5/16/2013

1

Convertibles and hedge funds as distributors f itof equity exposure

Brown, Grundy, Lewis, and VerwijmerenRFS, 2012

Arnaud CaveUniversity of Rochester

FIN 523April 18, 2013

Context: selling seasoned equity

Why? Need cash to finance positive NPV projectsp p j

How? Underwritten offerings

Shelf registration

Rights offerings

Dividend reinvestment plans

Private placements of equity

Sell convertibles to hedge funds (private placement of convertibles) Sell convertibles to hedge funds (private placement of convertibles)

When are private placements of convertibles optimal?

May 16, 2013 2

5/16/2013

2

Background: convertible bonds and convertible arbitrage hedge funds

A convertible bond is a bond that can be exchanged against a predetermined number of shares of the borrower during p gpredetermined periods

The strategy of convertible arbitrage hedge funds is to buy underpriced convertible bonds and to short sell the equity of the issuer in order to lock in profits

May 16, 2013 3

An indirect way of issuing equity

Setting aside the problematic of call provisions, buyers of convertible bonds do NOT have to convert

However, the authors mention that “more than 92% of the bonds issued to hedge funds (HFs) are converted within five years”

The process: The HFs buy convertibles, borrow shares, and sell them

The number of long positions in the stock increases by the number of shares short sold by the HFs (“HFs distribute equity exposure”)

The HFs convert the bonds and close their short positions The HFs convert the bonds and close their short positions

The firm has indirectly issued equity

May 16, 2013 4

5/16/2013

3

When are private placements of convertibles optimal?

The authors predict that “firms will issue convertibles to hedge funds when the costs of issuing seasoned equity are high relative to the costs of establishing and maintaining a short position.”

Firm characteristics associated with high costs of issuing seasoned equity High probability of financial distress High return volatility NASDAQ listing Low tangibility High R&D intensity

These characteristics could also lead a firm to prefer bank debt

May 16, 2013 5

When are private placements of convertibles optimal?

Firm characteristics associated with low costs of establishing and maintaining short positionsg p High institutional ownership

Small relative size

High liquidity

Not a dividend-paying company

“Firms that decide to issue convertibles should structure the issue so as to reduce the cost of establishing and maintaining a shortso as to reduce the cost of establishing and maintaining a short position” Limits on callability

Concurrent stock repurchase

May 16, 2013 6

5/16/2013

4

Data / HF involvement

“Sample of 1,142 privately placed convertible issues in the period January 2000 to March 2008 from the SDC database”y The percentage of convertibles that are privately placed is equal to 85% over

the sample period

803 issues with detailed info on the buyer and the design of the security Average number of buyers per issue = 64%

Average % of buyers classified as HFs = 56%

Average % of issue purchased by HFs = 73%Average % of issue purchased by HFs 73%

But large SD: HF involvement varies from 0 to 100%

Further requirements (data on Compustat,…) leave us with a sample of 629 issues

May 16, 2013 7

HF involvement and the costs of issuing seasoned equity (Table 3)

May 16, 2013 8

5/16/2013

5

HF involvement and the costs of establishing and maintaining short positions (Table 3 cont’d)

May 16, 2013 9

The choice between issuing convertibles to HFs vs. issuing seasoned equity (Table 4)

May 16, 2013 10

5/16/2013

6

Counterfactual analysis (Table 4 Panel B)

What would have been th ithe issuance costs for the sample of convertible issuers had they chosen a seasoned equity issue instead?instead?

May 16, 2013 11

Counterfactual analysis (Table 4 Panel C)

May 16, 2013 12

5/16/2013

7

Other results

Security design Issues with above-median HF involvement include are more likely to y

associated with a stock repurchase and less likely to include a call provision (Table 2)

% of issue purchased by HFs is positively associated with the length of call protection (Table 6)

HFs distribute equity exposure to well-diversified shareholders % of institutions increasing their holdings of convertible issuers is higher when

hedge fund involvement is above the median

Is this piece important?

May 16, 2013 13

Concluding remarks

Provided that the costs of taking short positions in the stock is not too high, firms that are risky and opaque may find it optimal to raise g , y p q y pcapital by issuing convertible bonds to HFs

The results in Hadlock and James (2002) suggest that firms which are risky and opaque favor bank loans over public securities (equity and debt)

Do firms that chose to issue convertibles care about increasing their equity or do they simply pick the cheapest alternative to raise capital?

May 16, 2013 14

5/16/2013

8

Appendix

Convertible arbitrage

May 16, 2013 16

5/16/2013

9

17

18

5/16/2013

10

19

20

5/16/2013

11

21

22

5/16/2013

12

23

24

5/16/2013

13

25