It is not every day that the Wall Street Journal has a front-page article about “happy meal” convertible offerings with registered stock borrow facilities so I’m going to tell you about them. Here is what they are:1
- A company sells a convertible bond to convertible arbitrageurs.
- At the same time, it lends shares of its own stock to the arbs so they can establish their hedge for the convertible.
As the Journal points out, these deals go pear-shaped with horrific frequency – a third of them go bankrupt within five years, versus 7% of all convertible issuers.2 And now people are all mad and suing and stuff, and there are insinuations that evil hedge funds made lots of evil money on these evil deals. All of this is very confused so let’s talk about it in excruciating detail shall we?
First of all: are these deals bad for companies, or are bad companies doing these deals? The Journal:
Such deals can make shareholders nervous. “It’s a negative slant on the stock from a perception perspective,” says Brian Blackman, vice president for investor relations at Molycorp Inc., a Greenwood Village, Colo.-based mining company that has done two Happy Meal deals.3 Investors want to know “what do traders know that I don’t?” he explains. “Executives don’t like it because people are shorting the stock…and everybody wants to see their shares go up and up.” …
Traders and bankers say the failure rate has more to do with the type of companies willing to sell Happy Meals than anything about the deals themselves, and that the investors in the deals aren’t out to hurt the companies.
Now, some background. A convertible bond is a bond with an option to convert it into stock at a fixed price. The majority of convertible bonds are bought by convertible arbitrage hedge funds, which buy them not to bet on the stock but as hedged volatility plays. To hedge, they sell short a fraction – the delta – of the shares into which the bonds can convert. Then they act like hedged option traders: As the stock goes up, the conversion option becomes more in-the-money, the delta goes up, and the hedge funds sell more shares short. As the stock goes down, the conversion option becomes more out-of-the-money, the delta goes down, and the hedge funds buy in some of their short sales. If the stock goes up and down a lot, they do a lot of buying low and selling high and so they make a lot of money. If not not.
Normally hedge funds do their short selling the usual way, by borrowing stock in the stock borrow market like every other short seller. If they can’t do that, then they can’t hedge, and if they can’t hedge they won’t buy your convertible, and if they won’t buy your convertible then nobody else will, and if nobody will buy your convertible they probably won’t buy anything else, so it’s hard for you to raise money. So if you want to raise money and hedge funds can’t borrow your stock in the market, one of your limited set of unappealing options is to lend them the stock yourself, and that’s what this happy meal is.4
So two obvious facts here are:
- If you’re doing this you don’t have a ton of other appealing options, and
- if you’re doing this it’s because your stock is hard to borrow which is usually because lots of people have already sold it short.
Not always! But companies with (1) hard-to-borrow stocks and (2) a proclivity for spivvy financing transactions tend to be risky companies. So that’s why they go bankrupt. The spivvy financing transactions probably stave off the bankruptcy for a while, but if you’re in this situation a lot of people probably already think you’re going bankrupt. The fact that only 1/3 of issuers do seems like a victory. So I vote that these deals are for bad companies, not bad for companies.
Which I guess is no reason not to sue over them. The Journal:
Mark Leevan, another former Energy Conversion shareholder, filed suit in San Francisco federal court in June against the bond underwriter, a unit of Credit Suisse Group AG, and unnamed hedge-fund investors, alleging a “fraudulent scheme to manipulate the common stock.” The deal left the company vulnerable to “massive and prolonged short attacks,” the suit said. Credit Suisse hasn’t yet responded to the suit and declined to comment.
Here’s his complaint. The main claim is this:
The Prospectuses disclosed that ECD would simultaneously issue a convertible note and common shares. The disclosures stated that some investors may short the common shares as a supposed “hedge” against their investment in the convertible notes. The Convertible Notes Prospectus stated that an affiliate of the underwriter “has agreed to use the borrowed shares to facilitate the establishment by investors in the notes, and certain other of our securities, of hedge positions in such securities.” …
These disclosures are entirely false and misleading. In reality, it was the bonds that were being used as a hedge against the shorting of stock by the [hedge funds]. The disclosures misleadingly suggest that the short positions were to make the convertible notes more attractive by facilitating a net long or (at best) neutral position by the [hedge funds]. The opposite was true: the convertible notes were designed to facilitate a net short position by the [hedge funds] by taking away the risks associated with large short positions, and the Credit Suisse Defendants knew it.
This is a pretty weird claim. Were the convertible notes a hedge to the short sales, or the short sales a hedge to the convertible? Well obviously both: hedging is a reciprocal arrangement, and convertible arbitrage is stereotypically stock-price-neutral. But equally obviously Energy Conversion didn’t wake up one day and decide “hey let’s help people short our stock.” They decided they needed to raise money, and this convoluted thing let them raise more money than they could have with just a stock offering.5 The fact that the hedge funds, on net, gave ECD money in exchange for a credit-and-equity position rather strongly suggests that their overall position was at least in some loose sense “long.”6 If you gave ECD money, and you want them to give it back to you, you’re necessarily rooting for them to survive.
It will not surprise you to learn that I am basically rather fond of the convertible with registered stock borrow.7 After all, I’m fond of basically any piece of financial complexity that banks dream up to accomplish things that are impossible in nature. But with most of my favorites, my fondness is of the aesthetico-cynical variety, because the things that they accomplish are usually some flavor of regulatory arbitrage: lowering capital requirements, avoiding taxes, that sort of thing. But the registered stock borrow facility is actually pretty benign! A company comes to its bank, low on options, unpopular with equity investors, and desperate for money. And the bank finds a way to raise money that would otherwise be impossible to get. This isn’t spivvy financing as a tax-or-whatever-advantaged alternative to wholesome normal financing, it’s spivvy financing as an alternative to not raising money. It’s financial innovation that actually helps actual businesses raise actual money. That’s what banking should be! The fact that it’s delightfully complicated is just a nice bonus. For me, I mean. The fact that it’s widely misunderstood, and in a way that leads to lawsuits, is a less fortunate side effect.
