Convertible Securities in a Raise: Debt Now, Equity Later

A convertible security starts life as a borrowing and carries a switch: its holder, not the company, may swap it for shares at a price agreed on the day it was issued. While it stays a borrowing it pays less cash interest than a plain loan would. The gap is not a saving. The company charged for the switch, and the lighter coupon is how the holder paid.

A convertible sits between two arrangements already established. The first is that a borrowing costs a contracted rate in cash and leaves the share count alone. The second is that issuing shares costs no cash at all and permanently shrinks the slice every existing holder has. A convertible refuses to be either one, so reading it needs both halves at once. The money in question is the Rs 1,140 crore that Harivansh Packaging Limited has to find, a figure that arrives here as the equity valueWhat the sellers of a business are actually paid for their shares, once the debt sitting inside that business has been taken off the enterprise figure. of its purchase of Sundarban Polymers Private Limited: an enterprise value of Rs 1,320 crore, from which the target's own net debt of Rs 180 crore comes off. The bridge from enterprise value to equity value is set out under equity value. Here it is simply the size of the hole.

What is a convertible security, and who is holding the switch?

A sweet shop sits on a busy corner. The owner needs Rs 5,00,000/- to put in a second counter. A neighbour offers the money and says: pay me four per cent a year, but I keep the right, any time in the next five years, to take a quarter of the shop instead of my money back, at a valuation written down today. The owner gets cheap money now. The neighbour gets a small cheque and a claim on something that might become much larger. Neither of them knows yet which of the two arrangements they are actually in.

The neighbour’s offer is a convertible security. Formally it is a debentureA written borrowing a company issues to investors, who hold it as a security in their own name and can usually pass it on to somebody else. with a conversion right attached. Until the right is used, the instrument behaves in every way like a borrowing: it sits with the company's other borrowings on the balance sheet, it pays a couponThe cash interest a borrowing contracts to pay, set as a percentage of the amount borrowed and owed whether or not the year went well. in cash, and the share count is untouched. Once the right is used, the borrowing disappears, the coupon stops, and new shares appear in its place. One instrument, two states, and a gate between them.

The company does not stand at that gate. Standing away from the gate is the single feature separating a convertible from every other route to the same money. A placement of shares is settled on the day the shares are allotted. A rights issue is settled when the offer closes. A borrowing is settled when the money is drawn. Each of those is a completed act. A convertible is not completed on the day it is issued; it leaves a decision open, and the decision belongs to somebody who is not the issuer and who owes the issuer nothing. Devyani Kulkarni signs the financing off as chief financial officer at Harivansh Packaging Limited. She can plan around that open decision; she cannot make it, delay it, or refuse it.

Why does the interest sit below what a plain loan would cost?

A landlord charges a tenant well under the going rent, and has done for years, with no sign of resenting it. The reason turns out to be that the tenant also has a written first refusal to buy the flat at a price fixed in the original agreement. The landlord is not being generous. The landlord sold something, and the discount on the rent is how the buyer paid for it. Read alone, the rent looks like a poor arrangement. Read alongside the first refusal, it is an exchange.

A convertible works exactly that way. Harivansh Packaging Limited would pay a contracted 9.0 per cent on a straight borrowingA plain loan or debenture with no conversion right attached: it is repaid in cash at the end and never turns into anything else.. On the convertible it pays 4.0 per cent. On Rs 1,140 crore that is Rs 45.6 crore of interest a year instead of Rs 102.6 crore, a difference of Rs 57 crore before tax and Rs 42.75 crore after it. The holder did not agree to five percentage points less because the credit improved; the borrowing sits behind exactly the same claim on exactly the same business. The holder agreed because alongside the coupon they were handed the right to buy 3.04 crore shares at Rs 375/-.

