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One of the most debated issues in the corporate finance literature is the security issue decision.1 Against the background of the existence of capital market imperfections, a large number of studies show that different external financing decisions may entail different kinds of costs for an issuing firm.2 These costs have an impact on firm value and therefore, the security issue decision is not trivial.3

Hybrid securities combine characteristics of equity and debt capital. “They usually give their holder the right to convert a debt-like instrument into common stock.” Sometimes a conversion obligation exists. Figure 11.1 illustrates the spectrum of hybrid securities according to their degree of resemblance to common stock and straight debt.

Available theories for the use of convertible debt emphasize the security’s useful role in mitigating costs of external debt and equity finance that arise due to capital market imperfections. Green (1984) argues that convertible debt eliminates risk-shifting incentives and aligns the interests of stock- and bondholders.4. Stein (1992) shows that firms with valuable investment opportunities can use convertible debt to reduce the costs of adverse selection arising in equity issues41, and Mayers (1998) illustrates that convertible debt can alleviate costs of free cash flow.42 Empirical tests of the short-term valuation impact of convertible debt offerings support the implications of these theories: convertible debt issues on average entail higher announcement returns than equity issues.43

The analysis of the risk characteristics of an issuing firm provides a further test of the rationing-hypothesis for convertible debt issuance. If investors gradually learn about changes in an issuer’s systematic risk as they apparently do about a firm’s post-issue earnings, this learning process may influence the convertible debt issue decision: it is possible that risk- averse investors deny an issuer the direct access to equity capital, if they have difficulties in evaluating the risk characteristics of an issuing firm or if they anticipate a future increase in systematic risk that may not be compensated with an adequate increase in returns. In these situations, a firm may use convertible debt to enable investors to screen it before the bond can be converted into common stock. During this screening period, uncertainty about the firm’s risk (and earnings) may decrease. The advantage of convertible debt is that its value is relatively insensitive to the risk of the issuing firm, which protects investors from adverse consequences of risk 71

This chapter aims to explain the use and valuation impact of an interesting and innovative transaction structure: in concurrent offerings, firms issue seasoned equity and convertible securities in combination. Concurrent offerings have neither theoretically nor empirically been examined before. However, a comparable structure exists when firms go public: in unit initial public offerings (IPOs), firms sell bundles of stocks and warrants. Chemmanur/ Fulghieri (1997) present a signaling-model for the use of unit IPOs, which receives empirical support from investigations by How/Howe (2001), Lee/Lee/Taylor (2003) and l3youn/Moore (2003).192 This model can be adapted for concurrent offerings and is used as a basis for the discussion.

Exchangeable debt bears structural resemblance to convertible debt. However, it is not converted into common stock of the issuer, but exchanged into stock of a third firm.

The purpose of this investigation was to explain the use and performance impact of hybrid securities issued by US and Western European firms. A contribution to existing literature was made for three forms of hybrid securities: convertible debt (objective 1), concurrent offerings of convertible securities and common stock (objective 2) and exchangeable debt (objective 3).