Mr. Theo Vermaelen's presentation for our Financial Innovation: COERC as a New Financing Instrument for Corporations

1. The case for COERCS
Theo Vermaelen
Professor of Finance
INSEAD

2. How should an Ideal Financial Security
look like?
• Tax efficient
• No negative information signal
• No costs of financial distress
• No agency costs
• No wealth transfers from shareholders to others
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3. Equity
• Not tax efficient if company is profitable (-)
• Negative information signal as market expects timing (-)
• Low costs of financial distress (+)
• high agency costs (-)
• If shares undervalued, wealth transfer to new shareholders
(-)
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4. Debt
• Tax efficient when company is profitable (+)
• No negative information signal (+)
• Costs of financial distress (-)
• Low agency costs (+)
• If shares undervalued, no wealth transfers to new
shareholders (+) 4

5. Choice between Debt and Equity
Imperfection Debt Equity
•Corporate taxes 1 2
•Expected COFD 2 1
•Agency costs 1 2
•Undervaluation 1 2
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6. Government policies can correct tax disadvantage
• Example : Cooreman-De Clercq ( 1982)
• Companies that issued equity could deduct 13 % of the
amount issued from their taxable income for 10 years
• Personal tax advantages for individuals who invest in
common stock
• Result : More equity issued in 1982-1983 than during
previous 13 years
• Belgian stock market became “market of the year”
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7. Cooreman-De Clercq and the stock market
Monthly cumulative return difference between KB-index and the “world”
index, from January 1981 until January 1984
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8. However : how to elimate COFD ?
Imperfection Debt Equity
•Corporate taxes 1 2
•Expected COFD 2 1
•Agency costs 1 2
•Undervaluation 1 2
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9. 9
Coco bonds
• Contingent convertibles (CoCos) are bonds that mandatorily
convert to equity after a triggering event such as a decline
in the bank’s capital (Flannery (2005).
• Motivation: providing discipline of debt (tax deductions?) in
good times, avoiding COFD (bailouts!) in bad times.
• Since 2009 : 20 banks for $ 100 bn
• Although designed for banks potentially interesting for other
corporations ?

10. Cocobonds
• In good times: normal debt
• Bad times: mandatory conversion into equity
• Today mostly issued by banks
• Sometimes no conversion but total writedown
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11. Problems with Cocos
• How to define “bad times”?
• If “bad times” are based on stock prices how to avoid
manipulation and undeserved conversions?
• How to make sure they are not very risky so it is very
likely you are going to get your money back ?
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12. 12
Solution: COERC
• Call Option Enhanced Reversed Convertible
• Trigger based on market values
• When the trigger is hit, bondholders are forced to
convert at huge discount from stock price, creating
large potential dilution
• However,shareholders get the pre-emptive right to buy
new shares at the conversion price and repay debt
• As a result Coco bond becomes nearly riskless
• COERC coerces shareholders to pay back debt holders
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13. Example
Assets: 100 Equity 60
COERCS 40
5 million shares outstanding (stock price $12)
Coerc converts into equity when equity falls to 1/3 of firm value.
When this happens the conversion price is 25 % of the stock price.
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14. Conversion will create Dilution
• Assume equity market value falls to 1/3 of assets because
assets fall to $ 60 million and equity to $ 20 million
• Assume that when this happens stock price is $ 4 which
means the conversion price is $ 1
• If conversion would take place bondholders would end up
with 40m/ 1 = 40 million shares or 40/45 = 89 % of total
assets = 89% x 60 = $ 53.3 million
• This means a windfall gain of (53.3 – 40) = $ 13.3 million
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15. Preventing Conversion
• In order to avoid this wealth transfer to bondholders,
equityholders have pre-emptive rights to buy the shares by
repaying the debt
• Rights issue is announced for 40 million shares at $1
• After completion of rights issue firm is all equity financed with 60
million assets divided by 45 million shares or $1.33
• Rights issue would be unsuccessful if during rights period assets
would fall below 45 million
• Insurance against this failure can be bought by buying an
underwriting contract ( put option). Otherwise bondholders will
ask credit spread to compensate for this risk.
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16. How much would insurance cost ?
• Put option
• Maturity : 20 days
• Stock price : 1.33
• Exercise price 1
• Volatility : 70 %
• Jump process with 3 jumps per year jump size 50%
• P = 0.006 or 40 m x 0.006 = $ 0.24 m
• So you pay insurance fee of 0.6 %
• Ideally issuer should provide cash collateral for this fee.
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17. • There are 5 million shares outstanding
• Each share has 1 right
• 40 million new shares, so with each share you can
buy 8 new shares if you pay $ 1 x 8 = $ 8
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Payoffs to Investor

