UK: Alternative Sources Of Corporate Finance: Convertible Bonds

Last Updated: 26 October 2011
Article by Appleby  

In an age of tight credit and nervous stock markets, alternative sources of corporate finance are becoming increasingly important. Indeed, maintaining liquidity in the general economy is essential. There are several potential forms of non-bank, alternative financing suitable for small to mid-cap companies. These would include:

  • private equity
  • invoice discounting
  • asset based securities
  • Islamic finance
  • convertible bonds

What is a convertible bond?

A convertible bond is an unsecured debt instrument issued by a corporate entity usually a company listed on an internationally recognised Stock Exchange.

The instrument pays a fixed annual coupon and the principal amount of the bond is either repaid at maturity or converted prior to maturity into a fixed number of shares in the issuer, usually at a premium to the issuer's share price at the time of issue.

Normally the bond is issued by the listed company itself and is convertible into its shares however the bond is sometimes structured through a ring-fenced subsidiary Special Purpose Vehicle ('SPV') with SPV's obligations guaranteed by the listed holding company and conversion into the listed holding company's shares. Such SPV's are often formed in an offshore jurisdiction, particularly the main domiciles covered by Appleby. Convertible bonds are generally rated, listed on a recognised bond Exchange market and publicly traded by global institutions active in the secondary convertible bond market.

Convertible bonds are traditionally issued by multi billion pound market capitalisation companies - recent examples include; BA, 3i, Tui, WPP and Aegis.

The market has started to open up to smaller fully listed companies and the larger market capitalisation companies on AiM e.g. Sportingbet Plc and Lonrho Plc.

What are the attractions of convertible bonds for issuers?

  • Source of fixed rate medium term debt that is usually cheaper than standard corporate bond debt because of the potential vale of the embedded equity option.
  • Issuer is effectively issuing equity at a premium as the conversion price is fixed at a premium of typically 20-30% of the issuer's current share price compared with the typical discount in conventional pure equity issues.
  • Process is fast with an abbreviated road show and limited distraction of management time.
  • Unsecured debt obligation with limited restrictive covenant provisions.
  • Access to a different constituency of institutional investors-convertible bonds are purchased by specialist funds within global institutions, convertible bond funds, convertible bond hedge funds, single and multiple family offices.
  • Market data shows that c80% of convertible bonds are converted to equity in the issuer rather than repaid.

What characteristics should an issuer have?

  • Growing strong cash generative profitable listed business.
  • Proven management team.
  • Meaningful market capitalisation - £65 million plus.
  • Modest or low gearing.
  • Reasonable trading volumes in the company's shares.
  • Sound reasons for convertible bond issuance e.g. to finance an acquisition, to pay down expensive debt or to provide development capital to exploit organic growth opportunities.

What are the attractions of convertible bonds for investors?

  • Strong and visible cash generation secures annual payment of the coupon on the bond and the repayment of principal amount at maturity.
  • Perfect hedged position either to receive coupon and repayment or realise significant upside by converting into equity in the event that the issuer's share price outperforms.
  • Opportunity to further hedge the convertible bond by buying or selling the underlying listed securities.
  • Liquid investment that can be realised at a profit in the secondary convertible bond market rather than waiting for repayment or conversion into equity in the issuer.
  • There is significant interest in convertible bonds in the larger market capitalisation sector as turbulent market conditions make it difficult for companies to raise either debt or equity at sensible prices.

An example

  • Main listed Sportingbet (£210 million market cap) – a global online gaming operator.
  • Five-year, £65 million convertible bond issued in May 2011.
  • Coupon rate 7.0%, payable six monthly in arrears.
  • Initial conversion price is 50.4p per share – a premium of 20%.
  • Net proceeds will be used by the company to fund the proposed acquisition and integration with Centrebet, the Australian-listed parent of online betting outfit Sportsbook.

The CEO of Sportingbet, Andrew McIver, commented:

"The Bond has brought a whole new group of institutional investors to the Sportingbet story."

Emerging market for smaller capitalisation companies

Whilst the convertible bond market is predominantly a market for large corporate issuers and institutional and family office investors there is a fledgling but growing market for convertible bonds in the sub £60 million market capitalisation sector on AiM.

Given the greater element of risk at this end of the market, convertible bonds are more expensive and punitive than their larger market capitalisation counterparts. Typically the bond will be secured against the issuer's assets and the lender will require a full range of lending covenants.

The coupon on the bond is typically 10% or more, early redemption of the bond attracts a redemption penalty at 10% per annum, and conversion is usually at a discount to the issuer's share price at the time of issue.

In addition the lender generally has the right to appoint non-executive directors and to receive monthly financial reports.

Notwithstanding these obligations there is significant demand for convertible bonds in the smaller market capitalisation sector on AiM as a result of the dramatic contraction of the small company credit and equity markets.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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