Panthera Advisers Call Spread Services Summary
To increase the price upon which dilution occurs and achieve tax and accounting benefits, issuers will often concurrently execute a call spread overlay with a convertible bond. Since most call spreads are one-offs, many issuers have limited experience in structuring, valuing and negotiating the call spread. Instead, issuers rely on the advice of auditors, company counsel (who typically neither posses trading nor quantitative expertise, and do not offer financial analysis), and most deleteriously, investment bankers, who have an inherent conflict of interest.
Panthera Advisers provides call spread issuers with the analytical and negotiation skills necessary to ensure a fair, equitable outcome for stock holders. We do not replace investment bankers; we act as neutral, independent advisors. Management’s goals are our goals. Through structure analysis and deal execution, we drive price negotiations with the dealers on management’s behalf, saving a significant amount in execution costs (measured often in the millions).
Call Spread Background
A call spread is an option strategy comprised of two call options (one long and one short), with different strike prices. Investors typically purchase call options (buy a long call option at one strike price while selling a call option at a higher strike) to reduce the out-of-pocket expense, i.e., lowering breakeven (this is a core strategy Panthera Capital routinely deploys across various strategies to provide a combination of continued upside while increasing current yield). In the context of convertible issuance, issuers also purchase call spreads to hedge against dilution from the convertible.
In a typical concurrent convertible plus call spread transaction, the issuer sells the convertible to investors, purchases a call option from its investment banks (the long lower call) while concurrently selling the bank another call option with a higher strike (often dubbed the warrant). Structurally, the long lower call strike price is matched to the strike price (conversion price) of the convertible, which has the effect of perfectly offseting the dilution effect from the convertible. Meanwhile, the short upper call (warrant) have a dilutive effect if the stock price exceeds their strike price strike, which is far higher than the convertible and lower call strike (typically near 200% of the current stock price). By essentially pushing the dilution up to the upper strike, these call spreads are attractive tools for managing the dilution from the convertible bond. Plus, depending on structure, call spreads can generate a large tax deduction, which significantly reduces the overall cost of the convertible transaction (and corporate WACC), thereby increasing IRR.
The Problems – Complexity, Cost, Conflicts
Call spread structures are very specialized and technically complex. Since most call spreads are one-offs, many issuers have little to no experience in structuring, valuing, or negotiating the call spread to minimize cost and IRR. While the investment bankers typically provide salient advice on structuring the convert, they are on the opposite side of the trade with the issuer on the call spread. These private transactions tend to be very profitable for the dealers in the underwriting group who often act as counter parties to the call spread, and are therefore inherently conflicted. While counsel typically provides very knowledgeable legal advice and auditors provide invaluable counsel on accounting and tax, neither focus on the economics nor represent the issuer in negotiations on cost. Pricing of the call spread unfavorably to the issuer rapidly deteriorates the IRR of the overall transaction and is therefore critical for ensuring a positive outcome.
Panthera Advisers Offers Independent Structuring Expertise
To ensure both an economic and efficient outcome for the issuer, Panthera Advisers provides several key functions in the call spread execution process. First, we model what the transaction should cost based on our assumptions of volatility skew (the key determinant of the cost of the call spread). We are then prepared to instruct management on what to ultimately expect during the pricing process. During the pricing process, we become the primary interface between the banks and management, insulating management from the negotiation process. We craft a bid sheet for the counter parties designed to ensure a competitive process, carefully planning for how to maximize competition. We then distribute the bid sheet to the counter parties and detail a timeline for the responses. Once we receive the responses, we conduct a Dutch auction process to ensure the entire transaction can be executed at the minimum cost. We also work with management to ensure the parties to the transaction are treated in a manner consistent with how management would desire the economics to be distributed while working to inform management on the benefits the individual underwriters provided to the process. As a result, we drive outcomes that are mutually favorable, hopefully leaving all parties satisfied, with the underwriters comfortable in the profitability of the trade but within the appropriate spectrum of return such that the issuer retains a highly favorable cost of capital.
Terminations and Amendments
Whether due to a change of control, spin-off or other event, the termination or amendment of a call spread can be very expensive for the issuer and very profitable for the dealers. Often occurring in the midst of major changes within the organization, the negotiation of the call spread tends to take lower priority or may be neglected until the final phases of a transaction.
The magnitude of unwind values may also come as a surprise to management or the buy-side of a transaction as periodic mark-to-market valuations provided by the dealers, if any, do not necessarily reflect unwind levels. Because the call spread is a private transaction between the issuer and the dealer, understanding and responding to each dealer’s valuation of the unwind or adjustment can be challenging, technically complex and time consuming. Panthera becomes a member of your deal team allowing senior management to concentrate on the aspects of the primary transaction. We have saved our clients millions of dollars from our pricing valuation and direct dealer negotiations.
Additionally, following the recent Volcano Corporation Shareholder Litigation among others suits, Boards of Directors have become increasingly sensitive to understanding any conflict of interest that may exist with their advisor on a potential transaction who may also be a dealer counterparty. Panthera acts as an independent third party to senior management and the Board to assist in identifying and quantifying the materiality of any potential conflict benefiting all parties involved.
Commercial Terms of the ISDA
ISDA Agreements contain many complex terms and conditions. We work in close partnership with your internal and external counsel to ensure that the commercial terms in the ISDA confirmations work in your best interest during the life of the transaction.
Additionally, in a typical transaction, your counsel will negotiate directly with one counsel who represents all of the dealers on the convertible bond and call spread transaction. On your behalf, Panthera negotiates key elements of the material economic terms directly with the decision-makers on the trading desks, which reduces the “club” effect for all decisions and provides fair and competitive terms to all parties. Examples can include counter party risk mitigation, and pricing or valuation methods upon termination to set you up for a more fair and equitable outcome.