Law firms interviewed: Jingtian & Gongcheng, Linklaters, Skadden, Arps, Slate, Meagher & Flom

In recent months, a wave of convertible bond issuance has breathed new life into Hong Kong’s anaemic capital markets. Since late May, four major Chinese internet and technology companies - JD.com, Lenovo Group, Alibaba Group, and Trip.com - have successively issued convertible bonds totalling $10.5 billion.

 

Notably, Alibaba’s $5 billion issuance set a record for the largest U.S. dollar-denominated convertible bond by an Asian company. This issuance and others have lifted the spirits of Hong Kong’s bankers and lawyers hoping for a prompt revival of Asia’s erstwhile fundraising powerhouse after a persistently subdued IPO scene so far threatened to choke the city’s investment prospects.

Jonathan Stone, partner and head of global transactions at Skadden, Arps, Slate, Meagher & Flom in Hong Kong, and counsel Vincent Sze point out that an increasing number of companies are using convertible bonds as an alternative source of funding.

“Many of the issuers are U.S.-listed (or dual U.S./Hong Kong-listed) companies with substantial PRC operations, particularly in the technology sector. We believe that this trend is likely to continue while interest rates remain high and primary equity market issuances remain challenging,” say Stone and Sze.

Tian Mingzi, a partner at Jingtian & Gongcheng based in Beijing, believes a warm reception to large-scale convertible bonds can “boost market confidence and attracts more investors,” thereby “increasing trading volume and liquidity in Hong Kong's capital market.”

In particular, the issuance of convertible bonds has given rise to new business opportunities that may enable other companies to follow suit in Hong Kong, thus further enhancing the market's activity and international influence, Tian adds.

The issuance of convertible bonds by China concept stocks is not something new. But what makes the latest round unusual is a combination of global macroeconomic pressure and China’s policy directives. 

"Amid the current high interest rate environment, the low stock prices of China concept stocks, and China's supportive policies for overseas financing and outbound business expansion, these companies are issuing convertible bonds to improve their debt structure, expand overseas operations, and repurchase shares,” explains Tian.

Taiki Ki, a capital markets partner at Linklaters in Hong Kong, points out that the trend of companies issuing equity-linked financing instruments “has been seen globally over the past few years in a rising interest rate environment” albeit taking longer to take hold in Asia given “challenging market conditions for Chinese equities”.

“However, with the recent rebound in Chinese equities, we are seeing significant renewed interest in this product in 2024," notes Ki.

This optimistic sentiment is shared by Skadden’s Stone and Sze. They believe that convertibles and other equity-linked products often serve as a gateway to primary equity markets.

“We have seen this over the past few decades during times when there is uncertainty in the equity markets, but as a sign that a market window is beginning to open. The hope is that the financing activity from convertible bond issuances and similar transactions will drive other deals, particularly IPOs, of Asia-based issuers,” say Stone and Sze.

 

EQUITY SWEETENERS

For issuers, one of the primary attractions of convertible bonds is their low funding cost. As the U.S. Federal Reserve stands still on “higher for longer” interest rates, which have propped up the U.S. dollar, pure debt financing for issuers through bonds or loans continues to be relatively expensive.

Under this circumstance, equity-linked instruments such as convertible bonds will remain popular as the value of the embedded equity will lower interest payments, according to Ki.

Take Alibaba as an example: The interest rate on its recent convertible bond is 0.5 per cent. However, the rate on comparable term ordinary bonds previously issued by Alibaba would have exceeded 5.1 percent, according to estimates from market institutions.

"Before conversion, convertible bonds can swap high-interest debt for low-interest debt. After conversion, they can lower the debt ratio and improve the company's debt structure," Tian explains.

Another perceived advantage of convertible bonds is the instrument’s ability to help well-performing domestic companies expanding overseas gain higher access to foreign exchange reserves and reduce transactional losses caused by exchange rate fluctuations.

In addition, convertible bonds have been increasingly winning the favour of investors. Apart from lowering interest payments in a high-rate environment, “such instruments offer significant arbitrage opportunities between the bond and the underlying equity for certain types of fund investors, allowing such investors the ability to manage volatility arising from external factors such as market movements and for issuers from certain regions and political tensions,” Ki adds.

Given these characteristics, convertible bond issuances tend to be popular amongst industries such as technology, the internet, new energy, and biotech.

"These sectors have high growth potential, high capital needs, and significant stock appreciation potential. From the perspective of both the company's financing costs and the investor's returns, convertible bonds are more appealing," notes Tian.