18. Wealth of the Investor with $ 8 in cash who owns
1 share worth $ 4
• If he exercises the right : 9 new shares at $ 1.33 = $ 12
• If he sells the right to buy new shares to someone else and
keeps his $ 8
cash $ 8
1 share $ 1.33
1 right = 8 x (1.33-1) $ 2.64
-------------------------- ---------
Total $ 12
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19. After the dust has settled
Assets: 60 Equity 60
45 million shares outstanding (stock price $1.33)
You cleaned up your balance sheet without transferring
wealth to debt holders
Potential to re-lever
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20. Implication for Bondholders
• The fear of dilution coerces equityholders into
repaying the debt as long as conversion price is
set at a significant discount from trigger price
• Debt is very likely to be repaid, rather than forced
to convert
• The only risk is that because of “jumps” the value
of the assets falls below $ 40 milion so that fully
diluted stock price falls below $ 1.
• In order to largely eliminate this risk issuers can
pay for firm commitment underwriting contract.
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21. Implication for Shareholders
• Because you are able to make a credible
commitment that you will pay back debt holders in
periods of financial distress, credit spreads will be
very small
• ROE will go up, although WACC remains the same
• As debt has become large risk-free, no more costs
of financial distress, hence total firm value will
increase
• Death spirals because of manipulation and panic
can be prevented
• COERC issuance is not a signal of overvaluation ! 21

22. Choice between Debt, Equity and Coerc
Imperfection Debt Equity Coerc
•Corporate taxes 1 3 1
•Expected COFD 3 1 1
•Agency costs 1 2 1
•Undervaluation 1 2 1
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23. Intuition
• “Normal“ debt is risky because equityholders have
limited liability
• The Coercive feature of the COERC forces
shareholders to bail out bondholders to avoid dilution
• Because financially constrained shareholders can sell
their rights to others these constraints don’t matter
• Of course, this assumes that rights can be sold at fair
value
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24. Difference with other bonds
• Covered bond : collateral is put up front, illiquid?
> COERC: collateral is cash provided by Coercive rights
issue when needed
• Subordinated debt : credit spread charges for default risk
> COERC : no credit spread but firm commitment rights
underwriting fee when trigger is hit
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25. A case study
• Bidder is considering making a $ 120 million bid for Target
• It does not want to pay with stock
• If it borrows to pay for it it will have to issue bonds below
investment grade
• Can COERC be the solution ?
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26. 26
Balance sheet of Bidder ( $ million)
Assets Liabilities
230 Debt 50
Equity 180
230 230
Stock price : $112 shares outstanding : 1.7 million
Debt/Assets = 22 %

27. 27
Balance sheet of Target
Assets Liabilities
115 Debt 25
Equity (E) 90
115 115

28. 28
Bidder after merger (assume $120 m purchase price for
target equity paid by issuing COERC; assume other debt)
Assets Liabilities
375 Debt 75
COERC 120
Equity 180
375 375
Debt/assets = 195/375 = 52 %
COERC converts when Debt/Asset = 65 % Discount of 50%

29. The trigger
• Based on market values of equity and book values of debt
• Because book values are normally calculated only quarterly,
company should update book values if it changes more than
1 %
• Note that this is not the same as a stock price trigger : you
can’t control the stock price but you can control leverage to
a large extent
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30. What happens at conversion ?
• Debt/Assets = 65 % and Debt = 195
• Assets = 195/0.65 = 300
• Equity = 300 – 195 = 105
• This represents a fall in equity of (180-105)/180 = 42 %
• Current stock price is $ 112
• A 42 % decline means new stock price will be $ 65
• Then you announce a rights issue at a 50 % discount ($
32.5)
• This means new shares issued : 120 m/32.5 = 3.7 m
• Total number of shares outstanding is 3.7 m + 1.7 m =5.4 m
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31. After the dust settles
• Total firm value is still 300
• Non-Coerc debt = 75
• Equity = 225
• Stock price (fully diluted) = 225/5.4 = $ 42
• Issue will fail if stock falls below $32.5 in 20 days
. Insurance : Underwriter firm commitment = put option
• Value of put ? Volatility = 70 % 3 Jumps per year of 50%
• Put = 0.226
• Total cost = 0.226 x 3.7 m = $ 0.836 m
• Total cost =0.7 % of 120 m raised
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32. 32
Bidder after merger + conversion
Assets Liabilities
300 Debt 75
Equity 225
300 300
Debt/assets = 25 %

33. Why issue COERCS ?
• You can borrow at (almost) the risk-free rate (A rating)
• You have however to commit to buy insurance by having the
rights issue underwritten.
• The underwriting fee only has to be paid when conversion is
triggered
• You may however put enough collateral aside to pay for the
underwriting fee
• Only if you are a true high credit risk you will pay the
insurance !
• This is better than issuing subordinated debt now with a
large credit spread to be paid every year
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34. Why buy COERCS ?
• You have a corporate alternative to buying government
bonds (low risk, A rated)
• Because the company has committed to insure the proceeds
of a rights issue to repay you when conversion is triggered,
your risk is largely eliminated
• High risk-aversion ( Banks ?)
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35. Why no COERC issued by Banks so far?
• Regulators insist on capital ratio triggers, not
market based triggers
• This in spite of proven failure of such triggers during
the financial crisis
• Regulators/bankers like capital ratio triggers for a
variety of reasons
• Corporate non-banking sector has freedom to
design contracts
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36. Regulatory Capital versus Market Value Capital Triggers
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37. Barclays partially Endorses COERC
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38. The ideal issuer
• Company perceived as risky
• Management feels market undervalues cash flows/
overestimates risk
• Profitable and therefore taxable business
• Current large shareholders don’t want to issue equity now
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