Warrants And Convertibles

Companies wanting to raise capital are often faced with an unappealing choice between issuing bonds with restrictive covenants and high coupons and issuing equity, which dilutes the interest of existing shareholders. One apparently attractive alternative is issuing convertible bonds. These are bonds that the investor can exchange for a fixed number of shares at some point in the future.

Investors like them because they have the security of a bond. They also allow the investor to share in the good fortune of the issuing company since they can swap the bonds for the shares if the shares do well. They appear attractive to issuers because they have a lower coupon than straight debt - investors accept the lower coupon in return for the conversion option.

 

If the debt is converted into equity - and this has tended to happen historically - the company will have ended up issuing equity but it will have sold the shares much more dearly than if it had issued straight equity originally.

Bonds with warrants are a variant on convertible bonds. The warrants entitle the investor to buy shares at a fixed cash price in future. Issues are frequently designed so that the cash that the company receives if the warrants are all exercised is equal to the face value of the bonds so the exercise of the warrants extinguishes the company's liability to the bondholders.

Any argument that convertible bonds are generally a cheaper form of capital than either debt or equity must be fallacious. Miller and Modigliani showed that, under certain simplifying assumptions, a company's cost of capital could not be altered by splitting up its cash flows between securities in different ways. The implication is that a company can only increase its value by financing in one way rather than another if it can exploit some tax rule or some inefficiency in the capital markets or if it leads to the company's assets being more efficiently managed.

It is true that convertibles represent cheap debt when they are not converted and cheap equity if they are converted. But there is an offsetting disadvantage to the company issuing them. If the company does well the shares will be converted, so the convertible holders will dilute the equity when the existing shareholders least want to be diluted. If the company does badly it will be left with debt when it least wants to have issued debt. The argument for the cheapness of convertibles, though seductive, is flawed.

The very complexity of convertibles and warrants invites such illusions. Box 1 recounts the rise and fall of the Japanese equity warrant market. Bonds with warrants appeared to offer issuers a form of debt capital at negative rates of interest they would probably never have to repay.

Box 2 shows how the complexity was exploited by the advertising company Saatchi & Saatchi in 1988 to raise capital at a time when debt and equity looked hard to raise at any reasonable price. The cost of the convertible would not have been obvious to a casual observer but turned out to be sufficient to bring on a major financial crisis for the company.

Convertible bonds do not provide a golden road to a reduced cost of capital. But a company that wishes to raise capital may be unwilling to issue pure debt (because of strain on the balance sheet, cost of servicing in the short term and so on) or pure equity (unwilling to accept immediate dilution). Convertibles offer a middle way with intermediate advantages and disadvantages. In this respect a convertible bond may be an alternative to issuing a mix of debt and equity. But there are circumstances under which the convertible structure has particular attractions.

For example, consider a new venture that wishes to raise equity capital. There may be great advantages in leaving the original owners with full control so long as things go well. But outside investors may wish to take control of the assets if the company does badly. Convertible bonds offer a way of doing this.

If things go well they will initially be bonds with no control rights and then convert into a minority equity stake. If things go badly the company will be unable to service the bonds and the bondholders can take control of the business.

Another case where convertibles may be useful is where the total value of the assets of the company is clear but where the split of that value between shareholders and debtholders is not. If the company chooses to issue debt to finance expansion the market may deduce that management believes that debt is overpriced; they will therefore only buy the debt at a substantial discount.

Similarly if the company issues equity the market will only take it at a discount. If the company wants to avoid this discount it can issue convertible bonds because they are intermediate between debt and equity and their value is not so sensitive to information to which the company's management is privy.

The valuation of convertibles has been revolutionised by advances in option pricing techniques. Previously, investors tended to value convertibles on the basis that they would be converted into equity, so they were valued like equity with a high yield.

Now it is accepted that the right way to look at convertibles is as straight bonds plus an option to buy the shares, where the price of exercising the shares is surrendering the straight bond.

Modern methods of option pricing normally used for valuing traded options can be used for valuing convertibles. There are a few specific issues - the dilution that accompanies the conversion option, the estimation of dividends and volatility in long maturity options, the risk of the company defaulting before the bond matures - but the same broad principles apply.

Convertibles have an important role to play in financing companies as a hybrid between debt and equity. But their complexity means that their true nature can be easily misrepresented and misunderstood.

