Hedging Hedge-Fund Risk

Convertible bonds are in vogue once again. But skirting the shorts requires some fancy footwork.

With equity markets slow and debt markets cautious, hybrid vehicles such as convertible bonds may be the only refuge for capital-starved companies this quarter. Indeed, after a sharp slowdown in third-quarter issues, many expect the convertible market to rebound.

“I think we’re going to see massive convertible issuance toward the end of the year, because companies just aren’t going to get this capital from anywhere else,” predicts Andy Reckles, chairman of Hyperion Partners Corp., an Atlanta brokerage. Hyperion had three such deals pending in mid-September.

The good news is there’s plenty of hedge-fund money waiting to absorb the convertibles, according to Tim Rudderow, president of fund management firm Mount Lucas Management Corp., despite the low coupon rates and favorable 30 to 50 percent conversion premiums that issuers have been able to command. The bad news, however, is that hedge- fund investors may push stock share prices down by shorting the underlying instruments, thereby triggering a sell-off among long-term equity investors.

Share shorting in convertibles “is always a concern,” says Finisar Corp. CFO Stephen Workman, but it becomes more acute when share prices are low. In response, Finisar executives are planning a mini-road show for the company’s first convertible offering, originally announced September 10 and now postponed until later in the year. “You can put a fence around some of the downside if you’re able to engage a broader base of investors,” says Workman. “Some will still be hedge funds, but some will hold your stock afterward.”

About 50 percent of Finisar, a $189 million fiber-optic equipment maker based in Sunnyvale, California, is held by institutional investors, which accepted the plan despite reservations about the net income losses the company has suffered during the past year. Finisar didn’t require the approval of investors, but “we had a general nod of understanding from them,” says Workman.

Stealth Mode

Other convertible issuers try to minimize the impact of the hedge funds’ arbitrage by going into stealth mode around such a deal, providing little future notice and sealing it after the markets close.

“It’s important to be very quiet before going to market so your stock isn’t driven down,” says Mike Jennings, vice president and treasurer of Cooper Cameron Corp., a pressure-control equipment maker in Houston. Last May, the company, which is more than 80 percent institutionally held, sold $450 million of convertible bonds with an average annual yield of 1.5 percent in a two-part overnight deal. Although Cooper’s stock price bobbled for about two weeks after the issue, Jennings says the long-term benefits were enough to win a “very positive” reaction from equity holders.

“We probably saved 400 to 500 basis points relative to straight-debt borrowing costs at that time,” he says, “so the feedback from institutions was generally, ‘Great job.’ ” Comments Lennar Corp. treasurer Waynewright Malcolm, who also prefers overnight deals in an equity-linked transaction: “Even in a down market the strategy still works, because you remove the uncertainty about what the share price is when you do the transaction.”

Obviously, deal structures can also help eliminate convertible- arbitrage opportunities. Floors, collars, and restrictions on pre- and postconversion trading tend to make convertibles less attractive to hit-and-run investors. However, Reckles, who also owns a hedge fund, believes such fears about shorting are overblown. Hedge fund managers have to “tie up so much money on top of what is already invested, and face so many risks about being able to trade it, that the cost to carry a short position becomes enormous and short-selling doesn’t make any economic sense,” he maintains.

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