Convertible Bonds as Backdoor equity financing
Jeremy Stein
(JFE 32, 1992)
Executive Summary:
Firms use convertible debt for many reasons but a big reason is as a way of avoiding adverse-selection problems. In English, good firms will use convertibles because the firm's true value will be made known before the debt is due. Thus by issuing convertibles now (generally with a call provision) the good firms can issue equity (by forcing conversion) which will allow the firm to raise more debt if they need it in the future.
This is a fairly theoretical paper with some empirical findings (done by others) and a case study of MCI tacked on at the end.
Model:
Assumes 3 firms (good, medium, and bad) and 3 time periods (0,1,2). Further assumes a zero discount rate and risk neutrality. Each firm has an investment I. Probability of success is a function of the type of firm. Good firms more likely to have success. Firms know what type of firm they are, but investors can not tell at time zero. True value of BAD firms becomes known at time 1.
If the firm can not pay off debt, the bankruptcy costs, C, are imposed on owners.
"Convertible bonds make it possible to sustain a separating equilibrium in which all types of firms issue fairly priced claims." Stein shows this equilibrium is not possible with just straight debt and equity.
Stein proposes that Good firms will issue debt, bad firms will issue equity, and medium firms will issue convertibles.
Stein also shows that none of the parties would want to imitate the other parties.
Why? Suppose a bad firm imitated a good firm and issued debt (either convertible or straight). Then they would be unable to pay it off and would suffer the consequences in the form of high bankruptcy costs.
1. Characteristics of issuers, 2. Conversion features, and 3. stated managerial motivations behind issuance support Stein's views.
If high costs of bankruptcy (example higher R&D) then more likely to issue convertibles.
Firms with better bond ratings have more negative announcemnet reaction. (Mikelson and Parcth 1986)
Model predictions:
Firms with higher bankruptcy costs more likely to issue convertibles
Firms with higher than industry average debt ratios more likely to issue convertibles IF they expect good times ahead and can force conversion.
Interesting facts:
- Essig (1991) reports more than 10% of Compustat firms have convertible debt of at least 33% of total debt.
- 82% of managers cite as a reason for issuing convertibles "a desire to raise equity of a delayed basis." (Pilcher 1955). Hoffmeister (1977) found similar results (especially for industrials).
- Asquith (1991) finds 21% of convertibles were callable immediately and the median length was only 252 days. Further, most firms do use the call when it is feasible (and not more expensive) If the firm's dividends are less than the after-tax interest payments, then the median delay is only 18 days after a call is allowed. (page 14)
- Studies of the market response on convertible bond issues find a reaction from -2.31% (Dann-Mikkelson 1984) to -1.25% (Eckbo 1986) which represents approximately 9% of the money issued. This is much less than the approximate 30% for common issues. (table 1) (page 16)
MCI example/case
MCI went public in 1972 with issue of $30 million and immediately had large losses. By 1978 things had improved and MCI entered a growth stage. However, MCI (high FC and losses) was highly leveraged. Further, the firm had high costs of bankrupcty. Needed money to grow, but did not want to issue--CFO: "it was always our conviction that issuing more common stock would knock the props out from under our stock." (page 18).
As the firm had no income, MCI first issued convertible preferred stock but then changed to debt. In the course of approximately four years they forced conversions of 5 consecutive issues.
Eventually MCI could not force the conversion of their last two issues (including a "'synthetic' convertible, consisting of…bonds and detachable [and] callable warrants" due to a falling stock price, and had to resort to issuing equity.
When the success of a project is unknown, Convetible Bonds allow firms to raise new debt in the future if successful, if not successful, then controls FCF problem rather than allowing further investments in it.
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