4

Strategic Equity Transactions around Convertible/Exchangeable Bonds

This chapter examines strategic equity transactions built around convertible or exchangeable bonds. I will start by analyzing the structure around an exchangeable issued with a third-party guarantee. I will continue analyzing how Novartis issued a convertible bond through a third party to avoid a potential tax charge on its own shares. Then, I will analyze how Richemont crystallized gains in a convertible bond investment through warrants. Later, I will describe how Deutsche Bank monetized a stake with an exchangeable and a put option. Next I will analyze strategies to increase or decrease the likelihood of conversion with two cases: one from CSM and another from Microsoft. Next I will describe a transaction that allowed a double issuance of exchangeable bonds. I will continue with Cap Gemini's repurchase of conversion rights and repurchases of convertible bonds. Finally, I will give an example of pre-IPO convertible bonds.

4.1 ISSUING AN EXCHANGEABLE WITH A THIRD-PARTY GUARANTEE

4.1.1 Case Study: Controlinveste's Exchangeable Bonds on Portugal Telecom

Sometimes a private entity owns a substantial stake in a public company. A common thread of these private entities is the following: the founder and majority owner of a privately owned successful business acquires a significant stake in a publicly traded blue chip to diversify his/her assets. In a weak market environment, the owner wants to raise financing, but he/she is unwilling to sell the stake because its stock price is too low. One alternative is to raise financing by issuing an exchangeable bond on the stake, but the issuer will be a company which is not known to institutional investors, is unrated and is difficult to analyze. However, the owner and his/her companies are well known by a bank that has witnessed the expansion of the private entrepreneur's empire since its beginnings. One solution to raise financing is for the private entity to issue an exchangeable bond guaranteed by the bank. In order to cover the intricacies of exchangeable bonds guaranteed by third parties I will next dissect a real-life transaction.

In January 2010 Controlinveste International Finance (“the issuer”) issued an exchangeable bond into shares of Portugal Telecom and guaranteed by Banco Comercial Portugues (“BCP”). Controlinveste was one of the largest media groups in Portugal, controlled by the entrepreneur Joaquim Oliveira. The exchangeable had the following main terms:

Controlinveste's Exchangeable Bond Terms
Issuer	Controlinveste International Finance, a wholly owned subsidiary of Controlinveste International
Guarantor	Banco Comercial Portugues S.A.
Rating	BBB+ by Standard and Poor’s
Notional amount	EUR 224 million
Redemption amount	100% of notional amount
Denomination	EUR 50,000
Issue date	28-January-2010
Maturity	28-January-2015 (i.e., 5 years)
Underlying stock	Portugal Telecom, SGPS, S.A.
Issue price	100%
Coupon	3%, annual Act/Act
Exchange price	EUR 10.97
Underlying number of shares	20.42 million (= 224 million/10.97)
Exchange ratio	4,557.885 (= 50,000/10.97)
Exchange premium	35% above the share price at issue
Share price at issue	EUR 8.13
Exchange period	From 22-December-2014 until 7 days prior to the maturity date
Issuer call	None, except clean-up call and tax call
Extraordinary dividend protection	Protection for any cash dividend in excess of the threshold amount (defined below)
Bookrunners	Credit Suisse and Banco Comercial Portugues

4.1.2 Transaction Overview

For the sole purpose of issuing the exchangeable, Controlinveste International S.A.R.L. created Controlinveste International Finance (“the issuer”), a wholly owned SPV incorporated under Luxembourg laws. Controlinveste International was in turn a subsidiary of Controlinveste Communicacoes, SPGS, S.A., which was part of the Controlinveste group. On 27 January 2010, Controlinveste Communicacoes, SPGS, S.A., within a share capital increase through contributions in kind, transferred the ownership of 20.42 million shares of Portugal Telecom corresponding to 2.28% of Portugal Telecom's share capital to Controlinveste International S.A.R.L. (“Controlinveste International”).

The structure of the transaction at inception had the following elements (see Figure 4.1):

4.1.3 Dividend Swap and Transaction Flows during the First Four Years

Under the exchangeable, the issuer had to pay a 3% coupon and its only source of income was the dividend payments distributed to the exchange property. As a result, the issuer was exposed every year to a dividend amount lower than the annual coupon payment. To mitigate this exposure, the issuer entered into a dividend swap with Controlinveste International. Under the terms of the dividend swap the issuer paid any cash dividends received by it in respect of the exchange property (except for any cash dividends paid on or after the fourth anniversary of the issue date). The dividend payments under the swap were limited (i) up to the threshold amount (as defined below) and (ii) up to an amount equivalent to the coupon payments on the bond in return for receiving payments matching the coupon payments of the bonds, except the last regular coupon amount due on the maturity date. In other words, as the issuer had to pass to the bond holders any dividend excess over the dividend yield threshold, this excess was kept by the issuer, and thus, was not paid under the dividend swap. The issuer also kept any dividend amounts up to the 3% coupon. Therefore, under the dividend swap the issuer paid to Controlinveste International the dividend excess over the upcoming 3% coupons, up to the threshold amount. Also under the dividend swap, Controlinveste International paid to the issuer any deficits from the dividends kept by the issuer, so it could meet the 3% coupon payments and the extraordinary dividend protection payments.

Figure 4.2 depicts the issuer cash flows during the lifetime of the bond, except its last year.

Protection for any cash dividend in excess of the threshold amount was added to the exchange property during the first four years of the bond. The threshold amount was the product of (i) the arithmetic average of the daily VWAPs of the underlying stock over a period of five consecutive trading days including and ending on the dividend record date and (ii) the dividend threshold for the relevant financial year. The dividend yield threshold in respect of each financial year was:

• Financial year ending 31 December 2009: 7%.
• Financial year ending 31 December 2010: 7%.
• Financial year ending 31 December 2011: 7%.
• Financial year ending 31 December 2012: 5%.
• Financial year ending 31 December 2013: 5%.
• Financial year ending 31 December 2014: none.

The obligations of Controlinveste International under the dividend swap constituted unsubordinated and unsecured obligations of Controlinveste International ranking pari passu with all present and future unsecured and unsubordinated obligations of Controlinveste International.

Note that under the dividend swap, the issuer did not have to pay any “dividend amounts” on or after the fourth anniversary of the bond, and that Controlinveste International did not have to pay any “deficit amount” on the bond maturity date. The coupon payable on the maturity date was financed via the repurchase agreement (explained below) while any cash dividends received on or after the fourth anniversary of the bond were paid as dividend on the issuer's shares held by Controlinveste International.

If Controlinveste International did not pay the “deficit amount” on time for the issuer to pay the coupon, with the result that the full coupon was not paid by the issuer on the due date, the trustee would have demanded payment of the unpaid coupon amount from the guarantor under the guarantee and the guarantor would have been required to make payment of the relevant coupon amount within two business days following such demand.

4.1.4 Transaction Flows in Case of Exchanges or at Maturity

From 22 December 2014 and up to seven days prior to the maturity date, the bond holders could exercise their conversion right. If Portugal Telecom stock price was above the EUR 10.97 exchange price minus the per-share sum of the excess dividends above the threshold amounts (accumulated during the first four years), the bond holders would elect to exchange the bond for Portugal Telecom stock. The issuer then had the option to either deliver the exchange property or to pay a cash amount (see Figure 4.3). The cash amount represented the market value of the exchange property, including any accumulated excess amounts. The cash amount was calculated as the product of (i) the arithmetic average of the VWAP of the stock over five days starting on the fifth trading day after the relevant exchange date and (ii) the number of shares included in the exchange property.

Bond holders not exercising their exchange right received the final coupon and the redemption amount on the maturity date (see Figure 4.4). Pursuant to the repurchase agreement, Controlinveste International had the obligation to repurchase the exchange property for a cash amount equal to the sum of (i) the outstanding aggregate notional amount of the bond and (ii) the last coupon due on the maturity date. Controlinveste International had to pay to the issuer the cash amount on the third business day before the maturity date. If Controlinveste International failed to pay the cash amount on such date, BCP would have had to purchase the exchange property for the cash amount on the second business day immediately prior to the maturity date.

4.1.5 Exchange Property Pledge and other Security Mechanisms

The exchange property initially comprised 20.42 million ordinary shares of Portugal Telecom. The exchange property was owned by the issuer. There were two pledges over the exchange property (see Figure 4.5):

• A first-ranking pledge in favor of the bond holders. This pledge made sure that upon conversion the bond holders would receive the underlying shares by preventing the issuer from selling the shares or using them for transactions other than the exchangeable during the exchangeable bond's life.
• A second-ranking pledge in favor of the guarantor. If the bond holders redeemed the bonds for cash, BCP guaranteed that the issuer would repay the bond holders. In case of the issuer becoming insolvent, BCP would be exposed to the issuer. To reduce this exposure, the exchange property was pledged on a secondary basis in favor of BCP. If the issuer did not meet its obligations upon the bond redemption, BCP would take ownership of the exchange property and would sell the shares to partially or totally mitigate BCP's exposure to the issuer.

