An interesting article. QDEK is mentioned concerning financing back in 96 and 97.
DH
FLOATING BETWEEN A ROCK AND A HARD PLACE
A certain breed of convertible preferred stock may lead weak issuers to an ill-advised choice.
By Ellen Jovin
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Informix was in turmoil last August. The chairman and other senior officers at the Menlo Park, Calif.-based database technology company had resigned, and a pending restatement of its financials would reduce reported revenues between 1994 and 1997 by hundreds of million of dollars. Adding insult to injury, $662 million Informix needed cash.
"The company clearly was going to have trouble continuing to sell to its customers with the financial cloud hanging over it," says Informix's former treasurer Margaret Brauns, who is now chief financial officer at Red Brick Systems, a $43.3 million data warehousing company in Los Gatos, Calif. "So all [the] usual sources of capital simply were not available to the company."
Enter New York-based Fletcher Asset Management, a private investment management company. Fletcher stepped in with a private placement deal that gave Informix a $40 million cash infusion, as well as the time and space it needed to right itself. The company issued preferred stock, convertible into common shares at a price that floats with the market price of the company's common stock.
Specifically, the conversion price would be equal to 101% of the common stock's average price for the 30 trading days ending five trading days prior to the conversion, with a $12 upper limit on the conversion price. In addition, Informix issued a warrant to acquire up to an additional 140,000 shares of Series A convertible preferred stock at an aggregate exercise price of up to $35 million.
The structure meant that if the common stock price at conversion was lower than at issue date, Fletcher would get more shares. If the stock price was higher, Fletcher would get fewer shares.
But the type of convertible preferred deal that Informix did is not always the rule. And while this financing strategy has been a boon to some companies, it has brought disaster to others whose common stock price has nosedived soon after a deal was done. This fact has not been lost on short sellers, and some stock manipulation is occurring.
Also, unlike Informix, many issuers add a little wrinkle to the structure, in which investors get discounts at conversion of as much as 20% to 40% off the stock's average trading price. Such discounts give investors built-in profits.
Expensive Deal
In late December, Informix's stock price descended to a year low of 4, and then began to climb again. On February 13 Fletcher converted its preferred stock, including shares acquired through the exercise of the warrant, and ended up with 13.7 million common shares of the company, or 9% of its outstanding stock. While Fletcher did not disclose the conversion price, the number of shares acquired suggests a 4 5/16 conversion price--an expensive bit of financing for Informix, whose stock price has ranged from 4 to17 1/8 over the past year.
Nonetheless, the deal provided the company with cash at a time when it needed it and lacked other financing prospects. In recent years, similar private issues of what is known as floating convertible preferred stock have raised hundreds of millions of dollars for companies unable to go a more traditional financing route.
Kell Benson, former chief financial officer of Zenith Electronics and now managing director of corporate finance at Fletcher, says that his boss, Alphonse Fletcher Jr., originated the structure. Fletcher, chairman and chief executive officer, does most of his floating convertible preferred deals under Regulation S of the Securities Act of 1933, which, along with Regulation D, exempt issuers from registering securities.
"The convertible preferred is much safer than common stock," Fletcher says, from the investor's point of view. "Yet it still has a lot of upside if the stock actually takes off." By definition, in the event of bankruptcy, preferred shareholders' claims come before those of common shareholders.
For treasurers, however, some cautionary words are in order. Discount deals, perhaps, top the danger list. Regulations S and D allow them, too. Benson frowns on the notion of a discount deal. "It is certainly allowed under the regulations," he says, "but I don't think it is good for the company or its shareholders. To us it is very important that everybody--the company, the shareholders and Fletcher--benefit by paying market price for the common stock into which we convert."
The investors who participate in discount deals automatically make a profit when they convert, since the conversion price is below the prevailing market price. However, what really hurts corporations that undertake such financings is the short-selling threat that conversions encourage. Armed with a discount and automatic profit, investors face no downside from shorting the company's stock for an even bigger gain, especially since the issuers are generally in financial trouble.
The short-selling can further weaken an already falling stock price. Then, after ceasing the short sales, investors convert at a low stock price, covering their short sales by converting into common shares or buying common stock on the market. At that point the market often runs up again, providing them with a big profit in a short period of time.
Why, then, would a treasurer ever be drawn to this type of financing? Public issues are typically not an option for companies that are losing money, on the verge of a restructuring or in other situations inherently unattractive to investors. The floating convertible preferred offers a company a way to get some equity on the balance sheet quickly, before a bank yanks its line of credit or an exchange moves to delist it.
In addition, a growth company that is no longer a candidate for a secondary public offering might consider such a security. After all, it provides the company with quick cash while pricing the equity in the future, when potentially higher market prices would make it less dilutive. "An investor is going to be more flexible and faster to move in this case than he would be if he were just buying common stock and were at the full risk of the market," Fletcher says.
Consider a $25 million convertible preferred deal in December 1996 for $188.8 million Integrated Process Equipment, a supplier to the semiconductor industry. With San Francisco-based investment bank Hambrecht & Quist acting as the placement agent, Fletcher, the sole investor, completed the transaction in a mere 17 days. At the beginning of negotiations, the stock price was around 13; when the deal closed, it was at 17. Fletcher converted a month later at an average price of 23--meaning far less dilution for the company than if it had done a deal at the lower stock price.
No Coupon, No Debt
Quarterdeck, an $80 million software company based in Marina del Rey, Calif., has done two floating convertible preferred deals, one a Regulation S transaction with Fletcher in September 1996 for $20 million, and a second in September 1997 under Regulation D that raised $29 million, working with Cappello Capital Group of Santa Monica, Calif., a boutique investment bank. Cappello placed the September 1997 deal with a group of about 20 investors.
Chris Karkenny, who was Quarterdeck's treasurer at the time of both issues but is now a partner at Anaheim, Calif.-based Unique Investment, a leveraged buyout firm, describes the financing as a good alternative to debt. "Additional debt can bring your equity level too low," he says, "and a typical convertible preferred is treated as debt because there is an attached coupon." But because the Quarterdeck issues had no coupon, the company was able to treat them as equity on its balance sheet.
Karkenny, however, was careful not to give any discounts. In the first deal, the conversion price was based on a 45-day volume-weighted average. In the second, the conversion price was the average of the three low trades of the 22-day period prior to conversion. The no-discount policy, Karkenny believes, attracted a different breed of investor for Quarterdeck.
"The guys that have these trailing 40-day averages really want to take advantage of an upswing in the market," he says, noting that such investors are in for the longer haul and less likely to short the stock. "They want to see the stock rise from 5 to 10, and then they will have a huge return which is well in excess of 20%."
Possible Dilution
A former investor in these types of securities, who declined to be named, points out that with the discount structure, it does not matter which way the stock goes. "As long as it doesn't go to zero, you make money, because you are always converting at a discount to essentially the current market price," he says.
While he has made several of these investments, it has been more than a year since the last one. "The companies that are issuing these things are very low-grade companies now," he says, adding that their stock price can drop to almost zero. The deals can attract some unsavory investment practices, too, he observes. "Some [investors] are short-selling, I'm sure," he says, "although they are not allowed to under the investment agreement with the company. But they are doing it illegally anyway."
For a company with a low stock price and whose stock has a significant chance of dropping further, the financing strategy may be ill-advised.
"Because of that floating [conversion]-rate mechanism," says Jamie O'Brien, the president of Promethean Investment Group, a New York private investment fund, "the instruments have the potential to be very dilutive if a company does not perform fundamentally." Promethean often invests in this class of security, including one last June for $188 million Borland International, a Scotts Valley, Calif.-based software company. Promethean put together a group of 22 investors for that deal.
Borland raised $27 million through the sale of convertible preferred shares and warrants. The preferred is convertible at 100% of the issue date price, which was 6 15/16, or 100% of the market price at conversion, whichever is lower. Built into the structure was a kind of collar, saying Borland could buy out the investors if the stock dropped to 5, thus preventing Borland from having to hand over large chunks of the company to them.
In the six months Promethean has been involved in the company's stock, the share price has been erratic, going from 6 15/16 to 12 3/16, then to 6 5/8, and now to 9 1/8, but the company was also in the midst of a major acquisition during that period. There have not been any conversions on that deal.
O'Brien says the fund typically holds on to its convertible preferred investments for between one and two years before converting. "We generally have the right to convert after, say, three months," he says. "But we have found--assuming we continue to have faith in the company--that our average holding period before converting is, on the short end, a year, and on the longer end, out to two years."
Curiously, larger-capitalization companies are entering into a market once dominated by very small issuers, O'Brien says. The larger companies, he notes, receive better pricing terms than some of the smaller issuers would receive. "It's a way for them to raise a really significant amount of capital without the uncertainty and the time and effort that goes into more traditional financings," O'Brien says. "If they find one investor or even a small group of investors with whom they are comfortable, it's very low impact for management to raise that money, rather than spending two months on a road show around the world."
