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By Tom Winnifrith & Brian Kinane of Riverfort Global Capital | Thursday 20 April 2017
It’s a bloody death spiral - sell! That seems to be the standard response to an announcement that an AIM company has raised cash via a structured financing plan rather than a, often deeply discounted, placing. But that "truism" is a falsehood. Some structured financings are death spirals, bad news for all bar the provider. Others, however, are put together in a way that only work if the share price rises. And that, surely, has to be better than a deeply discounted placing to bucket shop flippers?
Forgetting the spin from those who specialise in deeply discounted placings, the fact is that structured finance can provide a valuable source of capital to listed companies to enable such companies to execute on positive catalysts to enhance shareholder value whilst recognising other stakeholder interests.
In this article, we hope to achieve three goals:
In essence, a structured financing instrument is equivalent to a debt or preference share instrument that can be converted into ordinary free-trading shares in listed equities at a conversion price linked to the current share price at the time of the conversion. Typically, the structure provider (funder) will sell the shares it receives into the market to recover principal risk and a generate profit.
All variations of structured finance – be it mezzanine loans, convertible debt, equity placings and swaps, placings and sharing agreements (in which shares are issued upfront), placings plus exchangeable warrants (essentially deep-discounted placings), or various convertible preference shares – can be reduced to this core underlying concept. Each structure just approaches the core concept from a different perspective.
Generally the reasonable structured finance product transforms into the unreasonable “death-like-spiral” instrument based on specific terms and trading characteristics. Such instruments can give the structure provider significant control over the trading aspects of the instrument and the potential to maximise profits as the company’s share price declines - clearly an unreasonable approach. Such structures encourage the structure provider to aggressively convert in order to maximise the speed of capital recovery and profit to the detriment of shareholders. A structure provider may mask the intent of their structure with talk of being a “strategic investor” in order to convince the company to sign egregious terms.
So what makes a structured financing instrument reasonable? Let us consider some structured fundings that were recently implemented with AIM-listed companies. An O&G company issued a convertible debt instrument with the following characteristics: two-year amortisation, transaction fee and coupon, each repayment convertible at discretion of company (not structured provider / funder), fixed premium conversion price and warrants priced at a premium. This would appear to be a fair deal for both parties: the share liquidity of the listed company provides a mechanism for principal recovery via conversion, conversions are controlled by the company and the funder’s return is weighted to positive share price performance.
On the other hand, let’s consider a recent convertible funding by an AIM-listed fraud (sorry we meant to say tech) company which has been covered extensively on ShareProphets, whereby it issued a loan that was fully convertible at the funder’s option at prices below the initial price. This structure could allow the investor to maximise trading spreads as the share prices falls and grants the funder with permanent “in-the-money” warrants as the funder converts at an ever lower price. In essence it may be in the funders’ interest to aggressively sell shares into the market to realise enhanced profits as the share price declines. This would appear to be a very short-term, aggressive structure which maximises the funder’s profits on the back of negative performance of the company and its shareholders.
Clearly there is a spectrum of structured funding products. It is incumbent on the listed company and their advisors to engage with reputable funding providers who are willing to collaborate to develop reasonable structures that consider the interests of different stakeholders. Companies also need to be cognizant that the weaker their underlying fundamentals the more limited will be the capability to access a reasonable funding source/structure.
In practice, many companies do not invest sufficient time assessing the funder’s track record and intent, nor have the knowledge and experience to ensure that such instruments are structured appropriately. Many advisors do not seem able to deal with the complexity of such instruments, or their business models inhibit them from providing objective guidance.
When implemented correctly, structured instruments can provide many benefits. They can reduce funding risk by providing a quasi-underwriting capability for open offers and placings, provide bridging finance to enable companies to complete value accretive activities which can be refinanced at higher share prices, augment equity placings to minimise the placing discounts, provide a bridge to cash flow at a lower risk than traditional debt (similar to a contingent convertible issued by banks), provide flexible project finance with lower covenant requirements and generally provide more efficient and quicker access to capital.
In order for companies to optimise funding structures to maximise benefit and create win-win situations, they should consider the following principles:
1) Share liquidity should be viewed as an intangible asset that can be monetised prudently to manage financial risk;
2) Recovery of the principal (risk capital), should to the extent possible be disconnected from profit generation. The funder should have the capability to recover principal via share liquidity however profit generation should be separated from that process to reduce incentives for aggressive trading;
3) Alignment between structure provider and the company should be maximised via the weighting of profit generation to positive share price and/or operational performance;
4) A transparent and rule-based trading protocol should be implemented to ensure the structure provider is acting in an orderly manner.
If companies and their advisors adopt the above principles, structured instruments are a valuable funding solution that enhances shareholder value. Ultimately, an industry-wide code of conduct between all the stakeholders will lead to the most beneficial outcome for all. Shareholders and advisors need to recognise that a blanket negative attitude merely encourages companies to implement the worst “death-spiral” solutions and not to transparently design positive solutions.
Considering the regulatory environment, it is very difficult for regulators to determine the best approach to this sector whilst also allowing a free market to operate. However, the current approach appears to be reactive and addresses symptoms rather than underlying causes. This most recent guidance related to equity finance facilities, has to an extent followed the law of unintended consequences and resulted in the emergence of different instruments that are less favourable for companies and shareholders compared to what the guidance addressed.
AIM needs to embrace the structured finance category, encourage approaches that lead to a race to the top, reduce the number of bad actors and educate companies, advisors and regulators to adopt best practices that fairly consider the interests of all stakeholders. That will ensure that there is a depth and range of funding available to companies that will benefit all stakeholders involved. If regulators fail to strive for that goal we will experience the ultimate death-spiral where quality providers are dis-incentivised and predatory providers run amok, ultimately resulting in a market failure which may require more costly intervention.
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