Is Back-Door Equity Financing Always a Bad Idea?

Companies are often criticized for raising capital by selling mandatory convertible bonds that pay high interest rates, but the instruments can be a good way to shore up a firm’s finances.
October 10, 2008
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Last November, Citigroup announced that it had raised $7.5 billion from the Abu Dhabi Investment Authority. The sale would make the sovereign fund the bank’s largest shareholder, with a 5 percent stake. Citigroup, the largest U.S. bank by assets, had recently acknowledged that it would absorb up to $13 billion in losses from failed subprime mortgage investments.

The funding came in the form of mandatory convertible bonds that paid an 11 percent interest rate. The financial media interpreted that relatively high rate as a further sign of the bank’s distress. The Wall Street Journal noted that the bank was paying a higher rate than companies that must sell their debt on the junk bond market. (At the time, the average yield on a junk bond was a significantly lower 9.4 percent.) The New York Times wrote that the “coupon suggests the bank is paying a high price for funding.”

Some analysts and investors said Citigroup would have been better off selling more shares, rather than selling convertibles. To determine whether the bank made the right decision, Professor Enrique Arzac came up with a formula that compares these alternatives and predicts which method has a lower cost for the issuer.

Unlike a standard convertible bond, which an investor can convert into common stock at any time, a mandatory convertible has a required redemption date. This gives the issuer more control. The longer it takes for the conversion into stock, the higher the cost for the issuer. In Citigroup’s case, the convertible will be turned into stock after a period of about three years.

Citigroup needed to raise cash to meet regulatory requirements for its capital base. Uncertainty in the credit markets and a series of acquisitions had taken a toll on its finances. (Other investment banks rocked by the collapse in the subprime mortgage market would soon follow Citigroup’s lead. In December, UBS and Morgan Stanley sold mandatory convertibles to sovereign funds in Singapore and China to replenish their core capital.) As much as it needed the money, Citigroup faced risks in attempting to raise capital through the typical method, the sale of new shares of common stock.

“When a company issues new equity, it is saying to investors, ‘Trust me,’” Arzac explains. “But when investors are worried about the extent of future losses, they are reluctant to part with their money.” For banks, the situation can be even more serious. Asking for more money risks unnerving not only shareholders and bondholders but also depositors. “In the worst-case scenario,” Arzac says, “you can get a bank run.”

Citigroup needed to assure investors that it wasn’t running out of cash. Issuing a convertible that pays a high dividend is one way of doing so, Arzac says. (With common equity, there are no guarantees that investors will receive a dividend.) And by forcing investors to convert the bonds into stock at the end of a three-year period, the bank signals to investors that it expects to be in better financial health in the near future.

This leaves the question of whether the 11 percent coupon was too high. To answer this, Arzac estimated the implied stock price from the mandatory convertible and compared it to a common equity offering. (There are particular tax benefits to Citigroup’s issue of mandatory convertibles, Arzac notes, that reduce its cost. A portion of the coupon is tax deductible.) In Citibank’s case, Arzac concluded that its sale was the equivalent of selling new equity at most at a 5 percent discount. At the time, Citigroup was trading at about $29–$30 a share, meaning the mandatory convertibles were the equivalent of selling new shares at $28.

Citigroup’s move compares favorably with strategies taken by other banks at the time, Arzac found. Under similar pressures, in January 2008 Merrill Lynch sold a private placement of common stock at more than a 20 percent effective discount to its current market price. (This isn’t a criticism of Merrill, Arzac says; the investment bank had already sold mandatory convertibles to meet its regulatory capital obligations and likely had to raise additional money through other means.)

“Mandatory convertibles are often called back-door equity financing, because it’s an indirect way of selling equity,” Arzac says. “Analysts and the press tend to see it as a costly way of raising capital.” Though Citibank was criticized for its mandatory convertible sale, the numbers show that the bank made the right decision, he says. “Citigroup was actually very clever.”

Enrique Arzac is professor of finance and economics at Columbia Business School.

Enrique Arzac

Professor Arzac is an expert on corporate finance and valuation. He teaches the advanced corporate finance courses in the MBA and Executive MBA programs, directs the Merger, Buyouts and Corporate Restructuring program for executives, and co-directs the Mergers and Acquisitions program for executives at London Business School. He is the author of the book Valuation for Mergers, Buyouts and Restructuring and has published many...

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Enrique Arzac

"Back-Door Equity Financing: Citigroup's $7.5 Billion Mandatory Convertible Issue"


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