Catching the convertible trend

Larger companies are tapping their shareholders with a spate of rights issues, currently amounting to an estimated £25 billion, as they seek to restore their finances in today’s tough markets. For smaller companies, without the same muscle to cow the institutions, issuing loan notes that are convertible into shares after a set time and at a pre-arranged price or pricing formula is often proving a more realistic route to funding.

A convertible loan note or convertible loan stock, offering a fixed interest rate well in excess of the negligible yields now on offer from the banks, has obvious attractions to investors – provided they believe the company issuing them will be able to pay the coupon and make the principal repayments as and when required. Sometimes quoted themselves, the notes spare existing shareholders the immediate dilution and, often, share price damage of an equity placing. If the terms on which they can eventually be converted into shares look attractive, they can provide an incentive to investors to hold on until the outlook for equities improves.

Veteran asset stripper and investment sage Jim Slater recently told an investors’ forum that it made sense to hold 20 per cent of their portfolios in convertible bonds. And Philip Kenny, chief executive of Firestone Diamonds, says issuing a convertible has been one of the options considered by the company as it was poised to win a hefty, cash-generative long-term contract with gem giant De Beers.

He maintains that ‘convertibles make sense if you have an income stream to hang them on’. Paying coupons many times minimum lending rate might seem onerous, despite the historically low level of that rate, but other forms of funding, such as mezzanine finance, can still be punitively expensive.       

Nevertheless, convertible loan notes can still store up problems for issuing companies if the terms are too exacting. ‘Convertibles have the potential to be quite toxic, if the conversion formula does not set a minimum price,’ warns Michael Laurier, chief executive of degradable plastics specialist Symphony Environmental Technologies, which recently successfully renegotiated the terms and timing of £340,000 of convertible loan notes with US hedge fund Headstart.

Dodging dilution

Ciaran Morton, boss of acquisitive ATM supplier Cashbox, had no such qualms about the £1.5 million of convertibles issued in December by the company, whose previously ailing fortunes he has been seeking to restore since joining from Thomson Business Intelligence. The loan notes, with an eight per cent coupon, mature in five years’ time but are convertible into shares at the option of the holder, an offshore investment group that is taking a seat on the AIM-quoted group’s board.

‘A convertible made sense,’ recalls Morton. ‘The equity market was poor [Cashbox’s shares having fallen from 36p in 2006 to below 6p] and investors feared dilution.’

At the same time, the offshore fund wanted to rank ahead of equity holders if the company ran into problems before Morton’s restoration strategy had paid off. The fund can convert the notes into shares at either a five per cent premium over the price at which Cashbox next issues shares or the company’s average share price in the three days before conversion.

That offers a potential incentive to the fund, which would have about 20 per cent of Cashbox if it converted. And it gives Morton time to see the company take advantage of a noticeable upturn in ATM use for cash withdrawals and balance checking prompted by credit crunch conditions and to pursue ‘sector consolidation’.

Mark Robinson, chief executive officer of AIM-quoted Advanced Power Components, cites stock market conditions as the reason his company raised £400,000 in convertible loan notes last month to swell its working capital. Despite recent brisk acquisition-fuelled profits growth, the electronic component distributor’s AIM rating had taken a knock.

‘We wanted funds,’ explains Robinson, himself a key shareholder. ‘But, if we had gone out and placed shares, we would have found it very tough and would have had to take a big discount.

‘It made sense to talk to our biggest shareholders [including family member Roger Robinson] and they preferred a convertible.’ Advanced Power duly issued the notes, which mature on 10 February 2014 and carry an annual coupon of eight per cent.

Holders may convert the notes into shares at the lower of their mid-market price on 10 February 2009 and the mid-market price for the 14 days after the conversion date. This gives them an incentive to hang on in the hope the price will recover by then, giving them a built-in profit and blunting the dilutive effect of conversion.

‘We have the option to repay at our discretion,’ points out Robinson, who says the company won’t leave the notes overhanging the market any longer than it can avoid. Unlike an equity placing, a convertible loan note issue did not oblige Advanced Power to seek shareholders’ authorisation (though issuing conversion shares will) or force it to accept a heftily discounted share price.

Avoiding dilution was a key factor in acquisitive headhunter Hexagon Human Capital’s decision to go for a £1.5 million convertible loan note issue as a means of cutting its senior debt to Barclays Bank. Despite strong recent interim results and the presence of an unnamed potential bidder, AIM-quoted Hexagon ‘needed about £2 million headroom to weather the market storms’, argues finance director Carl Thompson.

