Convertible Securities: Risk Arbitrage

   

A convertible bond is a bond that an investor can return to the issuing company in exchange for a predetermined number of shares in the company, which be thought of as a corporate bond with a stock call option attached to it. The price of a convertible bond is sensitive to three major factors:

• Interest rate: When rates move higher, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (and the aggregate tends to move lower).   In this instance, a zero coupon bond may be the best structure, which functions like convertible equity security. 

• Stock price: When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.  

• Credit spread: If the creditworthiness of the issuer deteriorates (e.g. rating downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).  In the case of research & development partnerships, unless a true debt instrument is used, this factor is negligible or irrelevant.

   

Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value. Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price.  For instance an arbitrageur would first buy a convertible bond, then sell fixed income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration). Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price. He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares.

   

Off Balance Sheet R&D Partnerships: Hybrid Models of SPV, SPE, VIE

   

Case Study: Tocor, Inc. and Tocor II, Inc.

Ticker: OTC|TOCR, OTC|TOCRZ

Parent Company: OTC|CNTO

In the 1990s, while a securities analyst at what is now J.P. Morgan Chase H&Q, I had my first exposure to structuring and covering a Special Purpose Vehicle or Variable Interest Entity, called Tocor II.  This was a pure equity instrument, with an integrated derivative security (detachable warrants) which was listed on NASDAQ.  Though the specific reasons at the time for using such a structure were slightly different, they have applicability to both the proposal at hand, and BMW’s current situation as outlined by the chairman earlier this year.

The entity was used to fund future R&D projects, which were critical to the long term success of the company, as they represented the future pipeline of research products, which were perhaps 5-7 years from final development.  The capital raised was used to finance the operations of the corporation which, though a separate legal unit, still maintained its operations within the four walls of the company, utilizing a separate management team, maintaining separate books.  There was a strict budget which was adhered to, which at the then current cash burn rate of the entity, could last for well over 10 years, in the event that the entity was never subsumed into the company, was formally spun out as another business, or was licensed or acquired by another corporation. 

Strict covenants were put in place with an independent board of overseers ensuring that operation remained separate (as this unit had technology licensing arrangements) with other entities, though the parent company was given first right of refusal to acquire the entity using an equity swap as currency to acquire and reintegrate the unit over the course of the first  5 years, at escalating buy back prices which represented a scaled 15% to 25% ROI (return on investment) to the investors who funded the project.  The first tranche was so successful, that it was similarly restructured and a second issue was released.  This structure was not uncommon earlier in the decade for other development stage corporations or operating subsidiaries of companies as they neared commercialization of their product pipelines, or a point of operating profitably, where they could successfully contribute revenues and profits to the bottom line of the parent entity.  It was a win-win for all:

• New (or strategic) Investors: The new investors received what amounted to approximately 22% ROI for the R&D entity over 3-4 years, at which point the entity was repurchased, which represented a higher return than the parent stock over the same time period, and then were rewarded with ownership in the parent company, which was a less speculative investment to own.

• R&D Subsidiary:   The future projects were funded, and remained unencumbered, were able to enjoy close physical proximity to the parent, and were staffed (mostly) with employees and representatives of the R&D group within the parent company.

• Parent Company (Anchor): The parent company was the biggest winner, as they were able to maintain control over the project, fund a portion of their R&D from a source other than cash flows of the company, cash in the bank, or profits from then current operations, and then use equity to regain control, with nearly negligible dilution to their shareholders, as their stock price (generally) continued to rise during that period.  In addition, it served as a form of corporate finance, as the excess cash which remained in the SPV, was placed into their coffers.

Potential Impact on BMW AG: In the case of BMW’s operations, such a structure can be used to ameliorate the hit to current operating cash flows and earnings caused by the push in new directions with R&D initiatives, increasing operating margins (and hence multiple on the stock, translating to increase in trading range for the stock), all the while allowing the company to maintain control over the projects.  Projects such as this are most effective if there are potentially several other potential buyers in the event that the parent opts out (such as VW or other OEMS), as the research would be transferable to competing entities.  There also exists the opportunities to license the technology (for example, completed hybrid engine configurations or telematics technology developed from Car IT) to other companies (e.g. to some less sophisticated car companies such as the Chinese car companies).   

More selfishly, my interest would extend to using variations of this schema to finance the proposal at hand, which would represent an opportunity for BMW to expand into business areas which are more profitable than current operations, in a risk adjusted fashion, which offers the opportunity for long term growth and further expansion of operating margins driven by growth in new areas, as opposed to financial engineering or sophisticated cost reduction measures.

