Convertible bond issuance by a growth medtech company
Helix Medical is a UK-listed medtech company with £300m revenue, £30m EBITDA, £60m net debt and 100m shares at £9. It plans a £150m acquisition expected to add £15m EBITDA by year three. A bank offers five-year straight debt at 8.5% with a net debt/EBITDA covenant of 4.5x. An alternative is a five-year convertible with a 4.0% coupon, conversion price £12, and no maintenance covenant. The CFO notes the coupon saving and believes the share price will reach £15. The chair worries about dilution and whether the acquisition is being priced for optimism. The company currently has a BB- rating and £20m of cash. The board wants to fund the acquisition without losing investment-grade aspirations and without a rights issue. The convertible would be issued at par and rank behind the bank facility.
1. Calculate the pro forma net debt/EBITDA under the straight-debt and convertible alternatives at completion and at year three. State whether the 4.5x covenant is likely to be breached, and explain why the covenant definition matters.
Read the worked answer
Assume the £20m cash is retained for liquidity. Current net debt is £60m; new debt is £150m; pro forma net debt is £210m. At completion, EBITDA is £30m, so net debt/EBITDA is 210 / 30 = 7.0x. At year three, if the £15m EBITDA synergy is fully delivered, EBITDA is £45m and the ratio is 210 / 45 = 4.67x. The straight-debt covenant of 4.5x is therefore breached at completion and still breached at year three on these assumptions. The convertible has no maintenance covenant, but rating agencies will usually treat it as debt until conversion, so net leverage remains 7.0x at completion. The covenant definition matters because EBITDA may be calculated on a pro forma basis, may include or exclude synergies, share-based payments or exceptional costs, and net debt may include or exclude the convertible, leases or cash. A lender could also require the convertible to be subordinated and excluded from the bank covenant, but that does not remove rating-agency leverage. The board should not assume the bank facility is available without a waiver, equity cure or a smaller acquisition.
2. Decompose the convertible's economics. Estimate the annual coupon saving versus straight debt, the dilution if converted at £12, and the value transfer to convertible holders if the share price reaches £15. Discuss whether the CFO's £15 expectation makes the convertible cheap or expensive.
Read the worked answer
Straight-debt interest is 8.5% × £150m = £12.75m a year. Convertible coupon is 4.0% × £150m = £6.0m a year, a pre-tax saving of £6.75m, or £5.06m after tax at 25%. Undiscounted over five years, the coupon saving is £33.75m pre-tax. Conversion at £12 creates 150 / 12 = 12.5m new shares. Post-conversion shares are 112.5m, so dilution is 12.5 / 112.5 = 11.1%. At £15, holders receive 12.5m × £15 = £187.5m for £150m principal, a £37.5m value transfer. The total undiscounted cost to the company in that scenario is £30m of coupons plus £37.5m of value transfer, or £67.5m, versus £63.75m of straight-debt interest. So if the CFO genuinely expects £15, the convertible is not cheap on pure cost; it is a way to avoid a covenant breach and to defer dilution. If the share price stays below £12, the company repays cash and keeps the coupon saving, but faces refinancing risk. The decision should be based on financing capacity and probability-weighted outcomes, not on the £15 forecast alone.
3. Advise the board on funding structure, covenant headroom and investor communication. Consider rating agency treatment, accounting and the chair's concern.
Read the worked answer
The pro forma leverage of 7.0x is inconsistent with investment-grade aspirations, so the board should first reduce the funding requirement or restructure the consideration. Options include a smaller acquisition, deferred or earn-out consideration, a modest equity raise, or a mix of £100m convertible and £50m straight debt if the bank will reset the covenant. The convertible should not be sold to shareholders as cheap financing without explaining that rating agencies treat it as debt, that IFRS accounting splits it into a liability and an equity component, and that reported interest expense will exceed the cash coupon. The chair's concern is valid: the acquisition case should be stress-tested for lower synergies, and the board should disclose dilution at various share prices. Investor communication should cover use of proceeds, conversion price, dilution, covenant headroom and the path to lower leverage. If the board cannot tolerate dilution or a covenant waiver, it should not proceed with the £150m debt-funded acquisition. A convertible is a financing tool, not a solution to an over-leveraged acquisition.