3 risks Merrill investors face

NEW YORK (Fortune) -- Merrill Lynch took additional steps to shore up its depleted capital base today when it sold $6.6 billion in preferred stock to a group of investors including Mizuho Financial Group Inc., the Kuwait Investment Authority and the Korean Investment Corp.

Devastated from a nearly five-year attempt to dominate the once super-lucrative CDO underwriting market, Merrill's new chief executive John Thain has, including this sale, accepted $12.8 billion in capital injections - and sold off a unit - to stabilize the firm's once rock-solid balance sheet. On Thursday, according to The New York Times, the firm might announce as much as $15 billion in further write-downs, primarily in its CDO book.

While it is clearly one of CEO Thain's primary tasks to bring in the capital to keep Merrill's diverse businesses running and preserve financial flexibility, the moves were not without some risk.

The first risk is dilution. In just under three years, the convertible preferred securities will convert into common stock and become freely exercisable. When that happens, tens of millions of Merrill (MER, Fortune 500) shares might not only hit the market - and the share price - but will dilute the key earnings-per-share ratio.

The second is cost. According to Merrill's release, the firm has to pay a hefty 9 percent dividend on the convertible preferred stock - $594 million annually - to the investors in the latest round.

Veteran securities lawyer Steve Siesser of Lowenstein Sandler says that's the type of trade-off a CEO in a pinch has to make.

"This deal was likely attractive to Merrill for all the reasons a PIPE [private investment in public equity] deal is attractive to smaller companies: speed and flexibility," said Lowenstein Sandler's Siesser. He said that the firm avoided a prolonged registration period - mandated in all rights or standard share offerings - and skirted having to issue possibly restrictive and longer-term debt.

A third concern is the passive nature of the investment.

Merrill seemed to place great emphasis in the fact that neither money manager nor sovereign wealth fund investors seek seats on its board nor would they demand a role in the firm's management.

That is undoubtedly great comfort to Merrill's new management, who now have a free hand cleaning up the results of the Stanley O'Neal regime's bet on sub-prime and CDO trading and origination.

It is perhaps less of a comfort to more modestly sized shareholders.

They will have no vocal - or even behind the scenes - advocate on a board that approved the likes of the $1 billion purchase of sub-prime mortgage origination powerhouse First Franklin in 2006, or that allowed its balance sheet to be used to store multiple billions in CDOs long after the firm's clients lost interest in the paper.

Like Lowenstein's Siesser said, there are trade-offs in everything.