Consortia and Game Theory In Practice: Lowering Supplier Pricing and Raw Material Costs.  The potential also exists for BMW and other OEMS to band together in a consortium, a structure which allows collaboration without formal collusion or triggering anti-trust concerns, in which the companies involved, which could be, for example, the various members of the company’s supply chain (such as Bosch, or other publicly traded companies), which would share in the buy back of research being developed, and could restructure current supply agreements by lowering prices for components (or even raw materials, if taken far enough back along the supply chain).  Another option would be for the German manufacturers (BMW, VW, Daimler) to band together in a consortium in the aftermarket (read further in the proposal) to counter inherent disadvantages in the market which exist due to the strength of the euro and currency fluctuations which currently makes the playing field against the Japanese and Koreans (in particular), and to a lesser degree, the American car companies.  Given the strength and long term viability of the equity in these entities, a bundle of securities could be created, with the express purpose of buying back R&D operations of an SPV, and can even be structured such that future revenues are split in a pre-determined fashion, not unlike other consortia which exist, such as SEMATECH, which is one of the most famous consortia (the one which developed the personal computer, or PC, and the strategic relationship which exist between Intel, the core supplier, and OEMs which manufacture computers).  This level of detail can be flushed out in future discussions, if the Innovation Agency takes interest in this proposal.

Some Accounting and Tax Considerations: Variable Interest Entities (VIE)

   

Under International Financial Reporting Standards (IFRS), the relevant standard is SIC12 (Consolidation—Special Purpose Entities).  Not necessarily relevant to the purposes of this discussion, as the distinction between Special Purpose Vehicles and Entities and Variable Interest Entities depends on the percent share of ownership of the “parent” or “anchor” company, and the specific terms of the structure.  For the purpose of elucidating the entire range of entities which could be applicable to some type of transaction between our two companies (or, between BMW and other companies with which you have R&D interests), I will enumerate a range of options which I think may be relevant to future discussions.

   

FIN 46, revised and replaced in its entirety by FIN 46R, is a statement for the purposes of US GAAP published by the US Financial Accounting Standards Board (Also known as FASB).  FIN 46 is an interpretation to GAAP relating to consolidation. The normal consolidation rule is consolidation based on majority of voting interests. However, in case of specially incorporated purpose entities such as those used for securitization and structured products (known as Variable Interest Entities (or "VIEs") under this interpretation), determination as to who (if anyone) should consolidate the entity will be based on an analysis of the variable interests held by various parties in the entity, and not simply on voting interests. Under FIN46R the holder of the majority of the risks and rewards in the assets (known as the Primary Beneficiary) in a VIE will be required to consolidate it.

   

Note that where, as in a securitization, a party selling assets to a VIE and maintaining an ongoing involvement with those assets (for example as a swap counterparty to the VIE with respect to asset cash flows) then Financial Accounting Standard 140 (FAS140), which deals with the recognition of assets upon transfer to a special purpose entity) will also be relevant.

 

The primary variable interest in any entity is its equity: equity is defined as residual economic interest. Residual interest is a variable interest by its very nature. The idea of capturing variable interest other than equity assumes that there are certain entities where the legal equity is insignificant and irrelevant from the viewpoint of risk/rewards. In such cases, consolidation based on equity does not serve the purpose of effective reporting.  Though ideologically, this principle should be applicable to all entities, the current FIN 46 applies this rule to variable interest entities, which is largely the same as the commercial notion of special purpose entities.  With this long set up, both meant to answer some of the issues raised by the Chairman, but also meant to set up the backdrop for the proposal which I am presenting. 

It is one thing to have methodologies in place which can assuage the impact of growing costs to improve operating results and manage risk, however, it is even more important to have strategies in place which can bring GROWTH, both of revenues, and EXPANSION OF MARGINS, driven by higher quality profits, which I what I believe my proposal will offer.

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The Shifting Fundamentals of the Premium Segment

Market Dynamics: Top Down Analysis

                                                    

To properly set up the "Nash game", it is important to go back to the 1990s, to document the evolution of the premium segment in the United States, as that is BMW's core market, and of which BMW is the global leader.  At that time, the premium segment was largely dominated by Mercedes and BMW, with Audi showing rapid growth in market share.  The domestic manufacturers' premium brands: Cadillac, Lincoln and Chrysler were built on aging platforms, and had a customer base and demographic which was, quite frankly, near death.  Then, two things occurred which began to shift the market: