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Best of both worlds: Convertible bonds offer lower risk means to make returns

JOHANNESBURG — In recent months, Rand Merchant Bank’s Capital Markets teams raised R7.7 billion for two mining clients by structuring and facilitating the issuance of convertible bonds in the local and international markets. In this interview with BizNews publisher and editor Alec Hogg, Debt Capital Markets transactor at RMB Dave Sinclair explains the advantages for issuers and investors when it comes to this capital raising instrument. The dual nature of convertible bonds also means that issuers and investors can benefit from the protections of debt instruments and the potential equity upside, potentially offering the best of both worlds as Sinclair explains. – Gareth van Zyl

This special podcast is brought to you by RMB and I’m with Dave Sinclair here in Johannesburg, Sandton. It’s amazing how incredible the South African weather is during winter when you come here from another part of the world.

Sure, I think that’s one of the key reasons we live in this country beautiful weather, great people, and an advanced financial sector.

Dave Sinclair, RMB

It’s interesting, Dave, you guys recently anyway have been focusing on the platinum sector. Platinum being the biggest export that South Africa generates its foreign exchange from. Has it been a particular area that you wanted to focus on?

Well, I would say it’s more broadly on the resources sector as a whole. At present we have some platinum clients that are expanding their operations in one case and another client that was actually looking to roll some of its funding. But I suppose it’s really a general resources sector focus, as the country is quite a commodity exporter. As the rand weakens, obviously, commodities become more favourable especially for South African producers. Platinum is a hot topic at the moment.

Let’s talk about the deal that you’ve just done, which is with Royal Bafokeng Plats. It is an expanding story, so a good one.

We’ve actually done two deals in the last three months Royal Bafokeng Platinum and Impala Platinum. Both deals were quite interesting and required funding for different reasons. In March this year Royal Bafokeng Platinum launched their first convertible bond for an amount of ZAR1.2-bn. That was part of a robust funding package for the ramp up of its Styldrift 1 Mine so that it could increase production from 50 000 tons per month to 150 000 tons per month.

Which mine is Styldrift, where is that?

If you’re on your way to Sun City, just before you get to Sun City on the traditional Sun City road, you’ll see a nice big sign to your left where “Styldrift” is.

They have many reserves there clearly, if they’re able to ramp up production three times?

Absolutely, it’s part of the Merensky Reef. RB Platinum is relatively low on the cost curve as platinum producers go. The development of that section of the reef is to further enhance their production. Once again, this bond issuance is helping them raise the funding to reduce the costs even further, because it’s relatively mechanised and therefore assists to lower their basket cost of production.

How much money did you raise for them?

This convertible bond was ZAR1.2-bn, but it should actually be seen together as part of a complete package where both RMB and Nedbank put together an RCF and term debt package. This ZAR1.2-bn convertible bond complemented that packet, so all in all a ZAR3.2-bn transaction for Royal Bafokeng Platinum.

Royal Bafokeng Mine mining

So the ZAR1.2-bn is the convertible bonds. We’ll talk about them in some detail because they’ll be listed on the stock market and ordinary people can invest in them and the rest is debt to enhance the business and that mine?

Yes, that’s right. RB Plat has quite a nicely structured package in that they have revolving capital and term debt facilities (RCF). They now have a number of different facilities that they can draw down on. Obviously regarding the convertible bond, the cash comes in right upfront which means that they have this funding available immediately.

This will enable them to deploy this funding before they start drawing down on the other facilities. The good news is that the other facilities have a seven-year term. So, while they can use the convertible bond funding upfront, they are still able to draw down as and when required to the extent if their cash flow (coming out of operations) are insufficient to service the Capex expansion.

So, that’ll only pay the interest on the additional amount that they need for this expansion programme when they draw that money, which could be months or maybe a couple of years into the future.

Yes, pretty much. Obviously, as with anything, if you have a facility available to you, there are small commitment fees and costs upfront and over time, but certainly not as large as the interest costs that you would incur when using the funds. They can use it in the future, albeit in months or probably a few years’ time. But they at least have their funding secured upfront for their entire life of the project.

Now this convertible bond, what did interest me was that it’s at a relatively small premium to the current share price, given that you have five years to exercise it in. And what I mean by that is the convertibility into shares at a time. Just take us through the thinking there.

A convertible bond is quite a simple product, contrary to many folks who think it’s incredibly complex. I suppose that the truth lies somewhere in between. What it really is, is a debt instrument that has an embedded equity option in it. It gives you the benefit of both worlds from a debt and an equity point of view. The way it works is that you issue the bond and the investor will receive coupons on a semi-annual basis.

