Contingent Financing

1
Contingent Financing

• Neil Doherty

2
Contingent Financing Insurance

• Problem
• Firm may lose positive NPV projects after a loss
  (external funding unavailable or too costly)
• Solution 1
• Carry surplus cash surplus equity so that firm
  can ride out shocks
• The cost of surplus capital can be high
• Firm may become takeover target
• Solution 2
• Arrange contingent financing with counterparty
• Insurance or other hedge
• Contingent Debt
• Contingent Equity

3
Contingent Financing

• Insurance and Hedges
• Policy pays an amount related to some specified
  loss
• E.g. the amount of damage from a fire
• The amount needed to settle a liability suit or
  pay damages
• The amount of default on a debt.
• The insurance payment can be thought of as
  capital contingent and is available for
  investment after the loss
• To pay the fire damage
• To settle the liability claim
• Had the insurance not been in place, the firm
  would have needed another source of capital for
  these investments
• Differs from other capital in that premium is
  prepaid and is based on expected loss

4
Contingent Financing Debt

• Contingent debt
• Line of credit
• Can be open or conditional on a second trigger
• Can be simple way of funding smaller LIQUIDITY
  losses
• Can increase costs of future distress if loss
  large
• Note that sudden loss tends to increase leverage
• Contingent debt can therefore further leverage
  the firm

5
Contingent Financing Debt

• BEFORE LOSS
• V2000 E1000 D1000 D/E1
• AFTER LOSS NO REPLACEMENT
• Loss 500, V1500 E500
• D 1000, D/E2
• REINVESTMENT
• Reinvest costs 300, V1900
• NPV 100, paid w/ debt
• E600 D1300 D/E2.2

6
Contingent Financing Contingent Equity

• Put Options on Own Stock
• A firm is worried that a future adverse event
  will prevent it from funding ongoing investment.
  Solution
• Firm buys PUT OPTIONS to sell NEW ISSUES of its
  own stock to a counterparty at an agreed strike
  price.
• If the event occurs, and this drives down the
  stock price, the put is in the money. Thus, the
  firm can issue new shares at an attractive price
  and fund new investments.

7
Contingent Equity Illustration of Put Option for
Insurer

• Insurance firm insures against hurricanes on East
  Coast.
• If hurricane occurs then
• The firm pays many claims and its capital is
  depleted
• But most of its rivals pay many claims their
  capital depleted
• Because the ability to sell insurance is scaled
  to the level of capital (by regulation and
  ratings), then there will be a general reduction
  in the supply of insurance in the region
• However, after a hurricane demand increases
• Thus firm faces a perfect market but is unable to
  exploit it because of lack of capital

• Impact of hurricane hard market

8
Contingent equity Puts on Own Stock

• Triggers
• Option can be triggered by decline in stock price
  expected after adverse event
• Option can be triggered directly by adverse event
• Option can have dual triggers
• CatEPuts
• Trade mark for product designed by Aon for
  insurers with catastrophe risk
• Triggered if natural catastrophe occurs and stock
  price lt strike price
• Capital helps insurer exploit post-loss hard
  market - see previous slide
• Problems with CatEPuts
• Moral hazard problem. Suppose stock price falls
  and option in the money but loss not big enough
  to activate second trigger. Insurer might simply
  pay more claims
• After natural catastrophes, insurer stock price
  often rise? Any idea why?

9
OTHER CONTINGENT EQUITY SOLUTIONS

• Call options on own stock
• Cephalon case. Drug firm faces possible FDA
  approval of new drug. If approved, firm will need
  capital to develop product. Solution calls on
  own stock.
• Michelin
• Carries excess cash as buffer against events such
  as
• Fall in reserves
• Fall in GDP
• Fall in car sales, etc
• Cost of carrying cash and vulnerability to raid
• Secures Commitment to purchase Subordinated
  Securities from Swiss Re
• Subject to specific triggers such as those
  described above
• Benefits
• Leaner balance sheet
• Lower financing costs

10
Contingent Equity The Pricing Feedback and the
Problem of Hedging

• Firm buys put options for a new issue of its own
  stock
• Stock price must fall below strike price for
  option to be exercised
• However, if put exercised, shares issued ABOVE
  current market price
• This ensures gain in value to firm
• But stock price is an expectation of future cash
  flows
• Thus, ex ante, stock price will rise in
  anticipation of this possible gain in value
• DILEMMA is this fatal?
• Stock price has to fall to exercise option
• But expectation of gain from exercise will prop
  up the stock price

