secured claims. Further, distressed companies may face lawsuits or legal threats that could significantly impact the company’s financial position. The ‘workout’
process requires legal expertise and the navigation of legal pitfalls.
Besides bearing large exposure to firm-specific risks, Distressed Security strate- gies are also exposed to general market riskfactors. Especially in environments of falling equity markets and rising interest rates, the performance of distressed secu- rities investment is highly correlated to the broader market. A generally negative equity market perception worsens the outlook for distressed companies signifi- cantly and rising interest rates make it more difficult for companies to refinance themselves. Furthermore, long duration debt positions are exposed to durationor interest rate risk. For non-publicly traded instruments such as bank debt and trade claims, the investor is exposed to settlement risk as trades are complex to docu- ment and can take months to settle. Besides foreign currency risk as part of the operational risk of the company, the investor faces foreign exchange risk if the company goes bankrupt and its claims are all converted into the applicable cur- rency in the jurisdiction of the bankruptcy.
A market environment favourable to Distressed Securities strategies is generally characterized by economic growth, rising equity prices and low interest rates. The strategy is very vulnerable in environments of rapidly falling equity markets and deteriorating economic conditions. An example was the second half of 2000/first quarter of 2001, when Distressed Securities strategies had significant losses.
Event Driven – Convertible Debenture
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
maturities ranging from 18 to 60 months which can, upon registration with the SEC, partially (e.g. 1/18th every month in case of an 18-month debenture) or entirely be converted into ordinary shares of the issuer. Conversion usually happens at a predefined discounted price. Investments are made pursuant to an exemption from registration as provided by Regulation D of the US SEC Act of 1933.
Normally after 75 to 90 days, the SEC declares the registration of the convertible securities effective. The Regulation D manager can then sell the fully tradable and registered shares in the public markets and realize the spread between the market price and the discounted price of the stock he converts into (usually about 15–20%) as a return. The Convertible Debenture Arbitrage strategy can be seen as Convertible Arbitrage with privately structured debentures.
Unlike standard convertible bonds or preferred equity, the exercise price can be floating at a predefined discount or subject to a look-back provision. Convertible debentures can also have a fixed price and it sometimes is at the investor’s discre- tion to choose the fixed or floating price on conversion. A floating price has the effect of insulating the investor from a decline in the price of the underlying stock. Investments are therefore fully price hedged. In some cases the manager also receives warrants on top of the debenture.
The process of Regulation D investments requires extensive bottom up analyti- cal work. Pre-investment due diligence usually consists of:
1 thorough analysis of the firm’s financial position (earnings, cash flow, assets and liabilities, ratio analysis)
2 examination of the company’s stock liquidity (volume, volatility, market capitalization, number of market makers, diversity of shareholder, short interest)
3 assessment of the business and the quality management (interviewing management, examination of competitive environment, firm’s strategy, product and market structure, country and sector analysis).
On the sale of the convertible security to the investors, the company begins the process of filing for registration of the privately placed shares, typically an S-3.
Pursuant to the terms of the offering negotiated between the company and the
8409 Chapter 3 p38-110 11/4/02 1:13 PM Page 74
3 ■AIS: Hedge funds and Managed Futures
investor, there is a time period by which the company must submit the registra- tion to the SEC and cause it to be declared effective (i.e. ‘the common shares are registered and freely tradable’). The term is generally between 60 and 120 days. The debenture agreement can be structured such that, if the registration is delayed beyond a certain time, the company has to pay a penalty to the investor.
On approval of the registration, the investors may sell the newly registered common stock at any time after a specified holding period. The holding period is negotiated such that the stock is not immediately ‘dumped’ on the market, but rather sold in an orderly fashion. As a general rule, once the shares are reg- istered and converted, it will take a month or more to sell the shares in the open market. Experience shows that most Regulation D transactions, all in all, take 18 months to five years from the day of closing until the conversion and sale of all shares is completed.
The most critical decision to be made during the negotiation process is the price at which the investor will be able to convert his position into common stock.
In this regard, the investors must decide whether to fix a ‘price’ of the stock (which is ‘higher risk – higher reward’), or the less risky approach of protecting a fixed ‘discount’ to the market price.
E X A M P L E
Company ABC’s stock currently sells for $10.00 per share and on average 130,000 shares are traded per day. The company negotiates with an investor (Hedge fund manager) for a private placement of a debenture convertible into its common stock. ABC and its investors agree to a 15%
discount to the share price at the time of conversion with registration to be completed in 90 days. The share price is defined as the average of clos- ing bids for the five days prior to conversion. On completion of registration the investors can exercise their conversion right and begin sell- ing the shares in the open as described in the offering memorandum. In this example, assuming that the share price remains at $10 and the invest- ment is $10 mio, the discounted price would be $8.50 and the number of
8409 Chapter 3 p38-110 11/4/02 1:13 PM Page 75
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
shares the investor receives equals 1,176,470 shares ($10,000,000/$8.50).
The investor trades out of the position and receives a total sale price (assumed to be $10 per share) of $11,765,000 or a non-annualized 17.65% profit. If the stock drops to $8.00 before the investor can convert his shares, under the agreement ABC would now have to issue enough additional shares at the new discounted price of $6.80, i.e. 1,470,588 shares. Alternatively, the investor could have chosen to ‘lock in’ the share price of $8.50 and assumed the price fluctuation risk. However, in most cases, managers choose the ‘protected discount’ structure as opposed to the ‘protected price’ alternative.
Sources of return
When public companies need to raise capital, e.g. in order to make an acquisition that has to close quickly, they have three alternatives:
1 debt issuance 2 secondary offerings
3 private equity placements pursuant to Regulation D.
Each of the first two alternatives has certain requirements which make access to the capital very difficult and time consuming and, in some instances, impossible.
These encumbrances include limited borrowing capacity, high expenses in the case of a secondary offering and time constraints. These factors, along with other more subjective issues, cause many companies to pursue the third option, which allows smaller companies to raise equity capital more quickly, cheaply and conveniently.
Similar to the returns of Distressed Securities strategies, Convertible Debenture Arbitrage strategies’ returns are mostly related to credit and liquidity premiums earned for taking positions with lower credit quality that cannot be easily liqui- dated. Large parts of the returns of the investments arise from smaller companies conceding an advantageous price to investors willing to hold an illiquid invest- ment for a certain period (until registration with the SEC occurs). Manager skill and expertise in evaluating potential investment targets are essential for Convertible Debenture Arbitrage investments.
8409 Chapter 3 p38-110 11/4/02 1:13 PM Page 76
Risk factors
A Regulation D investment is a debenture from a company in need of capital whose debt is non-rated. The strategy faces a similar risk profile as private equity invest- ments. The most significant risk factor of the strategy is credit risk, in the form of default risk, on the principal amount or on the coupon payments. A debenture with a floating conversion price provides some marginal protection from default risk (if the default comes after registration) through the possibility of converting into the com- pany’s equity. However, tradability and liquidity of the stock may be very low. In cases where the market capitalization of the company drops to levels close to where the entire company’s equity is insufficient to cover the debenture, the conversion right no longer protects from the company’s default. In some cases default risk is decreased by the issuance of a letter of credit from a bank for part of the debenture.
Important risk factors of the strategy are the registration riskand the related (pre- registration) liquidity risk. While the usual process of registration with the SEC takes about 90 to 120 days, significant delays in the process can occur if the company is not providing necessary information or is facing deteriorating financial conditions. The length of registration can then increase significantly with an uncertain outcome. Before registration with the SEC there is no market for investors to liquidate their position.
In many instances, the need to protect their investment during the registration or the ‘non-conversion’ period leads investors to hedge their investment through shorting the firm’s stock. The credit risk related to the financial condition of the company might mandate these hedging activities. This can result in a dramatic reduction of the company’s market price. The consequence is a dilution of the stock once the debenture is converted, i.e. the debenture will be converted to more stock. The industry refers to this as the ‘death spiral’ of Regulation D deals (and often refers to Regulation D deals themselves as ‘death spiral convertibles’).
Most Regulation D transactions involve companies with micro or small capital- ization. The necessary trading volume equals a significant percentage of the firm’s capitalization (especially after a significant stock price decline, when more shares have to be issued against the Convertible Debenture). Trading out of the con- verted stock can become rather difficult, despite an SEC registration. The strategy faces a great deal of (post-registration) liquidity risk.
3 ■AIS: Hedge funds and Managed Futures 8409 Chapter 3 p38-110 11/4/02 1:13 PM Page 77
Due to the private nature of the transaction, Convertible Debenture Arbitrage strategies are exposed to legal risk and also to fraud risk; for example, the com- pany may misinform or use manipulated earnings statements.
Besides bearing large firm specific risks, the Convertible Debenture Arbitrage strategy is exposed to general market risk factors. The strategy is vulnerable in environments of rapidly declining equity markets, as falling stock prices increase the number of shares received from conversion which make liquidation of the position more difficult. The company itself might also face less favourable busi- ness conditions in such environments. The duration riskof the debenture depends on its time to maturity, but is usually rather low.
As for Distressed Securities strategies, a market environment that is favourable to Convertible Debenture Arbitrage strategies is generally characterized by rising equity prices and low interest rates. During the boom years of equity markets in the second half of the 1990s, Convertible Debenture Arbitrage strategies were among the most outstanding performers of all Hedge fund strategies. With falling equity prices in 2000/2001, however, Convertible Debenture Arbitrage strategies suffered significant losses.