Orchid CB receives brutal treatment in the secondary market

A hefty increase in the deal size and concern about the use of proceeds push the bond price sharply below par.
The convertible bonds issued by Indian drug maker Orchid Chemicals & Pharmaceuticals on Monday have been the talk of the CB community this week û and not for reasons that the company would likely want to remember.

Still, the ordeal has highlighted the importance of proper communication, not only by the banks involved in the transaction but by issuers too as they need to make sure investors are fully aware of their intentions.

OrchidÆs zero-coupon CB appears to have failed on both these accounts.

The mayhem started when the share price dropped 9.8% on the day after the issue. This led to confusion among the bond holders, who promptly started to offload the CBs pushing their price as low a 97% of face value at one stage.

A substantial drop in the share price will always have a downward impact on a CB since it effectively means that the conversion premium is increasing, but according to specialists, in this case, the drop in the bond price was too large to simply be explained away by either the decline in the share price or the dilutive effect that the CB could have on the stock if it is converted.

Instead, the main reason investors dumped the bonds appears to have been disappointment over the fact that the size of the CB issue was increased significantly in between launch and pricing, which some investors say they were unaware of until they received their allocations.

A source familiar with the process says the fierce reaction took sole bookrunner Merrill Lynch by surprise as on the night of the transaction the bank did contact a large number of the investors by phone û and alerted everyone in writing - to ask them whether they wanted to keep the original size and price the deal around the mid-point of the indicated ranges or would agree to upsize it and price at the wide end.

The inquiry about a size increase initially came from the issuer who saw an opportunity to raise enough cash that it wouldn't need to return to the capital markets for a very long time.

According to the source, Merrill received a lot of support for increasing the size and therefore decided to go ahead. The base size of the five-year, zero-coupon deal was increased to $175 million from $125 million, while the greenshoe was kept at $25 million, resulting in a total allocation of $200 million.

The deal was priced with a yield of 7.25% and a conversion premium of 30% over MondayÆs closing price of Rs267.95 on the National Stock Exchange of India.
There is an issuer call after three years, subject to a hurdle of 130%, to speed up conversion if the share price continues to perform.

With an order book totaling $350 million, there ought to have been enough demand to cover the larger size, but as the deal increased it altered the pricing parametres on which investors had based there valuation models. Some investors also claimed that the asset swaps provided failed to cover the enlarged offer in full.

But what really should have set off the alarm bells, CB specialists say, was the fact that the final deal size accounted for 50% of the companyÆs market capitalisation. Typically, CB issues will account for no more than 20%-25% of the market cap and one of the specialists argued that this large size creates ôa massive overhangö.

ôJust to unwind your position will take days and even if the bonds trade well you will need a very cheap option and a high bond floor to compensate for that,ö he says, suggesting that the 95.2% bond floor on the five-year Orchid CB wasnÆt adequate.

In addition to the fall in prices, the credit also widened out from the 300 basis points that were used to price the CB û some say it was being swapped at no less that 425 basis points the day after the deal û and this, CB specialists say, could end up having negative ramifications for future Indian CBs.

ôEverybody is going to be super careful about the credit that the banks are using,ö one of them argues.

Merrill was said to be confident about the credit at 300 basis points, however, and sources close the bank said it attributed the widening to the fact that there was concern among investors over how the company would use the additional $50 million it raised. As of Thursday, the management had yet to make an announcement with regard to this although it had attempted to talk up the share price by explaining to retail investors that any potential dilution wonÆt be immediate and wonÆt be at the current prices.

"The company doesn't have a past earnings record that can suggest what it will do in the future," one source notes. "It needs to explain what it plans to do with the money."

According to the term sheet, the money raised from the initial deal size will be used to cover the companyÆs large capital expenditure needs as its plans to steadily expand its portfolio of drugs, and to repay some outstanding debt. Orchid specialises in developing ways to manufacture drugs that are about to come out of their patents.

As of the close of trading yesterday, share price had recovered to Rs258.85 after closing at Rs241.90 the day after the CB transaction. It was still down 3.5% from its last close before the deal, however. Meanwhile, the CB had ticked up slightly to 98.5% to 99%.

Prior to the deal, the stock had gained 37% this year, but was down about 32% from its 2006 peak of Rs394.45 that it hit in April.

People close to the lead manager noted that Merrill was reluctant to acknowledge that a $175 million or $200 million issue was too sizeable for Orchid, which is currently working on a long list of pharmaceutical products that it plans to add to its portfolio once they become available for generic production over the next two to three years.

ôThe confidence we have in this company isnÆt changed by movements in the pharmaceutical sector or in this particular stock over a few daysàand it is really our judgment that in three or six months' time, the company will have made investors money,ö says a participant familiar with the situation.

Still, CB specialists at rival banks argue that the poor outcome of the Orchid deal was down to poor execution and could perhaps have been avoided by better communication with investors on the night of the deal.

ôInvestors are upset at the way it was upsized. If they had done it at the right time (as opposed to late at night when few investors were still around) and issued a new term sheet to let everybody take another look at the deal, it might have done okay. This was a simple deal and there is no reason why it should have gone this badly,ö says one banker.
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