Hung Convertibles

Hung convertibles, a term widely recognized within the finance and trading sectors, refer to convertible securities, often convertible bonds, that have not been fully sold or marketed by the underwriters. These securities remain with the underwriting firm after the public offering, indicating that the demand among investors was insufficient to fully absorb the issuance. This typically signals a lack of confidence or interest in the underlying security, the issuing entity, or the overall market conditions.

Basics of Convertible Securities

Convertible securities are a hybrid financial instrument that combines elements of both debt and equity. Common forms include convertible bonds and convertible preferred shares. These securities provide investors with the option, but not the obligation, to convert the security into a predetermined number of shares of the issuing company’s common stock.

Convertible bonds, for instance, usually offer lower interest rates compared to regular bonds due to the conversion feature, which provides the potential for investors to benefit from an increase in the stock price of the issuing company. The appeal lies in the combination of fixed-income characteristics along with the potential for equity-like returns if the company’s stock performs well.

Process of Issuing Convertible Securities

When a company decides to issue convertible securities, it typically hires an underwriting firm or a syndicate of firms to manage the offering. The underwriters are tasked with pricing the security, marketing it to potential investors, and ultimately selling the securities.

Underwriting and Potential Risks

The underwriting process involves several steps:

1. Due Diligence: The underwriting team evaluates the issuing company’s financial health, business model, and growth prospects.
2. Pricing: Based on their evaluation, the underwriters determine a fair price and conversion terms for the convertible securities.
3. Marketing: The securities are marketed to potential institutional and individual investors.
4. Sale: The securities are sold, usually during a public offering or a private placement.

However, if there is insufficient demand, not all the securities may be sold. The unsold portions, known as hung convertibles, represent the risk that the underwriters have taken in guaranteeing the sale.

Factors Leading to Hung Convertibles

There are several factors that can result in hung convertibles:

Market Conditions

The broader market environment has a significant impact. During periods of high volatility or economic uncertainty, investors may be less willing to take on the added risk associated with convertible securities. This was notably seen during the financial crises, where market participants sought safer, more stable investments.

Company-Specific Issues

If the issuing company is facing particular challenges, such as declining earnings, high debt levels, or significant competitive pressures, investors may be wary of purchasing its convertible securities. For instance, if a company operating in a declining industry tries to issue convertibles, it might struggle to find buyers.

Security-Specific Terms

The terms of the convertible security itself can also influence demand. Complex conversion terms, unfavorable interest rates, or unattractive conversion ratios can deter investors. If the features of the security do not align well with investor expectations or market standards, the underwriting firm might have difficulty in selling the entire issue.

Consequences of Hung Convertibles

The existence of hung convertibles can have various implications:

For the Issuing Company

A hung convertible issue can be detrimental to the issuing company’s financial goals. It may limit the capital raised, impacting the company’s ability to finance growth initiatives, pay down debt, or pursue strategic objectives. This, in turn, can negatively affect the company’s stock price and investor sentiment.

For Underwriters

Hung convertibles pose a financial risk to underwriters since they have to hold the unsold securities on their books. This ties up capital and can lead to potential losses if the value of the convertible securities declines post-issuance. Furthermore, it can harm the underwriter’s reputation, affecting future underwriting business.

Case Studies

Example 1: Tesla Convertible Bonds 2019

In March 2019, Tesla issued $1.84 billion in convertible bonds as part of its fundraising efforts. The offering was fully underwritten and did not result in hung convertibles, underscoring the strong investor demand for Tesla’s securities at the time. This success was driven by Tesla’s promising outlook and innovative business model, reflective of how positive company-specific and market factors can facilitate complete placement of convertible securities.

Example 2: Hertz Global Holdings 2020

Contrast this with Hertz Global Holdings’ attempt to issue convertible securities in 2020 amid financial distress and a looming bankruptcy. The market conditions and company-specific problems led to weak investor interest, resulting in underwriters being left with unsold securities. This example highlights the higher likelihood of ending up with hung convertibles when investor confidence is low.

Management of Hung Convertibles

Strategies for Underwriters

To manage and mitigate the impacts of hung convertibles, underwriters may employ several strategies:

• Secondary Market Sales: Attempting to sell the unsold securities in the secondary market, albeit typically at a discount.
• Hedging: Using derivatives or other hedging mechanisms to offset potential losses.
• Holding and Reselling: Holding onto the convertibles until market conditions improve, then reselling them at a more favorable time.

Corporate Communication

Issuing companies must maintain transparent communication with investors and the market, explaining the rationale behind the capital raise and outlining how the proceeds will drive future growth. Effective communication can sometimes alleviate investor concerns and improve the success rate of convertible security offerings.

Conclusion

Hung convertibles spotlight the inherent risks and complexities in the issuance of convertible securities. Understanding the dynamics of investor sentiment, market conditions, company-specific factors, and security terms is crucial for underwriters and issuing companies alike. Managing these factors effectively can facilitate successful convertible offerings and mitigate the risk of unsold securities burdening underwriters.

For further information on underwriting practices and convertible securities, you can visit Goldman Sachs.

The concept of hung convertibles remains a critical consideration for financial decision-makers, influencing strategies in capital raising, risk management, and investor relations. With the evolving financial landscapes and market dynamics, ongoing analysis and adaptation are essential for navigating the challenges associated with these hybrid instruments.