Hedge Fund Involvement in Convertible Securities

• Author: Craig M. Lewis,Stephen J. Brown,Patrick Verwijmeren,Bruce D. Grundy
• Date: 01 December 2013
• DOI: http://doi.org/10.1111/jacf.12043
• Published date: 01 December 2013

Journal of Applied Corporate Finance

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VOLUME 25 | NUMBER 4 | FALL 2013

JOURNAL OF APPLIED CORPORATE FINANCE Risk Management VOLUME 25 | NUMBER 4 | FALL 2013

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Navigating the Changing Landscape of Finance 8James Gorman, Chairman and CEO, Morgan Stanley

Reforming Banks Without Destroying Their Productivity and Value 14 Charles W. Calomiris, Columbia University

How Companies Can Use Hedging to Create Shareholder Value 21 René Stulz, Ohio State University

Do Trading and Power Operations Mix? 30 John E. Parsons, MIT Sloan School of Management

Aligning Incentives at Systemically Important Financial Institutions:

A Proposal by the Squam Lake Group

37 The Squam Lake Group

Managing Pension Risks: A Corporate Finance Perspective 41 Gabriel Kimyagarov, Citigroup Global Markets, and

Anil Shivdasani, University of North Carolina at Chapel Hill

Synthetic Floating-Rate Debt: An Example of an Asset-Driven Liability Structure 50 James Adams, J.P. Morgan Securities, and Donald J. Smith,

Boston University

Hedge Fund Involvement in Convertible Securities 60 Stephen J. Brown, New York University; Bruce D. Grundy Uni-

versity of Melbourne; Craig M. Lewis, Vanderbilt University;

and Patrick Verwijmeren, Erasmus University Rotterdam

Fine-Tuning a Corporate Hedging Portfolio: The Case of an Airline 74 Mathias Gerner, European Business School and

Ehud I. Ronn, University of Texas at Austin

A Primer on the Economics of Shale Gas Production

Just How Cheap is Shale Gas?

87 Larry W. Lake, University of Texas; John Martin, Baylor

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Sheridan Titman, University of Texas

Evidence from German Companies of Effects of Corporate

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APPLIED CORPORATE FINANCE

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60 Journal of Applied Corporate Finance • Volume 25 Number 4 Fall 2013

Hedge Fund Involvement in Convertible Securities*

* This article summarizes the ndings of and draws heavily on our article, Stephen J.

Brown, Bruce D. Grundy, Craig M. Lewis, and Patrick Verwijmeren, “Convertibles and

Hedge Funds as Distributors of Equity Exposure,” Review of Financial Studies, 2012. The

article has beneted from comments by Laura Starks, Renée Adams, Ali Akyol, Yakov

Amihud, Nick Bollen, Sudipto Dasgupta, Abe de Jong, Robert Faff, Joseph Fan, John

Finnerty, Doug Foster, Mila Getmansky, Andrew Hertzberg, Sagitas Karpavicius, Timo

Korkeamaki, Robert Kosowski, Mike Lemmon, Josh Lerner, Bryan Lim, Albert Menkveld,

Mark Mitchell, Narayan Naik, Phong Ngo, Vanitha Ragunathan, Tarun Ramadorai, Abra-

ham Ravid, Garry Twite, Chris Veld, Kathleen Weiss Hanley, and seminar participants at

the 2009 ANU Summer Camp, VU University Amsterdam, RSM Erasmus University, the

University of Queensland, the University of Maryland, George Mason University, the Uni-

versity of Stirling, the University of South Florida, Maastricht University, the University of

Glasgow, Norwegian Business School, Copenhagen Business School, the Helsinki Finance

Seminar sponsored by Aalto University and Hanken School of Economics, the Securities

and Exchange Commission, the 2010 LaTrobe Finance and Corporate Governance Confer-

ence, the 2010 European Finance Association Meetings, the fth Annual Conference on

Advances in the Analysis of Hedge Fund Strategies, the 2011 FMA Europe Conference,

and the 2011 American Finance Association Meetings. We gratefully acknowledge funding

from a Faculty Research Grant at the University of Melbourne. We thank Eric Duca for his

assistance in calculating convertible under-pricing and thank Melissa Roodzant and Daniel

Selioutine for assistance in data collection. Send correspondence to Patrick Verwijmeren,

e-mail: verwijmeren@ese.eur.nl. The Securities and Exchange Commission, as a matter of

policy, disclaims responsibility for any private publication or statement by any of its em-

ployees. The views expressed herein are those of the author and do not necessarily reect

the views of the Commission or of the author’s colleagues on the staff of the Commission.

