Understanding corporate finance: raising finance: the cost of borrowing: hybrid debt
Certain types of borrowing are often referred to as ‘hybrid’ debt, because there have both debt- and equity-like features. The most common example is debt that is convertible into the shares of the issuing company. This type of debt shares many of the features of Cumulative Redeemable Participating Preference Shares (CFM11020).
A borrower may reward a lender by letting the lender convert the debt into shares of the borrowing company. This might be attractive if the value of the shares is likely to rise above that of the debt.
The shares of a company just starting up are likely to be of little more than par value at the outset. But they may increase in value as the business develops and its profit-making potential becomes clear. Suppose the company borrows £10,000 and the shares have a value of £1 at the outset, but over the five years of the borrowing they increase to be worth £5. If the company decides to reward the lender by letting the lender share in this increasing value, it might offer to convert the loan into shares at an agreed rate. Thus, if it agreed to offer one share for every one pound of lending, at the end of the period of the loan the borrower would receive 10,000 shares, which would be worth £50,000.
If these really were the terms of the borrowing then it is expensive borrowing! The reward being offered is substantial if the lender could go on to sell the shares issued for cash. The borrowing company would need to take into consideration the effect of the issue of shares on the control of the company. Would the issue of 10,000 shares mean that the original shareholders lose control of the company? On the other hand, the company may have been such a poor risk at the outset that this was the only way of enticing a lender to lend.
Convertible debt typically carries a low interest rate, because the holder is compensated with the ability to convert the debt to shares.
There are many variations of convertible debt. Some convertible securities are mandatorily convertible on maturity into the issuing company’s shares. Such securities are usually short-term debt offering a high yield.
Or a convertible bond may only allow the investor to convert if the share price increases by a certain amount in a specified period, in which case it may be known as a contingent convertible.
Instead of being convertible into the shares of the borrowing company itself, the debt may be convertible into the shares of another company, perhaps in the same group.
Debt linked to value of shares or other assets
Instead of being convertible into shares, the return on debt may be determined by reference to a change in the value of shares, or a general index such as the FTSE, or some other type of property, and the amount to be paid back fluctuates accordingly.