Because the issuer, Controlinveste International Finance, was an SPV, BCP needed an agreement – the counter indemnity agreement – to give it recourse to Controlinveste International in case payments were made under the guarantee.

4.1.6 Attractiveness of the Transaction to the Issuer and to BCP

The issuer took advantage of a strong demand for convertible/exchangeable instruments at the beginning of 2010. As a result, the issuer was able to obtain very favorable terms. Additionally, if the bond were exchanged for stock, the issuer would have effectively sold its stake at a 35% premium.

BCP, the guarantor, was able to reduce its overall exposure to Controlinveste. The proceeds of the exchangeable were used to partially repay debt owed to BCP. In this way, BCP replaced unsecured senior debt with senior debt backed by Portugal Telecom shares. This collateral was relatively liquid, allowing BCP to hedge its exposure, if wanted, by for example buying puts on Portugal Telecom. Additionally, BCP charged a fee for the guarantee.

4.2 ISSUING A CONVERTIBLE THROUGH A THIRD PARTY

4.2.1 Case Study: Novartis LEPOs and Put Options with Deutsche Bank

This case shows how Novartis entered into a structured transaction with Deutsche Bank to allow it to avoid paying a 53% withholding tax on 55 million treasury shares. The case also shows a way to structure the issuance of a convertible bond through a third party. Finally, the case highlights the implications of a zero-coupon feature on a convertible/exchangeable conversion price and the motivations for investors for investing in such bonds.

In December 2001, Novartis needed to use treasury shares as the underlying of an equity-linked transaction in order to avoid an unfavorable tax countdown. Under Swiss law, a company had to pay withholding tax of 53% if it held its own stock for more than six years. The treasury stock owned by Novartis was acquired in a previous CHF 4 billion buyback program that prevented Novartis from selling its treasury shares before the moment the withholding tax would trigger. However, the 53% withholding tax was not levied if a company reserved the stock for its use in an equity-linked transaction. The transaction helped Novartis to stop the tax clock for the time being.

One alternative for Novartis would have been to directly issue a convertible bond. The issuance of a convertible bond would have increased Novartis debt. However, being an AAA-rated company, Novartis was not keen to increase its leverage to solve a tax problem.

4.2.2 Transaction Overview

In December 2001, Novartis sold a total of 55 million 10-year call LEPO (“Low Exercise Price Options”) options on Novartis shares, with an exercise price of CHF 0.01, to Deutsche Bank. Novartis received EUR 2.2 billion in proceeds (i.e., EUR 40 per LEPO). Simultaneously, Novartis sold a total of 55 million 9- and 10-year put options on Novartis shares to Deutsche Bank with an initial exercise price of EUR 51. Novartis received EUR 0.6 billion in proceeds (i.e., EUR 11 per put option). Overall, Novartis received EUR 2.8 billion from the sale of the two options.

The position was, in turn, resold by Deutsche Bank in the market through the issuance of two exchangeable bonds into Novartis stock. The exchangeable issuance allowed Deutsche Bank to offload most of its options exposure. The new offering consisted of two zero-coupon bonds that could be redeemed at a premium to their sale price. This deal was offered in two equally sized tranches of EUR 1.4 billion: one maturing in 2010 with a 3.125% effective yield and another maturing in 2011 with a 2.75% effective yield. Each bond came to the market with a 28.2% initial conversion premium. Figure 4.6 illustrates the transaction flows at inception. The following table summarizes the terms of the exchangeables:

Deutsche Bank's Exchangeable Bonds into Novartis
Issuer	Deutsche Bank Finance N.V.
Guarantor	Deutsche Bank A.G.
Form of security	Bonds exchangeable into ordinary Novartis common stock
Size	Total size EUR 2.8 billion Tranche-2010: EUR 1.4 billion Tranche-2011: EUR 1.4 billion
Status	Senior, unsubordinated and unsecured
Maturity	Tranche-2010: 9 years (6-December-2010) Tranche-2011: 10 years (6-December-2011)
Issue price	100% of par (both tranches)
Coupon	Zero (both tranches)
Yield to maturity	Tranche-2010: 3.125% (annual) Tranche-2011: 2.75% (annual)
Redemption price	Tranche-2010: 131.9% of par (= EUR 1.8466 billion) Tranche-2011: 131.2% of par (= EUR 1.8368 billion)
Exchange price	EUR 51.00
Exchange premium	28.2% premium over the EUR 39.78 share price at pricing (both tranches)
Put features	Tranche-2010: Puttable in years 4 (at 113.1%) and 6 (at 120.28%) Tranche-2011: Puttable in years 3 (at 108.48%), 5 (at 114.53%) and 7 (at 120.91%)
Call features	Not callable for 3 years, thereafter callable at the accreted notional amount subject to the Novartis shares trading at 130% of the accreted notional amount
	Hard callable from year 5 (both tranches)
Use of proceeds	General corporate purposes
Other provisions	Issuer's cash-out option, takeover protection (at bond holders option put at 105% or substitution into new entity), anti-dilution protection, extraordinary dividend protection (3% threshold), no tax gross up, tax, legal, accounting and regulatory call at greater of market value and accreted principal amount, clean-up call (25%)

4.2.3 Deutsche Bank's Exposure to Novartis's Stock Price

Let us take a look at Deutsche Bank's flows at inception:

• Deutsche Bank bought a call with strike almost zero (CHF 0.01) on 55 million shares of Novartis. The bank paid EUR 40 per option, or a total of EUR 2.2 billion.
• Deutsche Bank bought a put with strike EUR 51 on 55 million shares of Novartis. The bank paid EUR 11 per option or a total of EUR 0.6 billion.
• Deutsche Bank issued the two exchangeable bonds, raising EUR 2.8 billion.

As a result, Deutsche Bank's cash position at inception was flat (= – 2.2 billion – 0.6 billion + 2.8 billion).

In order to match the exchangeable bond redemption amounts, were the bond holders to exercise their bond put rights, the equity puts traded between Novartis and Deutsche Bank had an increasing strike profile:

• The 9-year put had an initial strike of EUR 51.00. The put could be exercised at the end of years 4 and 6, and at maturity. The put strike increased to EUR 57.68 in year 4 (= 113.1% × 51), EUR 61.34 in year 6 (= 120.28% × 51), and EUR 67.27 at maturity (= 131.9% × 51).
• The 10-year put had an initial strike of EUR 51.00. The put could be exercised at the end of years 3, 5 and 7, and at maturity. The put strike increased to EUR 55.32 (= 108.48% × 51) in year 3, EUR 58.41 (= 114.53% × 51) in year 5, EUR 61.66 (= 120.91% × 51) in year 7 and EUR 66.91 (= 131.2% × 51) at maturity.

Let us take a look at Deutsche Bank's flows at maturity, assuming both bonds were redeemed for cash at their respective maturities:

• Deutsche Bank would exercise the call, receiving 55 million shares of Novartis and paying to Novartis CHF 550,000 (= 0.01 × 55 million). Due to its small size, I will ignore this payment in the upcoming calculations.
• Deutsche Bank would exercise the 9-year put, delivering 27.5 million (= 55 million/2) shares of Novartis and receiving from Novartis EUR 1.85 billion (= 67.27 × 27.5 million).
• Deutsche Bank would exercise the 10-year put, delivering 27.5 million (= 55 million/2) shares of Novartis and receiving from Novartis EUR 1.84 billion (= 66.91 × 27.5 million).
• Because the first bond redemption price was 131.9% of par, the first bond would be redeemed for EUR 1.85 billion (= 131.9% × 1.4 billion).
• Because the second bond redemption price was 131.2% of par, the second bond would be redeemed for EUR 1.84 billion (= 131.2% × 1.4 billion).

As a result, Deutsche Bank's cash and stock positions at maturity in case of the bonds’ redemption was flat (= 0 billion + 1.85 billion + 1.84 billion – 1.85 billion – 1.84 billion), as shown in Figure 4.7.

