Optimal Design of Financial Instruments

Optimal Design of Financial Instruments

Currently, many companies in Spain are trying to raise financing through both debt and additional capital. Choosing the right financial asset to refinance is generally an important decision. Within financial economics, the optimal design of financial instruments is precisely how to choose the structure of financial contracts to generate value within the company. Today I would like to talk about two alternative ways to inject funds into companies and especially into banks and savings banks. In particular, I am going to focus on two types of financial assets: contingent convertible bonds and convertible preference shares.

Optimal Design of Financial Instruments

Contingent convertible bonds, also popularly known as CoCos, are bonds in which, when certain conditions are met, the issuer must transform the borrowed capital into shares of its own company. There are many possible variations within this definition, but the most common CoCos are those issued by banks in which if the capital (Tier 1) of the bank falls below a certain level, the bonds are automatically transformed into shares.

The debtors therefore become bank shareholders. This is a form of financing that has generated much interest recently among both academics and banks. The advantages of CoCos are obvious; the automatic conversion into shares associated with low capital levels implies a recapitalization of the bank when it needs it most. For creditors it is a way to obtain high returns, without the risk of strangling the debtor. They offer a kind of illiquidity insurance to the bank and therefore it is a risky form of investment, but the automatic conversion into shares is a much more orderly way of recovering part of the value of the debt than the bankruptcy or the negotiated restructuring of the debt.

The benefits of transforming debt into equity automatically just when it is most needed have also caught the attention of regulators, who encourage the use of CoCos by including them in the capital calculation of banks. An important detail is that it might seem that the voluntary transformation of debt into capital could also work. This is not entirely true. If there is not a well-defined event that obligatorily transforms the debt into capital, all sorts of problems of clientele and reputation appear (as explained very well in this presentation of the Financial Times)

An alternative option to the CoCos is the entry into the capital of the companies of the so-called strategic investors. These are fundamentally active investment funds, sovereign funds and private equity funds (private equity and venture capital). One of the preferred ways for venture capital funds to grant financing to their investments is the convertible preferred shares. The convertible preferred shares are shares with the possibility of being converted into debt if the investor wishes. Why do venture capital funds consider that convertible preference shares are the optimal way to channel their investments? There are reasons associated with economic rights, but also political ones.

In terms of economic rights, convertible preference shares maximize the possibilities of recovering venture capital investments. If the company is doing very well, investors remain shareholders and share in their profits. If the company is going regular, they can transform their investment into debt and receive a moderate return with a reduced risk.

If the company goes very badly and is liquidated, the investors participate in the liquidation as debtors, with an advantageous position with respect to the ordinary shareholders. Some people may think that these conditions are abusive, after all the convertible preferred shares give the venture capital fund the possibility of having the right asset for each situation. However, given the very risky nature of the companies in which they invest.

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