Wednesday, 19 September 2018

No more net-share settle

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Nearly three-quarters of the convertible bonds issued in 2006 were structured with net-share settlement provisions. The popular feature could disappear and make convertibles a less attractive financing option altogether when new rules take effect, requiring issuers to account for both the debt and equity components of these bonds. Philip Scipio reports.

After living with the threat, US companies with net-share settle convertibles have come to the realisation that they will most likely have to account for both the debt and equity portions of the bond separately beginning January 1 2008. While bifurcation was largely expected and adoption will bring US accounting standards in line with those of the rest of the world, the short-term impact is dramatic and will challenge originators to come up with alternative solutions.

Net-share settled convertibles, or cash-par settle, allows issuers to account for earnings dilution for shares that would be issued only for levels above the conversion price. Because of their favourable accounting treatment, the net-share settle bonds proved a popular way for companies to undertake leveraged recapitalisations or to repurchase stock in a way that was friendly to existing stockholders.

Since the beginning of 2005, when the provision gained popularity, 220 of the 390 convertibles issued have been structured with net-share settle provisions. That represents about US$120bn principal of the US$170.9bn raised over that time period. “The rule change may very well kill the use of net-share settle,” said Dana Trier, a partner at Davis Polk & Wardell, of the Financial Accounting Standards Board (FASB) decision to bifurcate net-share settle bonds.

The proposal, which was approved in principle by the accounting board’s board of directors at a meeting on July 25, would obligate companies with net-share settle converts to account for the debt and call options as distinct securities. The board was expected to put out a proposed staff position formalising the proposal by late August; followed by a 45-day comment period, making ratification likely by early December.

If approved, bifurcation would require issuers to account for the value of the bond at what an issuer would pay for a similarly structured straight debt instrument. Any residual value is attributable to the call option, or vice versa – the actual interpretation has not been determined.

A company that issued a US$100m, 10-year net-share settle convertible with a 2% coupon, for example, initially would be bifurcated as US$64.5m of debt and US$35.5m of equity. The value of the debt would accrete toward par at the issuer’s ordinary cost of debt, requiring adjustments over the life of the security.

The change would result in higher interest expense flowing through the income statement, though the accreted value is non-cash, “phantom” interest. Instead of US$2m, annual cash interest expense for the 2% convert, the expense would rise to US$4.6m, a 127.8% increase, in the first year, increasing to US$6.7m in the final year, according to a recent report by Bear Stearns.

Phantom menace

Overall, the “phantom” interest expense would depress net earnings of net-share settle issuers by 9.0% and 9.2% in 2007 and 2008, respectively, estimates Venu Krishna, head of US equity-linked strategies at Lehman Brothers. The FASB proposal does not currently envisage a grandfather provision, obligating companies to retroactively restate earnings back to the date the net-share convertible was issued. “It’s not so straight forward to restate the earnings data to account for the security on a bifurcated basis,” says Krishna.

Indeed, the restatement would be a significant burden. Even if issuers redeem net-share settle converts prior to approval, they would still need to restate earnings. Krishna estimates that bifurcation would result in an additional US$12.4bn of interest expenses, reducing net earnings by a similar amount. Instead of an average coupon of 2.6% for the net-share universe, interest expense would increase to about 4.7%.

Bifurcation would also result in the elimination of about US$30bn from corporate balance sheets. The counterbalance is a similarly sized increase in stockholders’ equity to reflect the value of the call option. It is unclear what impact, if any, the restatement would have individual companies’ leverage tests on more senior debt.

The fact that bifurcation would cause liabilities to be understated is one of the main criticisms of the proposal. If a company were to default, it is on the hook for the full value of the bond, not the discounted value. For small unrated companies, which historically have comprised the bulk of convertible issuance, that obligation would be significant.

Another criticism is that the phantom interest expense could lead to investor confusion in analysing the quality of corporate earnings. Companies may elect to issue pro forma net earnings reflective only of their cash-interest expenses.

In its attempt to reflect the true economic value of net-share settle convertibles, FASB is treating the instrument as debt and equity. Instead of only accounting for a percentage of the convertible bond as debt, it would be more accurate to view the instrument sequentially as debt, then equity.

“The net share settlement rules generally resulted in a greater amount of EPS accretion upon issuance,” notes Steven Winnert, head of equity-linked origination at Credit Suisse. “But the FASB did not seem to focus on the fact that it could become more dilutive as the stock price increased.”

Will the change make convertibles a less viable alternative going forward? The general consensus is that investment-grade companies may be less inclined to turn to look to convertibles. If they are forced to account for a convertible at their ordinary cost of debt, why not get the full benefit (deductibility) of selling straight debt?

Investors reacted to the FASB board decision in July by bidding up investment-grade paper on scarcity value. The thinking was that these companies may seek out alternative source of funding in the future and, in fact, that they may tender for existing bonds at a premium to eliminate the accounting complexities.

So what?

Instead of being struck by a case of separation anxiety, convertible bond originators have taken the reality in stride. The proposed changes do not alter the economics of issuing a convertible, only the accounting treatment. The implication on cash flow is unchanged, regardless of bifurcation, and ultimately they believe that economics will trump accounting.

“The FASB change has been expected for about a year, and the volume of convertible debt has only soared,” says Brooks Harris, head of US convertible origination at Deutsche Bank. “Issuers are more focused on the economics than the accounting. The era when corporate finance departments made decisions based on the accounting has passed. People do things because they make economic sense.”

Indeed, companies continued to access the convertible bond market at near-record levels, despite the prospect of accounting changes. Volume stood at US$66.1bn, as of August 15, or US$106.7bn on a run-rate basis. That would be the second-heaviest year of issuance, trailing only the US$113.5bn raised in 2001.

In anticipation of an adverse outcome on the accounting front, issuers have structured recent net-share convertibles to allow for physical settlement entirely in stock, notes Davis Polk’s Trier. Physical settlement would require accounting under “as-if converted” methodology when calculating EPS – the more dilutive of interest expense or additional shares underlying the convert.

If anything, conditions may be ripe for convertible bond issuance to accelerate. Credit spreads on single-B high-yield paper have ballooned from Treasuries plus 240bp earlier in the year to Treasuries plus 410bp as of mid-August. Unrest in the credit markets has spilled over to the equity markets, where CBOE volatility (VIX) spiked to the mid-30s, its highest level since early 2003.

At a time when companies may hesitate to sell stock, the combination increases the economic benefits of a convertible relative to straight-debt. In the grip of a credit crisis, the convertible market was one of the few options to raise capital during the first weeks of August.

The convertible bond market is notorious for product innovation. After all, net-share settle only became popular after FASB struck down Treasury-stock method accounting for contingent convertibles in late 2004. Bankers already have some viable alternatives that achieve similar results to net-share settle.

One potential successor is variable conversion ratio (VCR) bonds that enhance deal economics by offering investors additional shares above the conversion price. Chesapeake Energy and Cogent Communications have been among the handful of companies that have utilised the structure to lower coupon and/or increase the conversion premium on convertible debt sales this year.

Another possible successor is long-dated, deeply subordinated notes that are convertible into preferred stock, allowing issuers to defer interest payments without triggering a default. Verisign recently raised US$1.1bn through the sale of 30-year junior subordinated bonds, which cannot be put, to fund a share repurchase. The 3.25% coupon was seen as an attractive alternative from a cost of capital perspective.

While such securities do not achieve Treasury-stock method accounting afforded to net-share settle bonds, they accomplish a similar goal. Similar to net-share settle, the low-cost capital and share repurchase are immediately accretive to earnings.

What’s the next innovation? That depends on the needs of the market, according to DB’s Harris. “Like most previous innovative product development the next feature will come when companies present a challenge that can’t be met with the current offerings.”

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