COERCS :
an Ideal Financing Instrument ?
By
Theo Vermaelen
Professor of Finance INSEAD
The Ideal Debt Instrument
• Have the benefits from debt in good times :
- interest tax deductibility
- discipline (improve governance)
- avoid dilution when stock is undervalued
The Ideal Debt Instrument
• Avoid the costs of financial distress.
- customers, suppliers, employees concerns about firm
survival lower free cash flows
- shareholders destroy firm value at the expense of
bondholders :
- overinvestment in high risk projects
- underinvestment in low risk projects
- refusal to raise equity to repay debt
Cocobonds
• In good times: normal debt
• Bad times: mandatory conversion into
equity
• Today mostly issued by banks
Problems with Cocos
• How to define “bad times “ ?
• If “bad times” are based on stock prices how
to avoid manipulation and undeserved
conversions ?
• Fixed income investors typically not interested
in becoming shareholders when a company is
in trouble
Solution: COERC
• Call Option Enhanced Reversed Convertible
• When conversion trigger is hit, shareholders
get pre-emptive right to buy the shares and
repay the debt
• By setting conversion price significantly below
the trigger price, such repayment can be
made highly likely
Example
Assets : 100
Equity
60
COERCS
40
5 million shares outstanding (stock price $12)
Coerc converts into equity when equity falls to 1/3 of firm
value.
When this happens the conversion price is 25 % of the stock
price.
Conversion will create Dilution
• Assume market value of equity falls to 1/3 of
assets : assets fall to $ 60 million and equity to $
20 million
• Assume that when this happens stock price is $ 4
which means the conversion price is $ 1
• If conversion would take place bondholders
would end up with 40m/ 1 = 40 million shares or
40/45 = 89 % of total assets = 89% x 60 = $ 53.3
million
• This means a windfall gain of (53.3 – 40) = $ 13.3
million
Preventing Conversion
• In order to avoid this wealth transfer to bondholders,
equityholders have pre-emptive rights to buy the shares at
the conversion price and repay the debt
• Rights issue is announced for 40 million shares at $1
• After completion of rights issue firm is all equity financed
with 60 million assets divided by 45 million shares or $1.33.
• Rights issue would be unsuccessful if during rights period
assets would fall below 45 million.
Implication for Bondholders
• The fear of dilution coerces equityholders into
repaying the debt as long as conversion price
is set at a significant discount from trigger
price
• As a result debt holders will be repaid, rather
than forced to convert
Implication for Shareholders
• Because you are able to make a credible
commitment that you will pay back debt
holders in periods of financial distress, credit
spreads will be small
• As debt has become large risk-free, no more
costs of financial distress, hence total firm
value will increase
Intuition
• “Normal“ debt is risky because equityholders
have limited liability
• The Coercive feature of the COERC forces
shareholders to bail out bondholders to avoid
dilution
• Because financially constrained shareholders
can sell their rights to others these constraints
don’t matter
Simulation
• Pennacchi, Vermaelen and Wolff (2013)
simulate credit spreads when COERCs are
issued by a highly levered company ( Bank)
• As potential dilution increases, credit spreads
fall
COERC Credit Spreads by Dilution Ratio
→ A greater dilution ratio, α, lowers COERCs’credit spreads.
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Why no COERC issued by Banks so far ?
• Regulators insist on capital ratio triggers, not
market based triggers
• This in spite of proven failure of such triggers
during the financial crisis
• Corporate non-banking sector should be free
of this constraint
Regulatory Capital versus Market Value Capital Triggers
16
Barclays partially Endorses COERC
Barclays CoCo plan seeks to allay
investor dilution threat
The Association of British Insurers (ABI) failed to give Barclays its backing for the new CoCos
ahead of the vote by shareholders on April 25.
The ABI, whose members account for about 15 percent of the UK stock market, issued an
"amber top" alert on the plan, people familiar with the matter said, which flags a contentious
issue but stops short of recommending investors reject it.
The ABI said it was concerned that shareholders are not guaranteed the right to buy shares,
which Barclays described as only an intention.
PIRC, another advisory group, said investors should abstain from the resolution and opposed a
separate proposal by the bank that would allow debt to be issued that would not offer
shareholders the chance to buy the shares.
"While the reason provided is understandable, the dilution involved for those shareholders not
able to subscribe may significantly decrease their interest in the bank," PIRC said.
Barclays said issuing Cocos that convert to equity would give it flexibility, be more efficient and
may give it more room to pay dividends.
By Steve Slater
LONDON | Wed Apr 17, 2013 3:05pm BST
(Reuters) - Barclays (BARC.L) is seeking to head off any future row
with shareholders about dilution of their holdings by proposing they
get the right to buy shares if new instruments kick in that force debt
holders to convert to equity.
Regulators are demanding that bondholders help strengthen a bank if its capital position
weakens, which would provide greater protection for depositors and taxpayers. Banks are trying
to develop the best structure for such debt.
Credit Suisse (CSGN.VX), UBS (UBSN.VX) and KBC (KBC.BR) have also issued CoCos. Lloyds
(LLOY.L) sold 10 billion pounds of convertible bonds in 2009, but a hedge fund investor last year
said the bonds were "expensive and uneconomic", underlining the wariness of mainstream
investors toward hybrid securities.
PIRC also recommended that Barclays shareholders vote against its pay plan, saying its variable
awards for executives are excessive, and opposed the re-election of John Sunderland, the head
of the bank's remuneration committee.
(Additional reporting by Sinead Cruise; editing by Jane Baird)
Banks Report
The Secret Truth about Lloyds, RBS and Barclays
Barclays in recent months has issued $4 billion (2.6 billion pounds) of contingent capital debt,
whose value is wiped out if the bank's core capital ratio falls below 7 percent.
It has said it may issue 6 billion pounds more contingent debt, some of which could convert into
ordinary shares in the event the ratio is breached, or contingent convertible debt (CoCos).
The bank will next week ask shareholders to approve this type of debt instrument.
Barclays said it intends to give them the opportunity to buy any shares from a conversion of debt
to enable them to avoid dilution of their stakes. This would also offer an exit for bondholders who
don't want to own shares, but it is not clear whether they would be forced to offer the shares.
The dilution issue is sensitive for Barclays, which provoked fury in 2008 when new Middle East
backers invested in the bank on terms that many existing shareholders said was more attractive
than they could get.
CoCos have been issued by other banks, but there is no standardised structure. How they will
work at times of stress remains uncertain.
SHAREHOLDER GROUPS WARY
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Implementation Issues
• When existing shareholders don’t have the funds
to subscribe, they have to sell the rights
• The example assumes only equity and COERCS.
Analysis does not change as long as COERCs are
subordinated to other debt
• Risk (and therefore yield) can be increased by
narrowing distance between conversion price and
trigger price