Let us take a look at Deutsche Bank's flows at maturity, assuming bonds were exchanged for Novartis shares at their respective maturities:

• Deutsche Bank would exercise the call, receiving 55 million shares of Novartis and paying to Novartis CHF 550,000 (= 0.01 × 55 million). Due to its small size, I will ignore this payment in the upcoming calculations.
• Deutsche Bank would not exercise the 9-year put.
• Deutsche Bank would not exercise the 10-year put.
• Upon exchange of the first bond, Deutsche Bank would deliver 22.5 million shares to the bond holders.
• Upon exchange of the second bond, Deutsche Bank would deliver 22.5 million shares to the bond holders.

As a result, Deutsche Bank's cash and stock positions at maturity were flat, ignoring the strike amount of the call option, as shown in Figure 4.8.

Therefore, in any scenario, Deutsche Bank's position was neutral. However, this outcome was true if Novartis did not fail to pay the strike amount of the puts upon their exercise. Remember that under the puts Deutsche Bank had the right to sell the shares back to Novartis in exchange for the strike amount. So, if in any scenario Deutsche Bank did not profit, why did it enter into the trade? It was not publicly disclosed but most probably Deutsche Bank received a structuring fee from Novartis for putting in place the transaction. Also, by placing the bonds, Deutsche Bank's place in the convertible lead tables was enhanced, probably improving its chances of being mandated in other convertible deals.

4.2.4 Effect of Deutsche Bank's Zero-coupon Convertibles on the Exchange Price

Zero-coupon convertibles/exchangeables tend to be issued by companies with a high credit rating. In our case, Deutsche Bank's exchangeable did not pay a coupon. Deutsche Bank was rated AA by Standard and Poor’s, a very strong credit rating. Instead, the bonds could be redeemed at a premium to their face value, if not exchanged into stock. Zero-coupon convertibles/exchangeables have no current yield. The yield to maturity (or to each put date) is achieved by means of either (i) an issue price at a discount to par and a redemption price at par, or (ii) an issue price at par and a redemption price at a premium to par. In our case, Deutsche Bank exchangeable bonds included the second alternative.

Let us take a look at Deutsche Bank's 2011 exchangeable. The bond was exchangeable into 27.5 million shares of Novartis (= EUR 1.4 billion/EUR 51.00). At maturity, the bond could be redeemed for EUR 1.8368 billion (i.e., 131.2% of par). The effective yield to maturity of the bond was 2.75% [= 131.2%(1/10) – 1].

The redemption of the bond at a premium meant that at maturity Novartis's stock price had to trade above EUR 66.79 (= EUR 1.8368 billion/27.5 million shares) – the effective exchange price – to elicit bond holders to exchange. The effective exchange price was 31% larger than the initial EUR 51.00 exchange price. Thus, by exchanging the bond into a fixed number of shares, the zero-coupon profile caused the effective exchange price to rise, as shown in Figure 4.9. The graph also shows that the return on the bond remained constant unless the stock price rose a long way.

4.2.5 Attractiveness of Deutsche Bank's Zero-coupon Exchangeables to Investors

Due to the substantial difference between the conversion price based on the issue price and the conversion price based on the final redemption price, Deutsche Bank's exchangeable bonds were attractive for investors looking for upside equity exposure but with a very large fixed income component. However, for investors looking for a large equity component the bond was notably less attractive. Figure 4.10 compares the total return of a zero-coupon convertible/exchangeable with the total return of a direct investment in equity, a straight bond and a coupon paying convertible/exchangeable. It can be seen that the inclusion of the zero-coupon feature made the bond behave more like a straight bond and less like a direct equity investment.

4.2.6 Advantages to Novartis and Relevance of a Call Right

The transaction had several advantages to Novartis:

• It allowed Novartis to avoid paying a 53% withholding tax on the 55 million treasury shares.
• Under Swiss GAAP, the transaction had a very favorable accounting treatment. It allowed Novartis to account for the transaction as equity, as share premium, a total of EUR 2.8 billion. Novartis accounted for the option premium associated with the call and the put options as an increase in share premium at fair value less related issuance costs.
• It allowed Novartis to avoid accounting for the transaction as debt, protecting its AAA credit rating.

The introduction of a new rule by the US GAAP over the treatment of hedging practices and the adoption of IFRS rules rendered the transaction unattractive. For example, under IFRS the increasing strike profile of the puts obliged Novartis to account for them as derivative instruments instead of as a capital instrument. From 2005, Novartis's profit or loss statement was exposed to changes in the put fair value, notably increasing the volatility of its profit or loss statement. As a result, Novartis redeemed in advance these equity instruments on 26 June 2003. This case also highlights the importance of a call mechanism in a convertible/exchangeable. This bond was not callable for 3 years (i.e., until December 2004). Consequently, the bond could not be called in 2003 and Novartis had to repurchase the exchangeable in the market, paying a significant premium to elicit bond holders to sell their bonds.

4.3 CRYSTALLIZING A GAIN IN A CONVERTIBLE INVESTMENT THROUGH WARRANTS

4.3.1 Case Study: Richemont Warrants Issue on Back of Convertible Preference Shares

This case analyzes how Richemont, a Swiss luxury goods group owning a portfolio of leading international brands including Cartier, Montblanc and Dunhill, effectively crystallized the profit embedded in a subsidiary's holding of a convertible preferred stock through the issue of call warrants exercisable into common stock of British American Tobacco (BAT).

In December 2002 R&R Holdings S.A. (R&R), a Luxembourg-domiciled subsidiary of Richemont, was BAT's largest stock holder. BAT was one of the world's leading tobacco groups. Richemont held 66.7% of R&R and the remaining 33.3% of R&R was owned by Remgro Limited, a South African-listed company. R&R acquired its stock holding in June 1999 upon the merger of BAT and R&R's subsidiary Rothmans International B.V. At the time of the merger, BAT issued to R&R common stock and convertible redeemable preferred stock that equated to approximately 35% of the fully diluted issued common stock of BAT, 25% in ordinary shares and 10% in convertible preferred stock. R&R's voting rights were limited to a maximum of 25% under the terms of the standstill agreement with BAT. Under the terms of the merger agreement between Richemont, Remgro and BAT, the preferred stock could convert into 120.9 million shares of BAT at GBP 6.75 per share, as shown in the following table:

BAT Convertible Preferred Stock
Issuer	British American Tobacco
Buyer	R&R Holdings S.A.
Issue date	7-June-1999
Instrument	Convertible preference shares
Underlying stock	British American Tobacco ordinary shares
Notional amount	GBP 816 million
Number of shares	120.9 million
Conversion price	GBP 6.75
Maturity	7-June-2004
Exercise date	28-May-2004
Redemption price	100% of notional amount
Other	The preference shares will automatically convert to ordinary shares in BAT if they are sold to the market prior to maturity

The preferred stock would automatically convert into common stock of BAT on a one-for-one basis on any sale of R&R to a third party. Otherwise, the preferred stock would be converted into BAT stock at GBP 6.75 per share on 7 June 2004.

Richemont announced in December 2002 that its subsidiary R&R was to offer 120.9 million secured European-style warrants exercisable at the option of the warrant holder into BAT common stock.

4.3.2 Warrants’ Terms

In December 2002 R&R offered 120.9 million secured European-style warrants exercisable at the option of the warrant holder into common stock of BAT. A warrant is an option that is listed on a stock exchange. The warrants’ expiration date was 28 May 2004, coinciding with the exercise date of the convertible preferred stock, and their strike was GBP 6.75 per warrant.

R&R Warrants on BAT
Issuer	R&R Holding S.A.
Announcement date	11-December-2002
Stock	BAT ordinary shares
Warrant type	Call
Style	European
Number of warrants	120.9 million
Exercise price	GBP 6.75
Reference price	GBP 5.98
Conversion premium	12.9%
Exercise date	28-May-2004
Settlement date	7-June-2004
Premium per warrant	GBP 0.3428
Total premium	GBP 41.45 million
Listing	Luxembourg Stock Exchange
Settlement type	Physical delivery

On 28 May 2004, all the holders of the warrants exercised their rights, causing R&R's effective interest in BAT to decline to 18.6%. R&R subsequently exchanged its entire holding of preferred stock for BAT stock. In addition, R&R retained all of its original 25% holding of common stock in BAT.

4.3.3 Analysis of R&R's Position

The issuance of the call warrants realized the value of the conversion rights embedded in the terms of the preferred stock. In June 2004, R&R was to receive GBP 816 million either upon exercise of the warrants by warrant holders or through the redemption of the preferred stock by BAT (see Figure 4.11). The share of these proceeds, either through the disposal or the redemption, attributable to Richemont was to amount to GBP 544 million (= 816 million × 66.7%).

