Morgan Stanley’s convertible bond deal for Kestrel Solutions was the first outing for an innovation the firm has dubbed a “going-public convertible debt offering”. It offers an effective solution to two problems: first, it satisfies a demand from investors who want to participate in a firm’s potentially significant upside following an IPO but who cannot invest in IPOs or in companies which are private, or both. And second, it provides a cheaper source of funding for a company than a last round of mezzanine or venture capital.
“We noticed that there was a group of companies who had the potential to register gains of 200% or 300% in the first weeks after an IPO, and keep those gains, yet who still had to give up to 100% appreciation to those investing in their last round of pre-IPO funding,” says Brooks Harris, head of convertible origination at Morgan Stanley Dean Witter. “And also there was a class of investor whose charters would not allow them to invest in pre-IPO companies who might have to wait until up to two years after the IPO before getting an opportunity to invest.”
The terms of the deal keep all the elements necessary for a successful IPO in place. The convertible places no valuation on the company, that is left to the IPO marketing stage, when the convert price is finally set. And there is no danger of the convertible investors cashing out. “The deal is designed for them to hold long-term, until way after the IPO,” says Harris. It demands, therefore, that the investors have a great deal of faith first in the company and second in the book runner to make sure the IPO is run and priced properly.
As a result, says Harris, “this kind of deal really is only intended for a small number of companies. But any company that can raise money this way should do so.” A knock-on benefit for the bank, of course, is that this kind of deal will almost certainly secure them the IPO mandate.
Once his team had thought through the dynamics they approached Kestrel Solutions. “They had looked at some more conventional ways of raising pre-IPO cash, and could not find a way of avoiding the higher costs associated with them,” says Harris. So he provided them with the solution.
Kestrel has yet to launch its IPO, although it is planned for the first quarter this year. Only then and thereafter will the true value of this new convertible structure be known.