1. Such trading practices may raise legal issues outside the scope of this paper.

2. Stephen J. Brown, Bruce D. Grundy, Craig M. Lewis, and Patrick Verwijmeren,

“Convertibles and Hedge Funds as Distributors of Equity Exposure,” Review of Financial

Studies, 2012.

3. Constantinides and Grundy (1989) present a model of a signaling equilibrium with

optimal investment in which the proceeds of convertible issues are used partly to nance

investment and partly to repurchase stock.

by Stephen J. Brown, New York University; Bruce D. Grundy, University of Melbourne;

Craig M. Lewis, Vanderbilt University; and Patrick Verwijmeren, Erasmus University Rotterdam

I

n a widespread practice known as convertible

arbitrage, hedge fu nds buy convertibles and then

short the stock of the issuing company with the

aim of eliminating their exposure to the rm’s

equity. In economic terms, hedge funds use their k nowledge

of the borrowing and short-sale market to hedge themselves

while distributing equit y exposure to a large number of well-

diversied investors into the open market t hrough their short

positions.1

In an article published in the Review of Financial Studies

in 2012,2 we presented evidence in support of the hypothesis

that “would-be” equity issuers that would pay high issue costs

when raising seasoned equity choose instead to issue convert-

ible debt to hedge funds to benet from the funds’ expertise

in distributing equity exposure. is process allows corporate

issuers to raise capital today while avoiding the discounts and

underwriter fees associated with a secondary equity oering.

Earlier studies have shown that corporate issuers often

prefer convertible issues to seasoned equity issues because of

the ability of convertible securities to resolve problems associ-

ated with asymmetric information.3 Perhaps most relevant

to this article, a 1992 article by Jeremy Stein presented a

model in which companies issue convertible debt as a kind

of deferred equity issue. In this model, a convertible issue

provides a more favorable signal than a direct equity issue

because companies are likely to favor convertibles over equity

issues only when they are optimistic that their stock prices will

exceed the conversion prices before the bonds mature.

Our study provided a new rationale for issuing convert-

ible debt that does not rely on signaling explanations. We

argued that companies that face relatively high costs of issuing

seasoned equity may nd convertible debt to be the preferred

issue choice because certain factors that are associated with

high equity issue costs—notably, high stock return volatility

and high probability of nancial distress—are actually sought

out by the kind of hedge funds that purchase convertibles. For

example, convertible arbitrage hedge funds typically prefer

the underlying stock to have higher return volatility because

their hedging strategy leads them to buy stock after stock price

declines and sell after stock price increases.

To test whether companies with characteristics that are

likely to make a seasoned equity oering expensive instead

issue convertibles to hedge funds, we obtained information on

hedge fund involvement for 803 privately placed convertibles

issued under Rule 144A. (Rule 144A was introduced by the

SEC in 1990 and allows companies to sell securities without

registration if the securities are issued only to qualied insti-

tutional buyers, or QIBs.) Because the names of the QIBs

are contained in the registration statement, we were able to

directly examine the participation of hedge funds.

e rst thing that became clear from our research is that

hedge funds are heavily involved in the convertible security

market. In our sample of over 800 convertible issues that were

oated between 2000 and 2008, almost 75% of the nancing of

newly issued convertibles was provided by hedge funds. When

we compared companies that issued convertibles to hedge funds

to rms that issue seasoned equity, we found that the convert-

ible issuers were closer to being nancially distressed and had

more volatile stock returns than seasoned equity issuers.

Moreover, using a two-stage model that accounts for “self-

selection,” we estimated the issue costs that would have been

incurred if the set of companies that chose to issue convertibles