Good News, Bad News

European companies are warming up to mandatory convertibles -- even if they risk alienating shareholders.
Ian RowleyMay 1, 2003

From a fundraising perspective, it’s hard to quibble with Deutsche Telekom’s debut mandatory convertible bond issue. For one thing, the deal raised over E2 billion for the cash-strapped German telecoms giant in a single morning in February. For another, the funds are recognised as equity capital by ratings agencies—important for a company with a net debt of E64 billion.

However, as DT and a host of other European issuers have discovered in recent months, mandatory convertibles have a downside: angry shareholders. “They’re giving away free gifts to the people who take up the bonds at the expense of the shareholders,” one anonymous DT investor griped at the time of the deal.

Under the terms of its three-year bond, DT raised E2.3 billion of fresh capital, and as CFO Karl-Gerhard Eick confirmed in March at the company’s annual results conference, most of that will be used to shore up the company’s pension liabilities and maintain the firm’s BBB+ credit rating.

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In return, bondholders will receive an annual coupon of between 6.375% and 6.875% and newly issued equity when the notes convert in February 2006. According to DT, which is now fully financed until 2005, the bond opened up the firm to a whole new investor group.

Not Pleased

Nevertheless, identifying the source of investors’ ire isn’t difficult. Many of DT’s shareholders—who didn’t receive a dividend last year—are riled because their equity funds are precluded from buying convertibles (despite the fact that they have strong equity-like characteristics).

What’s more, a company’s share price usually takes a hit when it issues a mandatory convertible. Nearly all such deals issued in Europe in the last 12 months have coincided with share price dips, primarily because the bonds are typically bought by hedge fund investors who short-sell issuing companies’ shares.

In DT’s case, bankers say around 90% of its mandatory deal was snapped up by hedge funds, which led to the stock being shorted by E2 billion. “Obviously, that’s galling for long equity fund investors,” says Adrian Lewis, an equity capital markets banker at UBS Warburg.

Despite the potential knock-on effect, bankers insist that concerns over the impact of mandatory issuance on company share prices are over-played. As a case in point Tareen Hussein, head of convertible bond research at BNP Paribas, points to Vivendi’s E1 billion mandatory deal last November. “While there was criticism that the existing shareholder base wasn’t involved [in the fundraising], the use of the proceeds [to buy Cegetel, a French telecoms company] was clearly seen to be creating value,” he says. Hussein adds that after falling 7.4% in the four days following the deal’s completion, Vivendi’s share price recovered beyond its pre-deal level.

As for DT, its share price was E12.64 as CFO Europe went to press—still below its pre-mandatory price of E12.90.

Saul Nathan of Morgan Stanley, which alongside Goldman Sachs advised DT on the deal, says CFOs should keep things in perspective and consider the negative impact on share prices caused by other financings such as discounted rights issues.

There’s also the fact that rights issues also take longer—several weeks as opposed to days—to execute. “The traditional rights offering leaves companies exposed to the risk that the market could turn against them while they’re waiting for investors to decide whether to take up their rights,” he says.

Slow going

Nathan adds that investors’ concern may say more about investment management in Europe than mandatory instruments. In his view, European investors have been slow to accommodate mandatory convertibles, which have been widely used in the US for more than a decade. “Some European equity investors may not yet have the models in place to value some of these instruments,” he sniffs.

That’s a view shared by George Philips, chief investment officer of Axis Capital, a London-based hedge fund investor. He says that debate over relative merits of mandatory deals is clouded by a lack of understanding of convertibles instruments. “While there’s equity at one end and debt at the other, there’s a wide spectrum of deals aimed at different investors in between,” he says. “It makes sense for companies to use different instruments to appeal to different types of investors.” Some of DT’s shareholders might beg to differ.