And you’ll get interest on your investment?

Absolutely and specifically in resource stocks at the moment as many resource stocks aren’t paying dividends. So if you’re an equity holder, you won’t be receiving a dividend, but if you’re a convertible bond holder, you’ll be receiving regular interest payments every six months as opposed to a zero dividend.

File Photo: The mining shaft and main buildings stand at the Impala Platinum mine in Rustenburg, South Africa. Photographer: Nadine Hutton/Bloomberg News

Your income then is guaranteed, before the next five years you’re going to be getting, in this case, a 7% return on your investment as interest that’s paid to you.

That’s correct, yes. Some people might look at these particular companies and go, “Wow 7%, that’s pretty low. As you know, JIBAR (The Johannesburg Interbank Average Rate) is just above 7%. So why can they raise new funding at 7%?”

The reason is the embedded equity option. The embedded equity option allows the investor to participate in a fixed income product, as well as in the equity upside. Obviously, they can’t participate in the equity upside from day one as they need to have a little bit of skin in the game as well. That’s why we set the conversion premium i.e. the strike price of the option at 30% above today’s share price. In other words, the share price has to appreciate 30% before it’s in the money – only then can the investor start enjoying the equity upside. They do give a little bit away in the equity participation, but they are receiving this semi-annual coupon that benefits them in a regular form of income.

Now if you say, “A little bit”, in five years, 30% in a share price is not a lot. It certainly seems as though it’s a viable proposition that you can make money both on the interest that you’re getting from the debt and from the share price appreciation?

Certainly.

Is that the idea?

That is indeed the idea. Obviously it depends on your view of the company. Some people believe the company will be going sideways, whereas others believe there’s massive equity upside. I suppose if you speak to the management of these companies they’ll definitely be looking to the upside. But yes, as you could see in the Shoprite deal that we did five years ago, for around about 3.5 years, the share price would rise, drop, rise, drop and always be floating close at or near that strike price. And it was only in the last 18 months that it really kicked quite high above the strike price, and that’s when the equity or the investors got that equity upside.

So, I suppose the story is the same here as both companies, Royal Bafokeng Platinum and Impala, have very well-defined Capex programmes that they disclose during their financial results presentations. People know when these should be coming into effect and thus impacting the cash flows and therefore the share price. Obviously, investors have a view that there’ll be either a sideways movement or a certain amount of appreciation in the shorter term, but from the medium to long term, they’re seeing value in these companies above that 30%.

The worst case scenario is the share price goes down in the next five years, but you get your 7% and you get your capital back. The best case scenario is that the share price appreciates and you make money, both on the shares and on your debt?

Correct. That’s why I say it has the best of both worlds. You have the downside protection in that if the share price drops you get your capital back, which wouldn’t be the case if you were an outright equity investor. But you also get to participate in the equity upside of the share price performance. However, I must say that is capped. There is a certain point at which the conversion of the instrument can be triggered forcing people to convert into the equity. However if the share price is doing so well, that’s not terribly bad for the investor in this instrument because the share price would’ve gone to such a high level that the issuer could say, “I’m making you convert into equity”. You are then in the equity and you can continue to appreciate the share price upside.

So, that’s Royal Bafokeng, who presumably, you worked in quite a few things that you had also implemented on Impala Platinum, a similar scheme with the convertible bonds, which though it is a different story as you mentioned earlier, with Royal Bafokeng, they’re expanding. Impala Platinum had a different challenge.

Impala Platinum actually already had two convertible bonds in existence. These bonds were issued in February 2013 and it was also the same story: expansion of the mines, capital expenditure, etc. They intended to roll that funding. Their bonds were going to mature in February 2018 which would’ve then (as a result of the share price not being above the strike) forced them to refinance that debt. What they could do is they could just pay out the bond holders and say, “Thanks guys, we had funding for five years, appreciated it, and here’s your money back”. So, the bond holders are happy that they have that capital protection.

Platinum bars are stacked at the safe deposit boxes room of the ProAurum gold house in Munich March 6, 2014. REUTERS/Michael Dalder

To an extent the bondholders may not be a 100% happy because they didn’t trigger the strike price on those original converts, but what Impala then did is, they rolled the convert. So often people think that you have a convertible bond, and at some point it converts into equity and then you cause dilution to the existing shareholders. What Impala has demonstrated is something we see very regularly in the offshore markets. It’s called “rolling the convert”.

