ADRs and GDRs and other things just like ‘em
Intro – Investing in Companies Listed Abroad
UK-resident equities investors are spoiled for choice in their home market, with the London Stock Exchange playing host to over 2,600 publicly-traded companies. The majority are British but the LSE is also, arguably, the world’s leading exchange for the listing of securities in foreign companies.
There are two routes by which a non-UK company can offer its securities in the UK – either by a direct listing, complying in all respects with the stringent listing requirements for UK companies, or by the creation of ‘depositary receipts’, or DRs, which provide an easier route to establishing a presence on the British equities market.
In the following paragraphs, we take a look at DRs, explaining their relationship to shares and the difference between ‘American Depositary Receipts’ – ADRs – and ‘Global Depositary Receipts’ – GDRs. We’ll see that a GDR can originate in any country in the world and be otherwise known by reference to its country of issue, as for example an Indian DR, or region – a European DR. And we’ll look at both the advantages and the risks with investing in DRs versus shares.
Born in the USA
The depositary receipt started life, as with many other innovative financial products, in the United States – specifically on Wall Street. On 29 April 1927, JP Morgan – the merchant bank, not the man – issued the world’s first example of the instrument, in respect of a company whose name had become synonymous with British retailing at its best and whose shares were at the time also of great interest to American investors. That company was Selfridge & Co.
Back in the 1920s and for decades thereafter, the buying and selling of shares in listed companies was a cumbersome and entirely paper-based process, with the actual possession of paper share certificates accorded presumptive evidence of their ownership and therefore of critical importance. The settlement of a sale and purchase transaction required the movement of the certificates from seller or seller’s agent to the buyer or buyer’s agent, passing en route through the listed company’s share registry for the transfer to be recorded, or for cancellation and the issue of a new certificate. Even within the one country, the process took days and with offshore transactions, absent airmail quite apart from the Internet, weeks might be required. It made the purchase and sale of foreign shares problematic, to say the least.
DRs a ‘Mirror Image’
The answer which JP Morgan came up with was to leave the physical share certificates and register in their country of origin and to create, in effect, a mirror image in the United States. This was and remains the essence of the depositary receipt, so called because the ‘document’ acquired by a purchaser of DRs functions as a receipt for a specified number of original shares in the listed company which have been deposited with a custodian in the country of origin and which are held on behalf of the depositary, which in turn holds the interest for the DR holder.Nowadays of course, the process is almost exclusively electronic, with data strings having replaced paper share scrips, but depositary receipts have retained their functionality. An investor in the United Kingdom is able to buy and sell securities which act as proxies for shares in an foreign country, to all intents and purposes as if they were shares in a UK-incorporated company.
Key Players in DR Creation
As noted, there are three key participants in the creation of depository receipts. Firstly, the issuer – an offshore company, probably already listed on a stock exchange elsewhere in the world, seeking to raise capital in the United Kingdom via a DR listing on one of the three boards of the London Stock Exchange (the Main Board, the Professional Securities Market or the Alternative Investments Market). Then there is the depository – typically a major merchant bank which will for suitable reward fund or arrange the purchase and ‘warehousing’ of a certain quantity of the issuer’s shares in the country of origin and substitute them with DRs for supply via brokers into the target market. Finally there is the custodian, again likely to be a major bank and quite possibly related to the depository, which is based in the issuer’s country of origin and which holds the warehoused shares in effect on behalf of the holders of the associated DRs.
DRs Go Global
For a long time after that first creation of DRs, in 1927, the instrument remained a purely American invention and the NY Stock Exchange, and more recently the NASDAQ also, were the undisputed go-to places for investors seeking an equity interest in companies from outside their home territory. Globalisation changed that state of affairs in the latter part of the last century, with exchanges elsewhere in the world – notably the LSE and the Luxembourg and Frankfurt exchanges – starting to seek a piece of the DR action. And hence the attendant expansion in the terminology, so that DRs became ADRs – listed in the United States (which means primarily the NYSE and NASDAQ) – and GDRs – listed any place else around the globe. The development was in large measure prompted by growth in Emerging Markets, with the likes of India leading the way. Its first global depositary receipts programme involved Reliance Industries (LSE:RIGD) in 1992. More recently, listed banks in Nigeria – created during a period of bank consolidation – started listing GDRs on the London Stock Exchange in 2006-2007.
CIS and The City
But the greatest impetus in London has been provided by the CIS – the Commonwealth of Independent States, a loose affiliation of parts of the former Soviet Union and comprising the Russian Federation, Belarus and nine other countries, with Ukraine a founding member but now a ‘de facto’ participant. The privatization of oil & gas and other energy enterprises, of agri-complexes (notably in fertilizer and machinery) and transport providers, and the huge growth in IT in the former communist countries, created conglomerates dominated by oligarchs but with an insatiable appetite for fresh capital. A favoured destination proved to be London and in 1996 Russian energy behemoth Gazprom (LON:OGZD) became the first CIS company to sponsor a listing of GDRs on the LSE. And in April 2008, Russian food retailer Magnit became the 100th CIS-origin GDR listing on the Main Board.
In the previous year, before onset of another acronym – the GFC (or global financial crisis) – there were 269 IPOs at the LSE, with total capital raised of more than US$52 billion, of which CIS companies were major contributors, raising more than US$19 billion in 24 IPOs. The bulk was in the form of global depositary receipts. And while the GFC and ensuing recession has had its effect, the CIS region continues to dominate the GDR scene in London.
