The case for COERCS

Theo Vermaelen

Professor of Finance

INSEAD

How should an Ideal Financial Security look like?

• Tax efficient

• No negative information signal

• No costs of financial distress

• No agency costs

• No wealth transfers from shareholders to others

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Equity

• Not tax efficient if company is profitable (-)

• Negative information signal as market expects timing (-)

• Low costs of financial distress (+)

• high agency costs (-)

• If shares undervalued, wealth transfer to new shareholders (-)

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Debt

• Tax efficient when company is profitable (+)

• No negative information signal (+)

• Costs of financial distress (-)

• Low agency costs (+)

• If shares undervalued, no wealth transfers to new shareholders (+)

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Choice between Debt and Equity

Imperfection Debt Equity

•Corporate taxes 1 2

•Expected COFD 2 1

•Agency costs 1 2

•Undervaluation 1 2

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Government policies can correct tax disadvantage

• Example : Cooreman-De Clercq ( 1982)

• Companies that issued equity could deduct 13 % of the amount issued from their taxable income for 10 years

• Personal tax advantages for individuals who invest in common stock

• Result : More equity issued in 1982-1983 than during previous 13 years

• Belgian stock market became “market of the year” 6

Cooreman-De Clercq and the stock market

Monthly cumulative return difference between KB-index and the “world” index, from January 1981 until January 1984

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However : how to elimate COFD ?

Imperfection Debt Equity

•Corporate taxes 1 2

•Expected COFD 2 1

•Agency costs 1 2

•Undervaluation 1 2

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Coco bonds

• Contingent convertibles (CoCos) are bonds that mandatorily convert to equity after a triggering event such as a decline in the bank’s capital (Flannery (2005).

• Motivation: providing discipline of debt (tax deductions?) in good times, avoiding COFD (bailouts!) in bad times.

• Since 2009 : 20 banks for $ 100 bn

• Although designed for banks potentially interesting for other corporations ?

Cocobonds

• In good times: normal debt

• Bad times: mandatory conversion into equity

• Today mostly issued by banks

• Sometimes no conversion but total writedown

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Problems with Cocos

• How to define “bad times”?

• If “bad times” are based on stock prices how to avoid manipulation and undeserved conversions?

• How to make sure they are not very risky so it is very likely you are going to get your money back ?

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Solution: COERC

• Call Option Enhanced Reversed Convertible

• Trigger based on market values

• When the trigger is hit, bondholders are forced to convert at huge discount from stock price, creating large potential dilution

• However,shareholders get the pre-emptive right to buy new shares at the conversion price and repay debt

• As a result Coco bond becomes nearly riskless

• COERC coerces shareholders to pay back debt holders

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Example

Assets: 100 Equity 60

COERCS 40

5 million shares outstanding (stock price $12)

Coerc converts into equity when equity falls to 1/3 of firm value.

When this happens the conversion price is 25 % of the stock price.

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Conversion will create Dilution

• Assume equity market value falls to 1/3 of assets because assets fall to $ 60 million and equity to $ 20 million

• Assume that when this happens stock price is $ 4 which means the conversion price is $ 1

• If conversion would take place bondholders would end up with 40m/ 1 = 40 million shares or 40/45 = 89 % of total assets = 89% x 60 = $ 53.3 million

• This means a windfall gain of (53.3 – 40) = $ 13.3 million

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Preventing Conversion

• In order to avoid this wealth transfer to bondholders, equityholders have pre-emptive rights to buy the shares by repaying the debt

• Rights issue is announced for 40 million shares at $1

• After completion of rights issue firm is all equity financed with 60 million assets divided by 45 million shares or $1.33

• Rights issue would be unsuccessful if during rights period assets would fall below 45 million

• Insurance against this failure can be bought by buying an underwriting contract ( put option). Otherwise bondholders will ask credit spread to compensate for this risk.

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How much would insurance cost ?

• Put option

• Maturity : 20 days

• Stock price : 1.33

• Exercise price 1

• Volatility : 70 %

• Jump process with 3 jumps per year jump size 50%

• P = 0.006 or 40 m x 0.006 = $ 0.24 m

• So you pay insurance fee of 0.6 %

• Ideally issuer should provide cash collateral for this fee.

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• There are 5 million shares outstanding

• Each share has 1 right

• 40 million new shares, so with each share you can buy 8 new shares if you pay $ 1 x 8 = $ 8

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Payoffs to Investor

Wealth of the Investor with $ 8 in cash who owns 1 share worth $ 4

• If he exercises the right : 9 new shares at $ 1.33 = $ 12

• If he sells the right to buy new shares to someone else and keeps his $ 8

cash $ 8

1 share $ 1.33

1 right = 8 x (1.33-1) $ 2.64

-------------------------- ---------

Total $ 12

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After the dust has settled

Assets: 60 Equity 60

45 million shares outstanding (stock price $1.33)

You cleaned up your balance sheet without transferring wealth to debt holders

Potential to re-lever

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Implication for Bondholders

• The fear of dilution coerces equityholders into repaying the debt as long as conversion price is set at a significant discount from trigger price

• Debt is very likely to be repaid, rather than forced to convert

• The only risk is that because of “jumps” the value of the assets falls below $ 40 milion so that fully diluted stock price falls below $ 1.

