I was very surprised about the floorless convertibles today.
Please read the following and the links. We need to discuss and sort out what is going on here. It seems TSIG fits into the pattern that is described below. The article below is from an instructional type site
where they are searching for stocks to short that have done a floorless convertible.
My biggest question is have the convertible holders been shorting?
If they have not been will they in the near future just before the conversion?
Will this situation continue to put pressure on the stock price regardless of any news?
Basically where do we stand?
members.aol.com
members.aol.com
"What are these convertibles, what kind of trading
is involved with them, and how does one discover
and research them?
About the convertibles
What we are interested in are convertibles that don't have a fixed conversion
price, but rather convert into common stock at a price that floats with the
market price of the common stock. Usually the conversion price is at a
discount to the market price. This discount typically ranges from 0% to 25%.
Common stock is registered is so that the holder can sell the shares of
common that are newly created by conversions, and make these sales on the
open market.
The convertibles themselves will almost never be traded ... they normally
have a very short life ... institutions buy them intending to convert them and
sell the resulting stock as soon as they can, in order to capture the discount.
Here's how the convertible owner makes money:
First, they charge the co. a 'fee', which is part of their profit, when they
close the deal.
Later, about the time the common stock is registered, which typically
takes a few months, they convert into common and sell the common on
the open market. Their profit is the discount that they captured.
They also make a little money on the dividend or interest paid by the
preferred while they waited to convert, but this is typically only 5%
annual rate, and is not significant.
The convertible owner is also often given 'warrants' as a sweetener for
the deal. The warrant is basically a free lottery ticket that the holder can
cash in someday if the stock goes up above its 'exercise price', which is
typically well above the current market price.
Mostly they rely on the fee and the discount to make their profit. If they got a
20% discount, and they turned their money over in 6 months, then they made
a 44% compound return on their investment, plus the fees and interest they
fetched, and maybe the warrants too. Pretty nice for them. Pretty lousy for
the regular shareholder.
Why do companies get this kind of financing?
Generally this is a kind of financing of last resort. Typically the companies are
low on cash, have negative cashflow, and are unable to get financing the more
conventional ways (bank loans, secondary offering, etc.).
Development stage companies (biotech, software, etc.) frequently get these
deals. Typically after the co. is started with venture capital and does an IPO,
it still has years of R&D ahead of it before it might see any revenues. The
IPO might raise enough cash for a year or two, but what then? No bank would
loan them money because they have no cashflow to pay the loan. If the co.
has a market cap of half a billion, they can easily get a secondary offering.
Quite often, though, the co. has a low stock price and a market cap of less
than $200 M, and no underwriter will do a secondary offering for them. So
they do a private placement. Usually a discounted convertible. They get
enough cash to last about a year, then they do another. And another.
Small manufacturing companies that run into cash problems due to
competition, bad management, etc. also get these kinds of deals. Again, if
they burn cash and have a low cash position, if their market cap is too low to
do a secondary, and if they have already tapped out their credit line (which is
typically secured by their accounts receivable), then they have little choice but
to seek a private placement. A Reg. S or Reg. D private placement lets them
get their cash fast. If the co.'s situation is ugly, the financier will want a
risk-free deal, which means a discounted convertible.
Aside from development stage co.'s and small manufacturing outfits, various
other kinds of businesses that have done these kind of private placements
include restaurant chains, resellers of long-distance telephone service, etc.
You will probably never see a bank or financial company get this kind of
financing.
Speed in coming up with cash is often a critical matter. A bad manufacturing
company will sometimes be caught by surprise by a cash crisis, and will need
cash fast. The funds that do these private placements can often close a deal
and get the cash to a company in a week or so .
Is there any limit to how much dilution can take place?
Sometimes people call these convertibles 'floorless', meaning there is no floor
on how low the conversion price can go. The lower the stock price, the lower
the conversion price, and the more the dilution of the stock. If the stock goes
to zero, the convertible would convert into an infinite number of shares.
Some discounted convertibles actually have floors on the conversion price. (If
they do, it is mentioned in the S-3 where it describes the 'conversion price'.)
Another factor that limits the dilution is a Nasdaq rule that a co. must seek
shareholder approval before diluting the stock by more than 20%. A co. might
need to do this if it is in terrible trouble and needs to raise a lot of money in
comparison to its market cap. It will then file a DEF-14A proxy to call a
special shareholders meeting to approve an increase in shares. When this
happens, it is terrific for short sellers. More often though, deals are designed to
dilute the shares outstanding by about 10%, so that the fund will not be
delayed by the waiting for the co. to hold its special meeting.
What is the process for these private placements?
Here's the chronology:
A facilitator, who might be a private person, brings the co. and the fund
together.
In deciding whether to do the deal, the fund was primarily concerned with the
liquidity of the stock. They want to make sure they can get their money back
out. Thus, they want to see the stock price, market cap, and volume above
certain levels. And they want to be sure the co. won't go bust before their
money out.
The fund and the co. negotiate and close the deal, and the co. gets the cash.
The co. will often issue a news release announcing the deal, although often it
fails to do so. The announcement sometimes is fairly honest, for example
announcing that mgmt. determined this was the best financing they could get
under the circumstances. Often, though, the announcement gives something
rather different from the whole truth: the announcement often touts some
minor provision in the deal that favors the co. while saying nothing about the
dilution and the floorless provisions, or how desperate mgmt. was to raise
cash. Occasionally you will even see an amusing positive spin on things, such
as bragging that the deal is a gesture of the confidence of institutional
investors in the co. (when in fact it was funding of last resort, done in a way
that is almost risk-free for the fund.)
The co. is supposed to file an 8-k to report the deal, although often they fail to
do so.
