A convertible note, also called a hybrid security or hybrid, refers to a debt instrument that can be converted into equity (ownership in a company) at some point in time in the future.

Like a bond/loan, hybrids typically guarantee interest (either fixed or variable) however, because they also possess characteristics similar to shares, they offer the potential of a higher return than debt.

Convertibles can be attractive to investors because they offer some downside risk protection (like debt) but still have some upside (like equity). Not all convertibles are the same, however, and the risks and the opportunity can vary significantly.

The risk-return trade-off principle asserts that the higher the return with typical require a higher level of risk. Convertible notes have less risk than equities but are unlikely to deliver the same return if things go well. Conversely, they have the potential to deliver a higher return than traditional debt, but that is because most of them have terms that are higher risk.

Some of the risk associated with convertible notes versus traditional debt can include: reduced certainty in the timing and amount of income generated; subordination to other creditors; and, the right of the borrower to repay the loan at any time, even if not advantageous to the holder.

A convertible security is a loan with a built-in option. This embedded option has value if it is exercisable at the discretion of the holder, who can choose to convert into shares when it is attractive. However, this clause may also be a negative, when the option is exercisable by the issuer, meaning the investor may suffer enforced conversion into equity, even when it is not attractive to do so.

Over recent years there has been a significant increase in pre-IPO Convertible Notes, which typically have an enforced conversion event (the IPO). This can work well in a positive trending stock market, but the risk is that during the holding period the stock market turns down, and through the compulsory nature of conversion, the noteholders are forced into taking shares (potentially with an escrow) when they might otherwise prefer to stay in loan and accumulate interest.

How convertible notes work

Convertible notes are designed to convert into ownership in the issuer (company) sometime in the future. The process entails three main steps.

Firstly, there is the initial capital raising for the notes, where the noteholder lends capital to a company in return for security in the form of a convertible note which ranks ahead of equity.

Secondly, as part of the convertible note financing agreement, the noteholder earns interest (either in the form of cash, accrued interest, or shares) while the loan is still outstanding.

Lastly, there is the conversion (or repayment). This is when the investor (or the company) can convert the loan into shares, or like traditional debt, the borrower can be contractually obligated to repay the loan.

Convertible note terms

Convertible notes are a type of loan, so they carry terms like those that you would find with a traditional loan, plus terms supporting the conversion process.

The following are some of the more important terms to consider:

Interest rate

Since an investor is lending money, the loan will either pay a cash coupon or accrue (capitalise) interest. If the former, the interest would increase the final repayment, or it would increase the number of shares issued when the note converts into equity. The upside potential of conversion means (all other things being equal) interest rates on convertible notes are lower than ordinary debt.

Maturity date

The maturity date can be based on a fixed date or a future event, and it refers to a date when a borrower needs to repay the notes, paying back the principal and interest, or when the loan is required to convert into shares.

Conversion terms

The conversion price refers to the price at which a convertible loan is converted into shares. This conversion price will generally be determined by a predetermined process outlined in the convertible note terms, and is either fixed, capped, or a discount/premium to a reference share price. When converted, the number of shares issued to the convertible noteholder is typically calculated by dividing the loan amount (plus any accumulated interest) by the conversion price.

As discussed, it is imperative to know, who holds the right to conversion (the lender or the borrower), or if it is based on a future event. It is far more attractive to investor to retain the right to choose the timing, which means, if there is no upside from conversion, the note will be repaid at maturity.

Security

This defines the relative risk of the convertible note prior to conversion into shares. Most convertible notes are unsecured, but they can be secured against the borrower or specific assets owned by the borrower. This does not take into consideration the operational risks of the company, which the investor must assess, but the higher the security ranking the lower the risk the note holder is taking.

Broadly the levels of security are:

• Senior Secured
• Secured
• Unsecured
• Equity

Financial covenants

Financial covenants are the clauses that hold the company to account for its performance. Many convertible notes don’t have any covenants other than the solvency, the payment of interest and repayment at maturity.

Convertible notes that have additional covenants over the operational performance of the company are lower risk and superior, as they can provide the opportunity for the noteholder to demand repayment, or a higher return, should the business underperform.

Valuation cap

The valuation cap, also known as the conversion ceiling, limits the price at which the notes can be converted into equity. Lower valuation caps result in more favourable terms for investors.

For instance, if an investor invests $1 million in a company that is later valued at $100 million, the investor’s equity stake would be 1% after conversion. However, if there was a valuation cap of $25 million, and they have invested $1 million, even if the company was worth $100m at the time of conversion, they would convert at the valuation cap, so they would convert into 4% of the equity (i.e. $1m ÷ $25m).

PURE offers investors the opportunity of this attractive but underdeveloped instrument

PURE Asset Management is an Australian boutique fund manager that invests in convertible notes as a dedicated strategy and our funds are available to wholesale and sophisticated investors.

Our funds predominantly invest in emerging ASX listed companies via hybrid debt instruments. We typically self-originate and because of this we can often achieve superior loan terms than most convertible notes available to investors.

Convertible notes are an attractive middle ground between the risk & reward of shares, versus the fixed return & downside protection of debt.

Smaller companies have volatile share prices and less predictable operating performance, and so hybrid investing would appear to be especially suited to this part of the market.

We seek out win-win opportunities. Our aim is to reduce the equity dilution for companies looking for funding, while providing our investors with a better risk-adjusted return than either debt or equity.

Find out more about convertible notes and how it can work within your portfolio at PURE Asset Management.