So the coupon discount is not a saving at all: it is the price Harivansh Packaging charged for that right, collected in a currency that never reaches the profit statement. Money that comes in as a lower interest bill looks like thrift. The lower interest bill came in as payment for an asset that left the building, and the sale of that asset is recorded nowhere in the accounts. Every year the accounts will show a Rs 45.6 crore interest charge where a plain borrowing would have shown Rs 102.6 crore, and every year the accounts will be right about that and silent about the reason.

Conversion price and conversion premium: what are they, and how far apart do they sit?

Two numbers do all the work in a convertible, and both are written into the contract on day one.

The conversion price is the price at which the borrowing turns into shares. A conversion price is neither a market price nor a forecast. The contract makes it a divisor: whatever the shares happen to be worth on the day the right is used, the holder receives shares as though each one cost Rs 375/-. The conversion premium is how far that agreed price sits above the reference price the parties measured it from. Harivansh Packaging is carried at an illustrative Rs 300/- a share, so a conversion price of Rs 375/- is a premium of 25.0 per cent. Divide Rs 375/- by Rs 300/- and take away one, and there it is.

The premium is the company’s estimate of how dearly it can sell shares to a buyer under no obligation whatever to buy them, and raising the premium does two things at once rather than one. Push the conversion price from Rs 375/- to Rs 450/- and the same Rs 1,140 crore now buys 2.53 crore shares instead of 3.04 crore. For the people already on the register that sounds unambiguously better. But the shares now have to be worth more than Rs 450/- before any rational holder would switch, rather than more than Rs 375/-. Fewer shares handed over and a smaller chance of ever handing them over are one number moving, so the two arrive together. A negotiator who claims to have won a high premium without conceding anything has described half of what happened.

How many shares does Harivansh Packaging actually hand over?

The share count is a single division, worth doing slowly for what it implies rather than for any difficulty. Take the amount raised. Divide by the conversion price. The division is the whole of it.

The 3.04 crore is fixed on the day of issue and does not move again, whatever happens to the business, the shares, the rate environment or anybody’s opinion. A fixed count is the property that makes a convertible readable at all. Nobody needs to know what the shares will be worth in order to know how many of them are at stake. The number is not an estimate, not a range and not a scenario: it is a division of two contracted figures, and if the shares are worth Rs 200/- or Rs 2,000/- on the day of conversion, 3.04 crore is still the answer. The share price decides whether the shares move at all, never how many of them move.

Notice what this does to the register. Of the 18.00 crore shares in issue, 10.44 crore sit with the promoter group and 7.56 crore make up the free floatShares not tied up with the promoter group. Being unrestricted, they are the ones that ordinarily change hands in the market.; as proportions, that is 58.0 per cent against 42.0 per cent. Full conversion leaves the 10.44 crore exactly where it is and moves only the denominator beneath it. Measured against a register of 21.04 crore, the identical holding works out at 49.62 per cent. Raising the money by placing shares at Rs 285/- instead, taking the register to 22.00 crore, gives 47.45 per cent. Neither route leaves that group above half. The slip below half is arithmetic, not a warning, and what anyone should do about it is a different question.

What happens to earnings per share while it is still a borrowing?

Here is the state most readers skip, and it is the state that lasts longest. Before anything converts, a convertible is a borrowing and behaves like one. The coupon is charged against profit, so profit falls. No share has been issued, so the share count has not moved. Both halves of the fraction do what a borrowing does.

Hold the business completely still for a moment. The instrument is then the only thing changing. Profit after tax is Rs 225 crore on 18.00 crore shares. Per share, Rs 12.50/-. Charge the convertible's coupon: Rs 45.6 crore of interest, worth Rs 34.2 crore after tax at the company's 25.0 per cent effective tax rateTax paid divided by profit before tax. A cost multiplied by one less this fraction is what that cost really weighs once tax relief has run.. Profit becomes Rs 190.8 crore. Divided by an unchanged 18.00 crore shares, that is exactly Rs 10.60/-.

