Some material in this post was taken from BAC’s report titled, “Cash Takeover Protection’ published on 4/16/05.
Since convertibles lose all their option value in a cash takeover, and hedged investors get hurt on their short positions in the underlying stock, convertible investors started to demand cash takeover protection from new convertible issuers beginning in 2004.
The most common protection gives convert holders additional shares (increase conversion ratio) based on a matrix of prices and dates that are pre-determined at issue on a credit spread, volatility, and interest rates assumptions prevalent at the time. Over time, the convert could richen or cheapen so holders could still make or lose money on a cash takeout.
In order to qualify for the matrix, the takeover must satisfy certain conditions. These vary by indenture so you must read the fine print carefully. These could
include.
1) Cash takeover must be at least 10% cash.
2) The acquirer is not a public company. Public acquirer clauses were more popular at the beginning. This gives the acquiring
company the right to refuse the matrix and keep the convert outstanding which would then convert into the acquirer’s shares.
Fundamental Change
It is important to read carefully what constitutes a fundamental change. This term is usually defined in the Defined Terms section of the indenture. This usually states that a transaction is a fundamental change if it meets any of the following criteria:
1) A person or group obtains more than 50% of the voting interest
2) A recapitalization that results in existing holders owning less than before the transaction.
3) Delisting from a stock exchange
Provided that the transaction is not a fundamental change if the takeover consists of at least 90% stock consideration.
Change of control put provision – Various forms of “poison puts” are a common feature. The goal of these provisions is to allow the investor to exit a position at par in the event of mergers that are potentially harmful to the conversion option. There are several variations. Generally, poison puts are triggered by a “Change of Control”, in which a third party obtains a defined level of voting control of the company. Some simply provide for a cash put at par plus accrued interest; others aim to adjust the ratio so that parity will equal par.
Not all mergers will qualify (e.g., most all-stock mergers do not trigger the put) and the terms of issues can be unique, thus each issue needs to be looked at individually. While the change in control put benefits out-of-the-money convertibles trading below par, for convertibles trading at-the-money or in-the money this put option is worthless. Moreover, these convertibles get hurt the most from the loss of their option value associated with an all-cash or mostly-cash merger. Since the second half of 2004, virtually all new convertible bonds include some form of cash takeover protection as described in more detail below.
Make Whole matrix
BAC convert primer 7/7/11 – Cash takeover protection provision – Since convertibles lose all their option value in a cash takeover, and hedged investors can experience severe losses on short positions in the underlying stock, convertible investors have demanded cash takeover protection (“CTP”) from new convertible issues. The most common type of cash takeover protection is the ‘additional shares’ one.
Additional Shares protection method is most common and calls for an increase in the conversion ratio over a limited period of time, based on a matrix of prices and dates. The price-date matrix contains stock share amounts equivalent to a hypothetical premium over parity that would be lost at a future time at a given takeover offer price. The price-date matrix values for the Additional Shares protection method are generally predetermined at the convertible issue date, based on spread, volatility and interest rate assumptions prevalent at that time. This protection virtually always expires by the first call date. Cash takeover protection language includes other features besides protection type, which can affect a convertible’s ability to qualify for compensation, like protection triggering actions (most require conversion), protection triggering forms of merger consideration (only cash vs. any non-stock consideration), minimum triggering non-stock portion (most allow “10% or more” non-stock), protection expiration (most expire after the first call date), and presence of a “public acquiror” clause (this clause effectively transforms a non-stock merger into a stock-for-stock merger form the convertible bondholder’s view). Like other terms, cash takeover protection is subject to change with market conditions. Beware of very stringent non-stock portion requirements in older convertibles, like 100% in Cash.
Timing of make-whole matrix
In order to receive the extra shares from the make-whole matrix, the holder must convert the bond in connection with a Fundamental Change, which is usually a short time period after the close of the merger.
There is a multi-step process to determine this period.
1) Determine whether the transaction qualifies as a Fundamental Change
2) Determine when the company must issue a Fundamental Change Notice
3) Usually, the Fundamental Change Notice will have to specify the Fundamental Change Purchase Date
4) Check if there is language that allows holders to keep the interest if the Fundamental Change Purchase date falls between a record and payment date.
In the case of Sybase, the company agreed to be acquired by SAP on 5/17/10 with an expected close in July. The next coupon payment date is 8/15/10 so we need to figure out if you will get that coupon.
Section 3.7 says Sybase has up to 20 days after the deal to put out a fundamental change notice. In this notice, they must announce a day for the repurchase of the bonds which is between 20-35 calendar days later. The tender offer, which trigged the fundamental change, was completed on 7/26/10. The company put out the fundamental change notice on 7/27/10, which stated that bonds submitted for conversion before 8/17/10 (Fundamental Change Purchase Date) would get the make-whole. This also allowed convert holders to receive the final coupon payment.
