This article was written by Paul Schroder, Mark Vanderneut and Stephanie Rigg.
So far, the Australian Securities Exchange ("ASX") has provided a safe harbour for issuers to weather the COVID-19 storm, allowing traditional and accelerated equity raisings. Initially, it was not clear that would be the case. As the downturn wears on, there will again be times when the markets will shut and when they do, what are the alternatives?
During uncertainty, investors, in particular private equity sponsors and strategics, may offset the risk of distress by investing using convertible securities. Convertibles allow investors the down-side protection of debt, with fixed returns and lower volatility as well as optionality on a recovery though equity upside. For the issuer, convertibles are a good source of emergency funds: cheaper than ordinary debt and less dilutive than ordinary equity. These instruments continue to be popular elsewhere but have struggled to compete with generic equity on ASX.[1]
During the quiet, to be able to weather the next storm, it is worth considering the key legal and strategic considerations of private investment in public equities ("PIPEs"), in particular convertibles.
Timing and approvals
Longer due diligence timelines
Timing for due diligence is a significant barrier to PIPEs. Sponsors and strategic investors typically require months. Fund managers with smaller and more liquid investments can usually respond very quickly to a generic equity capital markets raising, as evidenced by many accelerated raisings on ASX. Issuers considering a PIPE should seek investors capable of expedited timeframes including sponsors or strategics already familiar with the issuer or the industry. Otherwise, the PIPE investor may withdraw because they feel unable to compete on execution speed.
Shareholder approvals
The need for an issuer to obtain shareholder approval for a PIPE undermines some of its key advantages.
Shareholder approval is usually required:
- 20% rule: under section 611 item 7 of the Corporations Act 2001 (Cth) prior to conversion into ordinary shares if conversion causes the investor's voting power to exceed 20% (or to increase from above 20% to less than 90%).
- Listing Rule 7.1: prior to the issue of convertible instruments if the number of ordinary shares issued on conversion exceeds the issuer's capacity to place equity on a non pre-emptive basis. Usually this is limited to 15% in a 12-month period but due to COVID-19, has been temporarily increased by ASX to 25% (for ordinary securities and if an entitlement offer or share purchase plan follows) (for further information on this temporary increase see Raising capital in the time of COVID-19 – ASIC and ASX grant temporary capital raising relief.
Shareholder approval introduces uncertainty for all involved, particularly the investor. It may also delay urgently needed funds. Some structuring solutions are more palatable than others:
- Issue as debt with the equity conversion subject to shareholder approval: If shareholder approval is not obtained, the debt cannot be converted into equity. Investors may seek early repayment rights or a step-up coupon to offset this.
- Tranches: Issuing in tranches, with the first tranche below the thresholds for shareholder approval, which provides the issuer with an urgent cash injection. However, an incomplete funding solution may not be attractive to investors.
- Shareholder approval prior to issue: This option trades timing for certainty and so will often be unworkable for an entity in urgent distress. However, investors will be reluctant to commit capital without compensation if shareholders do not approve.
- Cash settle: Some issuers are willing to compensate investors by cash-settling the investor's opportunity cost if shareholders vote no. Depending on the metrics, this may be coercive.
Stalking horse vs competitive tension
Distressed companies in volatile markets should not put all their eggs in one basket. To rely on the safe harbour against personal liability for insolvent trading[2], directors must pursue alternative courses of action which are reasonably likely to lead to a better outcome for the entity than an immediate administration or liquidation. Given this, issuers looking at a PIPE should in parallel prepare for a traditional or accelerated capital raising. The competitive tension also provides a critical source of leverage.
There may be scope to converge this dual-track and have the sponsor or strategic participate in a traditional or accelerated equity raising – for example through cornerstoning the placement or sub-underwriting. This provided a "win-win" outcome on some capital raisings during the COVID-19 period.
Sponsors may feel they have been COVID-19's stalking horse for equity capital markets, because so few PIPEs have gotten away. Exclusivity is too hard an ask for the issuer's board, and cost reimbursements have not proven a sufficient deterrent. The most effective competitive tool for would-be PIPE investors is to match the simplicity and speed of execution of equity capital markets – which private equity failed to do on some capital raisings during the COVID-19 period.
Key negotiation points
Governance and decision-making
While proportionate board appointment rights are not controversial, investors who try to secure veto rights from a distressed issuer over key decisions (e.g., M&A, budgets and succession) have become embroiled in protracted negotiations with defiant boards. Investment Committees insist on protections they consider standard for PIPEs in the US, but so far (other than proportionate board representation) these rights have been resisted by all but the most desperate issuers on ASX.
The fine line between compensation and coercion
"Naked no vote" break fees and other coercive elements
Investors commonly offset risk by including adjustment mechanisms in the notes. These might include adjustments in the conversion or coupon or acceleration on a change of control or a shareholder "no" vote.
While these mechanisms protect investors against losing equity upside, there is a fine line between legitimate risk mitigation, and coercion or anti-competitive conduct. In Billabong the Takeovers Panel[3] found shareholders were coerced into approving convertibles subject to 35% interest dropping to 12% interest on shareholder approval. Similarly, a 20% premium payable on the principal of a bridge loan on a change of control ($65 million), was found to be an unacceptable and anti-competitive break fee.[4]
Investors should ensure "compensation" is proportionate and reasonable.
We have seen ASIC be facilitative and flexible during COVID-19 but we also see them refuse routine waivers where they have collateral concerns about coercive and control features in convertibles.
ASX scrutiny on predatory convertible instruments
ASX has recently flagged a crackdown on highly dilutive and coercive features of convertibles being issued by smaller issuers. ASX considers these arrangements may fall foul of Listing Rule 6.1 which requires equity securities to be issued on "appropriate and equitable" terms.[5] The troubling features are the highly dilutive variable conversion price determined by the future market price of the conversion securities with no floor, and the use of "collateral shares".
ASX expects the issuer to disclose:
- alternative options considered before entering into these convertibles and if none, why so; and
- where the issuer has agreed to issue "collateral shares" to a noteholder, why other collateral is not sufficient.
ASX's attitude to convertibles may unfortunately be skewed by these predatory instruments.
Regulatory approvals
Notes can be issued subject to the convertible feature being approved by the Australian Foreign Investment Review Board ("FIRB"). If the investor cannot convince FIRB to fast track their review of its application on the grounds of its investment being needed to urgently save Australian jobs or businesses, then it will be subject to FIRB's new COVID-19 temporary 6-month statutory timetable (for further information on FIRB's approach see Impacts of FIRB changes on ECM deals during COVID-19. Controversy follows as to who wears the risk if FIRB approval is not granted.
We have seen some issuers agree to cash settle the conversion if it is not approved by FIRB, but this is usually resisted as an investor risk.
[1] ZIP Co Ltd announced on 2 June 2020 it intends to issue convertible notes and warrants to an affiliate of SIG, for growth finance. The full terms have not yet been disclosed limiting our ability to consider the instrument against the usual considerations.
[2] On 25 March 2020 the Treasurer effectively suspended directors' duty to prevent insolvent trading. Until 24 September 2020, an effective dry-dock has been established against personal liability for debts incurred in the ordinary course of the entity's business.
[3] Billabong International Limited [2013] ATP 9.
[4] The Panel's guidance is break fees below 1% of equity value will generally not give rise to unacceptable factors. In Billabong, the break fee represented approximately 54% of Billabong's equity value prior to announcement.
[5] Listed@ASX Compliance Update no 05/20, 1 May 2020.
