Convertible Loan Notes: to convert, or not to convert?

Convertible Loan Notes are increasingly popular, but easily misunderstood by issuers

What are Convertible Loan Notes?

Convertible Loan Notes (CLNs) are debt issued by companies that give the investor an option to convert to equity in the issuer depending on agreed criteria. They are increasingly popular as a way of raising finance, especially with start-ups and SMEs.

• For a company without established track records or strong revenue streams, they provide a way to raise funding with relatively low upfront costs by providing an equity linked “sweetener” to what would otherwise be more traditional debt
• For the investor, they can provide the best of both equity and debt financing – the relative safety of debt with the potentially lucrative upside from equity, without being exposed to all the risks of outright ownership in a fledgling company

CLNs are efficient funding instruments for investors. Because of their convertible nature, borrowers who issue convertible debt will generally pay a lower rate of interest on the debt than they would under a conventional loan, thus reducing their costs of borrowing.

They are, however, complex instruments to value correctly. To get it right requires modelling of the interaction between sources of risk in their complex payoff structures – they are more complex than the sum of their parts. After all, if a CLN could be viewed as a naïve combination of simpler instruments that can be priced in isolation and then added together, why would financial institutions create such instruments in the first place?

Accounting for Convertible Loan Notes: Getting it wrong can cost You

Unfortunately, we often find that these notes are incorrectly valued by the companies issuing the notes, due to attempts to approximate their payment structures.

One typical approximation is to decompose the instrument into simpler debt and equity parts and then deal with each of them in isolation. The problem is that they are in fact interlinked - hybrid instruments such as CLNs were created specifically to capture the subtle interplay between the different risk factors. If this is ignored, the valuation may miss the potential for large payoffs for the investors, resulting in the issuer being caught off-guard and not fully prepared to meet them.

The valuation must also reflect the optionality on the timing of conversion. We have seen examples where the only considered conversion date is either the maturity of the CLN or certain arbitrary dates, when in fact the CLN terms clearly state conversion could happen at any time by election of the investor.

These errors could lead to significant losses. The size of such losses depends on the CLN’s terms including its notional, the conditions for conversion and how equity, credit and other risks are assessed. If, for example, we estimate that for each 1% increase in credit risk of the issuer of the CLN, an increase of $500,000 in CLN’s value would materialise, then a deviation of 5% from the real credit rate would make the CLN $2.5 Million away from its fair value. It is therefore imperative that each of the risk factors is appropriately considered and estimated to avoid potential losses in value.

Convertible Loan Note Valuation

Correct valuation requires understanding conversion and the interplay of risks. The solution is to properly understand and model the hybrid payoff structure – including the correlation between risks to debt and equity components.

Understanding conversion

CLNs give the note holders the right to convert the loan into the company’s equity at their discretion, or conversion can be triggered automatically by certain events. Common automatic conversion events include the company raising finance above a certain threshold by a certain date, or the company being sold.

The source of equity upside in the event of a conversion comes from the price that the noteholders pay for their shares, which is normally at a discount to the price that other investors would pay during the funding round. For example, if investors are subscribing for shares at £1 per share, a convertible loan note may convert at a price of £0.80 per share.

The conditions on which convertibility can occur are defined in the CLN term sheet and generally fall under two categories:

1. standard payoff structure, in which there is a fixed conversion price, and the noteholder can convert into equity at any point during a pre-defined time window: this is an analytically tractable structure since all relevant risk factors can be modelled directly and calibrated to observed market data.
2. bespoke payoff structure, in which conversion occurs based on certain pre-defined trigger events, such as raising additional capital, the occurrence of an IPO or a sale event etc. This type of structure is less analytically tractable because it is dependent on events that are to some extent within management’s control.

If a CLN does not get converted into equity, the issuer will need to repay the loan at maturity. However, if the loan note is converted into equity, then no further repayment is required. The repayment condition may be either automatic or at the choice of the investor. Common events of automatic repayment include insolvency related events of default, failure to repay or convert before a set date and material breaches by the issuer. If an automatic repayment event is triggered, the notes will need to be repaid immediately.

Interplay of the risk factors

As a result of the option that the investor has to convert the loan into equity, the valuation needs to answer the question: would the investor prefer to wait for conversion to benefit from an upside in the share price, or would it be preferable to convert now?

This optionality feature is akin to a stand-alone American equity call option, but for a CLN it cannot be addressed in isolation. When pricing an American equity call option, the value of optimal exercise is calculated with respect to the equity price only – in other words, does an investor stand to make better gains if they exercise the option immediately rather than waiting until expiration? This decision is relatively straightforward and only depends on the future evolution of equity prices.

For CLNs, however, the conversion decision is also influenced by movements in interest rates and changes in credit spreads that affect the desirability of the debt component. Whilst CLNs, just like any other financial derivative, can be hedged by means of simpler traded instruments, the weights that should be applied to these simple instruments in a replicating portfolio is far from trivial and can only be calculated if the CLN is priced appropriately by using a methodology that is rich enough to simultaneously accommodate multiple risk factors in the same pricing framework.

Another potential complication arises from estimating an equity volatility needed for the pricing framework – for many smaller corporate issuers of CLNs there is no traded equity options market from which implied volatility can be derived, so historical volatility is the only alternative. The volatility estimate used by certain valuation approaches is often based on a static estimation over a lookback period at one point in time only. Historical volatility estimates are in general non-stationary, and therefore averages of the rolling historical volatilities should be used in order to better understand the long-term behaviour of volatility and whether there are any mean-reversion effects. Using the current historical volatility over a specific lookback period might be skewed if this is estimated during a unique volatility regime, such as the heightened volatility period.

For more complex CLN structures there may be other risk factors that require consideration. For example, notes that are issued with a principal in a different currency to the currency of the equity give rise to a “quanto adjustment”, introducing FX as an additional risk factor together with its respective correlations to other risk factors (i.e., interest rates, credit and equity).

Do you deal with CLNs? How we can help

CLNs are complex financial derivatives that are contingent on several risk factors. Correct modelling of this interplay is required to avoid an oversimplification of the payoff structure and a potentially material valuation error. Employing naïve, inaccurate, and approximate pricing methodologies to assign fair values to CLN instruments may lead to materially incorrect financial reporting and money losses.

We have the deep expertise and advanced analytics to handle these type of complex hybrid products, and a straightforward and practical approach to breaking down the intricacies of such instruments in simple terms. We can support your understanding of the risk factors you may be exposed to by issuing CLNs, and contribute to potential large money savings by means of an appropriate valuation of these instruments.

Our Quantitative Risk and Valuation Advisory team has developed deep expertise and advanced analytics in the field of pricing and risk managing hybrid instruments. We use our experience gained from leading investment banks and consulting companies to support our advisory clients and audited entities with the valuation of CLNs. We apply market standard modelling techniques to correctly consider all the relevant risk factors that impact the CLN’s payoff. To find out more, get in touch today.
 

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