The Happy Math of Convertible Issuance

by Bill Feingold

 

I don’t understand why many more companies haven’t raised money with convertible bonds over the past year.

If it were just me saying this, I’d figure it was one of my goofier ideas and let it go. But some of the smartest people I know are saying it too.

Frankly, I’m still astonished by what I heard—and didn’t hear—at a conference I attended last month. A lot of tech companies—social media, networking, semiconductors, big data, yada yada yada. Most of their stocks had doubled, tripled, quadrupled over the previous eighteen months. I heard a lot of big talk about growth initiatives, user experiences, good stuff all around.  One thing nobody asked, and nobody addressed, was whether it was time to take what the market was trying to give.  I tried to raise the topic with a few top executives, but they seemed more interested in talking about their share buyback programs, even at an all-time market high.

That was early March, 2014. A lot of those companies saw their stocks fall 20, 30, 40% between then and mid-April.  No good reason for it, but there was also no good reason for the stocks to have appreciated so much.

I recently asked a fellow convertible professional why these companies—I used Yelp as an example—weren’t taking advantage of riches upon riches through the convertible market. Forget about issuing stock near an all-time high, three or four times where it was last year. How about another 40 or 50% on top of that via a convertible, with the consolation prize, if the stock doesn’t get there, of borrowing free money for five years or so.  Similarly perplexed, my friend suggested that if the stock were to sell off, say, 10% in the aftermath of the convertible issuance, Yelp’s management would be engulfed with angry shareholders.  I suggested that any top manager of a company whose stock had quadrupled over the past year, but who couldn’t manage a call from an angry “investor” whose gain was now a mere 260%, didn’t deserve to be a top manager.

Now, a lot of companies can borrow very cheap money, no doubt. But these aren’t the ones whose stocks appreciated so much. They’re the ones that have graduated to the world of more predictable cash flows. The straight bond market will pay—and overpay—for them.  The high-fliers, though, have something their older brethren lack. Volatility. And while volatility doesn’t help you save money on your coupon when you issue straight bonds—if anything, it hurts--it certainly can with convertibles.  So the convertible market sees an asset where the straight debt market sees a liability. It’s a shame more potential convertible issuers don’t understand this, and an even bigger shame that their bankers haven’t been able to explain it.

Remember, the prime attraction of convertible bonds is their heads-I-win-tails-I-don’t-really-lose conceit.  As long as the tails part can sit tight, you can go aggressively for upside. So volatility is good as long as it can’t really cut into your chances of at least recouping your capital on the downside.  If volatility can hurt you on the downside, then the convertible isn’t that much different than its underlying stock.  In that case, if you’re looking to hedge, you need to sell most of those underlying shares when you buy the convertible bond.

But if you’re reasonably confident, even as a hedger, that the company will be able to repay your original bond investment, then a far smaller stock hedge is probably good enough to insulate you against most adverse moves. And if that’s the case, the math behind issuing convertibles gets happy indeed, especially for issuers in today’s market.

Here’s how it works. A good rule of thumb for a new convertible says that the proper hedge ratio (the percentage of underlying shares to sell short to immunize a convertible holding against stock moves) is roughly 100% minus the conversion premium. Today, with low interest rates and plenty of unmet demand for convertibles, premiums on new deals are higher than I’ve ever seen in a 20+ year career. Let’s say a deal comes with a 45% conversion premium. That means that hedge funds only need to sell short about 55% of the underlying shares to be neutral.

It gets better. First of all, even if all the convertibles were bought by hedge funds, and even if the hedge funds were shorting 100% of the underlying stock, the conversion premium means the dollar value of the shares is a lot less than the bonds. A 45% premium means $100 million of bonds controls under $70 million of stock. So if the issuing company wanted to sell $100 million of bonds and buy all the underlying stock back—a very bullish signal—it could pocket over $30 million before fees.

But since hedgers would only want to sell about 55% of the shares, the $70 million becomes $38 million. A neutral trade—assuming the issuer buys back all the stock hedgers want to sell—thus nets more than 60% of the principal amount in proceeds.

Finally, hedgers are not the entire market. In fact, they’re probably only a third of it these days. So if two-thirds of the deal goes to unhedged, directional investors, an issuer only needs to spend about 12-13% of the face amount to offset any negative short-term impact, assuming a deal with a 45% conversion premium and a 55% delta.

Here’s the beautiful part. Take the last paragraph one step further.  If the issuer wants to use more of the proceeds—say 30%—to buy stock, but two-thirds of the deal goes to unhedged buyers, then the rest of the shares to be bought will have to come from the open market.  In this case, that would be about 17% of the deal proceeds (30%-13%).

What if the issuer wanted to buy all the underlying stock back, avoiding any possible dilution?  That takes us back to our initial example—a net raise of over 30% of the face amount with a tremendously bullish impact on the stock.

That’s enough for now. In another piece, to come soon, we’ll get into some of the mechanics of a related technique that accomplishes a similar result—a technique that’s become increasingly common as part of convertible bond issuance.