Almost all new issue convertibles are sold through Rule 144A or registered offerings. So, our interest was piqued on May 8th, when Luminex Corporation (Ticker: LMNX) issued a $260mm convertible through a 4(a)(2) private placement. J. Wood Capital Advisors was the sole placement agent.
The decision to do a 4(a)(2) private placement proved to be very costly for the company:
- Notes traded up 5.5 points¹ post issuance versus 1.5 points for the average public market deal: $10.4mm cost
- Call spread priced inefficiently because the advisor could not facilitate the hedging process: $6.5mm cost
- Company paid a placement agent fee of ~2.25% versus an average gross spread of ~2.7% for similarly sized deals: $1.0mm savings
- We estimate the total avoidable cost to Luminex at ~$16mm
Why Issuance Format Matters
A general principle in securities offerings is that reaching the broadest possible number of investors creates the highest probability of achieving the best pricing. A broad auction should almost always produce a better result than a narrow auction. In keeping with this concept, almost all convertible issuances are offered under the Rule 144A resale exemption or a registered offering. These two methods allow for the broadest access to convertible investors.
Under the Securities Act of 1933, there are other methods for the distribution of securities that are also exempt from registration. Section 4(a)(2) is one such safe-harbor for the sale of securities through a private placement (i.e. non-public offering). The most significant limitation of a 4(a)(2) placement is that only a limited number of investors can be solicited. As a result, this method is only used when this constraint is not an issue (e.g. an exchange offer with existing holders) or when issuers want to avoid the disclosure requirements of a registered transaction (e.g. a foreign private issuer without any class of currently registered securities).
Luminex was not exchanging its securities. As a Reporting Company under the 1934 Exchange Act, that is current with its filings, there are no obvious disclosure related considerations to favor a 4(a)(2) offering. In fact, Luminex filed its 10-Q on May 5th.
The decision to pursue a 4(a)(2) offering and incur the penalty of reduced investor access is puzzling. It is baffling when the necessary consequence of electing a 4(a)(2) placement was that Luminex had to do an overnight deal.
Overnight vs. Marketed Execution
Convertible offerings can be executed on an overnight or marketed basis. In an overnight execution, the transaction is announced after the close and priced before the open the next day. In this format, the issuer transfers the stock price risk to the investor. In return for this risk transfer, the issuer accepts worse coupon and premium terms from the investor. In contrast, in a marketed execution, the transaction is announced after the close or pre-open and then marketed during the full trading day. The issuer bears the stock price risk during this marketing period but is rewarded with better coupon and premium terms than an overnight deal.
In an “efficient market,” both alternatives should yield similar net results. However, the behavior of convertible issuers reveals a very different perspective. In 2020 YTD, there have been 85 issues in total and only 8 have been overnight. In these volatile markets, issuers have concluded overwhelmingly that transferring stock price risk to investors is too costly.
Luminex was forced into this decidedly out-of-favor execution style because 4(a)(2) offerings cannot be publicly marketed. A general solicitation would undermine the private placement exemption.
The final terms achieved were 3.00% up 12.5%. The cost of the limited marketing and overnight execution was seen in the trading price of the bonds the next day. On a stock price neutral basis, the bonds traded up 5.5 points versus 1.5 point average this year. This was a $10.4mm economic loss for Luminex.
Collateral Impact to Call SpreadLuminex purchased a call spread to increase the effective conversion price from $43.68 to $69.89 (up 80%). The counterparties to the call spread need to buy stock as their initial hedge position. For securities law considerations, this purchase of stock is done through cash settled swaps. In a typical transaction, the lead bookrunner enters into these swaps with the counterparties and offsets them with equivalent swaps with some of the hedged investors in the deal that are looking to get short. By market practice, this swap intermediation service is provided at no cost to the issuer by the lead underwriter.
In this case, the placement agent did not have the ability to intermediate swaps. As a result, bidders in the call spread auction knew that the process had a significant weakness. Luminex would need one of them to provide the swap intermediation service. As a result, the auction was much less competitive and cost the company $6.5mm² more than a typical call spread.
As the discussion above no doubt confirms, convertible transactions are complex! Unsurprisingly, issuers have increasingly relied on advisors, like Matthews South, to provide them with unconflicted and unbiased advice in these transactions. The oddities of the Luminex transaction are striking because the placement agent is also a leading financial advisor. It is perhaps the surest confirmation for issuers that when advisors also have a placement practice, the door to conflicts of interest swings wide open.
In 2020 YTD, only 22% of convertible transactions had a sole underwriter. It was unusual for Luminex to have relied on only one party for the advice and execution of their transaction. J Wood and the investors in the deal were handsomely rewarded at the expense of Luminex.
¹ Convertible expansion based on the marketed stock reference price of $34.95 (down 10% from 7-May closing share price).
² The call spread traded at an ~8.5 skew versus a conservative ~5 skew estimate based on other call spreads.