However, the post-issuance damage to stock price for some recent issuers suggests that floating convertible preferreds are still far from the exclusive domain of stable companies and trustworthy investors.
Look at $3.75 million Casmyn, a tiny Sparks, Nev.-based mining company that saw a precipitous drop in price after issuing floating convertible preferreds in two tranches, one in April 1997 and another in September 1997. Cappello Capital acted as placement agent for the issue, with Soci‚t‚ G‚n‚rale as the primary preferred shareholder. Over the past year the company's stock has dropped from a high of 9, continuing a downward trend from the previous year to virtually zero in February and March. The company is in the midst of spinning off a subsidiary, WaterPur International, but trading activity may also be involved in the decline.
In fact, on March 2 Casmyn announced that it had asked investors in its first convertible preferred shares for a four-week suspension of conversions, through March 31. Casmyn also retained accounting firm Coopers & Lybrand to investigate trading activities in the company's common shares to determine whether there had been trading irregularities or market manipulation. In addition, the company is currently represented by Salomon Smith Barney in talks with investors about the proposed restructuring of the convertibles.
Reputable People
Cityscape Financial had similar troubles. The $153 million (in assets) subprime lender did a discount convertible deal on April 9, 1997. When one group of investors started converting and selling, other investors panicked and followed suit, sending the stock price spiraling downward from 11 1/4 last September 16 to 1 7/16 on November 12, although other bad news contributed significantly. This included deteriorating credit ratings and lawsuits by common shareholders. (The suits allege failure to disclose financial problems in the U.K. subsidiary.)
In January the company's common stock was moved from the Nasdaq National Market to the Nasdaq SmallCap Market, where it is being allowed to remain only through a temporary waiver of the required minimum $1-per-share bid price.
Keeping the number of investors to a minimum can help reduce this kind of risk. In addition, an oft-repeated piece of advice to issuers--from issuers and investors alike--is to know the people you are dealing with. "What I really think it comes down to is getting involved with people that are reputable," says Unique Investment's Karkenny. "Do your due diligence and understand the past deals they have done."
Short-selling is a tougher nut to crack. Karkenny concedes it is extremely difficult to track it, although he believes putting a no-short provision in the terms of the issue can be useful, if the investors are reputable people. "Especially if somebody is in Nasdaq," he says. "If they are a broker-dealer, they could lose their license if there was a no-short provision in the document and if somebody finds out they were shorting."
Of course, that's a very big "if."
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How A Floating Convertible Preferred
Is Supposed To WorkA company with a positive business outlook issues $10 million of convertible preferred stock to a single institutional investor. After a 45-day holding period, the preferred shares are convertible into common stock, whenever the investor chooses, at the average share price over the last 20 trading days prior to conversion. There are upper and lower caps on the conversion price: the investor won't have to pay higher than $15 under any circumstances, and he won't be permitted to convert at less than $5.
At the time of issuance, the company's common stock, which is undervalued, is selling for $10 per share.
Three months later, after a gradual decline, the company's stock price begins to rise.
Twenty trading days later, with the stock price at $16, the investor converts at an average conversion price of $13 and sells his shares for a profit of $3 per share. By using a structure that encouraged him to sell into a rising market, the company had to issue fewer common shares than it would have at any point
during the preceding months.
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The Anatomy Of Shorting
A Floating Convertible Preferred A company with a negative business outlook issues $10 million of convertible preferred stock to a group of 25 investors. After a 45-day holding period, the preferred shares are convertible into common stock, whenever an investor chooses, at a conversion price that is 90% of market price at the time of conversion.
At the time of issuance, the company's common stock is selling for $10 a share.
One group of investors immediately begins short-selling the company's common stock. The stock's short position soars, and the selling activity drives its stock price down. Other preferred stockholders panic and convert, selling their common shares and driving the stock price down even further. The short-sellers cover their positions as the stock price descends, pocketing the difference between the current price and the price at the time they initiated the sale.
The stock price hits $1. The short-sellers cease their selling activity and convert their preferred shares at 90% of the market price, or $.90. They cover any remaining short positions with newly converted common stock. In addition to the profits from their short sales in a declining market, the investors earn an automatic $.10 profit per share that they sell upon conversion. If they hold on to their investments and the company recovers, they will own a large percentage of its outstanding shares. |
