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. 14

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 16

Barclays partially Endorses COERC 17

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