, there was a whole lot of different definitions of capital. These hybrid instruments – preference shares – under Basel III, no longer qualified as CT1 capital,” he added.

“These instruments are being phased gradually, out of the bank’s regulatory capital – it’s called ‘grandfathering’.”

According to Saffy, these instruments are now being ‘grandfathered’ at 10 per cent effectively per annum.

“In essence, what is happening is that these banks went and issued these preference shares – 22 billion rand, that’s the number that we looked at under the big 5 banks, away from Investec’s offshore,” he said.

“They marketed them to the investor, particularly the retail investor – that’s where the majority of these instruments sit – as an alternative to cash and money market instruments.”

While these preference shares were originally seen as cheap forms of equity capital by the banks, as opposed to raising capital through equity rights issues, they’ve now become expensive forms of debt.

“What’s happening is that these instruments now, through regulation, are actually becoming more expensive every year for the banks to hold,” Saffy added.

“The banks are under pressure, they’ve got to deal with them so how do you put yourself into the best position to negotiate to get the fairest outcome as a holder?”

Currently there is no obligation on the banks to redeem them, and while there are other Basel III compliant instruments that they are looking to replace these instruments with, Saffy says that that should be a separate process.

He also stated that Cast Iron Capital’s stance is very simple – the banks sold it into the market at par value and should give investors that money back.

“The way that we’ve looked at it is by way of a voting pool. What the pools allow you in essence to do is that you, as an individual, have got the power to aggregate your votes and you’ve got a say,” he said.

“If you do sign up, it gives you a much stronger negotiating position in dealing with the banks as and when they come to the market to deal with these outstanding preference shares.”

According to Saffy, to his knowledge, a public voting pool has never been launched in South Africa, and there are several ways that the banks can deal with these preference shares through the pool.

“The one way is to say at a certain price, we will redeem. Typically the mechanism which they use is the old section 311, which is a scheme of arrangements. It’s the easiest way to actually get stuff done in the corporate finance world,” he explained.

“The other way they can deal with it, like Capitec did, is they went and bought these things back in the market, which, for us, is a fair outcome.”

He cautioned that different institutions may want different outcomes and emphasised the fact that there is a need to educate shareholders and to give them the ability to aggregate their votes.

“What you’re actually doing is pre-empting it. If they know what your mandates are, it steers them to a certain course, which is designed to be fair and equitable for the holders of these instruments.”

For more information on this, you can visit www.bpref.com