The convert forms a permanent part of your capital structure and in that way shareholders are less worried that it’s going to eventually convert and dilute them. As was the case with Impala as their converts were approaching maturity, they rolled them into a new instrument, which was struck at current market rates. It allowed Impala to avoid a sizeable cash payment out of their business in order to refinance the existing converts or pay back bond holders. They could simply roll existing bond holders either into the new, or use money raised from new investors to pay out the old bondholders, which is what they did.

So, what’s the difference in the strike price, given that in 2013 Impala’s share price was at a more favourable level than it is today?

If memory serves, the strike price was around the ZAR200 mark back in 2013. At present, the strike price of this newly struck convert is ZAR50. So, where Impala’s share price is today? Roughly ZAR37. This rebasing allows investors to come into Impala again. The view is that that the ZAR50 share price is certainly achievable and that’s the kind of thing that attracts investors back, because they still have faith in Impala as a credit. But now they’re also saying, “Hang on, to get to that ZAR50, that’s not a bad deal for us as investors, so let’s get into it”.

Read also: Looking for a career in corporate and investment banking? RMB wants you.

At the time that you had the original bond, they would have seen, or hoped that the Impala share price would go above R200. It’s quite a nice example because it shows what happens when the market goes against you. They haven’t made any money on the equity obviously, because no one’s going to buy shares at R200 when you can get them in the market at R37 or R38 today, but Impala’s going back to the same and saying, “Well, here this time round we’ll give you a better chance perhaps of making money on the shares as well as pay you a nice interest”.

Yes. It’s like another bite of the cherry really. The old bond investors have the comfort that they got their capital back, which is good. Yes, they went for a lower coupon than they could have had achieved in pure debt, but they used that to really bet on the equity upside. The question is did they lose out heavily? I don’t think so, because don’t forget they were getting that fixed coupon on a non-dividend paying stock. Although they didn’t get the equity upside, they still had safety of capital and a regular return. What’s happened here, is you’re just re-striking them and giving them that chance again.

But this is very interesting. If you can go back five years and you had the option between buying Impala ordinary shares or the Impala convertible bond, clearly, with hindsight you should have gone for the convertible bond? Your capital was protected and you got an interest, whereas the shares have fallen and lost their dividend. Do investors look at it that way when they consider whether to go for the equity or the normal shares rather than the convertible bonds?

Yes. If you went for the share by itself, you benefit massively in the upside, but you can also be hit massively on the downside. This convertible bond allows you both the positives of debt and the positives of equity, while protecting you from the negatives of equity. The negative on the debt side is obvious as you don’t get as much appreciation because your coupon is low, but then the convertibility of this instrument allows you to participate in that equity upside. It takes your debt return and enhances it if the share price performs.

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So it would be a lower risk investor presumably who would go for convertible bonds rather than relative to the equity investor?

I would say so. That’s a fair point. Yes it would be a lower risk. But at the same time, a convertible bond may not have the absolute upside of equity, and it may not have the absolute benefits of debt. But it is certainly better than both stand-alone debt and stand-alone equity when combined and looking at protecting the downside.

That’s from the investor’s perspective. From the company’s perspective, your clients, you will engage with, in this case, both Impala and Royal Bafokeng Platinum, what do they want to achieve out of this?

The benefit for the client itself, i.e. the issuer in particular, is when they’re trying to raise large amounts of capital. They can look at going the equity route or they can also look at going the debt capital markets route, or pure bank funding.

For pure bank funding, banks require massive amounts of security which they tend to lock up until a particular point in time and it’s relatively covenant heavy. In the debt capital market space, (particularly in the South African environment) there’s not that large an amount of funds available, so they could raise up to say, ZAR750 000 to ZAR1-bn and they would have to be a regular issuer in the South African market. They could go to the international markets and raise high yield bonds, but that can sometimes be expensive and it doesn’t necessarily raise the quantum of capital required.

Regarding equity capital you get large amounts of capital by way of an ABO, an accelerated bookbuild offering or a rights issue, but that in itself comes along with the concept of dilution, or existing shareholders don’t have the funds to put in. This convertible bond is quite neat for the issuer in that they can firstly raise very large amounts of capital much like an equity raise. But they have the benefit of doing it in the form of debt and that debt is deployed into its operations i.e. it’s tax deductible, whereas equity and dividends are not tax deductible. This allows for a relatively long-term instrument that’s often a little bit longer-term than banks would offer and it’s a fixed rate. So, they get certainty for a long period of time. It’s tax deductible and unlike equity, you can, through this product, defer the voting dilution.