What made Chinese technology companies one of the biggest players in this space recently was their robust balance sheets and a strong credit profile, coupled with volatility in the share price that bump up the value of embedded equity option.

As such, equity-linked securities, including convertible notes "offer a compelling narrative for investors through the combination of strong downside protection with potential for equity up-side, including from investment grade companies which historically may have been able to source pure debt financing at a cheaper cost,” explains Ki.

 

CONVERTIBLE STRATEGY

The recent wave of convertible note offers have had a notable common feature: Issuers such as JD.com, Alibaba, and Trip.com have concurrently executed share buybacks in a bid to ease any dilution effect.

Indeed, there has been initial skepticism that any future conversion of bonds into shares might dilute the company’s equity. But, as Tian explains, concurrent share repurchases can offset the dilution effect, attracting long-term investors who are bullish on the company’s growth, thereby supporting the company’s sustained development.

Convertibles issuances pared with a share buyback from the issuers are intended to match two significant liquidity events, according to Ki. Those are “the hedging from convertible bond investors” and “the share buyback from the issuer for a highly efficient execution with minimal disturbance to stock price”. Ki believes that is beneficial to both the issuer and the investors.

Such structures address two key concerns. For companies exploring a convertible bond issuance, Ki notes that the market impact of hedging investors shorting their shares could be a concern, especially with many companies experiencing significant share price declines following an issuance.

This concern could be mitigated by a simultaneous share buyback while “significantly reducing market risk associated with a more typical open market buyback where shares are bought back over longer periods of time," Ki says, adding that it could also open a pathway for companies looking at efficient method of returning value to shareholders.

Skadden’s Stone and Sze note that apart from making stock purchases, some issuers have also used a portion of the proceeds to purchase derivative instruments (known as call spreads) from the underwriters, which have the effect of raising the effective conversion price for the issuer.

Other strategies include synthetically raising the conversion price on a convertible bond by issuers for a larger upfront cost because of improved outlook on future cash flow.

This could offer companies flexibility to manage various levers, including cost of funding and dilutive impact to shareholders, as well as sending a bullish signal to the market that the issuer is optimistic on future share price appreciation, says Ki.

Beyond flexible combinations, convertible bonds could also be strategically tailored to meet company needs. For instance, while some notes were offered to the public, Lenovo Group targeted a specific $2 billion zero-coupon convertible bond to a subsidiary of the Saudi sovereign wealth fund.

"This illustrates the breadth of financing strategies involving convertible bonds, from pure fundraising and enhancing capital structure to strategic investments," says Ki.

Tian further unpacks the variety of strategic purposes underpinning convertibles issuances. "Some convertible bonds are publicly offered, typically by companies with higher ratings and better market reputations, attracting more investors and boosting market confidence,” she says.

“Others are aimed at specific buyers, showcasing the close relationship and potential for further cooperation between the investor and the company. Companies will choose issuance strategies based on their specific circumstances and needs,” Tian adds.

All in all, lawyers agree that the approach that an issuer takes largely hinges on its objectives and the level of perceived demand for the funding instrument from different classes of investors. 

In addition, “some issuers may choose to pursue private transactions to enable negotiation of more bespoke terms than would be available from a wider investor base, target a smaller number or particular type of holder (e.g. longer-term holders such as sovereign wealth funds) or for strategic reasons (e.g. the holder may provide business synergies to the issuer),” say Stone and Sze.

 

NO ONE-SIZE-FITS-ALL

Apart from issuing convertible bonds to serve different strategic or financing purposes, issuers are also confronted with varying requirements in capital markets of various jurisdictions.

For instance, the regulatory environment and approach towards issuances differ significantly between the A-share and Hong Kong stock markets.

"The A-share market targets A-share investors and is subject to A-share refinancing regulations and policies and focuses on funding for the company's core business development, usually through non-specific issuances," Tian explains, adding that the Hong Kong market caters to a more international investor base but is more susceptible to the global macroeconomic movement.

It is thus essential for Chinese concept stocks issuing medium to long-term convertible bonds overseas to consider obtaining pre-approval from the National Development and Reform Commission (NDRC) for foreign debt and post-issuance filing with the China Securities Regulatory Commission (CSRC).

Such a step would necessitate early preparation with professional institutions, Tian advises.

For dual-listed issuers, “convertible bonds sold into the U.S. market may be structured as convertible at any time, or contingently convertible only upon the happening of certain events or in the several months prior to maturity,” note Stone and Sze.

Furthermore, “an increasing number of dual-listed issuers are issuing convertible bonds that allow the investor the choice of converting their bonds into either U.S.-listed ADSs or Hong Kong-listed shares,” they add.