Additionally, section 4.2 says that no payment need to be repaid if the company has specified a Fundamental Change Purchase Date that is after a Regular Record Date and on or prior to the corresponding Interest Payment date. So the holder should have been able to receive the make-whole and the final coupon as long as the Fundamental Change was between 8/2/11 and 8/15/11.
In the case of OSIP, the indenture stated that the Fundamental Change Purchase Date would be 30 business days after the fundamental change has occurred.
Stock mergers
When a takeover qualifies as a stock merger, the acquirer takes responsibility of the convertible bond. This is usually spelled out in the section called Merger Treatment or Recapitalizations under Article Conversions. The trick part is if the target shareholders get a choice of cash or stock.
In the 2005 TEVA takeout of IVX, IVX convert holders lost out because convert holders received the consideration that non-electing shareholders get.
Case Studies: Teva acquires Ivax whereby Ivax shareholders will have a choice of $26 cash or 0.8471 Teva stock, subject to proration so that no more than one-half of such elections are for cash and no more than one half are for Teva stock.
IVA convertible bonds will become convertible into whatever consideration non-electing IVX shareholders will end up getting. Therefore, if TEVA stock price stays above $30.69 before the compensation election deadline, and all electing IVX shareholders choose all stock, the non-electing shareholders would end up with an all-cash merger consideration.
In other indentures such as LRCX 0.5% due 05/15/16, the indenture states that
If the Merger Event causes the Common Stock to be converted into, or exchanged for, the right to receive more than a single type of consideration (determined based in part upon any form of stockholder election), then (i) the Reference Property into which the Notes will be convertible shall be deemed to be the weighted average of the types and amounts of consideration received by the holders of Common Stock that affirmatively make such an election.
Public acquirer clause test
In older converts, there is a public acquirer clause that says if a publicly traded company acquires the company for cash, it can elect to keep the convert outstanding whereby the bond would convert into the acquiror’s common stock. This could be detrimental to the convert holder since the acquirer likely has a lower volatility and deprives the holder of receiving additional shares through the matrix.
In this case, the language will specify how the new ratio is calculated and when holders will be notified,
Section 12.04 . Exchange After a Public Acquirer Change of Control. (a) In the event of a Public Acquirer Change of Control, the Company may, in lieu of increasing the Exchange Rate by Additional Shares pursuant to Section 12.03 above and in lieu of application of Section 12.05, elect to adjust the Exchange Rate and the related Exchange Obligation such that from and after the Effective Date of such Public Acquirer Change of Control, Holders shall be entitled to exchange their Securities, subject to the conditions in Section 12.01(a) or (b), into cash and/or a number of shares of Public Acquirer Common Stock, if applicable, in accordance with procedures and elections contemplated by Section 12.01. The adjusted Exchange Rate shall be the Exchange Rate in effect immediately before the Public Acquirer Change of Control by multiplying it by a fraction:
(i) the numerator of which will be the average of the Daily VWAP of the Common Stock for the five consecutive VWAP Trading Days prior to but excluding the Effective Date of such Public Acquirer Change of Control, and
(ii) the denominator of which will be the average of Daily VWAP of the Public Acquirer Common Stock (determined in a manner consistent with the method used with respect to the Common Stock) for the five consecutive VWAP Trading Days commencing on the VWAP Trading Day next succeeding the Effective Date of such Public Acquirer Change of Control.
(b) In order to make the election pursuant to this Section 12.04, the Parent, the Company and the issuer of the Public Acquirer Common Stock shall execute with the Trustee a supplemental indenture providing that each Security shall be exchangeable into Public Acquirer Common Stock and execute an amendment to the Registration Rights Agreement (to the extent any Registrable Securities (as defined therein) remain outstanding) to make the provisions thereof apply to the Public Acquirer Common Stock. Such supplemental indenture shall provide for provisions and adjustments which shall be as nearly equivalent as may be practicable to the provisions and adjustments provided for in this Article 12 as determined in good faith by the Board of Directors of the Parent or such issuer (which shall be conclusive).
(c) At least 35 Scheduled Trading Days prior to the expected Effective Date of a Fundamental Change that is also a Public Acquirer Change of Control, the Company will provide a notice to all Holders, the Trustee and the Paying Agent stating whether the Company (i) elects to adjust the Exchange Rate and the related Exchange Obligation as set forth in this Section 12.04 or (ii) does not elect to so adjust the Exchange Rate and the related Exchange Obligation, in which case the Holders will have the right to exchange Securities and, if applicable, receive Additional Shares as set forth in Section 12.03. In addition, upon a Public Acquirer Change of Control, in lieu of exchanging the Securities, the Holders can, subject to the conditions set forth therein, require the Company to repurchase all or a portion of the Securities pursuant to Section 11.02.