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Theo vermaelen presentation

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Mr. Theo Vermaelen's presentation for our Financial Innovation: COERC as a New Financing Instrument for Corporations

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Theo vermaelen presentation

  1. 1. The case for COERCS Theo Vermaelen Professor of Finance INSEAD
  2. 2. How should an Ideal Financial Security look like? • Tax efficient • No negative information signal • No costs of financial distress • No agency costs • No wealth transfers from shareholders to others 2
  3. 3. Equity • Not tax efficient if company is profitable (-) • Negative information signal as market expects timing (-) • Low costs of financial distress (+) • high agency costs (-) • If shares undervalued, wealth transfer to new shareholders (-) 3
  4. 4. Debt • Tax efficient when company is profitable (+) • No negative information signal (+) • Costs of financial distress (-) • Low agency costs (+) • If shares undervalued, no wealth transfers to new shareholders (+) 4
  5. 5. Choice between Debt and Equity Imperfection Debt Equity •Corporate taxes 1 2 •Expected COFD 2 1 •Agency costs 1 2 •Undervaluation 1 2 5
  6. 6. Government policies can correct tax disadvantage • Example : Cooreman-De Clercq ( 1982) • Companies that issued equity could deduct 13 % of the amount issued from their taxable income for 10 years • Personal tax advantages for individuals who invest in common stock • Result : More equity issued in 1982-1983 than during previous 13 years • Belgian stock market became “market of the year” 6
  7. 7. Cooreman-De Clercq and the stock market Monthly cumulative return difference between KB-index and the “world” index, from January 1981 until January 1984 7
  8. 8. However : how to elimate COFD ? Imperfection Debt Equity •Corporate taxes 1 2 •Expected COFD 2 1 •Agency costs 1 2 •Undervaluation 1 2 8
  9. 9. 9 Coco bonds • Contingent convertibles (CoCos) are bonds that mandatorily convert to equity after a triggering event such as a decline in the bank’s capital (Flannery (2005). • Motivation: providing discipline of debt (tax deductions?) in good times, avoiding COFD (bailouts!) in bad times. • Since 2009 : 20 banks for $ 100 bn • Although designed for banks potentially interesting for other corporations ?
  10. 10. Cocobonds • In good times: normal debt • Bad times: mandatory conversion into equity • Today mostly issued by banks • Sometimes no conversion but total writedown 10
  11. 11. Problems with Cocos • How to define “bad times”? • If “bad times” are based on stock prices how to avoid manipulation and undeserved conversions? • How to make sure they are not very risky so it is very likely you are going to get your money back ? 11
  12. 12. 12 Solution: COERC • Call Option Enhanced Reversed Convertible • Trigger based on market values • When the trigger is hit, bondholders are forced to convert at huge discount from stock price, creating large potential dilution • However,shareholders get the pre-emptive right to buy new shares at the conversion price and repay debt • As a result Coco bond becomes nearly riskless • COERC coerces shareholders to pay back debt holders 12
  13. 13. 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. 13
  14. 14. Conversion will create Dilution • Assume equity market value falls to 1/3 of assets because 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 14
  15. 15. Preventing Conversion • In order to avoid this wealth transfer to bondholders, equityholders have pre-emptive rights to buy the shares by repaying 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 • Insurance against this failure can be bought by buying an underwriting contract ( put option). Otherwise bondholders will ask credit spread to compensate for this risk. 15
  16. 16. How much would insurance cost ? • Put option • Maturity : 20 days • Stock price : 1.33 • Exercise price 1 • Volatility : 70 % • Jump process with 3 jumps per year jump size 50% • P = 0.006 or 40 m x 0.006 = $ 0.24 m • So you pay insurance fee of 0.6 % • Ideally issuer should provide cash collateral for this fee. 16
  17. 17. • There are 5 million shares outstanding • Each share has 1 right • 40 million new shares, so with each share you can buy 8 new shares if you pay $ 1 x 8 = $ 8 17 Payoffs to Investor
  18. 18. Wealth of the Investor with $ 8 in cash who owns 1 share worth $ 4 • If he exercises the right : 9 new shares at $ 1.33 = $ 12 • If he sells the right to buy new shares to someone else and keeps his $ 8 cash $ 8 1 share $ 1.33 1 right = 8 x (1.33-1) $ 2.64 -------------------------- --------- Total $ 12 18
  19. 19. After the dust has settled Assets: 60 Equity 60 45 million shares outstanding (stock price $1.33) You cleaned up your balance sheet without transferring wealth to debt holders Potential to re-lever 19
