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COERCS : an Ideal Financing Instrument ?

COERCS : an Ideal Financing Instrument ?. By Theo Vermaelen Professor of Finance INSEAD. The Ideal Debt Instrument . Have the benefits from debt in good times : - interest tax deductibility - discipline (improve governance)

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COERCS : an Ideal Financing Instrument ?

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  1. COERCS: an Ideal Financing Instrument ? By Theo Vermaelen Professor of Finance INSEAD

  2. TheIdeal Debt Instrument • Have the benefits from debt in good times : - interest tax deductibility - discipline (improve governance) - avoid dilution when stock is undervalued

  3. TheIdeal Debt Instrument • Avoid the costs of financial distress. - customers, suppliers, employees concerns about firm survival lower free cash flows - shareholders destroy firm value at the expense of bondholders : - overinvestment in high risk projects - underinvestment in low risk projects - refusal to raise equity to repay debt

  4. Cocobonds • In good times: normal debt • Bad times: mandatory conversion into equity • Today mostly issued by banks

  5. Problemswith Cocos • How to define “bad times “ ? • If “bad times” are based on stock prices how to avoid manipulation and undeserved conversions ? • Fixed income investors typically not interested in becoming shareholders when a company is in trouble

  6. Solution: COERC • Call Option Enhanced Reversed Convertible • When conversion trigger is hit, shareholders get pre-emptive right to buy the shares and repay the debt • By setting conversion price significantly below the trigger price, such repayment can be made highly likely

  7. 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.

  8. Conversionwill create Dilution • Assume market value of equity falls to 1/3 of assets : 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

  9. PreventingConversion • In order to avoid this wealth transfer to bondholders, equityholders have pre-emptive rights to buy the shares at the conversion price and repay 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.

  10. Implicationfor 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 • As a result debt holders will be repaid, rather than forced to convert

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

  12. 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

  13. Simulation • Pennacchi, Vermaelen and Wolff (2013) simulate credit spreads when COERCs are issued by a highly levered company ( Bank) • As potential dilution increases, credit spreads fall

  14. COERCCreditSpreadsbyDilutionRatio → Agreaterdilutionratio,α,lowersCOERCs’creditspreads.

  15. Whyno 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 • Corporate non-banking sector should be free of this constraint

  16. RegulatoryCapitalversusMarketValueCapitalTriggers

  17. Barclays partially EndorsesCOERC

  18. ImplementationIssues • When existing shareholders don’t have the funds to subscribe, they have to sell the rights • The example assumes only equity and COERCS. Analysis does not change as long as COERCs are subordinated to other debt • Risk (and therefore yield) can be increased by narrowing distance between conversion price and trigger price

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