BOX 1: THE RISE AND FALL OF THE

JAPANESE WARRANT MARKET

Many Japanese companies issued bonds with warrants in the 1980s. They appeared to offer cheap financing. Consider a good-name Japanese company that could issue straight debt in the Euromarkets paying 7 per cent in US dollars or 3 per cent in Yen.

Suppose instead that it issues $100m of seven-year debt with warrants attached. The warrants give the investor the right to buy shares at a 10 per cent premium to the current price. Obviously no one would want to exercise the warrants now. Because of the warrants the company might be able to issue the bonds in dollars with a coupon of 3 per cent rather than the 7 per cent they would have to pay if they did not issue them with warrants.

Given the 4 per cent interest differential between US and Japanese rates the company could swap the bond into Yen debt with an interest rate of minus 1 per cent. At worst the company would have succeeded in borrowing at negative interest rates. But things could turn out much better than that. Provided the share price appreciates by at least 10 per cent over the period the company would not repay the debt. The cash from exercising the warrants would repay the debt.

This is not cheap capital. In this example the company could have issued straight equity more cheaply. If the warrants are exercised the company will have raised $100m by selling shares that it could otherwise have sold for $90m now. But it is also committed to paying 3 per cent interest for seven years. The net discounted proceeds will be less than $84m.

So by issuing bonds with warrants the company is actually raising less money than it would by a straight equity issue. It also has the disadvantage that if the share price goes down the company is left with having to repay the debt.

BOX 2: THE SAATCHI CONVERTIBLE

The complexity of convertibles provides much scope for disguising the nature of a company's liabilities. Saatchi & Saatchi, the advertising company, decided to raise new capital to finance its expansion plans in 1988. Its share price had fallen and it was unwilling to issue new equity. As a service company with few tangible assets and negative shareholders funds from a string of acquisitions, straight debt would have been costly and would have strained the balance sheet.

Instead the company decided to raise POUND STERLING 175m through an issue of convertible preference shares. This counted as equity for accounting purposes. The preference shares would be redeemable at par in 2003. To reduce the coupon the company gave investors the right to put the shares back to the company at 120 per cent of their face value after five years.

This meant that investors were happy to accept a coupon of only 6.75 per cent against a yield on Treasury bonds of close to 10 per cent. They reasoned that if they put the bonds after five years they could get an all-in yield of 10 per cent; in addition they could benefit if the share price rose substantially.

The balance sheet showed that Saatchi's had issued preference shares that might have to be redeemed in 15 years for POUND STERLING 175m. A naive reader of the accounts might have assumed they posed little danger to Saatchi's survival; as preference shares, Saatchi's could pass over the dividend. Problems could only occur in 15 years when the preference shares fell to be repaid, but by then they would probably have been converted into equity anyhow. Furthermore the fact that the coupon was only 6.75 per cent, and the conversion could only take place at a premium to the current share price, might be seen as evidence that Saatchi's had raised the capital very cheaply.

The reality was that Saatchi's had issued five-year deep-discounted debt with a yield of 10 per cent, together with an equity kicker. If presented in this way, the threat to Saatchi's survival some three years later would have come as no surprise. Because of a sharp deterioration in Saatchi's trading position it became clear that the company would not be able to honour the put. The terms had to be renegotiated with the convertible holders taking a massive slice of equity.

Although the information was all in the public domain, the convertible structure allowed the financing to be presented in a favourable light.

Signpost

Finance

The Module contains two sections this week: covering warrants and convertibles and acquisitions. It will continue in Parts 14,15 and 17. Further topics to be covered include, interest rates and currency swaps, project finance, equity capital, managerial remuneration and insolvency. Previous sections appeared in Parts 1,2,4,5,6 and 9. Subjects included the finance function within a company, financial markets and investment decisions, risk and return, the efficiency of markets, discounted cash flow analysis and other criteria for assessing the viability of projects, the cost of capital, choice of capital structure, dividend policy, the changing nature of finance, options, currency hedging and futures markets. Related topics can be found in the International Financial Markets Module.

Anthony Neuberger

Anthony Neuberger is assistant professor of finance and accounting at London Business School and S. G. Warburg group research fellow, Institute of Finance and Accounting. His research interests include the structure of securities markets, option theory and corporate finance