• In order to largely eliminate this risk issuers can pay for firm commitment underwriting contract.

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Implication for Shareholders

• Because you are able to make a credible commitment that you will pay back debt holders in periods of financial distress, credit spreads will be very small

• ROE will go up, although WACC remains the same

• As debt has become large risk-free, no more costs of financial distress, hence total firm value will increase

• Death spirals because of manipulation and panic can be prevented

• COERC issuance is not a signal of overvaluation ! 21

Choice between Debt, Equity and Coerc

Imperfection Debt Equity Coerc

•Corporate taxes 1 3 1

•Expected COFD 3 1 1

•Agency costs 1 2 1

•Undervaluation 1 2 1

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Intuition

• “Normal“ debt is risky because equityholders have limited liability

• The Coercive feature of the COERC forces shareholders to bail out bondholders to avoid dilution

• Because financially constrained shareholders can sell their rights to others these constraints don’t matter

• Of course, this assumes that rights can be sold at fair value

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Difference with other bonds

• Covered bond : collateral is put up front, illiquid?

> COERC: collateral is cash provided by Coercive rights issue when needed

• Subordinated debt : credit spread charges for default risk

> COERC : no credit spread but firm commitment rights underwriting fee when trigger is hit

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A case study

• Bidder is considering making a $ 120 million bid for Target

• It does not want to pay with stock

• If it borrows to pay for it it will have to issue bonds below investment grade

• Can COERC be the solution ?

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Balance sheet of Bidder ( $ million)

Assets Liabilities

230 Debt 50

Equity 180

230 230

Stock price : $112 shares outstanding : 1.7 million

Debt/Assets = 22 %

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Balance sheet of Target

Assets Liabilities

115 Debt 25

Equity (E) 90

115 115

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Bidder after merger (assume $120 m purchase price for target equity paid by issuing COERC; assume other debt)

Assets Liabilities

375 Debt 75

COERC 120

Equity 180

375 375

Debt/assets = 195/375 = 52 %

COERC converts when Debt/Asset = 65 % Discount of 50%

The trigger

• Based on market values of equity and book values of debt

• Because book values are normally calculated only quarterly, company should update book values if it changes more than 1 %

• Note that this is not the same as a stock price trigger : you can’t control the stock price but you can control leverage to a large extent

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What happens at conversion ?

• Debt/Assets = 65 % and Debt = 195

• Assets = 195/0.65 = 300

• Equity = 300 – 195 = 105

• This represents a fall in equity of (180-105)/180 = 42 %

• Current stock price is $ 112

• A 42 % decline means new stock price will be $ 65

• Then you announce a rights issue at a 50 % discount ($ 32.5)

• This means new shares issued : 120 m/32.5 = 3.7 m

• Total number of shares outstanding is 3.7 m + 1.7 m =5.4 m

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After the dust settles

• Total firm value is still 300

• Non-Coerc debt = 75

• Equity = 225

• Stock price (fully diluted) = 225/5.4 = $ 42

• Issue will fail if stock falls below $32.5 in 20 days

. Insurance : Underwriter firm commitment = put option

• Value of put ? Volatility = 70 % 3 Jumps per year of 50%

• Put = 0.226

• Total cost = 0.226 x 3.7 m = $ 0.836 m

• Total cost =0.7 % of 120 m raised

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Bidder after merger + conversion

Assets Liabilities

300 Debt 75

Equity 225

300 300

Debt/assets = 25 %

Why issue COERCS ?

• You can borrow at (almost) the risk-free rate (A rating)

• You have however to commit to buy insurance by having the rights issue underwritten.

• The underwriting fee only has to be paid when conversion is triggered

• You may however put enough collateral aside to pay for the underwriting fee

• Only if you are a true high credit risk you will pay the insurance !

• This is better than issuing subordinated debt now with a large credit spread to be paid every year

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Why buy COERCS ?

• You have a corporate alternative to buying government bonds (low risk, A rated)

• Because the company has committed to insure the proceeds of a rights issue to repay you when conversion is triggered, your risk is largely eliminated

• High risk-aversion ( Banks ?)

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Why no COERC issued by Banks so far?

• Regulators insist on capital ratio triggers, not market based triggers

• This in spite of proven failure of such triggers during the financial crisis

• Regulators/bankers like capital ratio triggers for a variety of reasons

• Corporate non-banking sector has freedom to design contracts

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Regulatory Capital versus Market Value Capital Triggers

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Barclays partially Endorses COERC

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The ideal issuer

• Company perceived as risky

• Management feels market undervalues cash flows/ overestimates risk

• Profitable and therefore taxable business

• Current large shareholders don’t want to issue equity now

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