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Descartes Meditations Revisited

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* Convertibles have a place as the currency used in takeovers. The bidder can offer a higher income on a convertible that the dividend yield on a bid victim's shares, without having to raise the dividend yield on all the bidder's shares. This eases the process for a bidder with low-yield shares acquiring a company with higher-yielding shares. Perversely, the lower the yield on the bidder's shares, the easier it is for the bidder to create a higher conversion premium on the convertible, with consequent benefits for the mathematics of the takeover. In the 1980's, UK domestic convertibles accounted for about 80pct of the European convertibles market, and over 80pct of these were issued either as takeover currency or as funding for takeovers. They had several cosmetic attractions.

The pro-forma fully-diluted earnings per share shows none of the extra cost of servicing the convertible up to the conversion day irrespective of whether the coupon was 10pct or 15pct. The fully diluted earnings per share is also calculated on a smaller number of shares than if equity was used as the takeover currency.

In some countries (such as Finland) convertibles of various structures may be treated as equity by the local accounting profession. In such circumstances, the accounting treatment may result in less pro-forma debt than if straight debt was used as takeover currency or to fund an acquisition. The perception was that gearing was less with a convertible than if straight debt was used instead. In the UK the predecessor to the International Accountancy Standards Board (IASB) put a stop to treating convertible preference shares as equity. Instead it has to be classified both as (1) preference capital and as (2) convertible as well.

Nevertheless, none of the (possibly substantial) preference dividend cost incurred when servicing a convertible preference share is visible in the pro-forma consolidated pretax



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