Editor’s note: Robbie Goffin is a senior adviser at FTI Consulting. Prior to that, he spent two decades on Wall Street where he developed advisory relationships with institutional investors and senior executives across a broad range of industries.
Uber just completed a $1.6 billion, six-year convertible debt raise via Goldman’s private wealth group. “But Robbie,” you say, “how do you even put a value on a convertible bond if there isn’t any stock to convert the bond into?” A great question, and one that has a number of significant implications. Since we’re all friends here, let’s go ahead and think about this.
A typical convertible bond gives the bond holder the option to convert the debt into a predetermined number of shares at a predetermined price at some point in the future. Which is to say, a convertible bond looks an awful lot like a stock call option – the option to buy stock at a certain price (the strike price) at a certain date in the future.
The difference is that when we buy call options, they may well expire worthless because the stock did not trade above the strike price – and thus, we spent money on something that turns out to have no value. If we own a convertible bond, we are a lender with an option, so even if the stock never trades to a price that lets us exercise the conversion option at a profit, at the end of the day, the company still owes us our money back (the principal). In return for giving us this stock option, which certainly has some value, the borrower pays a lower rate of interest.
Now, when you’re borrowing, say, $1.6 billion over six years, each 1 percent less paid in coupon interest is worth $16 million per year, or $96 million over the life of the bond. Save 3 percent and you’re talking about real money.
The other side of the coin is that putting a value on options is tricky. A lot of people with very sharp pencils spend a lot of time doing it, and if they get it right they get Nobel Prizes (Black and Scholes, anyone?) and even those guys get it spectacularly wrong from time to time (Myron Scholes was famously on the board of Long Term Capital Management).
So how do we do it?
A key factor in pricing these options is the price volatility of the underlying stock, which makes sense on the face of it. If I give you the option to buy a stock one year from now at $11, and it trades at $10 today, you could spend a lot of time trying to guess whether the value of the company is going up. Maybe you like management, maybe you think the company is very good at what it does, maybe you have a strong opinion of the sector it operates in, maybe you just feel lucky.
Alternatively, knowing nothing about the company, we could look at the price volatility of this particular stock over time. Let’s say we discover that in the last 10 years, the stock has been incredibly predictable, and in any given year has either gone up or down within a very narrow band, say plus or minus 5 percent in value. Which is to say, an option to buy equity at $11 when it trades at $10, or a 10 percent move in value, knowing its history of very low volatility, regardless of what we know about the actual company itself, doesn’t seem likely to pay out.
In a second scenario, imagine looking at the stock and discovering the thing goes up and down wildly all the time – say 25 percent in any given year. Now, the option to buy the stock for $11, when it is trading at $10, seems like a much better bet (even though we bear in mind that it could just as easily go down 25 percent as go up 25 percent).
In this case, we are willing to pay more for the option on the more volatile stock, because our odds of having it pay out profitably are higher. The math agrees with these scenarios, and those interested can Google “binomial expansion.”
In both cases, the longer the option exists, the more value it has, which again makes intuitive sense – there is simply more time available for the stock to move above its strike price and pay out for us.
Finally, I’ll note that in a typical convertible bond issue, investors can protect themselves against a deterioration in the health of the company because, owing to the fact that they have an option to buy shares of the company at some point down the road, they can always short the stock today and get it back, guaranteed, in the future thanks to the option. Note that you don’t have to do this, but the point is, you can.
All of this is what makes the Uber convertible so fascinating to think about from a financial point of view.
First of all, there is no publicly traded stock, so a key component of valuing the option to convert to equity, its observable historical price volatility, is absent (other than the noteworthy fact that Uber’s implied value thanks to various funding rounds grew was $3.4 billion in the summer of 2013, was $18.2 billion the next year, and right now the financial press seems to have settled on $40 billion).
How, then, do we generate investor interest in a convertible bond that is extremely difficult to accurately value?
Goldman appears to have solved this problem several ways:
- It appears that the bond will give the holders the right to convert to Uber stock at a 20 to 30 percent discount to its IPO price at the time of an IPO.
- To incent the company to go public, the interest rate on the bond will increase over time.
- Notably, Goldman sold the bonds to people (its private wealth clients) and not institutions. Institutional investors don’t buy lottery tickets, but people do.
This particular convert is what we used to call “innovative” on the trading floor, a sometime sales synonym for gimmicky.
What it tells me is that we have arrived at a point where institutional investors have balked at making additional equity investments in Uber at the current $40 billion implied value of the company. Smart money or, at least, private equity capital that is interested in growth scenarios doesn’t see much room for Uber’s valuation to grow.
So, to maintain the current implied value of the company, additional funds have come in the form of this “convertible debt.” However, where a typical convert would carry a strike price higher than the current stock price, the Uber convert is simply a six-year placeholder to let you in to the IPO (if there is one) at a discount.
Consider an alternate scenario where there was an agreed equity value for the company (in this case, the $40 billion). The convert could have been structured with that floor value as the basis for calculating the value of the equity conversion option, which would again have implied all parties believe that there is the option for growth off that floor. Said differently, the bankers didn’t say “we all agree this thing is worth $40 billion, we’ll give you an option to get stock if it hits $45 billion in the next six years.”
For a company that grew its equity valuation from $3 billion to $18 billion to $40 billion in a just few years, it appears to have been strangely difficult for Goldman to have sold the value of a call option – especially one that, in this case, lasts for six years.
So perhaps neither the borrower (Uber) not the lenders (rich people) really thought there was a chance for this thing to get bigger. This isn’t damning per se, but you don’t often want to be in a situation, either while looking for additional equity or before launching an IPO (which this convertible basically puts a time stamp on), where you’re saying “yeah, we did the math and we don’t really see ourselves worth much more than where we are today.”
Now, after all this, let’s be clear that buying these converts might turn out to be a great trade, and there are a lot of missing details here that preclude a serious analysis on my part.
Still, for a company losing money, which I assume Uber is doing as it tries to grow internationally (as well as gaining permission to operate in multiple domestic markets) debt capital is risky. Lenders are people you have to repay.
$1.6 billion in presumably low-coupon debt shouldn’t be an undue burden, but Uber now complements its aggressive business strategy with an arguably aggressive capital structure.
It will be interesting to see how both play out.