If BAT's stock price on 28 May 2004 was lower than or equal to GBP 6.75, R&R would receive GBP 816 million in cash:

• R&R would not convert the preferred stock, receiving from BAT GBP 816 million in cash.
• The warrant holders would not exercise their warrants. The warrants would expire worthless.

If BAT's stock price on 28 May 2004 was greater than GBP 6.75, R&R would exercise the preferred stock exercise right:

• R&R would convert the preferred stock, receiving from BAT 120.9 million shares of BAT.
• The warrant holders would exercise their warrants, paying GBP 816 million (= 120.9 million × 6.75) to R&R in exchange for 120.9 million shares of BAT.

Additionally, R&R raised GBP 41.45 million from the issuance of the warrants just after 11 December 2002. Thus, in total R&R received GBP 857.45 million (= 816 million + 41.45 million). The share of these proceeds from the disposal or redemption attributable to Richemont totalled GBP 572 million (= 857.45 million × 66.7%).

4.3.4 Main Benefits to Richemont of the Warrants Issue

The main benefits to Richemont (and to R&R) of the transaction were the following:

• It helped R&R to lock in the value of R&R's preferred stock stake. The combination of the preferred stock and the warrants guaranteed that R&R received GBP 816 million at their maturity.
• Richemont booked a EUR 301 million gain. Before the warrants issue, Richemont accounted for the preferred stock as an equity interest. The issue of the warrants irrevocably committed R&R to dispose of the balance of the preferred stock for GBP 816 million, either as a consequence of the exercise of the warrants or through the redemption of the preferred stock by BAT. Reflecting the fixed nature of the proceeds from the overall position, Richemont accounted for the preferred stock as a debt rather than as an equity interest, carrying it at the discounted present value of the GBP 816 million in June 2004 plus the present value of the preferred stock dividend payments. Richemont also recognized the valuation of the conversion rights embedded within the preferred stock as a liability. The change in fair value of the conversion rights was fully offset at all times by the change in fair value of the warrants.
• R&R received GBP 41.45 million in cash from the issuance of the warrants (i.e., the warrants’ premium).
• R&R crystallized the time value of the preferred stock embedded conversion right. The time value was GBP 41.45 million (i.e., the warrants’ premium).

4.3.5 Effect on BAT's Stock Price of the Warrants Issue

Hedge funds investing in the warrants needed to sell BAT shares on issue date to initially delta-hedge their position. The initial delta of the warrants was approximately 30%. If all warrant investors were to maintain a delta-neutral initial position, a total of 36 million (= 120.9 million warrants × 30% delta) shares of BAT would be sold on issue date. In order to successfully place the warrants, R&R/Richemont needed to take into account two important facts:

• Firstly, hedge funds needed to borrow the shares to initially delta-hedge their position. Usually the issuer would lend the shares. In our case, R&R directly held 302 million shares of BAT, so it could lend 36 million shares to the hedge funds to accommodate their shorting needs.
• Secondly, the sale of the shares could have a large impact on BAT's stock price. The daily average trading volume of BAT stock was approximately 10 million shares. An uncontrolled sale of 36 million shares could have created a substantial stock overhang, negatively affecting BAT's stock price. In order to avoid a stock overhang, a block trade was organized by the banks managing the issue. They offered to acquire the shares at a 3.4% discount to the stock previous closing price. As a result, BAT's stock price on 11 December 2002 was unaffected by the transaction, closing at GBP 6.20 while the previous day it closed at GBP 6.19.

4.4 MONETIZING A STAKE WITH AN EXCHANGEABLE PLUS A PUT

4.4.1 Case Study: Deutsche Bank's Exchangeable into Brisa

The two most common ways to implement a future disposal of a stake are by entering into an equity derivative (a forward or an equity swap) or by issuing a mandatory convertible. If these two alternatives are not sufficiently attractive, there are other ways to implement it. This case shows how Deutsche Bank acquired a stake in Brisa, the largest Portuguese toll road operator, from the Portuguese State and how Deutsche Bank hedged its exposure by (i) issuing an exchangeable bond into the stake and (ii) buying a put from Brisa. One interesting characteristic of the transaction was that it not only mitigated Deutsche Bank's market exposure to Brisa's stock price, but also mitigated Deutsche Bank's credit exposure to Brisa.

4.4.2 Transaction Overview

In November 2002, the Portuguese State-owned holding company Investimentos e Participacoes Empresariais, S.A. (IPE) was looking to sell its remaining 5.7% stake in Brisa comprising 32.6 million shares. IPE was set up in the 1970s to control companies that a revolutionary government seized. The Portuguese government was interested in selling this stake to help it keep its government debt level within the European Union limits. IPE was considering selling the stake through a block trade, but the discount required to place it was too large. In the meantime, Deutsche Bank proposed to IPE a transaction that could optimize such disposal. The transaction had three components (see Figure 4.12):

The terms of the exchangeable are outlined in the following table:

Deutsche Bank's Credit-linked Exchangeable Bond into Brisa
Issuer	Deutsche Bank A.G. London
Guarantor	Deutsche Bank A.G.
Issue date	10-December-2002
Settlement date	13-December-2002
Form of security	Bonds exchangeable into ordinary Brisa common stock
Notional amount	EUR 183.2 million
Status	Senior, unsubordinated and unsecured
Maturity	13-December-2007
Issue price	100% of par
Denominations	EUR 100,000
Coupon	Euribor 3-month – 50 bps, paid quarterly, Actual/360
Redemption price	100% of notional amount
Exchange price	EUR 5.62
Initial exchange premium	15%
Stock price at issuance	EUR 4.89
Exchange ratio	17,802.9 shares per denomination
Cash	The issuer shall be entitled upon exercise of the exchange right by a bond holder in lieu of delivery of all or a portion of the shares to pay to the bond holder a cash amount in EUR
Credit-linked clause	If a Brisa credit event occurs, for as long as such event continues, the issuer shall have no obligation to redeem the bond, whether at scheduled maturity or any date of early redemption, or make any interest payments, and interest shall cease to accrue on the bond
Brisa credit event	The occurrence of (i) any application for insolvency, bankruptcy or similar proceedings in respect of Brisa or any material subsidiary of Brisa or if Brisa or any material subsidiary of Brisa reaches an agreement with creditors in respect thereof or to suspend payments or otherwise suspend payments on its debts, (ii) any default or defaults, which continue after any applicable grace period, by Brisa or any material subsidiary of Brisa on payments in the aggregate amount of EUR 20 million or more (or the equivalent in one or more other currencies) in respect of financial indebtedness, or (iii) any default or defaults, which continue after any applicable grace period, by Brisa or any material subsidiary of Brisa in the aggregate amount of EUR 1 million or more owed to the issuer

4.4.3 Analysis of Deutsche Bank's Overall Position

The best way to understand Deutsche Bank's overall position under the transaction is to analyze its flows at maturity under two scenarios: (i) a first scenario in which the bond holders exercised the right to exchange the bond into Brisa shares, and (ii) a second scenario in which the bond is redeemed at its notional amount.

First Scenario at Maturity: Exchange

If, at maturity, Brisa's stock price was above the EUR 5.62 exchange price, the bond holders would exercise their right to exchange the bond into Brisa shares:

• Deutsche Bank would deliver 32.6 million shares of Brisa to the bond holders.
• Deutsche Bank would not exercise the put option.

Thus, upon exchange, Deutsche Bank would deliver the stake acquired from IPE (see Figure 4.13). No cash would flow among the counterparties to the transaction.

Second Scenario at Maturity: Redemption

If, at maturity, Brisa's stock price was below or at the EUR 5.62 exchange price, the bond holders would not exercise their right to exchange the bond into Brisa shares and the bond would be redeemed. Deutsche Bank would exercise the put option. Brisa had the right to elect to settle the option either physically or in cash.

If Brisa elected physical settlement, the flows would be the following (see Figure 4.14):

• Deutsche Bank would pay the EUR 183.2 million redemption amount to the bond holders.
• Deutsche Bank would exercise the put option. As Brisa elected physical delivery, Deutsche Bank would deliver to Brisa 32.6 million shares of Brisa and Deutsche Bank would receive from Brisa EUR 183.2 million.

If Brisa elected cash settlement, the flows would be the following (see Figure 4.15):

• Deutsche Bank would pay the EUR 183.2 million redemption amount to the bond holders.
• Deutsche Bank would sell the stake into the market.
• Deutsche Bank would exercise the put option. As Brisa elected cash settlement, Brisa would pay to Deutsche Bank the difference between (i) EUR 183.2 million and (ii) the proceeds from the disposal of the shares in the market.

