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)

- avoid dilution when stock is undervalued

The Ideal 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

Cocobonds

• In good times: normal debt

• Bad times: mandatory conversion into equity

• Today mostly issued by banks

Problems with 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

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

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.

Conversion will 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

Preventing Conversion

• 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.

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

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

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 small

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

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

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

COERC Credit Spreads by Dilution Ratio→ A greater dilution ratio, α, lowers COERCs’credit spreads.

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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

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

Regulatory Capital versus Market Value Capital Triggers

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Barclays partially Endorses COERC

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Barclays CoCo plan seeks to allay investor dilution threat

By Steve Slater LONDON | Wed Apr 17, 2013 3:05pm BST

(Reuters) - Barclays (BARC.L) is seeking to head off any future row with shareholders about dilution of their holdings by proposing they get the right to buy shares if new instruments kick in that force debt holders to convert to equity. Regulators are demanding that bondholders help strengthen a bank if its capital position weakens, which would provide greater protection for depositors and taxpayers. Banks are trying to develop the best structure for such debt.

Banks Report The Secret Truth about Lloyds, RBS and Barclays Barclays in recent months has issued $4 billion (2.6 billion pounds) of contingent capital debt, whose value is wiped out if the bank's core capital ratio falls below 7 percent.

It has said it may issue 6 billion pounds more contingent debt, some of which could convert into ordinary shares in the event the ratio is breached, or contingent convertible debt (CoCos).

The bank will next week ask shareholders to approve this type of debt instrument.

Barclays said it intends to give them the opportunity to buy any shares from a conversion of debt to enable them to avoid dilution of their stakes. This would also offer an exit for bondholders who don't want to own shares, but it is not clear whether they would be forced to offer the shares.

The dilution issue is sensitive for Barclays, which provoked fury in 2008 when new Middle East backers invested in the bank on terms that many existing shareholders said was more attractive than they could get.

CoCos have been issued by other banks, but there is no standardised structure. How they will work at times of stress remains uncertain.

SHAREHOLDER GROUPS WARY

The Association of British Insurers (ABI) failed to give Barclays its backing for the new CoCos ahead of the vote by shareholders on April 25.

The ABI, whose members account for about 15 percent of the UK stock market, issued an "amber top" alert on the plan, people familiar with the matter said, which flags a contentious issue but stops short of recommending investors reject it.

The ABI said it was concerned that shareholders are not guaranteed the right to buy shares, which Barclays described as only an intention.

PIRC, another advisory group, said investors should abstain from the resolution and opposed a separate proposal by the bank that would allow debt to be issued that would not offer shareholders the chance to buy the shares.

"While the reason provided is understandable, the dilution involved for those shareholders not able to subscribe may significantly decrease their interest in the bank," PIRC said.

Barclays said issuing Cocos that convert to equity would give it flexibility, be more efficient and may give it more room to pay dividends.

Credit Suisse (CSGN.VX), UBS (UBSN.VX) and KBC (KBC.BR) have also issued CoCos. Lloyds (LLOY.L) sold 10 billion pounds of convertible bonds in 2009, but a hedge fund investor last year said the bonds were "expensive and uneconomic", underlining the wariness of mainstream investors toward hybrid securities.

PIRC also recommended that Barclays shareholders vote against its pay plan, saying its variable awards for executives are excessive, and opposed the re-election of John Sunderland, the head of the bank's remuneration committee.

(Additional reporting by Sinead Cruise; editing by Jane Baird)

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Implementation Issues

• 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