Overview
- Frequently, a seller of a business will receive publicly traded shares of the buyer as part of a tax-free stock-for-stock exchange. The structures set forth herein allow the seller to monetize such shares in a tax-efficient manner
- To monetize the shares received in the exchange, the seller can enter into a derivative capital markets transaction or a derivative with its investment bank; examples of such are as follows:
- Mandatory Exchangeable Notes: A security issued by the Seller (i.e. holder of the Buyer’s shares) that mandatorily converts into Buyer shares after a designated period (usually 3-5 years); at the time of the mandatory exchange, the Seller incurs tax as if it had sold its Buyer shares
- Standard Exchangeable Notes: A security issued by the company which is exchangeable, at the holder’s option, into shares of the buyer; the term of the exchangeable security can be up to 30 years, allowing the company to accomplish tax deferral over a more significant period of time
- Collar Coupled with Loan: Seller enters into a put and call arrangement with its investment bank hedging its risk on buyer’s shares and borrows against hedged position. Hedge can typically be put on for up to a 10-year deferral period
- In addition to these strategies, the investment bank can develop a monetization strategy tailored to the Seller’s particular tax, accounting, and regulatory objectives
- Precedent transactions: Liberty/Media One
Mandatory Exchangeable Notes – Key Structuring Issues
- 3-5 year non-callable debt securities, which mandatorily exchange into underlying Buyer common stock, or its cash equivalent, at maturity at the Seller’s option
- At maturity, the number of Buyer shares delivered is calculated using the 20-day share price average
- The value due to investors at maturity can be either cash or stock settled; investor has no conversion option
- Senior Note is an obligation of the Seller
- Seller maintains ownership of underlying Buyer shares
- Number of shares delivered at maturity varies depending on the buyer’s stock price such that the Seller retains all of the first 20% of stock price appreciation and 17% of all subsequent appreciation
- Quarterly coupon payments are higher than the underlying Buyer common stock dividends to compensate investors for giving up a portion of the upside
Standard Exchangeable Notes – Key Structuring Issues
- Exchangeable notes rank as Seller senior debt, typically issued at 100% of face amount, although can be structured on an original issue discount ("OID") basis
- Exchangeable into a fixed number of underlying Buyer common shares
- Conversion premium remains fixed throughout life
- Generally callable after 3 years, but the non-call period can be extended and result in more aggressive pricing
- If not converted, the principal amount is redeemed in full by the seller at maturity
- The seller may keep a cash settlement option even if the note is in-the-money, but this may narrow buying universe
- Can be structured with high conversion premium and correspondingly high coupon
Transaction Structure
Step 1 – Stock-for-Stock Exchange | |
![]() |
|
Step 2 – Monetization | |
![]() |
|
Exhibit A – Exchangeable Notes – Advantages & Disadvantages
Advantages | Disadvantages | |||
Mandatory Exchangeable |
|
|
||
Standard Exchangeable |
|
|
Exhibit B – Comparison of Monetization Alternatives
Alternative | Risk Transfer | Monetization | Tax | Accounting | Credit | |||||
Mandatory Exchangeable |
Complete elimination of downside exposure; some retained upside interest | Full | Deferral for 3-5 years; interest capitalized in excess of yield on underlying security | Hedge accounting available; little earnings volatility | Little net credit impact | |||||
Traditional Exchangeable |
Some retained upside interest; full downside exposure | Full | Deferral for 5-30 years; interest capitalized in excess of yield on underlying security | FAS 139 permits mark-to-market election; little earnings volatility | Substantial credit impact (on balance sheet financing) | |||||
Collar/Loan | Small upside interest and downside exposure (i.e. within collar) | Less than full (ability to leverage non-recourse against asset) | Deferral for term of collar/loan, typically 1-5 years; interest capitalized in excess of yield on underlying security | Hedge accounting available; little earnings volatility | Little net credit impact (non-recourse loan) |