Takeover protection
Takeovers remain the biggest area of “event risk” concern within the convertible market. When the conversion/exchange property (ie the underlying equity) is acquired or merged with another entity, the overriding concern for convertible holders will be what the conversion rights change to and whether they will retain any optionality. A set of structures has been developed to protect investors in change-of-control scenarios. These structures fall into two categories, protection for convertibles and protection for exchangeables. Protection for convertibles generally takes the form of an increase in the conversion ratio, applicable for a short period after the takeover offer goes unconditional – usually referred to as an enhanced conversion window. Conventions There are two main conventions for enhanced conversion windows. The first is stepped conversion or ratchet clauses. Here the enhanced conversion ratio that is applicable is determined according to a schedule set out in the bond’s prospectus. This will generally fall over time. On the announcement of a change of control, convertible holders will have a window, usually of 60 days, to convert at the prevailing enhanced ratio. The second type of protection for convertibles is average premium enhancement. Here the clause states that under a change of control the conversion ratio is enhanced according to the average premium of the bond over a given time period, normally 12 months. Again, the enhanced conversion window only applies for a specified time period, typically 60 days. With exchangeables the situation is different. The issuer may not own any additional shares of the underlying equity and so might not be able to give an enhanced conversion window. Even if they did they certainly would not want to commit to delivering these extra shares in a takeover, as this would restrict their flexibility. However, the issuer will receive the proceeds of the offer in lieu of the underlying shareholding. This has become the new exchange property. Where the offer is entirely for shares there is no problem, but in the event of a cash takeover all optionality may be lost (since cash has no volatility), and where there is a partial cash element, optionality will be “diluted”. When cash does remain in the exchange property, the key factor is whether or not this is reinvested for the benefit of the investor or whether the issuer receives the interest. In recent months exchangeables protection has been included to prevent cash dilution of optionality in the event of takeovers. This has taken two forms: continued optionality and cash compensation. Continued optionality is the more common form. Here the issuer has agreed to reinvest any cash proceeds from a takeover in other equity securities in the exchange property, or in shares of the acquirer or if neither of these is applicable in an equity index. This essentially guarantees the investor optionality over the life of the bond. The alternative form of protection gives compensation for any cash element in an accepted offer. Here there is continued conversion in an all share offer, giving continued optionality.