  20. 20. 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 • Debt is very likely to be repaid, rather than forced to convert • The only risk is that because of “jumps” the value of the assets falls below $ 40 milion so that fully diluted stock price falls below $ 1. • In order to largely eliminate this risk issuers can pay for firm commitment underwriting contract. 20
  21. 21. 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 very small • ROE will go up, although WACC remains the same • As debt has become large risk-free, no more costs of financial distress, hence total firm value will increase • Death spirals because of manipulation and panic can be prevented • COERC issuance is not a signal of overvaluation ! 21
  22. 22. Choice between Debt, Equity and Coerc Imperfection Debt Equity Coerc •Corporate taxes 1 3 1 •Expected COFD 3 1 1 •Agency costs 1 2 1 •Undervaluation 1 2 1 22
  23. 23. 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 • Of course, this assumes that rights can be sold at fair value 23
  24. 24. Difference with other bonds • Covered bond : collateral is put up front, illiquid? > COERC: collateral is cash provided by Coercive rights issue when needed • Subordinated debt : credit spread charges for default risk > COERC : no credit spread but firm commitment rights underwriting fee when trigger is hit 24
  25. 25. A case study • Bidder is considering making a $ 120 million bid for Target • It does not want to pay with stock • If it borrows to pay for it it will have to issue bonds below investment grade • Can COERC be the solution ? 25
  26. 26. 26 Balance sheet of Bidder ( $ million) Assets Liabilities 230 Debt 50 Equity 180 230 230 Stock price : $112 shares outstanding : 1.7 million Debt/Assets = 22 %
  27. 27. 27 Balance sheet of Target Assets Liabilities 115 Debt 25 Equity (E) 90 115 115
  28. 28. 28 Bidder after merger (assume $120 m purchase price for target equity paid by issuing COERC; assume other debt) Assets Liabilities 375 Debt 75 COERC 120 Equity 180 375 375 Debt/assets = 195/375 = 52 % COERC converts when Debt/Asset = 65 % Discount of 50%
  29. 29. The trigger • Based on market values of equity and book values of debt • Because book values are normally calculated only quarterly, company should update book values if it changes more than 1 % • Note that this is not the same as a stock price trigger : you can’t control the stock price but you can control leverage to a large extent 29
  30. 30. What happens at conversion ? • Debt/Assets = 65 % and Debt = 195 • Assets = 195/0.65 = 300 • Equity = 300 – 195 = 105 • This represents a fall in equity of (180-105)/180 = 42 % • Current stock price is $ 112 • A 42 % decline means new stock price will be $ 65 • Then you announce a rights issue at a 50 % discount ($ 32.5) • This means new shares issued : 120 m/32.5 = 3.7 m • Total number of shares outstanding is 3.7 m + 1.7 m =5.4 m 30
  31. 31. After the dust settles • Total firm value is still 300 • Non-Coerc debt = 75 • Equity = 225 • Stock price (fully diluted) = 225/5.4 = $ 42 • Issue will fail if stock falls below $32.5 in 20 days . Insurance : Underwriter firm commitment = put option • Value of put ? Volatility = 70 % 3 Jumps per year of 50% • Put = 0.226 • Total cost = 0.226 x 3.7 m = $ 0.836 m • Total cost =0.7 % of 120 m raised 31
  32. 32. 32 Bidder after merger + conversion Assets Liabilities 300 Debt 75 Equity 225 300 300 Debt/assets = 25 %
  33. 33. Why issue COERCS ? • You can borrow at (almost) the risk-free rate (A rating) • You have however to commit to buy insurance by having the rights issue underwritten. • The underwriting fee only has to be paid when conversion is triggered • You may however put enough collateral aside to pay for the underwriting fee • Only if you are a true high credit risk you will pay the insurance ! • This is better than issuing subordinated debt now with a large credit spread to be paid every year 33
  34. 34. Why buy COERCS ? • You have a corporate alternative to buying government bonds (low risk, A rated) • Because the company has committed to insure the proceeds of a rights issue to repay you when conversion is triggered, your risk is largely eliminated • High risk-aversion ( Banks ?) 34
  35. 35. 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 • Regulators/bankers like capital ratio triggers for a variety of reasons • Corporate non-banking sector has freedom to design contracts 35
  36. 36. Regulatory Capital versus Market Value Capital Triggers 36
  37. 37. Barclays partially Endorses COERC 37 37
  38. 38. The ideal issuer • Company perceived as risky • Management feels market undervalues cash flows/ overestimates risk • Profitable and therefore taxable business • Current large shareholders don’t want to issue equity now 38

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