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Convertible Bonds Gain Following as Newest IPO-Entry Technique

At least two big Wall Street firms are working on deals in which investors buy bonds to guarantee an invitation to a hot IPO.
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The market for new issues may be so hot that investors will buy bonds just to guarantee an invitation to a company's IPO.

In an unusual twist, some investment bankers are engineering offerings that involve private companies selling bonds that convert into common stock, even though the companies have yet to even file for IPOs. The bonds then would be swapped for stock in an IPO.

At least two major Wall Street firms are talking to companies about issuing these so-called "going public convertibles," according to bankers at the firms. Neither banker wanted himself or his firm identified. One banker, who requested anonymity, says he already is talking to about a half-dozen tech and Internet companies about issuing convertible IPOs. He declined to name the companies involved.

Last June,

Donaldson Lufkin & Jenrette


underwrote a $100 million convertible IPO for

Conxus Communications

, a Greenville, S.C., communications company that markets a pocket-sized answering machine. But it was the first such deal in eight years, says the second banker. The company has not yet filed to go public.

"These instruments are very attractive to dividend investors who previously couldn't get into IPOs," says the first banker, adding that he expects to bring his firm's first convert IPO to market soon.

Issuers like the offerings because they bring capital to expand prior to going public, which can result in a higher valuation when the IPO does happen. They also like them because the convertibles can be structured as zero-coupon bonds, meaning the interest on the bonds is put off, ostensibly until the bond matures or the company goes public. And, of course, the companies figure they get to ultimately pay with stock, not cash.

But Barry Newman, head of technology banking at

NationsBanc Montgomery Securities

, a


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unit, says convertible IPOs are dangerous, too. A company that sells the bonds based on a high valuation for itself could face steadily climbing interest rates on the bonds if it fails to go public, Newman says.

"These convertible IPOs are designed to cause you to go public," he says.

Within investment banking circles, the possibility that convertible IPOs will become commonplace is much like the anticipation about establishing colonies on the moon: We've been there a couple of times, but that doesn't mean they're paving the parking lot for a


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"Pre-IPO converts are pretty much a backwater," says Larry Wieseneck, a senior vice president on the global convertible origination desk at

Lehman Brothers

. "People talk about them all the time, though."

The deals would need a particularly heated new-issue market, since, in many cases, investors are buying into the convertible issue only to secure a spot in the IPO, says Wieseneck, who believes the market may already have cooled too much.

"By the time bankers and issuers dust off an idea like pre-IPO convertibles and then allow some time for investors to get their arms around the concept, they end up having to wait for the next heated period," he says.

One possible reason for some investment banks pitching this instrument now is because of the heavier competition in the convertible arena. Convertible issuance has slowed since last year's record pace, and more banks are fighting for a piece of the smaller pie.

There have been 18 convertible issues raising $7 billion this year through April, compared to this point in 1998, when 74 convertible issues raised $15 billion en route to a record $33 billion year, according to

Securities Data


The concept of the convertible IPO is simple in theory, although there are always different wrinkles depending on the needs of the issuer, several bankers explain. For example, if an Internet company wants to issue a convertible IPO, its investment bankers will set a valuation on the entire company, or possibly just the portion of the company that will be sold in the IPO. Let's say the valuation is $500 million.

Then a convertible will be priced with a coupon, about 6%, and a conversion premium, about 10%. (The conversion premium dictates at what price the bonds can convert into common shares. A 10% conversion premium, for example, would mean the bonds convert at the price of the stock plus 10%.) The bonds are sold, and investors eager to secure a spot in the company's IPO snap them up. But if one year goes by with no IPO, the coupon on the bonds goes to 8% and the conversion premium falls to 5%.

In the IPO, the company sells $100 million in shares, but it also sets aside another $100 million worth of shares for the convertible bondholders. "Unfortunately, sometimes these converts cause an overhang on the IPO," Wieseneck says. "There ends up being a lot of people at the table."

This is a simplified example to be sure, and other structures often discussed include simply having the convert represent pre-IPO financing that is simply paid back by giving the investors a chance to buy IPO shares at a discount, bankers say.

Yet, regardless of how they're structured, convertible IPOs look like they're actually about to appear.