A retainer security is a type of security that gives investors the right to purchase additional shares of a company’s stock at a predetermined price in the future. Retainer securities come in two main forms: warrants and convertible bonds.
What are Warrants?
Warrants are securities that allow the holder to purchase a company’s stock at a set price, known as the exercise price, for a defined period of time. Warrants are often attached to bonds or preferred stocks as a “sweetener” to entice investors. Companies also issue warrants on their own as a way to raise additional capital.
Here are some key features of warrants:
- Exercise Price – This is the pre-determined price at which warrant holders can purchase shares of the underlying stock.
- Expiration Date – Warrants have a finite lifespan and expire after a set period of time. Typical warrant terms range from 1 to 5 years.
- Detachable – Warrants can often be detached and sold/traded separately from the bond or stock they were issued with.
- Leverage – Since warrants allow investors to buy stock below market prices, they exhibit leverage. A small warrant investment can yield outsized returns if the share price rises above the exercise price.
- Investor Rights – Warrant holders have no shareholder rights (i.e. no voting rights or dividends) until they exercise the warrants.
For example, say a company issues warrants with an exercise price of $20 that are exercisable for the next 3 years. If the stock trades at $25 after 2 years, warrant holders can exercise their warrants and buy shares at $20 – an instant $5 per share profit!
How Do Warrants Work?
There are two main ways investors can profit from warrants:
- Exercising the Warrants – Investors can buy shares at the preset exercise price by “exercising” their warrants. This allows them to realize the gain between the exercise price and market price.
- Selling the Warrants – The warrants themselves can be sold to another investor before expiration. If the share price rises, the warrants become more valuable, allowing the original buyer to capture profits by selling them.
Warrant holders must weigh the time value remaining on the warrants against the potential for added gains by exercising them. Typically, warrants become increasingly valuable/exercised as they near expiration.
Convertible Bonds
Convertible bonds are debt instruments that can be converted into a predetermined number of shares at the option of the bondholder. Here are the key features:
- Coupon Payments – Convertibles pay periodic interest payments (coupons) like regular corporate bonds.
- Conversion Ratio – This sets the rate at which bonds can be converted into stock, e.g. 10 bonds per 1 share.
- Conversion Price – The set price investors pay per share when converting bonds into stock.
- Maturity – Date when the bond must be repaid if not converted.
Convertible bonds allow investors to gain equity exposure while still earning interest payments. If the stock price rises, investors can choose to convert and capture the equity upside. The conversion ratio and price are set such that the stock price must appreciate substantially before conversion becomes worthwhile.
Convertibles are attractive for issuers because they usually pay lower coupons than standard debt since they offer the bonus conversion feature. This makes them less dilutive than issuing stock directly.
How Do Convertible Bonds Work?
There are two ways investors can profit from convertible bonds:
- Convert to Stock – If the share price rises sufficiently above the conversion price, bondholders can convert into common shares to realize a gain.
- Hold the Bond – Investors collect coupon payments by holding the bond. They can then sell the bond back to the issuer at maturity or to another investor prior to maturity.
The conversion feature becomes more valuable as the stock price trends higher. Because equity upside is capped by the conversion ratio, convertibles exhibit less volatility than the underlying stock.
Key Differences Between Warrants and Convertibles
| Warrants | Convertible Bonds |
|---|---|
| Give holder right to buy common stock at preset price | Allow bondholder to convert into common shares at preset ratio/price |
| No coupon payments | Pay interest coupons like regular bonds |
| Shorter term (1-5 years) | Longer-term maturity, often 10+ years |
| More leverage than convertibles | Less volatile than warrants due to coupons/capped conversion |
| Rarely investment grade | Often issued as investment grade |
Benefits of Retainer Securities
There are several potential benefits that warrant and convertible offerings provide:
- Cheap Financing – Companies can raise funds at better terms than typical stock or bond issuances since warrants/convertibles carry extra perks for investors.
- Delayed Dilution – Stock dilution only occurs if/when the warrants or bonds are converted. This avoids immediate dilution from a straight equity raise.
- Higher Proceeds – Attachable warrants can help entice investors and increase proceeds vs. issuing straight debt.
- Speculation/Marketing – The prospect of equity-like gains can drum up investor interest and improved demand.
In summary, retainer securities allow companies to tap into equity-type upside for investors while mitigating some of the negatives like immediate dilution. The flexibility helps maximize proceeds and tailor offerings to suit financing needs.
Risks of Retainer Securities
Despite their benefits, warrants and convertible securities also come with certain risks and drawbacks:
- Dilution – While delayed, dilution eventually occurs when warrants and convertibles are exercised for stock.
- Earnings Drag – Convertible bonds add interest expenses which reduce the company’s bottom line earnings.
- Volatility – Warrants can exacerbate stock volatility and price swings when exercised.
- Credit Quality – Warrants are junior in the capital structure and often Speculative Grade rated.
Companies must weigh the advantages against the risks before utilizing retainer securities. Proper structuring and prudent use can help mitigate potential drawbacks.
Common Uses of Retainer Securities
Here are some typical situations where companies employ warrants and convertibles as financing tools:
- Growth Companies – Young growth firms use convertibles/warrants for early stage funding needs. The ability to tap equity upside is appealing for speculative high growth stories.
- Acquisitions – Warrants are often used as “equity kickers” to close M&A deals. They provide upside for sellers to offset any risks.
- Stimulate Investor Interest – Wall Street underwriters attach warrants to bonds to generate excitement and help market/place the deals.
- Sweeteners – Convertibles are offered at lower rates when issued alongside straight debt to improve marketability.
- Alternate to Stock – Mature companies utilize convertibles instead of secondary offerings since they avoid immediate dilution.
The flexibility of retainer securities makes them applicable across the corporate lifecycle from risky startups to mature blue chip firms.
Conclusion
In summary, retainer securities like warrants and convertible bonds provide a hybrid option for companies to raise capital. Investors gain equity exposure combined with senior debt features. This results in cheaper financing costs for issuers and greater flexibility for investors.
However, dilution and volatility risks must be managed. When prudently employed, retainers can optimize capital raising and tailor offerings to suit unique financing situations across diverse issuing firms. The equity “kicker” provides desirable upside that caters to investor preferences.
For dynamic companies where future growth opportunities warrant flexible funding options, retainers strike an efficient balance on the risk-reward spectrum. Their versatility enables targeted capital raising while granting investors an equity-linked platform to participate in potential upside.