Imagine that you are running a PE firm and you have found one lucrative opportunity in terms of investment. This business is still in its infancy and has not reached the maturity stage yet where you can be assured of minimum cash flows arising out of its operations. Now you want to make an investment in this business. You have two options:
Invest the money and get common equity shares issued by the business
Invest the money and get compulsorily convertible preference shares (CCPS) issued by the business
CCPS is nothing but a fixed income instrument up to a certain time frame after which it has to be compulsorily converted to common equity shares.
To give you an example, say a company-issued CCPS to its investors at Rs 100 per share with the annual yield of 6%, maturity date of 28/06/2030, and the conversion ratio of 5. Say a PE firm is looking to invest Rs 100 cr in the company
This means the following:
PE firm would get 1cr CCPS issued by the company
PE would get Rs 6 cr (6% of 1cr CCPS of Rs 100 each) annually as yield
PE firm has to necessarily convert their CCPS into common shares on or before 28/06/2030
PE firm will get 5 common shares for every 1 CCPS when they exercise their right to conversion
This means that PE firm would see the capital gains only after the share price of the company reaches above Rs 20 (Rs 100/5) as they would forego Rs 100 worth of asset with 5 common shares of the company
CCPS is frequently used by VC/PE firms to hedge their risk in the investments they have made. This is due to the following reasons:
CCPS entitles the holders with the fixed income while promising the upside in the form of a future rise in valuation
CCPS holders have a higher claim to the company’s assets than common shareholders if the company gets liquidated
How CCPS trade?
Mostly CCPS trade in secondary markets. The following factors are taken into account in determining their price:
Conversion premium - Let’s say that in our example, the common share is trading at 15. Then the fair value of CCPS would be 15*5 = Rs 75. The conversion premium would be 25% ((100-75)/100). In general, lower the conversion premium, higher the chance that CCPS price will follow the common stock price as there is a higher chance of a profitable conversion. On the other hand, a higher premium is more like a fixed income instrument because, in the shorter run, it is less likely that the share would touch Rs 20.
Interest rates - Interest on AAA-rated government bonds affects the CCPS price in the secondary market. This is because if the interest rate is high, investors would find the yield on CCPS less attractive as compared to what they would get on AAA-rated bonds. This leads to a lack of demand for CCPS and hence lower prices in secondary transactions.
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