‘Our preference was to raise that in shares,’ he recalls. But non-executive director and 35 per cent shareholder Swee Quek objected to the potential dilution at a depressed share price.

Accordingly, Hexagon agreed with a ‘quite creative’ Barclays to issue the notes, which carry a four per cent coupon and mature in December 2011. The conversion price is the average for the 15 days before conversion plus an 18 per cent premium.

‘We can cash out if Barclays wants to convert or buy them back for £1.5 million,’ says Thompson. Hexagon is to raise £300,000 in shares as well as part of the deal and, if the mooted bid does emerge, the loan notes will be repaid or converted at Barclays’ discretion.

Thompson contrasts the four per cent coupon with the 25 per cent or more often demanded in mezzanine financing deals. ‘Some institutions wanted to do a convertible deal,’ he recalls, ‘but only on the sort of costly terms usually imposed by venture capital trusts,’ which is why the loan note agreement with Barclays seemed to make sense.

Tough terms

Seven institutions imposed tougher terms on leisure concern AMZ Holdings last year when it raised £5 million in convertible loan notes to fund ‘pre-development costs’ for its ambitious gaming resort project on Taiwan’s offshore Penghu islands. Secured on AMZ’s land holdings in the area, the notes, which mature in 2011, bear a coupon of fully 12.9 per cent and the note holders can demand repayment at par by the company at any time after October this year.

The conversion price will be 150p at any time up to maturity. That compares with AMZ’s present AIM price of 146.5p, its 2007 peak of 275p and last January’s low of 62.5p.  Chief executive officer Michael Treanor says, ‘The anaemic stock market dictated that we had to offer something highly attractive, and the terms provide downside protection and upside potential.’ Shanghai-based Taiwan Opportunities Fund, managed by the Martin Currie group, is the biggest holder of the notes, which are themselves traded on PLUS at Martin Currie’s insistence.

‘It is expensive for us,’ concedes Treanor, ‘but we had to find an effective way to raise money.’ AMZ believes its project, based on the recent legalisation of gaming on Taiwan’s offshore islands, will pay off so handsomely as to make the pain worth bearing.

Pain caused by convertible terms was what forced Michael Laurier to go back to hedge fund Headstart in January to agree a deal, which cut the loan notes outstanding from £340,000 to £240,000 and made them non-convertible into shares. In return, Headstart issued £110,000 of conversion shares to Symphony directors at 2.09p each – as against their 30p float price eight years ago and 14.5p value in 2006, when the notes were issued.

Laurier, who says Headstart ‘have behaved like gentlemen’, argues that the notes’ original conversion price formula – set at 95 per cent of the lowest price over the 15 days before conversion – had proved an intolerable drag, as he strove to turn the biodegradable plastics company from an over-ambitious non-deliverer that had lost its relationship with key US suppliers into an international ‘green’ brand, suitable for franchising. At the time the notes were issued, the company ‘urgently’ needed cash, but directors did not want to issue equity at a deep discount.

‘We felt we were going to do well and the conversion terms did not really matter,’ he recalls. But in a falling share market, ‘the terms can become toxic’.

With no floor conversion price, ‘you can lose control of your company if the institutions short your shares to weaken the conversion and gain control on the cheap’. In such ways, ‘convertibles can be incredibly dangerous’, but, warns Laurier, ‘in today’s climate, a lot of companies are going to be sucked into some of the more fancy types of convertible loan stock’.  

Scope for agility

By contrast, Simon Rees, the ex-WPP luminary brought in two years ago to restore the fortunes of bombed-out digital screen specialist Avanti Screenmedia, takes an altogether more sanguine view. ‘Using convertibles has allowed us to be agile,’ he contends.

Since Rees became chief executive, the AIM-quoted company has obtained £1.75 million through convertibles. Last month, Avanti raised £250,000 with a ten per cent loan, to be repaid or converted at 1p a share within 12 months.

Swiss group Neo Media has been a prime subscriber to these notes, bearing out Rees’s comment that convertibles ‘let us do deals with interested parties in our sector – they want Avanti to survive’.

Claiming that Avanti has restructured, slashed costs and trebled revenues, he does deplore the conversion terms, ‘a small discount to our massively depressed share price [1.62p]’, and points out that full conversion would give Neo Media 70 per cent of the company. That would amount to a ‘Swiss takeover’. ‘We are in discussions now,’ says Rees. ‘I’m keeping my fingers crossed.’