Why has the last 18 months seen a growth in the issuance of privately placed and pre-IPO convertible bonds?
Growth has been driven by investor demand, with private equity and hedge fund investors looking to structure transactions to meet their specific requirements. The private/club nature of many of the deals allows for increased structuring flexibility and a consequent ability to diversify risk and optimise returns.
What are the common features of pre-IPO convertible bond issues?
The pre-IPO convertible bond shares many features with traditional convertible issuances? The bond is a hybrid security (part debt, part equity option); it is convertible at the option of the holder into ordinary shares; it is redeemable in cash at maturity; and it carries a fixed coupon until maturity. However, pre-IPO convertible bonds have an important difference in that they are issued by an unlisted, private company and, therefore, the equity option either provides for conversion into unlisted shares or becomes exercisable only after a ôqualifying IPOö (known as a ôQPOö).
What is a QPO?
The QPO is the trigger for conversion. Therefore, it is important that this event is adequately defined. It is important that the QPO should represent a point where the issuer genuinely becomes a public company and that this should be an objectively recognisable event. Arrangers will be keen to ensure a minimum level of liquidity, a minimum IPO size, a minimum issue price or valuation and certification by an independent investment bank that the QPO has occurred. Other issues (such as the listing venue and the provision of ôtag-alongö rights for investors to sell shares realised on conversion into the QPO) will also be important.
Why do pre-IPO issuers find convertibles an attractive means of financing?
The pre-IPO convertible shares the advantages of a traditional convertible bond in that the equity option results in issuers having to pay a lower bond yield for the debt, resulting in cost effective borrowing. At the same time, a convertible bond represents an issue of shares in the future at a premium to the current share price. In a pre-IPO context, a convertible bond also allows the issuer to diversify its investor base away from traditional private equity investors (particularly in jurisdictions where the domestic banking system is relatively inefficient) and to attract cornerstone investors for a future IPO without any immediate dilution of the existing ownersÆ stakes.
Why do investors find pre-IPO convertibles an attractive asset class?
Buying into a company by way of a pre-IPO convertible allows an investor making a debt investment to participate in the equity upside on conversion while allowing the same investor the downside protection offered by the bond floor. In the case of a mandatorily converted pre-IPO bond, the investor will also have a guaranteed allocation of shares on the happening of a QPO.
Are pre-IPO convertibles underwritten? Are they listed?
Some pre-IPO convertibles may be underwritten but many are placed by investment banks acting as arrangers, and in other cases, investment banks and other financial institutions (eg hedge funds or private equity funds) will take a proprietary position. Some pre-IPO deals are listed but many will not be. Usually, the bonds will be cleared through international clearing systems such as Euroclear and Clearstream.
How do issuers price the equity option if the shares are unlisted?
Pre-IPO convertibles may be priced with a conversion price that is either at a discount to the QPO price or a premium to it. In either case, the value of the equity option will only become clear once the QPO has been priced. Alternatively, the pre-IPO convertible may give each bondholder the right to convert into a fixed percentage of the issuerÆs shares on the QPO date.
How do issuers avoid the ôoverhangö problem on the QPO?
The overhang in the market can be avoided by making the bond a mandatorily convertible bond, where the conversion is mandatory on the happening of the QPO and resulting shares are sold into the QPO. Alternatively, investors in the convertible bond may be subject to a lock-up, either with respect to the shares issued on conversion or with respect to their conversion rights.
How does an investor hedge its risk?
In a traditional convertible bond, investors will hedge their risk by shorting the underlying shares while protected by a stock borrow. In the pre-IPO scenario there is unlikely to be any liquid stock borrowing market, so investors may need to look at more creative and tailored derivative solutions to provide their hedging requirements (eg total return swaps, repackaging and credit protection products).
Are there any other innovative new structures Linklaters has been working on recently?
One big development is the renmimbi denominated/US dollar settled convertible bonds for Hopson Development. This is a landmark transaction as it lays the groundwork for other Mainland issuers to follow.
Like many Hong Kong companies with significant PRC operations, Hopson was faced with a potential accounting issue following the adoption of IAS 39 as part of HKFRS. These new accounting rules require companies to mark-to-market derivative transactions such as the equity option comprising part of an issue of convertible bonds if the currency of the convertible bond is different from the functional currency of the issuer. The difference in currency between the desired denomination of the bonds (US or HK dollars) and the functional accounting currency of such companies (renminbi) results in the revaluation being passed through the profit and loss account of the company, which in turn can cause significant accounting losses where the share price increases resulting in a diminution in value of the equity option from the perspective of the issuer. This is a major problem for many of the red chip companies with significant PRC operations, which have been key players in the CB markets in the last couple of years.
Linklaters was able to help Hopson overcome this obstacle by structuring renmimbi denominated but US dollar settled convertible bonds, which left Hopson with no residual foreign exchange exposure.
We expect that Hong Kong companies facing similar issues will follow this structure.
For further information on pre-IPO convertible bond financing and other innovative structures contact any of the following:
Tel: +852 2901 5373
Hwang Hwa Sim
Tel: +852 2842 4103
Tel: +65 6890 7333
Tel: +65 6890 7388
Or any of your usual Linklaters' contacts.
A winning combination?
Thanks to our clients for bringing us the most complex and high value transactions in the market. As a result, Linklaters has topped the Thomson Financial M&A league tables for six of the past seven years for announced and/or completed deals, and value and/or volume, and we currently hold over 50 Asian firm, team and deal awards including:
ò Best Financial Law Firm, FinanceAsia Awards 2006 (second year in succession)
ò International Law Firm of the Year (Asia), IFLR Asian Awards 2006
ò Asia Law Firm of the Year, Chambers Global 2006 (second year in succession)
ò Debt & Equity-Linked Team of the Year, IFLR Asian Awards 2006 (fifth year in succession)
ò Law Firm of the Year, Asia, Structured Products Awards 2006
ò Securitisation Team of the Year, IFLR Asian Awards 2006
ò Banking Law Firm of the Year, Asian Legal Business Awards 2006 (second year in succession)
ò Best Trade Law Firm in Asia, Trade Finance Awards for Excellence 2006