It was crucial that the volume-weighted average price at which Deutsche Bank would sell its Brisa stake into the market had to coincide with the final price computed under the put option. Otherwise, Deutsche Bank would be exposed to Brisa's stock price as the sum of (i) proceeds from the sale into the market and (ii) the put settlement amount would not equal the bond redemption amount.

Thus, under a redemption scenario Deutsche Bank would sell the stake acquired from IPE either to Brisa under the put or onto the market. If the stake is sold to Brisa, Deutsche Bank would receive EUR 183.2 million from Brisa, and would use this amount to redeem the bond. If, on the other hand, the stake was sold into the market, Deutsche Bank would receive EUR 183.2 million from the combination of the sale into the market and the payoff from the put option, and would use this amount to redeem the bond.

Deutsche Bank's Credit Exposure to Brisa

We just saw that either on redemption or upon exchange, Deutsche Bank did not bear any exposure to Brisa's stock price. This conclusion was true only if Brisa was able to meet its commitments under the put. The put protected Deutsche Bank if, at maturity, the bond holders did not exchange the bond into stock and the stock price was below the exchange price. Let us assume that the bond was redeemed and that Deutsche Bank exercised the put when Brisa was insolvent. Under physical settlement Brisa would fail to pay to Deutsche Bank the EUR 183.2 million strike amount. It would oblige Deutsche Bank to sell the shares in the market and the sale proceeds most probably would be notably lower than the EUR 183.2 million it had to pay to the bond holders. Therefore, an insolvency of Brisa could create substantial losses to Deutsche Bank. To make things worse, there was a high correlation between a low Brisa stock price and Brisa becoming insolvent.

By structuring the exchangeable with a credit-linked feature, Deutsche Bank could mitigate its credit exposure to Brisa. The credit-linked feature of the exchangeable bond offered bond holders a synthetic credit exposure to Brisa. Following a credit event the coupon payments would be stopped and will not accrue. If at maturity Brisa was still insolvent, the bond would not be redeemed. Once all senior claims to Brisa were settled, the bond would be redeemed at its outstanding notional balance adjusted by a percentage – the recovery rate – that represented the percentage of each payment claim that an unsecured and senior creditor of Brisa would have received in respect of such claim in an insolvency, bankruptcy or similar proceeding with respect to Brisa.

4.5 INCREASING LIKELIHOOD OF CONVERSION WITH A CALL SPREAD

4.5.1 Case Study: Chartered Semiconductor's Call Spread with Goldman Sachs

This case shows how a company took advantage of its low stock price to synthetically reduce the conversion price of its existing convertible, as a result increasing the likelihood of issuance of new shares. The case also introduces the call spread strategy.

On 2 April 2001 Chartered Semiconductor Manufacturing (CSM), a Singapore-based technology company, issued a convertible bond with a notional amount of USD 575 million. The redemption price of the bond at maturity was 115.5% of its notional amount (USD 664.1 million). The bond paid a 2.5% coupon. The maturity of the bond was 2 April 2006 (i.e., a 5-year term). The bond was convertible into common stock of CSM at a conversion price of USD 3.09, representing a 33% initial conversion premium. Upon conversion, CSM would deliver 214.8 million new shares to the bond holders. CSM's stock price prevailing at issuance was USD 2.32. Although CSM's stock price was denominated in Singapore dollars, I am using its USD converted price because the convertible bond was denominated in USD. Also because the convertible bond original terms were adjusted to various corporate actions, I have adjusted its terms as of August 2004.

In August 2004, CSM's stock was trading at USD 0.62, well below the USD 2.32 price prevailing at issuance of the convertible bond. At that time, the USD 3.09 conversion price represented approximately a 400% (= 3.09/0.62 – 1) conversion premium. Because CSM core shareholders were already willing to assume the potential dilution resulting upon the bond's conversion, CSM was looking to benefit from an increase in the likelihood of the bond's conversion.

As a result, on 11 August 2004, CSM entered into a compo call spread transaction with Goldman Sachs, with the following terms:

CSM's Call Spread with Goldman Sachs
Party A	Chartered Semiconductor Manufacturing (CSM)
Party B	Goldman Sachs
Intrument	Compo call spread
Trade date	11-August-2004
Shares	CSM ordinary shares
Number of options/shares	214.8 million
Lower strike call
Lower strike call buyer	Party B (Goldman Sachs)
Lower strike call seller	Party A (CSM)
Lower strike price	USD 0.93
Settlement type	Cash settlement or physical settlement, at CSM election
Expiry date	From 2-January-2005 to 2-April-2006
Upper strike call
Upper strike call buyer	Party A (CSM)
Upper strike call seller	Party B (Goldman Sachs)
Upper strike price	USD 3.09
Settlement type	Cash settlement
Expiry date	In coordination with the low strike call exercise
Overall premium	USD 40 million (assumed)
Soft call	To be covered later

CSM sold to Goldman Sachs a USD denominated compo call option on 214.8 million of its shares at a strike price of USD 0.93 per share (the lower strike price). Under the option, Goldman Sachs could purchase 214.8 million CSM shares at an agreed price of USD 0.93. This price represented a premium of 50% to CSM's closing share price on 11 August 2004. The number of shares under the call was equal to the number of shares that were originally planned for issuance under CSM's convertible bond. If the call option was exercised by Goldman Sachs, CSM could settle the option by issuing shares or paying cash to Goldman Sachs. The option was exercisable by Goldman Sachs from 2 January 2005 and expired on 2 April 2006, matching the maturity date of the convertible bond.

Simultaneously, CSM bought from Goldman Sachs a compo call option on 214.8 million of its shares at a strike price of USD 3.09 per share (the upper strike price). The option was cash-settled. By acquiring this call option, CSM effectively bought back the conversion option embedded in the convertible bond. Under the existing terms of the convertible bond, CSM expected the bond to be converted into shares by the bond holders if its share price reached USD 3.09.

4.5.2 Goldman Sachs's Overall Position

Goldman Sachs was long a call spread. A long call spread position was created by buying a call option and selling another call with a higher strike. Both calls were on the same underlying and had the same expiration date.

Goldman Sachs paid a USD 40 million premium for the call spread. This premium was paid upfront (i.e., in August 2004). At expiry there were three scenarios (see Figure 4.16):

• CSM's stock price trading below USD 0.93. Goldman Sachs would have lost the USD 40 million premium paid.
• CSM's stock price trading at or above USD 0.93 and below USD 3.09. Goldman Sachs would exercise the lower strike price call but CSM would not exercise the upper strike price call. CSM could elect between settling the lower exercise price call in cash or in shares. Let us assume that CSM elected cash settlement and that CSM traded at USD 3.09, Goldman Sachs would receive from CSM an amount in cash between zero and USD 464 million [= 214.8 million × (3.09 – 0.93)]. Therefore, taking into account the USD 40 million premium paid at inception, the payoff to Goldman Sachs would be between a loss of USD 40 million and a gain of USD 424 million (= 464 million – 40 million).
• CSM's stock price at or above USD 3.09. Both Goldman Sachs and CSM would exercise their calls. Assuming that CSM elected cash settlement under the lower strike price call, Goldman Sachs would receive from CSM an amount in cash equal to: USD [214.8 × (CSM stock price – 0.93)] million. CSM would receive from Goldman Sachs an amount of cash equal to: USD [214.8 × (CSM stock price – 3.09)] million. The sum of these two amounts would result in CSM paying to Goldman Sachs 464 million. Therefore, taking into account the USD 40 million premium paid at inception, the payoff to Goldman Sachs would be a gain of USD 424 million (= 464 million – 40 million).

These calculations are a bit misleading because they do not take into account the cash flows timing differences. Remember that the call spread premium was paid in August 2004 and the option settlement amount was received between January 2005 and April 2006.

4.5.3 CSM's Overall Position

CSM had two positions, one due to its convertible bond issue and a second one due to the call spread. During the exercise period, from 2 January 2005 to 2 April 2006, there were three potential scenarios.

Scenario 1: CSM's Stock Price below USD 0.93

Under this scenario, CSM's flows at expiry will be the following:

• The bond holders will not convert the convertible bond. The bond would be redeemed, paying CSM USD 664.1 million to the bond holders.
• Goldman Sachs will not exercise the lower strike call.
• CSM will not exercise the upper strike call.

As a result, CSM would not issue new shares and CSM would not receive or pay any additional cash through the call spread. However, CSM received a USD 40 million premium for entering into the call spread in August 2004. Figure 4.17 shows CSM's overall flows under this scenario without and with the call spread transaction. It can be seen that CSM was USD 40 million better off by entering into the call spread.

