Path Function Corporate Finance
Point Function Corporate Finance applies where the cost of capital depends on the initial point (issue date) rather than on the path between the initial and final dates.
Corporate Bond cost of capital is an example of a path function, known at the issue date. A bond’s coupon rate, set at the point in time the debt is issued, is the cost of capital, regardless of subsequent changes in interest rates or credit spreads over the term (the path) to maturity.
Path Function Corporate Finance applies where the outcome depends on the path between the initial and final dates.
Convertible Bond cost of capital is an example of a path function, known only at the end date. As a hybrid of debt and equity, changes in the share price and financing markets over the term of the bond (the path) are primary determinants of the cost of capital.
Our experience tells us a convertible bond’s structure, primarily its maturity term, early redemption provisions, and its derivative hedge, are often more important than coupon rate or conversion premium.
To illustrate:
Maturity Date
Incyte Corporation issued $200 million in 5.50% 7-year convertible bonds in January 2000.
- Shares never exceeded the conversion price during the initial 7-year term.
The convertible was refinanced twice to extend the maturity date, each time at a lower conversion price.
- The number of dilutive conversion shares issued upon conversion increased more than ten-fold.
Redemption Feature
Amarin Corp. issued $150 million in 5-year convertible bonds in January 2012.
Shares more than doubled in the next year, trading as high as 80% above the conversion price.
- The non-call life provision prevented an immediate conversion to equity.
Shares then fell more than 90%.
In 2014, the convertible was refinanced to add early conversion features and extend the maturity, at a lower conversion price.
- The number of dilutive conversion shares issued upon conversion increased more than three-fold.
Derivative Hedge
NVIDIA Corporation issued $1.5 billion in 1.00% 5-year convertible bonds in November 2013.
- A tax-integrated derivative hedge was included to minimize cost of capital
Shares surged more than six-fold over the next 3 years
- Most convertible holders early converted, requiring a premature repayment of cash
In December 2016, NVIDIA negotiated an early unwind of the derivative by issuing $6 billion of new NVIDIA shares to the underwriter
- The cost of capital over the three-year effective debt term approximated 68% per annum
These are not rare or isolated examples.
Over the years we completed several multi-year studies of end date convertible debt outcomes
A study of all biotech convertibles issued over a 6-year period found the majority had been refinanced prior to the maturity date at lower conversion prices. In many cases, non-call provision prevented conversion when share prices were high, with the maturity date occurring at a time share prices were low.
- The average 32% conversion premium became a 38% conversion discount to the initial share price
A study of all convertible debt issued with derivatives over a 3-year period found the overall after-tax cost of capital was in excess of 20% per annum. In many cases, non-call provisions prevented early redemption as share prices exceeded the derivative upper hedge price threshold.
A study of all airline convertibles issued over a 6-year period found most had been put back to the issuer, with the majority of the remainder refinanced to extend the maturity date. In many cases, non-call provisions prevented opportunistic refinancing during up-cycles, while short maturity terms exposed the issuer to funding cash puts during down-cycles.
- The average 41% conversion premium became a 36% conversion discount to the initial share price.
In each study, short maturity terms, non-call redemption features, and/or the use of derivatives were primary determinants of the end point cost of capital.
Conclusion
Diagnostics, getting the appropriate structure for each issuer, is a critical factor to ensure success and minimize cost of capital.
Note:
B. Dyson Capital Advisors team acted as sole advisor to both Incyte and Amarin in certain of their refinancing transactions and acted as advisor to NVIDIA on their derivative unwind.