The co. files a prospectus, usually an S-3, to register shares of common stock
so that the fund can sell their common. The deal specifically requires the co.
to go to this effort.
The SEC either declares the registration effective, or sends back 'comments'
to the co. causing it to file an amendment to the S-3.
When the registration is deemed effective, that gives the green light for
dumping newly created common shares onto the open market. This is done
with a minimum of hoopla. Most shareholders will be completely unaware
their stock will be diluted thusly.
Sometime around the date the SEC declares the registration effective, the fund
will begin converting convertibles into common. The fund will do this in
chunks, called 'tranches'. They will sell the common right away. Or, if the
fund is permitted to sell the common shares short, they sell the common
several days before they get it by converting --- they do this in order to
further reduce their risk. At one time, funds could sell shares short before the
registration was deemed effective, but a court case back in 1997 (against
Genesee, or GFL, which is an offshore fund) ruled that this practice was not
allowable, so perhaps it has stopped, although it would not surprise me if it
goes on anyway.
The conversion process of converting a tranche of preferred into common and
then selling common repeats for typically a few months until it's all gone.
The fund might still hold warrants that it got as a sweetener in the deal, and if
the stock price ever goes up very much, the fund can exercise its warrants to
buy stock, which it will promptly sell. The co. raises further cash this way. It's
not as reliable or timely a way for the fund to make a profit or for the co. to
raise cash, though, in comparison to the convertibles.
About the S-3
An S-3 is a prospectus. Usually it is a prospectus so that common stock can
be sold by its owners, and this is what we want, although it is sometimes a
prospectus so that other financial instruments can be traded by their owners. It
is similar to the S-1 prospectus filed in an initial public offering, but with fewer
details.
An S-3/a is an amendment to an earlier S-3.
An SB-2 is similar, but it is used by small companies, typically those listed on
the Nasdaq Small Cap market.
We are looking for shares of COMMON STOCK that are being registered.
(You will sometimes come across an S-3 where convertible preferred stock or
convertible debentures (i.e., notes) are being registered ... that is not what we
want. When somebody registers the convertibles, it is so they can be traded.
Good reputable convertibles often trade on stock exchanges, much like
common stock.)
More about the prospectus:
We want prospectuses that have a list of 'selling shareholders'.
These are the owners of the convertibles, and they are going to sell some
stock on the open market. Let's explain who these people are in the case of a
discounted convertible deal:
If they are an offshore fund, for example GFL Advantage Ltd., they
bought some convertibles from the co. in a private placement. That
private placement was not subject to SEC scrutiny, because it qualified
under 'Regulation S'.
If they are domestic, for example 'Joe Blow, PLC', everything is the
same except that it's 'Regulation D.' You have to be an 'accredited
investor' to buy something under Reg. D. (That probably excludes you
and me).
In either case, the convertibles themselves are never registered with the
SEC. That makes the private placement go quick and easy for the co.
They get their cash fast.
What is registered, ultimately, are the shares of common stock that will
be created when the owners of the convertibles flip their converts into
common stock.
In the case of discounted converts, the funds invariably have no interest in
owning the common stock. It's just paper for them that they want to get rid of
as quickly as possible in order to capture the discount as their profit.
Now from the perspective of the short seller:
Which deals are best?
Typically you sell short a stock with a discounted convert that will have a large
negative impact on the stock price. A lot of shares being sold in comparison to
the float and volume will do this.
When a deal permits the selling shareholders to sell short, in advance of
conversion, they will surely do so, so that they remove some of their risk.
They will be tempted to pound the stock hard by short selling a few days
before converting so that they lower their conversion price.
Factors that make a deal less desirable for shorting are those that provide an
incentive for the sellers to wait before converting, or convert slowly. These
include a graduated discount schedule (10% this month, 11% next month, and
so on) and warrants that become fully vested only if the convertible holder
waits a year before converting. These features aren't that unusual, and one can
detect them in the S-3.
When do you sell short?
Institutional selling associated with a discounted convert usually begins a
couple of weeks after the final prospectus is filed. When the co. files the S-3,
the SEC looks at it for maybe 3 weeks or so, and sometimes they deem it
effective just as it is, but more often it returns 'comments' to the company,
who then files the S-3/a. Sometimes that S-3/a is deemed effective a few days
later, but sometimes it needs still another S-3/a. It is useful to understand this
to know when the institutional selling will begin. Typically it happens a few
weeks after the final S-3 or S-3/a.
You don't have any way of knowing in advance which filing will be the final
one. The optimal method is to phone the co.'s CFO or lawyer and ask 'has the
SEC deemed your S-3 effective yet?'. Otherwise, the fact that the selling
usually begins a few weeks after the first or second S-3/a is often precise
enough for you to know when to short the stock. An exception occurs for
deals where the discount increases gradually with time - this will be mentioned
in the S-3 if it applies.
When do you cover?
You would like to cover right when the conversion process comes to its end.
The only way to know this for sure is to call the co., usually the CFO, and ask
how many convertibles remain to be converted. Otherwise you can just wait a
couple of months after the last S-3/a was filed.
One thing that can go wrong:
Occasionally, a company will get cold feet after filing an S-3 and not complete
the registration process. Management, which is often pretty stupid about these
things, realizes almost too late what a horrible thing the selling might do to
their stock price, and they decide to buy the convertibles back, for a lot more
than they sold them. So occasionally you will short a stock after seeing the
S-3 or S-3/a, only to read a few months later a news release announcing such
a re-purchase. When that happens, the stock often jumps up momentarily,
perhaps as short-sellers cover too hastily, and then it settles back down after a
week or so." |
