Pre-IPO Converts Target Tech Firms

Forget the fragility of the IPO market.

A number of infant tech companies in one of today’s few hot sectors – optical networking – are beginning to skip the last round of venture capital funding in favor of tapping the pre-IPO convertible market.

To give the issuers an extra incentive to go public sooner rather than later, the converts have a rare feature: the conversion premium is not predetermined, but is contingent upon how quickly the company goes public.

While bankers nervously anticipated a slew of upcoming IPOs, Morgan Stanley Dean Witter launched the convert product earlier this month with a $75 million placement for Kestrel Solutions Inc., an optical networking company that has yet to ship its first product. Credit Suisse First Boston is also working on a similar optical networking deal expected to launch soon.

These unusual bonds can be used only for a small group of companies that are in a hot sector, and need one more round of financing before tapping the public markets, say market participants. The advantages are that investors get an opportunity to participate in a pre-IPO investment and the upside of the stock after it goes public.

The alternative is another round of venture capital, which is much more expensive than the convert. “The converts are competing against the venture money,” says one banker, who adds that “venture capitalists did very well with these [optical networking] companies in the past.”

The unusual convert sells when investors think there is going to be “a sexy hot IPO,” said one equity capital markets pro familiar with the product. “It’s almost like getting a pre-IPO allocation.”

Pre-IPO convertible bonds are nothing new and have been used frequently. But what’s unusual is the variable conversion premium. Sources close to the deal say that the security is designed to persuade the company to go public as soon as possible.

If Kestrel goes public by the end of this year, the premium will be between 10% and 15% above the stock price at the time of the offering. If Kestrel delays the IPO by another quarter, the conversion premium drops to between 9% and 12%.

If the company has not gone public by the first quarter of 2002, the conversion premium will drop all the way to zero. At that time investors can either receive 10% of the company or their cash back. Because the conversion rate is not set, the hedge funds that have become so prominent in the convertible market aren’t interested. Equity and convertible funds are the main buyers.

The convert is still less expensive than venture capital financing. “The venture guys want a deeper discount,” said the equity capital markets pro. In other words, he’s looking for more of his dollars. Kestrel’s deal was slated to be a five-year pre-IPO convertible securities with a one-year call protection and a coupon between 5.5% and 6.5%.

Such variable premium pre-IPO converts have been used internationally from time to time, but have not been used in the U.S. for at least a decade, said industry sources. In today’s somewhat unpredictable market, the security has re-emerged, but for only a select few.

“The time is ripe for it because optical networking and the switching associated with that is in very short supply and it is an explosive growth area,” said a convertible bond analyst.