Some of the more eye-rolling moments in meetings with company management teams occur when the CEO argues that the stock market grossly undervalues his or her company. A slide listing a half-dozen or more “comps” then appears, each with a market capitalization two to ten-times greater than the CEO’s poor, misunderstood company.
Sometimes the CEO is right: his or her company has yet to attract the attention of investors, and time arbitrage should result in a higher valuation. But more often the CEO is half-correct. In these instances the “irrational” market has indeed placed too low a value on the company’s assets. But here the CEO misses a more important point: that the market has rationally chosen to ignore the value of the underlying assets of the company, instead focusing (correctly) on the stock price as an entity in and of itself, disassociated from the company, and a derivative of something else.
A share of common stock should represent ownership of a percentage of the assets of the issuing company, or a % of the discounted future cash flows of the company. But sometimes a share of stock is a just a share of stock, a free-floating financial widget whose value floats merrily along, ignorant of any value added to the company’s assets. In these cases, the company’s management, board of directors and the investment bankers advising the company have inadvertently conspired to weaken the connection between company progress and movements in the share price.
The cap structure of a company is the combination of debt and equity used to build and grow the company. Carefully constructed, the cap structure seeds the company with equity ownership, finances its large capital equipment needs using debt that can be repaid from the cash flows generated by that equipment during the useful life of that equipment, mortgages land against the underlying value of that land, and overall lets a potential investor know exactly what he or she is purchasing with an investment in the company’s common stock. A clean, logical cap structure tells a story of prudent financial management, transparent ownership, and proper alignment of the incentives of management, equity owners and debt holders.
A poorly constructed cap structure, one that contains unjustified layers of preferred ownership and convertible debt or fully diluted share counts wildly inflated by warrant pools, attests to haphazard and careless company financing, a condition that can make an otherwise interesting company completely uninvest-able.
A common component of these black-hole capital structures is the large pools of warrants issued by the companies with each secondary stock sale. Warrants are call options issued by the company, usually with strike prices 10-15% higher than the price of the stock at the time the warrants are issued, and with typical five-year expiration dates. In theory the warrants provide the basis for a subsequent financing; if the stock rises, making the warrants “in the money,” the warrant holders exercise the warrants and purchase stock from the company at a discount. In reality only a small percentage of in-the-money warrants are exercised until the expiration date nears; the rest are kept in a portfolio, often used as the basis for a hedged short sale.
In very volatile sectors, like the life sciences sector in which I invest, the ability to strictly define the exposure of a stock sold short is unusual, and the opportunity to hedge a portfolio with defined risk is very valuable. If a portfolio manager owns warrants and sells short the stock of the company that issued the warrants, he or she risks nothing more than the strike price of the warrants for each share sold short. For example, if he or she thinks a stock is expensive and sells the stock short at $5, the potential loss is unlimited if the judgment is wrong and the stock moves to $8, $10, $25 or higher. Owning warrants, however, the risk is strictly limited to the strike price of the warrant. If the stock runs the manager can easily cover. Even better, if the manager sells the stock short and the stock price drops, he or she can cover the short sale in the open market, reap the profits from the trade – and still own the warrant. When the shares rise again the process can be repeated, each time with a well-quantified risk. When a large number warrant holders hedge their portfolios is a similar way, the underlying stock has difficulty rising too far above the strike price of the warrant. A similar process occurs with convertible debt, which can effectively cap the common stock share price around the conversion price of the debt.
If you ask a banker, he or she will tell you that “straight common” deals appeal more to fundamental investors, and “heavily-warranted” deals appear to arbitragers, who in many cases immediately sell the common stock and “ride the warrants.” Of course these definitions can be fluid and there are exceptions to this scenario. The most important exception is when a single investor, or small group of fundamental investors structure a common + warrant deal with the intention of exercising the warrants after a milestone is reached. Much like venture capital investors who tranche an investment in an early round. But the combination of fundamental investors and arbitragers investing in a deal can create a prisoner’s dilemma when dealing with the warrants. If some of the investors derivatize the common stock by shorting against the warrants, then all of the investors are harmed; especially those who continue to hold both the stock and the warrants as pure long positions within their portfolios.
This should be preventable. Limiting the duration of warrants to six or twelve months would remove this unintended derivatization of the company’s stock, as investors would face the expiration and loss of any value the in-the-money warrants possess unless the warrant is exercised. But the five-year duration is pretty much an industry standard, for no obvious reason, and companies create unnecessary downward pressure on their stock prices, an outcome more rational than the process that created it.