It’s an interesting world that we’re in, in this highly sophisticated South African financial environment when you engage with clients and these are big companies. Do they ask for a smorgasbord of options or do they have a fairly good idea of what it is that they need given the project or the reason that they need to raise the funds for?

I think, depending on who the client is, and how long you have engaged with them, they’re in two different environments. Sometimes clients are very particular and know exactly what they want if you’ve walked a long road with them. With these particular clients, we’ve been involved over a number of years. With Royal Bafokeng Platinum, we were there for their initial listing and their rights issues thereafter. We have also been involved in their funding and have been chatting to them across the spectrum.

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With Impala, we’ve had numerous conversations as we are existing debt lenders to them. We’ve spoken to them in the past about their existing convertible bonds and the options they have. I think at the end of the day clients, as long as you partner with the client, they actually know what types of products they would require, and by virtue of your relationship, you can also recommend products even if they haven’t thought of them. It’s really about forming a partnership with your client, which is how RMB likes to operate.

And of course, it also depends, on the pricing etc. at the point in the cycle that you are raising the money, and how people are viewing the platinum market generally. If they were very positive about the platinum market then presumably the premium that you could charge for the equity would be much higher than it is at the moment?

Yes. Allow me to rephrase that a little bit. If they were very positive about the platinum market, that would mean that the coupon size would be a lot smaller. So for the issuer, they would have the benefit of a lower cash coupon or a lower fixed coupon, and the investors would be happy with that because they think that the industry would be doing well enough that they’re going to get that excessive equity upside.

Okay, so it is a balancing act both ways?

Absolutely.

What does the pricing tell us now about the way that investors perceive the platinum market?

It’s quite interesting in that both companies are very well-known examples within the platinum sector and the feedback we got from investors was very positive on both entities for different reasons.

When we went to market with Royal Bafokeng Platinum, the one comment was, it wasn’t a very liquid company because it’s tightly held by two key investors. Therefore, some bond investors were hesitant to come into the bond because they didn’t think there was enough liquidity in this convertible bond and the underlying equity. However, they truly believed in the company and the project.

Read also: South African mining sector – the need to stage a comeback

Now on Impala it’s a much bigger company, it’s not tightly held and that’s why we were able to raise more funding and tighten the pricing slightly because of that liquidity. That’s direct feedback from both local and international investors.

What was the split between local and international on both of these?

I would have to hazard a guess here. It was roughly 19% international for Royal Bafokeng Platinum, obviously 81% local. On Impala, I would say it was roughly 25% local and 75% international. There was actually incredibly large international demand in the Rand tranche for Impala Platinum, which was unexpected.

Why would that be?

Typically, the feedback we’d get from investors when investing into Rand instruments issued by Rand companies is that it’s usually about 100 basis points cost to switch from currency, which they have, into Rands. I thought that 100 basis points switch cost was a bit expensive, but we saw that coming through on Royal Bafokeng Platinum. That was one of the prohibiting factors for international investors coming in, but we saw that the liquidity overruled the cost of funding and internationals could come into Impala in more volume.

It’s interesting to see that they’re happy to buy the rand.

Two hundred South African Rand notes sit on top of American fifty dollar notes in this arranged photograph. Photographer: Jason Alden/Bloomberg

Yes. Although they Impala have a Rand cost base, they are taking the commodity out of the ground which is dollar based, so I suppose there’s an interplay between the cost base and the revenue and the investor’s views on how the Rand/Dollar exchange rate will move versus how the platinum price will move as well.

Of course it’s not a pure rand hedge, I get that now. Dave, overall are you dealing with more companies in the resources sector, if they’ve looked and seen the success you’ve had with Impala and Royal Bafokeng and remember these are multibillion Rand transactions in funding that you have with these companies are there others wanting to do the same?

Yes. We’ve approached a number of different sectors over the last 18 months. For obvious reasons, the retail sector initially was quite favourable and looked upon these as they were starting to expand overseas. Because once again, you can raise sizeable amounts of capital in Rands or currency. To the extent that you’re looking at an acquisition that would be accretive, these would be fantastic products. But of late, the retail sector has been in a bit of a dip mainly because of the lack of growth in South Africa.

That’s where you’re seeing the resource sector companies come to light. Given the fluctuation in the exchange rate and commodity prices, it’s quite a favourable time for them now to either be acquisitive or to continue with large capital expansion projects and take advantage of the improved commodity prices. Because of our volatile currency which has a long-term trend of devaluing, right now this kind of product is extremely favourable for a resource sector company.

Dave Sinclair is an Investment Banking Transactor at RMB.

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