Merrill convertible analysts say takeover protection priced into market; limitations still exist

By Ronda Fears

Nashville, May 16 - Merrill Lynch & Co. convertible analysts said in a report Monday that cash takeover protection features, now included on virtually all new issues, are priced into the market and have provided no out-performance to those issues compared with those without such measures. The analysts also found that limitations to the level of protection still exist.

"It was good to be invested in convertibles with cash takeover protection in 2004, but there has been no discernable outperformance by CTP convertibles since then, as their structure differentiation appears to be already priced in," the analysts said in the report.

There are three recurring types of cash takeover protection, the analysts found. Additional-shares protection increases the conversion ratio over a limited period of time, based on a matrix of prices and dates. Percent-of-principal protection provides an additional payment, based on a matrix of prices and dates. And market-price-premium protection provides an additional payment equal to: the average convertible price, prior to takeover announcement; minus or the greater of the par value of the convertible and the average conversion value of the convertible before the takeover announcement.

Buyers beware

As cash takeover protection language continues to evolve, Merrill analysts suggest it is very important for convertible investors to understand the shortcomings of the protection offered to them and to exercise their power to influence the specifics of the terms for the better.

They specifically pointed out the downfalls of "public acquiror protection," seen in more recent cash takeover protection clauses, which in the event that a public company acquires a convertible issuer's stock for cash, the convertible issuer has the right to have the convertible's conversion terms adjusted so the security becomes convertible into the common stock of the acquiror on fair terms.

In the unique case of the Maverick Tube 4% convertible due 2033, the analysts noted that it is the only cash takeover protection available. Were Maverick Tube acquired by a private company for cash, its convertible holders would get no protection against their loss of premium. Interestingly, the analysts point out, Maverick Tube included this "sweetener" as part of their CoCo exchange offer along with a 25 basis point cash "kiss," which was accepted by 96.2% of the then-current holders.

"We caution investors against accepting such inadequate protection in the future," the Merrill analysts said.

This clause effectively transforms a non-stock merger into a stock-for-stock merger, they said, and exposes holders to potentially negative implications of a merger, like lower underlying stock volatility going forward. But, on the flip side, they added, without the clause, holders would not get to benefit from potentially positive implications of a stock-for-stock-type merger, like credit improvement.

Proactive action necessary

Cash takeover protection language includes other features besides the broad type of protection, which can affect a convertible's ability to qualify for compensation, like protection-triggering actions, forms of merger compensation, minimum non-stock portion, etc.

For example, the analysts found that there is no protection for in-the-money convertibles with takeover protection triggered only by a put-back at par.

Moreover, a cash takeover event often requires a certain action by a convertible holder, such as protection only following conversion or protection only on conversion or put.

There also is protection offered only on exercise of a put and not on conversion, the analysts said. Importantly, the analysts added, this triggering action will not provide adequate protection to some at-the-money and most in-the-money convertibles, and warrants their takeover protection value to be discounted relative to more accommodating triggering action types.

Protection offered if the convertible is not put is rare, they said, but found on the Empire Resorts 5.5% convertible due 2014, which is governed by the percent of principal cash takeover protection method. Similar to the conversion-only triggering action, when convertibles trade out-of-the-money even after takeover announcement, investors would have to compare the value of the change-in-control put plus the accrued interest against the value of the conversion value plus the additional takeover protection compensation, and pick the higher of the two.

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