Stock-for-Stock Monetization

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

 

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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
  • Buyer acquires Sub shares from Seller in exchange for Buyer common or convertible preferred stock
  • If Buyer convertible preferred stock is utilized, must constitute participating preferred stock of long-term preferred stock (i.e. maturity of at least 20 years) to qualify as tax-free to Seller
Step 2 – Monetization
  • Seller enters into a derivative capital markets transaction or a derivative with its investment bank with respect to its Buyer shares, which monetizes the shares without triggering any current tax liability

Exhibit A – Exchangeable Notes – Advantages & Disadvantages

Advantages Disadvantages
Mandatory Exchangeable
  • Seller maintains ownership of Buyer shares until conversion
    • Receives dividend and has voting rights
    • Captures Dividends Received Deduction
  • Certainty of sale at current market price of higher while taxable event deferred until shares sold or delivered
  • High coupon costs
  • Interest is likely to be capitalized into basis in shares under Straddle Rules
  • Hedge Accounting – possible to structure with no mark-to-market mismatch
Standard Exchangeable
  • Seller maintains ownership of Buyer shares until conversion
    • Receives dividends and has voting rights
    • Captures Dividends Received Deduction
  • Provides for long-term deferral of capital gains taxes on appreciated shares
  • Not a definitive sale of Buyer shares
  • Longer-term structures will result in high coupons or lower conversion premiums
  • Interest is likely to be capitalized into basis in shares under Straddle Rules
  • Under FAS 159, possible to mark-to-market instrument with underlying asset to avoid mismatch caused by earnings volatility

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)

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