Convertible bonds depress shares when funds unload for quick profit
A controversial debt instrument blamed overseas for sending small caps' share prices into a 'death spiral' is now raising a stink in the local stock market.
These 'instruments of mass destruction', as one banker calls them, are a type of low- or zero-coupon convertible bond that can be converted into shares at a discount - usually 10 per cent - to the average share price in a look-back period, rather than only at a premium, as is normal.
In the past 12 months, at least 20 small cap companies here have issued 'death-spiral' convertibles - so named by detractors because shares converted at a discount are quickly sold for a near certain profit, often depressing the share price as a result. The issuance is typically divided into several tranches.
As each trance gets converted, the price spirals downwards, both diluting and eroding the value of existing shareholders' holdings.
A fund offering to subscribe to such issues gets two discounts - first, because they can look back in a period (usually 25 or 30 days) and select the lowest prices; and second, because they can convert notes into shares at 90 per cent of that price.
And since the conversion price is floating - it falls with the share price - the number of new shares issued to the subscribing fund balloons as the share price shrinks every time it converts a fixed-value note.
Such 'toxic' issues were first seen here about five or six years ago, according to sources. But recently, and especially since last year, activity has accelerated considerably.
By far the most active in the convertible note market is Pacific Capital Investment Management (PCIM), a UK-based fund that has been assiduously courting tiny, cash-hungry listed companies and which has ramped up its lending in the past 10 months or so. So far it has signed agreements to pump in up to $500 million to about 15 companies.
Others in the market are local-based Value Capital Asset Management, the Cayman Islands-registered Advance Opportunities Fund and Delaware-registered DB Zwirn Asia Pacific Special Opportunities Fund.
Companies often have little choice. Many don't have easy access to capital markets and find it hard to do share placements or rights issues. Banks are often unwilling to lend to them, or do so only at punitively high interest rates.
And the sums on offer can be hard to turn down. Companies with market caps of less than $200 million were inking deals for between $6 and $60 million. Jade Technologies, then diversifying into the energy business, was mulling an issue worth up to $150 million.
But bosses say disillusionment was quick to come. 'What we didn't expect is that they take the (converted) shares, then they quickly dump it in the market,' says one company chairman, pointing out that the agreement allows the fund to convert shares at its own discretion.
As the principal amount is typically split into between eight and 40 tranches, the convert-and-sell cycle could play out repeatedly - a heavy recurring overhang on the stock. 'So every week you will have this selling pressure on your share price,' the chairman says.
According to an industry source, each cycle could net the fund 2 to 5 per cent profit, and with relatively modest initial outlay - returns from one cycle could be used to subscribe for a subsequent tranche.
Many companies say they have seen their shares crash to single digit level - especially as in many cases, they were not assured of a minimum conversion price.
Alantac, over 50 cents last July, is now at 13 cents. HLH Group, worth 10 cents a share a year ago, is now at three cents. Lexicon's share price has fallen 80 per cent and Vibropower has lost half its value since subscription agreements were announced.
But company and industry sources say it's difficult to quantify the damage done by toxic issues.
An investment banking source says that in a good market such deals could actually work to the company's benefit, as strong investor demand may be able to absorb the constant dilution.
The trouble, he points out, is that equity markets in the past six months have been lacklustre. 'When the normal volume is a few hundred lots and the fund is selling five or 10 million shares all the time, then the share price will collapse,' he says.
Part of the damage may have been caused by investors seeing the issue of such notes as a sign of distress, as well as generally soured investor sentiment in recent months.
But tellingly, a number of companies have either terminated deals or declined to take up optional tranches. EMS Energy and Equation Corp cancelled deals before they began, but HLH Group issued 607.3 million shares to PCIM before backing out in March and paying 'all associated fees and costs'.
This year, Anwell, Centillion Environment & Recycling and E3 Holdings have all agreed to reduce the number of tranches issued.
Company chiefs ruefully admit they had been naive in expecting that the subscribing fund would hold on to converted shares for longer term gain. One chief executive officer says he was not very clear about convertible bonds and how they could be structured.
'We didn't know their method,' says another, adding, 'I thought it was just like a share placement deal.'
Toxic convertibles originated in the US in the 1990s and were widely used by dotcoms to finance expansion. In Hong Kong, they first made an appearance in the early 2000s. David Webb, a Hong Kong-based activist, told BT the flow of issues there was 'pretty much killed' by his 2005 article highlighting a number of deals done by Credit Suisse First Boston.
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