1. Per the Journal. Back in my day we said “happy meal” to refer to a different and, well, happier transaction – convertible + share buyback for remaining convertible delta – which is related in the sense that it’s a convertible plus the company doing something about the convertible delta, but different in that my happy meal involves no extra selling pressure on the stock while the Journal‘s does. For geeks, there is a delightful intermediate structure, used occasionally, where the underwriting banks facilitate the hedge funds’ short via swap and then sell the shares back to the company via a fixed-share forward with maturity equal to that of the convertible, which is my happy meal – convert + buyback – but done entirely synthetically and without the need for any share borrow. Anyway!
2. Though the borrow facility deals are a small sample, just 26 deals since this was invented in 2004.
3. So I’m puzzled that they got an IR guy at a company that’s done two of these deals to say, on the record, that these deals suck? But okay!
4. I MEAN. That’s the super-stylized intuitive form of what it is. What it actually is is:
- Company lends stock to underwriter under 5-year share lending agreement.
- Underwriter sells stock short in registered bookbuilt offering, with a prospectus and everything.
- Underwriter now has big short position.
- Which it simultaneously hedges by getting long on swap – typically matched-term 5-year swaps – with the hedge funds buying the convertible.
- Giving the hedge funds short exposure to hedge their convertible.
Once I spent a lot of time thinking about this. Anyway here is some SEC correspondence with a diagram at the back:
5. The math is complicated by the facts that (1) there’s a simultaneous actual stock offering and (2) Credit Suisse sold part of the delta in the underwritten deal and rolled out the rest in later at-the-market offerings, but basically:
- The happy-meal-related portion of the offering was 2,723,300 shares at $72 per share, raising $196 million of cash for the hedge funds from their short sales.
- The total convertible offering was $316 million, with the greenshoe (which was exercised).
- So the convertible increased ECD’s proceeds by $120 million, which came from convertible arbitrage hedge funds, which then had, simplistically, at least $120 million of exposure to ECD.
6. The Journal talks about the hefty returns that some hedge funds might have made on some of these deals that slid into bankruptcy, but they assume non-convertible-arbitrage behavior by those funds. So:
Energy Conversion’s stock, which had fallen to $60 from $72 in the two months following the deal [in June 2008], dropped to 20 cents by year-end 2011.
The hedge funds that bought bonds were positioned to profit. Wolverine Asset Management LLC, for example, bought $26 million of the bonds in 2008 and held most of them through 2011, securities filings show. That investment put the Chicago-based fund in a position to profit by nearly $9 million, a 34% return on its original bond investment, a Journal analysis shows. It would have lost about $14 million on the declining value of the bonds, yet earned nearly $23 million in bond interest and on short sales—if it shorted as much stock as it was entitled to under the deal and held that position until the end, the analysis shows. Wolverine declined to comment.
So bond interest is 3% on $26 million for like 3.5 years or around $2.7 million, meaning that the Journal thinks they made $20.3 million on the stock. This is not true! First of all it assumes that Wolverine sold 100% of the shares underlying its bonds, rather than the theoretical hedge ratio. But convertible arbitrageurs don’t buy convertibles and sell 100% of the underlying stock, which would represent a huge negative bet on the stock. They have a model, and the model gives them a theoretical hedge ratio, and they sell that much stock, give or take. Wolverine might have leaned more bearish than the theoretical delta (or more bullish) but you can be reasonably sure Credit Suisse didn’t set them up with a 100% short on the deal. According to the prospectus, Credit Suisse was selling around 79% of the shares underlying the bonds. If you assume that that’s the right hedge ratio, and that Wolverine shorted day one and never adjusted its hedge, then it made $16 million on the stock, not $20 million, for a net profit of $4.8 million. Math is here.
But that’s still totally wrong! A thing that convertible arbitrage funds do not do is just put on their hedge day one and wait to see if the company goes bankrupt or not. The whole point of convertible arbitrage investing is to make money on volatility, meaning that as the stock goes down and the delta gets lower, you’re buying back stock (at low prices), while as the stock goes up and the delta gets higher, you’re selling more of it. Energy Conversion Devices went more or less straight down:
The natural behavior for Wolverine here would be to buy back its ~224,000-share short over the course of those three years, not to just sit around for three years and then buy a bunch of shares at $0.20 at the end. If you make – really wrong and dumb! – simplifying linear assumptions – that the stock declined linearly and that Wolverine bought linearly over time – then it sold at $72, bought at $36, and made about $8 million on its short selling. Plus $2.7 million in interest and minus $14 million on the declining value of the bonds gets you a net loss of $3.2 million. Now of course this is wrong too – there’s convexity in the bonds, there’s some volatility instead of just straight monotonic decline, and Wolverine can make active decisions to make this work out better for them. (The Journal notes that Diamondback made $12 million on its own $37.7 million ECD investment, “according to a person familiar with the matter,” via active trading.) Nonetheless you can’t assume that the convertible arbs who bought this deal never acted like convertible arbs and were just fundamental short sellers with a 3-year time horizon and a just-for-kicks convertible bond.
7. Though my fondness is mixed with, like, post-traumatic stress. Also we haven’t even talked about what happens on these borrow facilities when the underwriter goes bankrupt, as Lehman did! Bad things, is the answer. Cf. Intel’s Lehman forward.