The "death spiral convertible" might sound like your last car, but it's a bond -- and it's making an unlikely comeback on Wall Street. These much-maligned securities, whose conversion into common shares can be triggered by precipitous drops in a company's stock, all but disappeared from the market three years ago. The near extinction occurred as investors got wise to the deleterious impact an endless flood of new shares can have on price. Subsequent allegations of manipulative trading by some of the hedge funds that invested in these deals looked to be the death knell of the death spiral convertible. Those allegations ultimately spawned a regulatory investigation that led to a number of enforcement actions against hedge funds accused of illegally profiting from declines in stock. Over the past year, however, there's been a surprising revival in the market for death spiral convertibles -- known officially on Wall Street as "floating convertibles.'' In particular, small, cash-strapped companies with market capitalizations often under $100 million are selling these bonds to hedge funds in deals covered by the Wall Street acronym PIPEs, or private investments in public equity. The resurgence in death spiral deals may be an indication that tiny, cash-strapped companies are finding fewer options for raising money. This year, 10% of the 478 completed PIPE deals brought to market have been death spiral transactions. By comparison, just 1.9% of all PIPE deals in 2003 were categorized as death spirals, according to research firm PlacementTracker. (PlacementTracker officially calls them floating convertibles). Last year, death spirals accounted for 6.4% of the $20 billion-a-year PIPEs market. Death spiral deals peaked in 1999, when they represented 20% of all PIPE transactions. Some of the companies that have done death spiral PIPE deals with floating conversion prices this past year include Generex ( GNBT) and Vasomedical ( VASO), according to PlacementTracker.
So far, two hedge funds are leading the way in investing in death spiral deals. Over the past 12 months, Cornell Capital Partners has emerged as the top investor in death spiral transactions, sinking $175 million into 42 deals. In second place is NIR Group, which has invested $77 million in 40 transactions. No other hedge fund comes close to Cornell Capital or NIR, says Robert Kyle, executive vice president of Sagient Research, the parent company of PlacementTracker. Mark Angelo, the founder and president of Cornell Capital, a $500 million fund located in Jersey City, N.J., declined to comment. Corey Ribotsky, the manager of Roslyn, N.Y.-based NIR Group, did not return several phone calls. NIR Group has $486 million in assets under management. PIPE deals, of course, come in all shapes and fashion. But almost every deal involves the sale of discounted shares to a group of hedge funds. Death spiral PIPEs got their unsavory reputation because, unlike typical convertible bonds, which get converted into shares only when a stock rises to a fixed price, the conversion price for these notes keeps getting adjusted downward whenever the underlying stock falls. The drop in the stock price also means the buyers are entitled to receive more shares when the conversion occurs. The floating convertible feature is intended to be an embedded hedge to protect investors in the event the stock doesn't rise in price after the deal. But, in the past, some unscrupulous hedge funds that bought the bonds saw the floating conversion feature as an invitation to make money by literally shorting the stocks to death. In many cases, those hedge funds violated contract provisions forbidding any shorting of the company's stock. (Nobody has lodged such allegations about Cornell or NIR.) A short sale is a market bet that a stock will fall in price.
To some degree, every PIPE deal, not just death spirals, is a bit of a Faustian bargain for a company. In selling discounted stock or a bond that converts into discounted shares, the company hopes all the extra shares coming into the market won't depress the price of its stock. PlacementTracker reports that six months after a death spiral convertible is placed, the stock of the issuing company is down, on average, 7%. Yet, ironically, death spirals are not the worst-performing PIPE deals. PlacementTracker says companies that sell bonds with a so-called "convertible reset'' conversion provision often see their shares plunge by 26% six months after doing a deal. A convertible reset PIPE is a modified death spiral that doesn't have an endless conversion feature. Indeed, the NIR Group, which mainly invests in death spiral PIPEs, reports having some stellar annual returns. The NIR Group's AJW Offhore hedge fund is up 6% this year, after rising 17% last year, according to a report sent to the hedge fund's investors. One hedge fund manager who didn't want to be identified says most investors in death spiral deals want a company's stock to go up. He says the floating convertible is intended to provide protection to investors. He says there's more money to be made from a company's stock rising than falling. The hedge fund manager says death spirals unfairly got a bad reputation because of abusive short-selling by some rogue hedge funds. Casper Hallas, a portfolio manager with Denmark's Scandium Asset Management, agrees with that sentiment. He says his fund invested with the NIR Group because he likes PIPE deals with a floating-conversion feature. He says the downward-conversion feature provides added protection for investors. "If the market goes down, you convert at the lower rate,'' says Hallas. "Having a floating rate is a little bit like riding a put.''