How the conversion mechanism works, step by step

What happens when regular sell orders are placed at almost fixed intervals on a thinly traded security? The share price falls. The Ambromobiliare study, which analysed the EGM (though the phenomenon can also be observed in other segments of the stock market), highlights how the relationship between the issuance of convertible bonds (POCs) and the decline in share prices is direct and, indeed, governed by a sort of cause-and-effect relationship. Here is what happens, in six stages.

A listed company (A) is in need of liquidity. A specialist firm (B) approaches the senior management of A with a proposal to issue a Poc – a convertible bond with warrants – with a nominal value of 5 million euros. For its part, B undertakes to subscribe to it in instalments, perhaps over two years, in 10 tranches of €500,000 each. The conversion date is chosen by B. In return, B asks A to pay an immediate commission (2–3 per cent) on the €5 million issue: that amounts to €100,000–150,000 straight away. And for B, that is an immediate profit. As for the warrants, they are normally designed to be convertible into shares at a ‘strike price’ (conversion price) significantly higher than the current market value of the shares at that time (30–40 per cent higher). The message that comes across is that there is an investor who will give a large sum of money to A, who will be able to convert it into shares and will receive, as a bonus, a series of warrants convertible into shares – but at a premium to the current stock market price – thereby creating the impression that the share price may rise in the future.

Until not long ago (it is no longer always considered necessary), the mechanism was set in motion by a securities lending transaction: B borrows 100,000 shares from A’s controlling shareholder at a notional value equal to the share price – let’s say 5 euros (and therefore for a total value of 500,000 euros).

How does B manage to raise the money needed to subscribe to the first tranche of A’s bond? He begins by selling on the market the very shares he borrowed from A’s controlling shareholder. As it is a thinly traded security, there isn’t much of a market for it, and so it is likely that the average price of A’s shares will fall. The first shares may be sold at €4.95, the last at €4.00: let’s say that the weighted average price will fall to €4.70. From the sale of the shares, B will therefore raise €470,000. It should be noted that, the moment B decides to sell the borrowed shares, B effectively becomes the market maker in a market that is already illiquid in its own right. They could therefore easily manage it through carefully timed buys and sells or by taking diversionary measures to prop up the share price, ensuring it does not lose too much value and preventing its price from falling too sharply.

At this point, B will subscribe to the first tranche of the bond, paying the nominal value net of any issue discount. And having already received 470,000 euros plus commissions of 100,000–150,000 euros, B has the necessary liquidity to meet this commitment. At this stage, B exercises its right to convert the bond at the market price of €4.70 per share, less a 10 per cent discount (which B had previously agreed with A): the conversion price will therefore be €4.23. In summary, B pays 423,000 euros for the bond. At this point, B has gained 18,000 shares as a result of the conversion.