Scenario 2: CSM's Stock Price at or above USD 0.93 and below USD 3.09

CSM's flows under this scenario at expiry will be the following:

• The bond holders will not convert the convertible bond. The bond would be redeemed, paying CSM USD 664.1 million to the bond holders.
• Goldman Sachs will exercise the lower strike call. CSM would elect to settle the option by either:

  i. Physical settlement. CSM would deliver 214.8 million new shares and would receive USD 199.8 million (= 0.93 × 214.8 million).

  ii. Cash settlement. CSM would pay to Goldman Sachs a cash amount equal to the difference between the share price at the time of exercise and the lower strike price of USD 0.93 for the 214.8 million shares.

• CSM will not exercise the upper strike call.

If CSM elected physical settlement, CSM would issue 214.8 million new shares. CSM would receive almost USD 200 million cash through the call spread. This cash amount could be used for partial repayment of the convertible bond. In this case, CSM would receive this USD 199.8 million cash amount in addition to the USD 40 million received for entering into the call spread in August 2004. Physical settlement under the lower strike price call was the most logical choice. Figure 4.18 shows CSM's overall flows under this scenario without and with the call spread transaction, were CSM to elect physical settlement.

If CSM elected cash settlement, the amount of cash to be paid by CSM to Goldman Sachs would be a function of the then prevailing CSM's USD stock price:

The maximum cash amount to be paid by CSM was USD 464.0 million [= (3.09 – 0.93) × 214.8 million] taking place when CSM's stock price was close to USD 3.09 at expiry.

Scenario 3: CSM's Stock Price at or above USD 3.09

CSM's flows under this scenario at expiry will be the following:

• The bond holders will convert the convertible bond. CSM will deliver 214.8 million new shares to the bond holders.
• Goldman Sachs will exercise the lower strike call. CSM would elect to settle the option by either:
• Physical settlement. CSM will deliver 214.8 million new shares, receiving USD 199.8 million (= 0.93 × 214.8 million).
• Cash settlement. CSM will pay to Goldman Sachs a cash amount equal to the difference between the share price at the time of exercise and the lower strike price of USD 0.93 for the 214.8 million shares.
• CSM will exercise the upper strike call. CSM would receive from Goldman Sachs an amount equal to the difference between the share price at the time of exercise and the upper strike price of USD 3.09 for the 214.8 million shares.

If CSM elected physical settlement, CSM would issue 429.6 million (= 214.8 million × 2) new shares. CSM would receive almost USD 200 million cash through the lower strike call plus the appreciation of the shares above USD 3.09. This cash amount could be used for partial repayment of the convertible bond. In my view, it was unlikely that CSM would elect physical settlement unless it experienced refinancing difficulties or/and if it needed to strengthen its equity base. It would cause a much larger dilution to CSM's shareholders than originally planned.

More likely, CSM would elect cash settlement under the lower strike price call. If the shares were trading above USD 3.09, probably CSM prospects would be positive, not needing to further strengthen its equity base. CSM would deliver 214.8 million new shares to the bond holders and would pay USD 464.0 million [= 214.8 million × (3.09 – 0.93)] to Goldman Sachs. This cash amount equaled the difference between the upper strike price of USD 3.09 and the lower strike price of USD 0.93 for the 214.8 million shares. Figure 4.19 shows the flows for CSM were it to elect cash settlement under the lower strike price call.

4.5.4 Attractiveness of the Transaction to CSM

The main benefits to CSM were the following:

• The call spread transaction had the effect of reducing substantially the conversion price of the existing convertible bond, as shown in Figure 4.20. The low strike price was USD 0.93, representing a 50% (= 0.93/0.62 – 1) conversion premium on trade date. Therefore, the call spread increased the likelihood of CSM issuing the shares originally planned for issuance upon conversion of the convertible bond. In other words, the call spread avoided additional dilution to shareholders beyond what was originally contemplated when the convertible bond was issued.
• If the lower strike price call was exercised, under the physical settlement alternative CSM would receive approximately USD 200 million, an amount that could be used to partially redeem the convertible bond.
• CSM received an upfront premium for the call spread. The amount of the premium received by CSM was not disclosed, but I guess it was approximately USD 40 million.

4.5.5 Additional Remarks

Net share settlement

In order to provide more flexibility to CSM regarding the number of shares to be issued under the transaction, it would have been interesting to include a third settlement method in the terms and conditions of the lower strike price call.

We just saw that in the third scenario, CSM's stock price being at or above USD 3.09, upon exercise of the lower strike price call CSM had to choose between:

• Electing cash settlement. It would imply the payment to Goldman Sachs of USD 464.0 million if CSM elected cash settlement and the issuance of 214.8 million shares to the bond holders. This election would mean the payment of a notably large cash amount.
• Electing physical settlement. It would imply the issuance of 429.6 million shares to the bond holders and to Goldman Sachs in exchange for approximately USD 200 million. This election would mean the issuance of a much larger than planned number of shares.

It would have been interesting to add a third settlement alternative for CSM to the lower strike price call terms and conditions, a combination of cash settlement and net share settlement. For example, if CSM elected this third settlement alternative, net share settlement, the settlement would have the following two parts:

• A first part, a settlement in shares representing the option payoff due to the stock price appreciation between the lower and the upper strike prices.
• A second part, a settlement in cash representing the option payoff due to the stock price appreciation beyond the upper strike price. This second part would be completely offset by the payoff of the upper strike price call.

The number of shares to be delivered under the first part, the net share settlement, would be a function of the stock price upon conversion, as follows (see Figure 4.21):

The maximum number of shares to be delivered to Goldman Sachs would be 150.2 million shares (= 464.0 million/3.09), taking place when CSM's stock price reached exactly USD 3.09. This number of shares is significantly lower than the 214.8 million shares that CSM had to deliver were it to elect physical settlement under the lower strike price call.

Soft call

Because the call spread transaction was contractually separate from the convertible bond, it did not affect the terms and conditions of the bond. However, the terms and conditions of the call spread had to mimic the put and call rights embedded in the convertible bond. For example, the convertible bond had a “soft call” feature.

The soft call feature allowed CSM to elect for early termination of the call spread if its share price rose and remained above USD 1.17 for a defined period of time. The price represented 125% of the lower strike price.

4.6 DECREASING LIKELIHOOD OF CONVERSION WITH A CALL SPREAD

4.6.1 Case Study: Microsoft's Convertible Plus Call Spread

This case shows how a company synthetically increased the conversion price in a convertible bond with a call spread, as a result reducing the likelihood of issuance of new shares. On 15 June 2010, Microsoft issued a USD 1.25 billion zero-coupon convertible bond. The bond had a 3-year maturity and was convertible into Microsoft stock at USD 33.40, representing a premium of 33% above Microsoft's stock price at issuance. The following table summarizes the convertible bond terms:

Microsoft's Convertible Bond
Issuer	Microsoft Corp.
Issue date	15-June-2010
Notional amount	USD 1.25 billion
Maturity	15-June-2013 (3 years)
Issue price	100% of par
Coupon	0%
Redemption price	100% of notional amount
Exchange price	USD 33.40 (a 33% premium)
Underlying shares	37.4 million shares of Microsoft

Concurrent with the issuance of the bonds, Microsoft entered into a cash-settled call spread (a “call spread overlay”) with several banks. Under the terms of the call spread overlay:

• Microsoft purchased a call option on its own stock with strike USD 33.40, equal to the initial conversion price of the convertible bond. The underlying shares to the call option were 37.4 million, equal to the full number of shares underlying the convertible bond.
• Microsoft sold a call option on its own stock with strike USD 37.16, or 48% above Microsoft's stock price on trade date (EUR 25.11). The underlying shares to the call option were 37.4 million.

The call spread transaction was intended to reduce the potential dilution upon conversion of the convertible bond (see Figure 4.22). The call spread had the economic effect of increasing the conversion price of the convertible bond to that of the call spread upper strike (i.e., USD 37.16).

4.7 DOUBLE ISSUANCE OF EXCHANGEABLE BONDS

4.7.1 Case Study: ABC'S Double Exchangeable

This case shows how a company can take advantage of a share price well below the exchange price of an existing exchangeable to issue a second exchangeable. Let us assume that on 1 June 20X1, ABC issued an exchangeable bond (the “first exchangeable bond”) into XYZ stock with the following terms:

ABC's First Exchangeable Bond into XYZ
Issuer	ABC Corp.
Issue date	1-June-20X1
Notional amount	EUR 1 billion
Maturity	1-June-20X6 (5 years)
Issue price	100% of par
Coupon	2% semiannual 30/360
Redemption price	100% of notional amount
Exchange price	EUR 10.00
Underlying shares	100 million shares of XYZ

After the issue date, XYZ's stock price has gradually fallen, reaching EUR 3.50 at the end of June 20X2. Since then, the shares have recovered and reached EUR 5.00 on 1 December 20X3. On this date, ABC believed that it was unlikely that the shares would recover to the EUR 10.00 exchange price and that the share price would be depressed for the next few years.

ABC first considered buying back the existing exchangeable and issuing a new one. This alternative faced three major hurdles from ABC's viewpoint:

• ABC would have to pay a substantial premium to repurchase a large size.
• ABC would redeem a large borrowing (EUR 1 billion) in which it was paying a very attractive financing cost (only 2%).
• A new exchangeable issue would raise much lower financing.

Therefore, ABC discarded this alternative. Instead, ABC decided to issue a new exchangeable (the “second exchangeable bond”) with the following terms:

ABC's Second Exchangeable Bond into XYZ
Issuer	ABC Corp.
Issue date	1-December-20X3
Notional amount	EUR 600 million
Maturity	1 June 20X6 (2.5 years)
Issue price	100% of par
Coupon	3% semiannual 30/360
Redemption price	If at maturity XYZ shares trade below, or at, the exchange price: 100% of the notional amount (i.e., EUR 600 million) If at maturity XYZ shares trade above the capped share price: 166.67% of the notional amount (i.e., EUR 1 billion)
Automatic exchange	If XYZ shares trade below, or at, the capped share price and above the exchange price at maturity: the bonds would automatically exchange for XYZ shares at the exchange price per share
Exchange price	EUR 6.00 (a 20% premium to XYZ's share price at issuance)
Capped share price	EUR 10.00 (the first exchangeable bond's exchange price)
Underlying shares	100 million shares of XYZ

The issue of the second exchangeable allowed ABC to raise EUR 600 million and to pay a low coupon. This second bond also increased the likelihood of disposal of the XYZ shares. The second exchangeable included some unique features:

• The number of shares underlying both exchangeable bonds were identical, 100 million XYZ shares. It meant that the XYZ shares could not be pledged to the second exchangeable as they were already pledged to the first one. As a result and upon default of ABC, the second exchangeable bond holders did not have any collateral to reduce their exposure to ABC. ABC could have set up a secondary pledge in favor of the second exchangeable bond holders, but this secondary pledge would probably need the acceptance of the first exchangeable bond holders, an approval not easy to obtain.
• The second exchangeable had a EUR 10.00 capped share price, the exchange price of the first exchangeable bond, causing the potential benefit of its bond holders to be limited to 66.67% of their initial investment. As a result, the overall exchange price upon exchange of any of the two exchangeable bonds was lowered to EUR 6.00. Figure 4.23 shows that the combination of the exchange right of both bonds was equivalent to an exchange right at EUR 6.00.

At maturity, three scenarios were possible:

• If XYZ shares traded below, or at, EUR 6.00. ABC would redeem in cash the first and the second exchangeables, paying EUR 1 billion and EUR 600 million respectively.
• If XYZ traded above EUR 6.00 but below, or at, EUR 10.00. ABC would redeem the first exchangeable, paying EUR 1 billion. ABC would deliver 100 million XYZ shares under the second exchangeable.
• If XYZ traded above EUR 10.00. ABC would deliver 100 million XYZ shares under the first exchangeable. ABC would redeem the second exchangeable paying EUR 1 billion.

The terms of the second exchangeable bond had to take into account any early redemption rights under the first exchangeable. Let us assume that the first exchangeable had a soft call that allowed ABC to redeem the bond if XYZ's stock price exceeded 150% of the exchange price (i.e., EUR 15.00). The second exchangeable had also to include an early redemption clause. In this case, ABC had to include a soft call in the second exchangeable allowing it to redeem early if XYZ's stock price exceeded EUR 15.00. Of course, early redemption would require ABC to pay EUR 1 billion (i.e., 166.67% of the notional amount) to the bond holders.

Advantages and Weaknesses of the Strategy

The advantages of the strategy were the following:

• ABC was able to raise new financing at a low cost.
• ABC did not need to pledge additional shares to issue the second exchangeable.
• ABC did not need to buy back the existing exchangeable bond.
• ABC participated in an appreciation of XYZ's share price up to the second exchangeable's exchange price.
• ABC increased the likelihood of disposal of the XYZ shares.
• ABC retained ownership of the stake, maintaining the voting rights and receiving the dividends.

The weaknesses of the strategy were the following:

• ABC reduced its participation in a potential appreciation of the underlying shares.
• The second exchangeable's bond holders did not have the underlying shares pledged in their favor. The absence of an exchange property would cause the bond holders to be unsecured, although ranked senior, in case of ABC becoming insolvent.
• The structured characteristic of the second exchangeable may make a public placement difficult. There are two reasons for this: (i) the underlying shares could not be pledged to the second exchangeable and (ii) the capped exchange price was an unusual feature. If the second exchangeable bond was privately placed with the bank arranging the transaction and it kept the bond in its books: (i) it needed to borrow a substantial amount of XYZ stock to delta-hedge its position and (ii) it would face a large credit exposure to ABC.

4.8 BUYING BACK CONVERSION RIGHTS

4.8.1 Case Study: Cap Gemini's Repurchase of Conversion Right from Société Générale

This case shows how a company took advantage of a share price well below the exchange price of an existing convertible to buy back the embedded conversion right. This buyback allowed Cap Gemini to issue a second convertible without substantially increasing the potential dilution upon conversion.

In June 2003, Cap Gemini, a French provider of IT consulting and services, issued a convertible bond. The total amount of the issue was EUR 460 million, initially convertible into 9 million Cap Gemini shares at an initial conversion price of EUR 51 per share. The bond paid an interest of 2.50% per year. The bond could be converted at any time from 11 August 2003 until 20 December 2009. The bond would be redeemed in full on 1 January 2010 in cash at par. The following table summarizes the convertible bond terms:

Cap Gemini's Convertible Bond
Issuer	Cap Gemini
Issue date	24-June-2003
Settlement date	2-July-2003
Notional amount	EUR 460 million
Maturity	1-January-2010 (6.5 years)
Issue price	100% of par
Coupon	2.50%
Redemption price	100% of notional amount
Conversion price	EUR 51.00 (a 70% premium to the EUR 30.00 stock price at issuance)
Underlying shares	9 million shares of Cap Gemini
Soft call	From 2-July-2007. Stock price must equal or exceed 125% of the conversion price

In June 2005, Cap Gemini's stock was trading at EUR 26.00. Therefore, the conversion price represented a 96% (= 51.00/26.00 – 1) premium to the then prevailing stock price. The implied volatilities of Cap Gemini options had been constantly decreasing over the last several months. The implied volatility of options with expiry January 2010 and strike 196% was trading around 24%, at similar levels to the implied volatility originally used to price the convertible bond.

Cap Gemini took advantage of the low stock price and the attractive implied volatility levels to neutralize in full the potential dilutive impact of the convertible bond. In order to buy back the conversion right embedded in the convertible bond, Cap Gemini bought from Société Générale a call option on 9 million Cap Gemini shares, equal to the number of shares underlying the convertible bond, with the following terms:

Call Option – Main Terms
Buyer	Cap Gemini
Seller	Société Générale
Notional amount	EUR 234 million
Expiry date	1-January-2010 (6.5 years)
Premium	EUR 16 million (6.8% of the notional amount, or EUR 1.78 per share)
Initial price	EUR 26.00
Exercise price	EUR 51.00
Underlying shares	9 million shares of Cap Gemini

The buyback of the conversion right of the existing convertible provided Cap Gemini with a great advantage. It could issue a new convertible without substantially increasing the potential dilution upon conversion. Thus, Cap Gemini also took advantage of the strong demand for convertibles to issue a new convertible bond. The new bond had a EUR 37.00 conversion price, a maturity on 1 January 2012, 11.8 million underlying shares and a EUR 437 million notional amount. Part of these proceeds was used to pay the premium of the call option.

The buyback of the conversion right of the existing convertible and the concurrent issuance of the new convertible also had the advantage of reducing the initial impact on Cap Gemini's share price. The convertible bond holders needed to sell Cap Gemini shares to initially delta-hedge their position. Société Générale, the call option seller, had to buy Cap Gemini shares to initially delta-hedge its position. As a result, part of the two executions offset each other, reducing the impact on Cap Gemini's stock price (see Figure 4.24).

