When good hybrids go bad

Paperlinx’s move to buy back its outstanding hybrid at a massive discount to face value is a timely warning about the many risks facing investors who hold the income-producing securities.

More than $12 billion in hybrids has been issued over the past two years, many of them with highly complex and unique clauses that allow them to suspend payments and be automatically converted into equity in perilous times.

Most of that issuance has come from financial institutions such as the big four banks, who are keen to reduce their reliance on overseas funding and make the most of the demand for income from retail investors.

While a large portion of these securities pose little danger, there will always be a small number that risk blowing up in the hands of private investors as the Paperlinx experience showed.

Late last week, the embattled paper company made an off-market takeover offer for holders of its PXUPA hybrid, which hasn’t made an interest payment to investors for more than two years.

For an instrument that was sold to investors back on the expectation of a steady income stream, the reality has been anything but.

Paperlinx has announced a debt-for-equity swap that would see note holders offered 250 shares for every hybrid they own or the equivalent of an 84 per cent writedown of face value.

GFC storm clouds gather

The hybrid was marketed with a headline rate of 9.3 per cent and raised $285 million from a mixture of retail and institutional investors back in March 2007.

With the sharemarket looking toppy and the note offering a margin of roughly 3 per cent above the cash rate, the offer was an attractive one at the time.

But as global financial crisis storm clouds gathered and the paper industry began battling spot fires on multiple fronts, the company was pummelled and investors who failed to read the fine print were savaged.

Massive losses unfolded over a period of several years and billions in shareholder value evaporated. Over the past five years Paperlinx equity fell 98.5 per cent while the hybrids fell 88 per cent.

As the dire reality of the company’s deteriorating situation became clear, Paperlinx’s management elected to stop paying hybrid holders from June 30, 2011.

Under the terms of the note, this was allowed under what is called a ‘step-up’. This means that when distributions do resume, they will do so at a higher rate of 11.3 per cent. However, investors aren’t holding their breath.

Board spill

Following a board spill in March 2012 that claimed the scalp of Tattersalls chairman Harry Boon, entrepreneur and paper industry veteran Andrew Price has been installed as Paperlinx CEO.

Price, who retains a significant stake in the company, indicated in the offer document circulated to investors that if hybrid holders do not accept, he may resign.

Under the terms of the offer, holders of the hybrids will emerge with approximately 54 per cent of the total equity in Paperlinx – which is currently valued at $30 million.

A number of key players have now emerged seeking to leverage what has fast become a type of pseudo-distressed debt deal reminiscent of what we saw with Channel Nine back in 2012.

US hedge fund Coastal Capital has acquired roughly 14 of the hybrids and is believed to be playing a key role in negotiations with Paperlinx. Coastal Capital will be pushing for a larger slice of the pie and leveraging their position in the capital structure ahead of the ordinary equity holders to push the company to brink.

For the long-suffering hybrid holders, who bought in six years ago with the expectation of a steady income stream and who are now dealing with US hedge funds and a management team threatening to jump ship, the complexities of investing in hybrids is all too clear.