Corporate finance is the general term given to the different types of finance used by companies to fund their business activities. For example, equity finance includes the issue of new ordinary shares to investors to raise capital and debt finance can include bank terms loans and bonds.
There is also another funding option: a form of hybrid financing known as convertible bonds. This article will explain the advantages and disadvantages of this form of debt financing and will also explore the use of convertible bonds by Hurricane Energy plc**, a UK listed oil and gas company, to illustrate how they work in practice.
What are convertible bonds?
Convertible bonds are similar in principle to corporate bonds, in that they are issued by a company to raise capital. Convertible bonds have a fixed repayment date with a specified coupon (or interest) rate. However, the “convertible” element means that the bondholder may also (but not always) have the option to convert the bonds into equity shares of the issuing company.
The conversion of bonds into shares is usually triggered by the company being unable to repay the facility in line with the agreed repayment date. Sometimes however, the company (borrower) may elect not to repay the bonds to maintain their cash reserves so will issue shares instead.
The share price at which the unpaid bonds are converted into shares can either be fixed when the convertible bond facility is arranged (like the Hurricane Energy example below) or the price might be linked to the prevailing share price of the underlying company at the time of conversion.
Advantages of using convertible bonds
The amount available under a convertible bond facility does not have to be drawn down in full once it is agreed; so, the company can access the funds as and when they are needed and avoid the interest charge associated with the fully drawn amount.
Not all convertible bonds need to be secured against the assets of the issuing company. This flexibility gives companies more options in securing additional finance as assets can be pledged as security in future funding arrangements.
The range of finance costs associated with convertible bonds including arrangement and commitment fees can be settled in the form of new shares; and even the interest charged can be rolled up as part of the facility itself (zero coupon bonds), which takes the pressure off the company’s cashflow.
Disadvantages of convertible bonds
The main concern for existing shareholders is the risk of dilution of their investment in the company. New shares need to be issued to satisfy the terms of the convertible bond facility so shareholders end up with a reduced equity stake in the business.
The timing of conversion can also work against shareholders especially if the bonds are converted in to shares when the share price of the company has been in decline. By default, bondholders acquire more shares in the company than they would have done had the share price been performing strongly.
Negotiating the terms of a convertible bond facility can present complex challenges for management. For example, deciding an appropriate conversion price that protects the interests of existing shareholder or the coupon rate charged on a high-risk, unsecured facility can have an adverse impact on the profitability of the company.
Case study: Hurricane Energy plc (HUR)**
Hurricane Energy used a convertible bond offering to raise US$ 230 million to fund capital expenditure in respect of one of the company’s oil fields. HUR agreed a coupon rate of 7.5% per annum, payable quarterly; to be redeemed at par on 24th July 2022 (the repayment date). The conversion terms of the facility were as follows:
The bond is convertible into fully paid ordinary shares of the company at an initial share price of US$ 0.52 (52 cents). The conversion price in this example was fixed at a 25% premium to the placing price of an equity fundraising held on the same date as the bond offering.
According to the company’s 2019 Annual Report the number of potential ordinary shares that could be issued if all the bonds were converted is 442,307,692 (assuming conversion at the agreed share price of $0.52); although Hurricane also has the option of settling the bonds in cash instead of shares.
**Hurricane Energy Plc was acquired by the Prax Group on the 8th June 2023.
Corporate finance
For a general overview on what corporate finance means, please click here.