The Good Bits About GDRs
So for the retail investor, what are the advantages of investing in GDRs? The obvious one is portfolio diversification but the associated point here is that, absent GDR programmes and despite technological advances since the 1920s, it remains difficult to invest in offshore companies, otherwise than via exchange-traded funds which track a selection of such enterprises.
For a UK-resident investor to buy shares in Gazprom, say, it would be necessary to use a Moscow or other Russian stockbroker. Except that it wouldn’t be interested in handling the order of a single investor in the UK. Also, and in any event, the investor would need to exchange sterling for the roubles needed to fund the purchase, no simple task and with attendant high (some would say exorbitant) bank charges, and get them into a Russian bank account. Any dividend on the shares would almost certainly need to be paid into that or a different Russian bank account. In practical terms it would also be difficult for that UK holder of Gazprom shares to exercise a vote at general meetings, should he or she be so minded – the notice of meeting and attendant documents would be in Russian for one thing, and there would be practical obstacles to either attending in person or appointing a proxy. And finally, a sale of the shares would necessitate heavy reliance on the intercession – and integrity – of brokers, and in all likelihood buyers, in a foreign country.
Making Life So Much Easier
All these difficulties with direct investment in foreign company equity are obviated with the purchase of GDRs on the home exchange. You place your order for Gazprom GDRs with your regular UK-based broker, as you would with a purchase of UK company shares. You pay in sterling, which is converted by your broker not into roubles but into US dollars, in which Gazprom – and the majority of – GDRs are denominated. Should a dividend be paid while you hold the shares, you will receive it from the UK depositary – via your broker – in sterling, exchanged for the US dollar value of the dividend. Should you wish to vote at a shareholder meeting, you will receive – via your broker again and again electronically – an instruction addressed to the depositary on how to vote your shares, which instruction will be passed to the custodian in Moscow for the vote to be cast and registered.
When the time comes to sell your Gazprom GDRs, from your perspective the transaction proceeds as if they were shares in a UK company, though behind the scenes things are different. Your broker will complete the sell order either by selling your GDRs on the LSE by or converting them to ordinary shares and selling such underlying shares via the market where they’re listed. That conversion process involves a cancellation of the GDRs, handled by the depositary and the custodian, and release of the equivalent shares by the latter. Either way, the transaction vis-à-vis the investor proceeds as seamlessly as if the investment had been in Gazprom shares directly.
But GDRs Can Come With Risk Attached
None of which is to say that an investment in GDRs is no different from a direct investment in the shares of a UK company listed on the Main Board of the LSE. There is, for one thing, an exchange rate risk – while you pay in sterling, as noted GDRs are typically quoted in US dollars, and the underlying shares are quoted in whatever happens to be the home-market currency. Movements in either adverse to the pound could materially impact on the value of your investment. There are a small but growing number of GDR listings quoted in sterling though, where this exchange rate risk can be lessened.
There is also, at least potentially, a taxation risk. In particular, the prospect of income tax on dividend receipts both in the UK, in respect of the GDR, and in the home country, in respect of the underlying shares. This double taxation will be avoided if the UK has a DTA – double tax agreement – with the GDR sponsor’s home country (as is the case with Russia and most other EMs, though curiously not as yet with Brazil, now a prominent GDR initiator). There might also be home-country restrictions on the repatriation of earnings on the GDRs, especially if their existence is seen by the home-country government as circumventing its controls on foreign ownership of domestic enterprises.
Especially from EMs
But perhaps the most salient risk lies in the fact that in many instances GDRs available for purchase on the LSE Main Board, or on AIM, or indeed on other stock exchanges round the world, mirror shares which would not themselves qualify for listing because of the sponsor company’s non-complying management and/or ownership structure. In particular, a lack of transparency as to who actually calls the shots, the existence or suspicion of a closely-held majority stake, typically via nominees, and thus of an easily-manipulated stock price – all of which have a tendency to feature in EM enterprises, especially from countries only now adopting ‘Western’ ways of doing and regulating business. The company may not be dodgy per se, but it may be run with scant regard for the interests of ‘freely-floating’ shareholders.
The stringent requirements for Official List membership in the UK, and for listing on the LSE’s Main Board, and to a lesser extent on AIM, pretty much preclude companies with murky management or ownership structures from achieving a direct listing, especially if they’re foreign. The threshold for a GDR programme is, generally speaking, rather more relaxed, yet the risk of mismanagement or share price manipulation is the same for GDR holders as for direct shareholders in the sponsor company. So the UK investor should do the necessary homework, albeit this may be constrained if a preponderance of the available background material (such as annual reports, management statements, broker reports and the like) is not available in English.
GDRs Alluring All The Same
As noted earlier, Gazprom first listed GDRs on the LSE 17 years ago. It has an established track record and is constantly in the public eye internationally and is not therefore to be equated risk-wise with, for example, a Ghanaian gold-mining start-up or a recently privatized Uzbekistani oil & gas prospector.
The alluring thing about global depositary receipts though, is that it is such companies which might just be both adequately managed and onto a brilliant thing and for the retail investor with the necessary risk appetite GDRs provide a convenient, indeed the only practical, means of taking a piece of the action.