Advantages and Weaknesses of the Strategy

The advantages of the strategy were the following:

• Cap Gemini neutralized in full the dilution upon potential conversion of the bond, without buying back the existing exchangeable bond.
• Cap Gemini issued a new convertible bond, without substantially increasing potential dilution upon conversion.
• Cap Gemini was able to repurchase the embedded option at an attractive price, taking advantage of the stock price fall since issuance and of attractive volatility levels.
• The bank selling the call option had to buy a significant number of shares of Cap Gemini to initially delta-hedge its position, providing a support to Cap Gemini's stock price.

The weaknesses of the strategy were the following:

• Cap Gemini had to pay a EUR 16 million premium.
• Cap Gemini stopped benefiting from a potential further decline of its stock price.

Special Clauses

The call option had to take into account the convertible's dividend protection clause. Commonly, convertible bond holders are protected against dividends representing a dividend yield in excess of a certain percentage in any given year. An adjustment of the conversion ratio is then performed for the portion exceeding the predetermined dividend yield percentage. Therefore, the call option had to include an adjustment mechanism such that the conversion ratio and the call exercise price remained identical over their term. In our case, Cap Gemini's convertible bond holders were protected against yearly distributions exceeding a 5% dividend yield. Thus, the call option needed to incorporate a similar mechanism.

The convertible bond included a soft call option. Under this option, Cap Gemini could redeem, from 2 July 2007 and until 20 December 2009, the outstanding bond at an early redemption price equal to par plus accrued interest, if Cap Gemini's stock price traded, at least on 20 trading days during the 40 trading days immediately preceding the date of publication of a notice relating to such early redemption, above 125% of such early redemption price. Upon early redemption, the bond holders could elect the redemption to be either in cash or converted into Cap Gemini shares. Usually the terms of the acquired call do not include a clause mirroring a convertible bond's soft call rights. Cap Gemini could do the following:

• If Cap Gemini believed that it would exercise the soft call right when entitled to, it could acquire an American-style call option. An American call option would allow Cap Gemini to exercise the call at any time.
• Otherwise, Cap Gemini could acquire a European-style call option. It meant that if Cap Gemini exercised it soft call right under the convertible it had to sell back the call option to the bank. Normally, it would work out because the total value of the option would exceed its intrinsic value. Therefore, the payout above the redemption price under the convertible bond could be covered by the proceeds from selling back the call option.

Another clause that needed to be carefully taken into account was the settlement type. Again, the call had to maintain the same flexibility that the issuer had under the convertible bond. In our case, Cap Gemini only allowed for delivery of the underlying shares upon conversion. As a result, the call option could only be physically settled upon exercise.

Any other clauses that could cause divergences between the conversion right and the call option features also had to be carefully taken into consideration. For example, any early redemption right (i.e., a put right) at the option of the bond holders. In Cap Gemini's convertible, bond holders could request the early redemption of all or part of their bonds in the event of a change of control of the company. The call option had to include a similar mechanism for early exercise.

4.9 BUYING BACK CONVERTIBLE/EXCHANGEABLE BONDS

4.9.1 Case Study: TUI's Convertible Bond

During the financial crisis of 2007–2008, a good number of market disruptions created unusual opportunities to buy back existing convertible and exchangeable bonds at fire sale prices:

• Stock prices plummeted sharply, reducing the value of the conversion/exchange rights embedded in the bonds.
• Convertible bond funds and hedge funds witnessed a record high number of redemptions as investors tried to obtain cash and to stop their losses, forcing these funds to sell their assets.
• Capital markets and investors became more risk averse, requiring sky high spreads to finance corporates. As a result, the existing convertible/exchangeable coupons became unattractive.

TUI A.G., the German tourism and logistic services company, could have bought back its 2.75% September 2012 convertible bond at half its issue price in October 2008, in March 2009 and in July 2009 (see Figure 4.25).

Equity Swap Alternative

The main problem with this strategy is that when the exceptionally attractive opportunity to buy back a convertible/exchangeable occurred, the company was also likely to experience a difficult situation. The company was probably devoting its energies to refinancing maturing debt and to lengthening the maturity of its existing debt. Raising additional financing just to take advantage of an unusual opportunity may not be the company's main priority.

One solution for the company was to enter into an equity swap on the convertible/exchangeable bond. As an example, let us assume that on 28 October 2008 TUI was willing to acquire EUR 200 million notional of its convertible bond at 50% price (i.e., EUR 100 million market value) and entered into a cash-settled equity swap on its convertible with Gigabank. The maturity of the equity swap was 1.5 years (i.e., 28 April 2010).

Flows of the Transaction

The flows of the transaction on the trade date were as follows (see Figure 4.26):

• TUI and Gigabank entered into the cash-settled total return equity swap on EUR 200 million notional of the convertible bond. The initial price was set at 50% of its par price, or EUR 100 million (the equity swap notional).
• Gigabank bought a EUR 200 million notional of the convertible bond, paying EUR 100 million (plus accrued interest), so the bank initially hedged its position.

The flows of the transaction during the life of the equity swap were as follows (see Figure 4.27):

• TUI paid an interest, the floating amount, to Gigabank based on the EUR 100 million equity swap notional.
• Gigabank paid to TUI an amount equivalent to the coupon Gigabank received through the underlying convertible bond. This amount was paid on the convertible bond's coupon payment date.

At the equity swap maturity (i.e., 28 April 2010), the convertible bond was trading at 90%. Therefore, the equity swap underlying convertible bond was worth EUR 180 million. The flows of the transaction at maturity were as follows (see Figure 4.28):

• Gigabank unwound its hedge, selling a EUR 200 million notional of the convertible bond, receiving EUR 180 million (plus accrued interest) in the market.
• TUI and Gigabank settled the equity swap after calculating the settlement amount, taking into account the EUR 100 million equity swap notional. The settlement amount was EUR 80 million (= 180 million – 100 million).

4.10 PRE-IPO CONVERTIBLE BONDS

Structures around convertibles can provide an interesting financing alternative to companies expecting their own IPO to take place. The structure covered in this section allows a company to pre-place a convertible bond ahead of an IPO. The company issues a bond that will conditionally become convertible, dependent upon whether or not an IPO occurs (the “triggering event”). If the IPO does not occur within a predetermined timeframe, the bond is simply redeemed at favorable terms for the investor, giving an extra yield above the company's straight debt. However, if the event does occur, the bond will become convertible on predefined terms.

The convertible bond will be priced based on variables known in advance, such as the company's credit spreads and the market interest rates. However, there are two other variables needed to price the convertible bond, the implied volatility and the assumed dividends, whose estimation is notably challenging. Unless investors in the pre-IPO convertible bond are given a put right, they may require a too conservative level on these two variables. As a consequence, these types of bond include a put right that gives the bond holders the right to put the bond back to the company, should they not want the convertible at the time of the triggering event.

As an example, let us assume that the yield on the company's one-year straight debt is 5%. Let us assume further that a convertible bond starting in 1 year and with a 3-year term, with a conversion premium of 20%, is estimated to pay a coupon of 2%. If the market remains unchanged and the IPO of the company takes within 1 year, an investor could invest in a 1-year bond receiving a 5% yield and then, at its maturity, invest in a 3-year convertible bond receiving a 2% coupon (see Figure 4.29).

Alternatively, the company could be issuing a bond that pays a coupon of 4% during the first year (1% lower than the yield of comparable debt). At the end of the first year (see Figure 4.30):

• If the IPO did not occur, the bond redeemed at a yield of 6% (1% higher than the yield of comparable debt).
• If the IPO did occur, the bond became a convertible bond with a conversion premium of 20% and a 3-year maturity. The coupon of the convertible bond was 3% (1% higher than the coupon of a similar convertible bond). If the investor did not want to remain invested in the convertible bond, he/she could put the bond back at par to the company, realizing a yield of 4%.

From an investor's perspective:

• If the IPO did not occur, the transaction provided an enhanced yield. The resulting yield to maturity was 1% higher than the yield of comparable straight debt.
• If the IPO did occur, the transaction provided a very attractively valued convertible, paying a coupon 1% higher than the coupon of comparable convertible debt. If at the end of the first year, the investor did not deem the convertible terms to be sufficiently attractive, he/she could have the bond redeemed, but then his/her 1-year investment would have realized a yield 1% lower than the yield of comparable straight debt.

From the company's perspective:

• The company was able to raise finance, tapping the convertible bond market.
• By launching the bond, the issuer sent out a very strong signal that it was expecting the IPO to occur.
• The company was exposed to an IPO not occurring. Upon this event, it would have incurred a financial expense higher than its cost of straight debt.