Rs 10.60/- is the figure Harivansh Packaging will report for as long as the instrument sits unconverted, possibly its entire life, and it is the figure most readers of a convertible never compute at all. The habit is to jump to the converted state because that is where the interesting arithmetic seems to be. But an instrument with a 25.0 per cent premium spends its early years, and quite possibly all of its years, in the unconverted state. Skipping it means skipping the only state the company has actually been in.

And what happens on the day it converts?

Two things move in opposite directions. The coupon stops, so the Rs 34.2 crore after-tax charge comes straight back into profit and the company is once again earning Rs 225 crore. The share count rises from 18.00 crore to 21.04 crore. Rs 225 crore divided by 21.04 crore shares is Rs 10.6939/-, printed here as Rs 10.69/-.

Sit with that pair for a second. Unconverted, Rs 10.60/-. Converted, Rs 10.69/-. Nine paise apart on a figure of ten and a half rupees. Less than one per cent separates them. Whichever state the company is in, the reported number is very nearly the same.

Two figures nine paise apart are why this instrument gets called cheap, and being close to each other is not the same thing as being free. The closeness is a property of these particular terms and it is fragile. Move the conversion price to about Rs 353/- on this same profit and the two states give an identical figure. Move it below that and conversion pushes the figure down instead of up. Nothing about the instrument guarantees the near-miss; it is what Rs 375/- against Rs 225 crore of profit happens to produce. A reader who concludes from a nine paise gap that conversion does not matter has confused a small effect on one reported ratio with a small effect on ownership. The two claims are entirely different. Conversion moves 3.04 crore shares permanently, and no line of the profit statement expresses the move.

What does the whole thing look like on one set of numbers?

A raise that sits in the bank is not a raise anyone would do, so now put the money to work. The purchase on the table is Sundarban Polymers Private Limited, taken outright, and it brings profit after tax of Rs 61 crore with it. The Rs 61 crore is a rounded figure and the record says so: the exact chain gives Rs 61.35 crore, being earnings before interest and tax (EBIT) of Rs 98 crore less Rs 16.2 crore of interest on the target’s own borrowings, taxed at 25.0 per cent. Rs 61 crore is the locked value used everywhere in this subject area, so it is used here, and the rounding is named rather than buried.

Combined profit after tax is therefore Rs 286 crore. To keep the three routes honestly comparable, each of them funds the whole Rs 1,140 crore and none of them touches the Rs 140 crore of cash the company already has. Here is the instrument first.

Then the cash cost, set beside the plain borrowing it replaces.

The difference between those two after-tax burdens is Rs 42.75 crore a year, or Rs 2.38/- a share. Against a private placementNew shares sold straight to a small chosen set of investors, rather than offered to everyone who already holds the stock. of shares today at Rs 285/-, the comparison runs the other way and is about count rather than cash: Rs 1,140 crore at Rs 285/- creates exactly 4.00 crore shares, where the convertible creates 3.04 crore. The convertible therefore creates 0.96 crore fewer shares, 24.0 per cent fewer for identical money.

Now run the earnings per share of all four positions on Rs 286 crore of combined profit. Unconverted, the convertible costs Rs 34.2 crore after tax, leaving Rs 251.8 crore to divide across an unchanged 18.00 crore shares. The division lands on Rs 13.99/-, up 11.91 per cent on today’s Rs 12.50/-. Converted, the whole Rs 286 crore spreads across 21.04 crore shares and gives Rs 13.59/-, up 8.75 per cent. Borrowing the full Rs 1,140 crore at 9.0 per cent costs Rs 76.95 crore after tax. Rs 209.05 crore then has to serve 18.00 crore shares, and that comes to Rs 11.61/-, down 7.09 per cent. Placing 4.00 crore shares at Rs 285/- divides Rs 286 crore across 22.00 crore shares and gives Rs 13.00/- exactly, up 4.00 per cent.

