Print
Email
Print Edition Stories
Friday, October 31, 2008
Inside Finance Strategies
Convertibles can benefit businesses and investors
How is the economic crisis affecting tech companies?
Need money? What business doesn’t? Borrowing is difficult today, while issuing stock is expensive and risky. For many companies, especially midsize public companies, convertible securities may provide a better option for raising capital.
Convertibles can provide benefits that make them attractive to the company that needs capital and the investor who buys them.
Why should a company consider issuing convertibles?
• Cost of capital. The cost of equity capital is typically at least 15 percent of the amount raised and can reach the high teens. For convertibles, it’s the coupon plus some stock, which often totals about half the cost.
• Cost of issuance. When issuing stock, an equity deal may cost 6 percent or 7 percent of the amount raised. Last year, when I was CFO of Skyworks Solutions Inc. in Woburn, we were able to meet our capital needs with convertibles for 2 percent of capital.
• Speed. The Skyworks deal, which involved issuing $200 million in convertible debentures, came together in a weekend. Issuing stock or debt would have taken at least four to eight weeks.
• Flexibility. There are many ways to structure convertibles. The convertible usually converts to common stock based on a fixed price, or it may convert based on fluctuating market prices. The company can structure the conversion so that all or some convertibles convert to cash instead of stock.
The right structure depends on corporate goals, economic conditions and other factors. Companies issue convertibles to make either their equity or debt securities more attractive, so the structure needs to draw the attention of investors.
Conversely, companies need to avoid diluting their stock price. Hedge funds often lock in convertible returns by shorting the underlying stock, putting pressure on a company’s stock price. One way to balance that pressure is to raise enough capital to buy back some shares.
Stock prices may also drop because of dilution when a significant number of convertible owners convert them to stock. Caps or other provisions may be used to prevent dilution.
A conversion based on market prices also puts the company’s stock price at risk, although it protects holders of convertibles against price declines. Such conversions may be appropriate in some cases, but, given the risk, fixed-price conversions are much more popular. Tax implications should also be considered.
Anyone issuing convertibles should be careful not to dilute the stock price by giving too much stock away and not to over-leverage the company with debt. It’s also important to work with experienced professionals who can introduce you to broad sources of financing and to seek financing when you don’t have an immediate need for the funds. If you issue convertibles when you don’t need the money, capital markets will be kinder.
Investor considerations
The big attraction for investors is that convertibles historically have provided returns comparable to stocks, but with lower risk.
Today, convertibles may be attractive to both institutional and individual investors. For investors whose portfolios are heavy with bonds, convertibles provide income, but add exposure to growth as a hedge against inflation. For investors whose portfolios are heavy with stocks, convertibles add income and reduce volatility.
Other advantages of convertibles include:
• Downside protection. In a down equity market, convertibles typically decline, at most, to their value as a fixed-income investment.
• High current income. Convertibles typically provide high current income, regardless of the price of the underlying stock.
• Equity participation. If the value of the stock rises, the value of the convertible typically rises.
• Diversification. Convertibles are issued by companies in a broad mix of industry sectors with a wide range of credit quality.
• Total return. Achieving both growth and income can add to total returns without adding risk.
Investors should seek convertibles that balance risk and reward. It is logical to seek higher yields, but higher yields typically mean more risk and a weaker underlying stock. Be certain to invest in a company that is financially secure enough to pay off the convertible. Also make certain the underlying stock is fundamentally sound and provides an upside opportunity.
Allan Kline is director of business development at Cutler Capital Management of Worcester, which invests in convertibles through hedge funds and individual portfolios. He can be reached at akline@cutlercapital.com.
RSS Feeds
Comments
Please Login/Register to post comments.
No comments have been added or approved.