Finance

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

The post-election rally in pharmaceutical stocks has created an opportunity for drug-makers to raise money. Step forward Bayer AG. The German life sciences group needs to find $19 billion of equity to help fund its all-cash $66 billion takeover of U.S. seeds giant Monsanto Co. This week it found nearly a quarter of that -- and got a decent deal too.

Late on Tuesday, Bayer sold 4 billion euros ($4.3 billion) of an unusual security called a mandatory convertible note. These start life as bonds, but investors get repaid in shares instead of cash at maturity.

Back To The Future
Bayer got its 4 bln euros fundraising done at 90 euros a share, roughly its average stock price in October.
Source: Bloomberg

At first glance, the terms look expensive for Bayer. It's paying an annual 5.625 percent coupon on the bonds prior to their conversion into Bayer shares in November 2019, whereas the company's existing bonds are yielding less than 1 percent. That also compares with a dividend yield of about 3 percent on the stock. The approximate 2.5 percentage points of extra yield is worth almost 300 million euros to the note investors, compared to what they'd get from simply owning Bayer shares.

However, what Bayer pays away on that juicy coupon (itself tax deductible), it is likely to make back -- and then some -- when the notes convert into shares at maturity. This is thanks to some fiendish terms.

To see how this works in practice, imagine if investors had simply bought 4 billion euros in Bayer stock at 90 euros each -- its level when the mandatory convertible was hatched. If the share price climbs 20 percent over the next three years to 108 euros, they'd make 800 million euros. By contrast, investors in the note would make nothing: they get back whatever number of shares is worth 4 billion euros. Under the notes' terms, this applies if Bayer shares rise by anything up to 108 euros.

If the share price climbs above that, the terms give the note investors 83 percent of the gains enjoyed by pure equity investors. Imagine Bayer's shares rising a further 18 euros to 126 euros. Stock investors make another 800 million euros. The note investors make only 667 million euros. All the value forgone by the note investors is kept by Bayer.

Worse, if Bayer's share price falls, the note holders suffer losses in the same proportion to equity investors.

It seems a bit bonkers that investors have swallowed these asymmetric terms just for some tasty short-term yield. Yet many have lapped up the offering. Why?

It's unlikely any of these investors were buying the notes as a straight investment -- the returns just aren't good enough. But getting into the notes would have two big pluses, especially for hedge fund investors.

First, it puts them on Bayer's radar before the really big equity issuance comes in the form of a 14 billion euros rights issue. That's an event that hedge funds can make money trading around. For example, support for the mandatory convertible might put them in a better position to receive an allocation of surplus rights issue shares.

Second, the mandatory is a chance to make money by churning Bayer stock in a so-called "delta hedge" trade. Investors in the notes are assured that they are going to receive a big block of Bayer shares in 2019. That lets them take out a corresponding short position, which provides an opportunity for some trading profit.

The investment banks behind the mandatory know this and actually helped facilitate it. They arranged the placing of about 1.6 billion euros of Bayer stock to create short positions for the hedge funds. So all the components of the delta hedge trade were there on a plate for investors. No wonder this combination of convertible issuance and stock shorting is dubbed a "happy meal" in the industry.

A Martian looking down at all this would find it a needlessly complex way of raising money, with layers of fees at every step. But Bayer's financing requirements are colossal. If it can raise money on okay terms it won't care how it does it.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Chris Hughes in London at chughes89@bloomberg.net
Marcus Ashworth in London at mashworth4@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net