The Rs 11.61/- needs one caution. A reader arriving from the accretion and dilution material will be carrying a different figure. The accretion and dilution treatment works the transaction as the record actually funds it: Rs 140 crore of the company’s own cash plus Rs 1,000 crore borrowed, costing Rs 67.5 crore after tax and giving Rs 12.14/-. Both figures are correct and they answer different questions, so the base has to be named every time either one is used. The gap between them is exactly the interest on the extra Rs 140 crore borrowed here: Rs 12.6 crore before tax, Rs 9.45 crore after it, Rs 0.53/- a share. Rs 0.53/- taken off Rs 12.14/- leaves Rs 11.61/-.

Three settings are worth walking to by hand. At the bottom of the control the conversion price is Rs 300/- and there is no premium at all: 3.80 crore shares go out, the register reaches 21.80 crore, and converted earnings per share is Rs 13.12/-. The middle setting, Rs 375/- at 25.0 per cent, gives the 3.04 crore, the 21.04 crore and the Rs 13.59/- already worked above. Push it to Rs 450/-, a 50.0 per cent premium, and 2.53 crore shares go out, the register reaches 20.53 crore, and the figure climbs to Rs 13.93/-.

Run the control up to its top setting and something worth noticing appears. At a conversion price of about Rs 466/-, a premium of about 55.4 per cent, converted earnings per share equals the unconverted Rs 13.99/-. Below that price conversion lowers the reported figure; above it, conversion raises it. Compare that with the isolated case earlier, where the crossover sat at about Rs 353/- and Rs 375/- was above it. The profit base changed, and the same conversion price flipped from raising the figure to lowering it. No clearer evidence exists that a nine paise gap was never a property of the instrument.

Why does the convertible beat both of the other routes?

Set the three side by side and the convertible wins every comparison the arithmetic above can run. Against the plain borrowing it costs Rs 57 crore a year less in cash and produces Rs 13.99/- against Rs 11.61/-. Against a placement of shares today it hands over 0.96 crore fewer shares and produces Rs 13.59/- even after full conversion, against Rs 13.00/-. Cheaper than debt on cash, gentler than equity on the register, and better than both on reported earnings.

In a market where three routes are priced by people who do their own arithmetic, one route being free is not a thing that happens. An instrument that beats every alternative on every measure available should prompt suspicion rather than satisfaction. The reason is not hidden and it is not subtle. The reason simply never appears in the figures. The holder handed over Rs 1,140 crore and accepted a coupon Rs 57 crore a year lighter than the going contracted rate, and accepted a conversion price 25.0 per cent above the reference. Nobody does that for nothing. The holder accepted both terms because the right received is worth something. The value of that right is the one quantity in the whole structure that none of the arithmetic above touches.

Look again at the nil-premium setting on the control. Even there, with the conversion price at Rs 300/- and no premium at all, converted earnings per share is Rs 13.12/-, still above the placement's Rs 13.00/-. The nil-premium setting looks like the convertible winning with its main advantage switched off. Nothing of the sort is happening. The placement is priced at Rs 285/-, a discount to the Rs 300/- reference, and a placement usually needs that discount to clear. The convertible was allowed to use the undiscounted number. Two instruments compared at two different prices are not being compared at all, and the only reason it passes unnoticed here is that both prices are stated.

What actually decides whether it ever converts?

One condition, stated plainly: the instrument converts if the shares are worth more than Rs 375/- when the right can be used. Below that price a holder who converted would be swapping a debenture repayable at Rs 1,140 crore for shares worth less than Rs 1,140 crore. Nobody does that on purpose. Above it, converting turns a fixed claim into something worth more than the fixed claim.

Whether that condition is met is an open question, and a plan built as though conversion is certain has quietly assumed an outcome the company does not control. A converted share count is a tidier thing to model than a conditional one, so the temptation is strong. The transaction team at Harivansh Packaging is led by Ashwin Rege, and he could write 21.04 crore shares into every forecast from tomorrow with every line still footing. Every one of those forecasts would rest on a decision taken by somebody else, on a date not yet known, on evidence not yet available.

