Convertible issuers frequently refinance upcoming maturities with the issuance of new convertible bonds. As most convertible bonds are non-callable, issuers must decide whether to leave the bonds outstanding or repurchase them concurrently with the issuance of the new bonds. If they are inclined to redeem the old bonds, there is an additional consideration of whether the refinancing should be done as a cash repurchase + new issuance or an exchange offer with the existing holders.
Ionis Pharmaceuticals (Ticker: IONS) had $685.5mm of 1% convertible notes due September 2021 outstanding. On December 11, 2019, IONS retired $340.2mm of the 2021 Notes through a direct exchange for $398mm of new 2024 Notes with 2021 noteholders.¹ ² IONS also purchased a call spread to increase the conversion premium on the 2024 Notes from up 35% to up 100%. JWood was the placement agent.
The decision to do a direct exchange proved to be very costly for the company:
- 2024 Notes traded up 2.6 points post issuance versus December average of 0.5 points for the other transactions: $11mm cost
- 2021 Noteholders paid a 2.25 point premium above the then current price of the bonds versus a more standard premium of 1 – 1.5 points: $4mm cost
- Call spread required a highly unusual averaging period to determine the final price IONS paid the counterparties. The stock price rose significantly during this period increasing the cost of the call spread by $2mm.
- We estimate the total avoidable cost to IONS at $17mm
Direct Exchange versus Repurchase + New Issuance
The significant flaw in the IONS transaction was the decision to execute a direct exchange. IONS quite simply does not fit the mold of the issuer that should ever do a direct exchange:
- $8.8 billion market capitalization
- $685.5mm of total debt trading at ~115
- $60mm of average daily trading volume
- Top rate stock borrow availability
There are two components to a refinancing: the retirement of the old bonds and the issuance of new bonds. The issuer’s objective is to repurchase the old bonds at the lowest price possible and issue the new bonds at the most favorable terms (lowest coupon and highest conversion premium). This is only achievable if the issuer can create a competitive “auction” in both legs.
IONS is well known in the convertible market as a repeat issuer. In 2019, only 15% of issuance was Healthcare/Biotech and the IONS financing would be the largest deal in the sector. As a liquid, diversifying investment there would have been considerable investor interest for the 2024 Notes. By choosing to do a direct exchange, IONS limited the auction for the new 2024 Notes to the dozen or so holders of the 2021 Notes that were contacted by JWood. A book-building “auction” with only 12 investors will almost always result in a worse outcome for the issuer than one with hundreds. The 2024 Notes pricing was therefore worse for IONS than what would have been achieved with broad marketing. This is why the 2024 Notes immediately traded up 2.6 points.
The direct exchange also makes the buyback of the maturiting notes less efficient. This is because the “auction” on the repurchase is limited to investors who are willing to exchange into a new note. In the case of IONS, the investment characteristics of the 2021 and 2024 Notes were very different (2 vs 5 year maturity, 1% vs. 0.125% coupon, $66.81 vs $83.28 conversion price). The direct exchange excluded holders that were willing to sell their 2021 Notes for cash and not be forced to buy the new 2024 Notes. This likely explains the higher than usual exchange premium of 2.25 points. In contrast, Alteryx paid a 1 point premium when it repurchased 63% of its outstanding 2023 Notes.
Direct exchanges can make sense. Its traditional application is in distressed situations where the prospect of attracting new investors is dim. In these cases, the issuer has no alternative but to turn to the existing holders. The direct exchange is therefore a negotiated compromise between the issuer and existing holders who are stuck with each other.
IONS, however, was not a distressed issuer!
Collateral Impact to Call Spread Pricing
IONS purchased a call spread to increase the effective conversion price of the 2024 Notes from $83.28 to $123.38. In 99.9% of call spread transactions, the issuer knows the cost of call spread at the time of the pricing of the new Notes. For IONS, despite the 2024 Notes pricing on December 11th, the cost of call spread was not known until December 16th. This was highly unusual and a result of the structuring of the direct exchange. It also proved costly.
The counterparties to the call spread need to buy a certain amount of stock as their initial hedge position. During the book-building process for the new issuance, they communicate this amount to the underwriter. The underwriter, in turn, “curates” the final allocation of bonds to ensure that hedge funds are allocated a certain minimum amount of bonds. The amount of this minimum allocation to hedge funds is calculated such that the number of shares these hedge funds will need to sell short is exactly equal to the number of the shares that the call spread counterparties are looking to buy. Immediately after pricing and allocating the bonds, the underwriter will make arrangements to “swap” these shares from the hedge funds to the call spread counterparties.
In a direct exchange, there is no allocation process since the new bonds are given to holders of the old bonds. If the holders are predominantly outright investors, it may not be possible to reach the minimum hedge fund participation level.
This was the case with IONS and so JWood could not deliver the required number of shares at pricing to the call spread counterparties. The counterparties therefore had to buy their shares in the market in the period between pricing and closing. IONS stock, unsurprisingly, rose during this period of buying and the company had to compensate the counterparties for their increased cost in acquiring the shares. We estimate that this added ~$2 million to the cost of call spread.
IONS could have achieved a better result had it refinanced the 2021 Notes through a cash buyback and new issuance. The direct exchange was an unsuitable choice. The transaction is a cautionary reminder of the importance for proper structuring.
¹ IONS also issued $109.5mm of additional new 2024 Notes to raise cash proceeds.
² On December 12, 2019, IONS exchanged an additional $35.4mm of 2021 Notes for $41.4mm of 2024 Notes. The total amount of 2024 Notes outstanding is $548.9mm. It amended the call spread agreements to cover the additional 2024 Notes.