A Most Sinister Form Of Financing
(FORTUNE Magazine) – If Dr. Evil were an investment banker, he'd surely be out hawking financing instruments known as death-spiral convertibles. These are bonds or preferred shares with terms so onerous that only companies with no alternative for raising capital would even consider issuing them. "It's desperation financing," says David Beim, a finance professor at Columbia University. Still, 23 companies (from video distributor e-VideoTV to telecom outfit Science Dynamics) issued $123 million of these noxious instruments in 2001, according to PlacementTracker.com. For the convert holders (hedge funds, typically), death spirals are a pleasure. But for unwitting shareholders, they can be torture.
Here's why. Unlike normal convertibles, which can be swapped for a fixed number of shares, death spirals can be converted into a fixed dollar amount of common stock (equal to the convert's price). So if the stock tanks, the death-spiral owners will scoop up more shares. And when they convert, they'll get a discount off the market price of the stock. That's great for them, but shareholders usually face severe dilution.
It gets worse. Hedge funds often short the issuer's stock at the same time they buy the converts. That creates a win-win scenario for the hedgers: If the stock goes down, they make money by converting and using the low-cost shares to replace the stock they borrowed when making the short sale. If it goes up, they make money by converting the bonds or preferred stock into common shares and selling them.
For shareholders the deals are almost always a losing proposition. In 2001 ten companies with death spirals bit the dust, including online retailer eToys and Internet comics company Stan Lee Media. (Of course, hedge funds that had shorted the stock still came out on top.) Companies that have issued the converts in the past two years have seen their stocks plunge by an average of 80%. Of course, the death spirals aren't the root cause of the problem; most companies that turn to this form of financing would qualify for a spot in the Business Model Hall of Shame. But there's no doubt that the death spirals hastened their downfall. Warning to shareholders of companies that issue such instruments: Even Austin Powers won't get you out of this one.