The disciplined treatment is to hold both states and refuse to choose. Report what the unconverted state does, report what the converted state does, name the price at which the second becomes the live one, and stop. Two states are less satisfying than a single number, and two states are the only honest output the available information supports.

What was handed over, and where does it get recorded?

Two things crossed between the parties on the day this instrument was issued, and only one of them has ever been written down. Rs 1,140 crore went one way. A right, exercisable by the holder, to buy 3.04 crore shares at Rs 375/-, went the other. The Rs 1,140 crore sits in the balance sheet as a borrowing. The right sits nowhere at all.

The conversion right is a genuine transfer of value out of the existing shareholders and into the debenture holder, and the absence of a number for it in any statement does not make the number zero. Think about who paid. If the shares do well, 3.04 crore of them are bought at Rs 375/- by somebody who was never obliged to buy them, and the gain on those shares goes to the holder rather than to the 18.00 crore shares already on the register. If the shares do badly, the holder walks away with a debenture and the existing shareholders keep everything. The asymmetry is precisely what makes a right of that shape worth paying for.

Valuing it is an option valuation, and it is covered separately in the derivatives layer. Do not attempt it from here, and be very careful of the shortcut that looks available: the coupon gap of Rs 57 crore a year is not the value of the right. The gap is a price two parties agreed, in a different unit, over a period nobody has fixed. Treat it as evidence that somebody has already valued the right rather than as the valuation itself.

The reporting question is separate again. How an unconverted convertible is reflected in a company's published earnings per share figure, on what is usually called an if-converted basisA way of restating earnings per share as though a convertible had already become shares, so a reader can see both states side by side., is an accounting matter settled by the Institute of Chartered Accountants of India. Both states are computed and printed above, and the reporting rule itself sits with that standard.

How does anyone actually use this in practice?

Four sets of hands pick this instrument up, and they read it for four different things.

A lender who has already lent to Harivansh Packaging cares about one thing before anything else: while the convertible is unconverted it is a borrowing, and it ranks alongside the rest. The company's borrowings do not become gentler because the coupon is small. A covenant struck on borrowings is struck on the amount, not on the cost, so a lender reading a leverage covenant counts Rs 1,140 crore of debt whether the coupon is 4.0 per cent or 9.0 per cent. The low coupon does buy interest cover. Rs 45.6 crore of charge is easier to cover from Rs 339 crore of EBIT than Rs 102.6 crore would be. So the same instrument improves one test and leaves another untouched, and a lender who reads only the one it improves has been handed exactly the reading the borrower would prefer.

An equity analyst does the opposite: computes both earnings per share states every time, and never quotes one without the other. The habit that separates a careful note from a lazy one is stating the share count as a pair rather than a number. Anyone reporting 18.00 crore shares for Harivansh Packaging without adding that 3.04 crore more exist on a fixed condition has reported a fact that is true today and misleading about tomorrow.

An investor whose name is already in the register asks a narrower question: what becomes of my slice? The arithmetic runs quickly. The 10.44 crore promoter holding measures 58.0 per cent of the register today and 49.62 per cent after full conversion. For a small holder the proportions differ and the mechanism does not. The useful question is not whether dilution happens but what came in through the door in exchange for it. On these facts, Rs 1,140 crore bought a business earning Rs 61 crore after tax.

A household meets the same structure far more often than it realises. A phone sold on a zero-interest instalment plan is not free credit; the finance charge is inside the sticker price, and the cash price at the same shop is lower. A relative who lends money to a small business at a friendly rate and takes a share of the upside is running a convertible. In every case the same rule transfers without alteration: when a price looks below the going rate, whatever was given in exchange is there to be found, and failing to find it proves nothing.