11
Contingent Equity The Pricing Feedback and the
Problem of Hedging

• VALUE OF EQUITY E CF L D - p
• EQUITY AFTER A LOSS E CF L D C - p
• FALL IN SHARE PRICE
• ?P (E - E) (-C )
• Fall in stock price depends on payout on option.
• PAYOUT ON OPTION
• Payout on option depends on fall in stock price
• STRIKE PRICE

• E equity
• CF PV of cash flows
• L cash (liquidity)
• D debt
• C amount lost
• amount paid by counterparty (strike price
  minus market value)
• p price of the put option
• k constant for strike price
• kgt0 put out of money before loss
• klt0 put in the money before loss
• h options written per share i.e., hedge ratio

12
Contingent Equity The Pricing Feedback and the
Problem of Hedging

• FALL IN SHARE PRICE ?P (E - E)
  (-C )
• PAYOUT ON OPTION
• Solve simultaneous equations
• Perfect HEDGE implies ?P 0
• Is this possible with PUT option on own stock?

13
Hedging with PUT ON OWN STOCK. Hedge is where m?P
0. Can specify hedge with klt0. This will
provide perfect hedge ONLY FOR ONE SPECIFIC VALUE
OF C. If C takes another value, firm will be OVER
(UNDER) compensated

• Impossibility of perfect hedge

14
CAT PUTS and the UNDERINVESTMENT PROBLEM

• Reinvestment cost 600 but equity gains 400.
  Shareholders prefer to walk away
• Suppose we tried to make new share issue of n
  new shares
• The answer we get is non-sense negative means
  this will not work
• Now suppose the firm had an existing CATEPUT
  under which it could issue 300 share to
  counterparty at strike price of 2
• And there were 100 existing shares

15
Solving an underinvestment without CAT
PUT.Owners walk away firm goes bankrupt

• The shareholders walk away and the firm is
  bankrupt
• Bankruptcy costs of 50 are incurred
• The creditors now become the owners (called here
  ex creditors)
• The ex creditors now raise new money of 600 (say
  by a new equity issue) to finance the
  reinvestment
• The reinvestment is undertaken leaving the ex
  creditors with a value of 350
• The ex creditors gain the full NPV of 200 from
  the re-investment but do incur the bankruptcy
  cost of 50

16
CAT PUTS and the UNDERINVESTMENT PROBLEMex post
analysis

• Firm exercises its option to issue 300 new shares
  at 2 per share
• Thus there is now 600 in debt and 400 shares
  outstanding
• The firm can use the proceeds of the option to
  pay for reinvestment
• Creditors now paid the full 600
• Total equity is therefore worth 400
• The counterpartys 300 shares (of a total 400)
  are worth 300 (but this party had to pay 600 for
  these shares)
• And therefore the original equity is worth 100

After deducting cost of reinvestment
Including 600 raised on exercise of put option
17
CAT PUTS and the UNDERINVESTMENT PROBLEMex ante
analysis. Suppose 10 chance of event.

• VALUE OF DEBT WHEN NO CAT PUT IN PLACE
• 0.9(600) 0.1(350) 575
• VALUE OF DEBT WHEN CAT PUT WRITTEN BY OUTSIDE
  COUNTERPARTY
• Approximate cost of option (crude method)
  0.1(300) 30
• 0.9(600) 0.1(600) 600
• VALUE OF DEBT WHEN CAT PUT EMBEDDED IN BONDS
• After loss creditor pays 600 on exercise of put
  and gets debt (600) paid in full because of
  reinvestment. Also the creditor now owns stock
  worth 300. So ex ante value of debt is
• 0.9(600) 0.1(-600600300) 570
• Embedding put option with value of 30 only
  reduces value debt from 575 to 570 Creditors
  only charge 5 for option of value of 30

18
TAKEAWAY ON CAT PUTS AND CONTINGENT FINANCING

• Contingent financing is partly hedging and partly
  post-loss funding
• Ex ante price of CAT PUT is paid to buy put from
  counterparty
• Ex post, put is exercised, counterparty provides
  equity capital at price in excess of post-loss
  market price
• Ex post dilution of equity
• Cheaper than full hedge which is all pre-paid
• Focuses attention on post-loss investment needs
  rather than on compensating the loss
• If creditors bear many of the costs of risk, then
  there is merit in embodying cat put in debt
  (structured debt). Thus the cost of the option is
  offset by a reduction in risk premium in the
  underlying debt.