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Special Report, The M&A Cycle: Turning the ratchet

Despite the US Treasury’s recent attempts to discourage M&A activity for tax engineering reasons, the M&A market remains strong. This promises a lot of potential for merger arbitrage funds, of course, but investors should be aware of the opportunity available to long-only convertibles investors. 

These strategies can overlap when a target company in a takeover bid has issued convertible debt, and the two sets of practitioners may well sit next to one another on the trading floor. 

Indeed, as Edouard Petitcollot and Olivier Baccam, senior merger arbitrage fund managers in the risk arbitrage solutions team at Candriam, note, there are great synergies to be had between a convertibles team and a merger arbitrage team. The former know what to look for when they are scanning the prospectus for a convertible debt, while the latter are heavily schooled in fundamental analysis and have a great feel for whether or not an announced M&A deal is likely to proceed to completion.   

Where a target company has convertible debt, they will look closely at both the equity and the convertible bond to decide how to play a merger situation. The aim is to find an asymmetric profile in terms of risk reward, and sometimes the convertible offers a better asymmetric than the equity, often thanks to the M&A ratchet coming into play. 

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“Our low volatility merger arbitrage fund only considers taking a stake in the target company, not the bidding company,” explains Petitcollot. “We also run a high volatility merger arbitrage fund and there it is permitted to take a stake in the bidder as well. We also take stakes pre- announcement in the high volatility fund where we think a deal is likely. In both cases we look at the entire debt structure and our convertibles team will analyse the prospectus for the convertible debt while we form a view on the prospects for the deal completing. With the low volatility fund, we may buy in on the day the deal is announced or it may be any time up to two weeks or so before the deal concludes.” 

Ratchet

Convertibles managers have an interest in the M&A prospects surrounding any convertible issuance since one of the features of a convertible bond is that it includes a ratchet mechanism. 

Annual convertible issuance 2004-14

“The ratchet is there because the company issuing the convertible could, theoretically, be taken over shortly after the issue,” as Justin Craib-Cox, convertible team fund manager at Aviva Investors, puts it. 

The ratchet is designed to compensate investors should a takeover be announced while the equity option on the convertible was, say, 30% out-of-the money. The holder of the target company’s convertible would be forced to forego conversion and accept the par value of the bond, losing all the upside optionality left until maturity – an unattractive proposition. Hence convertibles generally include both a ratchet and a table of mechanical calculations that depreciates the value of the ratchet according to the length of time since issuance. 

Because you can factor in both the ratchet and the likely premium that will accrue to a target company’s stock when it becomes the subject of a takeover bid by a stronger player, the equity portion of the convertible can produce stellar returns once an M&A situation develops. 

To account for the possibility of a takeover occurring hard on the heels of issuance, the ratchet is largest on day one. It is there to compensate the investor for the fact that the shares have not had time to grow in value if there is an immediate takeover. Without the ratchet all they would be left with would be the bond with its under-priced yield, with the whole thing about to be turned into cash when the target company’s shares are wound up. With the ratchet, M&A becomes very interesting for convertibles. 

Craib-Cox cites the convertibles issued by Autonomy, which traded in a par-to-low-110s range until the Hewlett Packard takeover was announced, at which point they adjusted to the low 150s. 

Similarly, Mike Reed, partner, senior portfolio manager at BlueBay Asset Management, offers the example of the takeover of Concur Technologies – the travel and expenses software provider – by SAP. Concur’s convertibles were issued in May 2013 with a conversion option strike price at $104.85 (€85.18), a 32.5% premium to the stock price of $79.13. By 19 September 2014, the stock was up at $107.98 and the convertible price had risen to 119; due to its equity sensitivity the convertible had participated in 52% of price rise of the equity. That evening, SAP announced an agreed cash takeover at $129 per share. 

Under the original conversion terms the parity value at takeover would only have been 123. However, the ratchet formula in the prospectus lowered the conversion price to approximately $97.70, increasing takeover parity to 132, an uptick of nine points, 40% of extra return.

“By contrast, the best outcome for the owner of a straight bond is getting taken out at 101,” Reed adds. “And if the company you’ve lent to gets taken out by an acquirer of lower credit quality that wants to get hold of a superior balance sheet – as often happens through private equity or leveraged finance acquisitions – you suddenly go from being a lender to a nice investment-grade company to a lender to a balance sheet that is being levered up like never before. Your bond can very quickly be down 10 points.”

Through an active M&A cycle convertible fund managers are trying to accumulate nuggets like Autonomy and Concur, putting in due diligence examining issuers for their potential attractiveness as takeover targets. 

Flow

“If as a fund manager or an investor in convertibles, you find yourself in a cycle where M&A activity is picking up, that is really good,” says Craib-Cox. “You need a catalyst to occur that gives the market an incentive to pay more for the underlying stock. However, when deciding which convertible issue to invest in, you have to look hard at the merits of the company concerned to assure yourself that it has the potential to follow through and grow, generating additional value for its shares in the absence of any takeover. The company may be issuing the convertible to fund a new product it is going to develop and launch, and that can be a good story, but you have to believe in more than the product. The company itself has to have real growth potential over time.” 

As Craib-Cox implies, many of these opportunities have a growthy flavour. That stands to reason: M&A activity is concentrated in growth sectors, because acquirers are, by definition, seeking growth, and they favour picking up assets that have growth potential; and it just so happens that growth companies tend to be the biggest issuers of convertibles.

“That is no accident,” explains Reed. “Convertibles are a natural fit for their capital structures because companies that can invest to generate growth want to minimize cash outflows, and therefore prefer lower coupons on their bonds. They also prefer not to dilute their equity because their assumption is that the share price is rising. A bond that exchanges lower coupons, not for equity but for equity optionality, is the perfect instrument, which is why we see a lot of convertibles in energy, biotech, medical equipment, IT.”

It is easy to see why a good flow of convertibles has been coming to the market as the global economy works to put the financial crisis behind it. The interest a company has to offer to get a convertible bond away is significantly lower than on a straightforward bond. They can do this because investors can look for compensation for accepting a lower yield from two sources. 

First, they can take the view that the call option on the underlying equity has a reasonable prospect of more than compensating them for the lower coupons. Second, they know that if something frightens the markets and stocks plunge, while convertible bonds will not be immune, they will in all probability not fall to the same extent as the stock since the bond can be held to maturity and the principal redeemed. If things get tough, because convertible bonds are often pari passu with other senior secured debt, investors can have some confidence that if the issuer fails, the bond will still have some value even when the equity is removed. 

Supply is abundant and demand is buoyant – and this almost certainly has a lot to do with where we now find ourselves in the cycle of corporate M&A.

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