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A few questions about Preferred Stock.


DanielGMask
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CAKE (The Cheesecake Factory) just entered into a Subscription Agreement to sell 200,000 shares of Series A Convertible Preferred Stock, par value $0.01 per share, for an aggregate purchase price of $200 million.

 

The preferreds have the right to receive dividends at a 9.5% annual rate. The Holders are also entitled to participate in dividends declared or paid on the Common Stock on an as-converted basis.

 

And each Holder will have the right, at its option, to convert its Convertible Preferred Stock, in whole or in part, into fully paid and non-assessable shares of Common Stock at a conversion price equal to $22.23 per share.

 

Here is the link to the filing: http://d18rn0p25nwr6d.cloudfront.net/CIK-0000887596/87d4687b-c18d-4743-b570-64048d3fa2c7.pdf

 

So, I have a few questions since I'm not familiar with preferred offerings.

 

1. This will be equal to borrowing money at a 9.5% interest rate. Why issuing preferred shares instead of borrowing?

2. This "The Holders are also entitled to participate in dividends declared or paid on the Common Stock on an as-converted basis." means that the Holders have the right to receive their 9.5% interest plus dividends as a common shareholder?

3. How does the conversion works? They are issuing 200,000 preferred shares ($1,000 dollars per preferred) for 200 million dollars. The conversion price is $22.23. Does that means that the result of 200 million divided by $22.23 is the number of common they'll get?

4. If they pay the principal amount for the preferreds the conversion expires or no matter what, the Holders have the right to convert?

 

Thx in advance.

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It’s not the same as debt. You can stop paying preferred dividends (usually along with stopping common stock dividends) and the pref holder cannot take you to bankruptcy court. Isn’t that the best way to boost liquidity now?

 

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It’s not the same as debt. You can stop paying preferred dividends (usually along with stopping common stock dividends) and the pref holder cannot take you to bankruptcy court. Isn’t that the best way to boost liquidity now?

 

I certainly don't think so! A 9.5% equivalent to yearly interest rate is very high for current market rates. Plus the fact that -as I understand- the Holders have the right to receive dividends as if their preferreds were already converted into common.

 

I'm not familiar with preferred offerings and that is why I asked a few questions, unfortunately nobody answered them.

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I'll answer the why not issue debt. It's because prefs are equity and not debt. They're issuing prefs at 9.5 because of 2 things.

 

1. Nobody will lend them money.

 

2. They're at serious risk of breaching their covenants on their existing debt.

 

While I've invested in prefs in the past and has been very profitable for me I would not touch this deal. You also have to keep in mind that CAKE stopped paying rent. So they're really also issuing debt. Super-senior debt, way ahead of you.

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I'll try answer your questions. All from a  very quick read, errors are very possible.

 

1. this is not equal to borrowing at 9.5%, this is equal to borrowing at a higher percentage, because the instrument has significant option value to a recovery at Cheesecake Factory. CAKE would take this because this is a flexible piece of paper with the ability to pay in kind (which is valuable to a closed restaurant company). A real "lender" would require cash interest and shorter effective maturity. It is in CAKE's interest to sell some upside to Roark and effectively raise this financing instead of a higher cost, cash-pay paper which is what the debt market would require [landry's just raised 1st lien loans at like 15%...https://www.bloomberg.com/news/articles/2020-04-06/landry-s-brings-first-u-s-leveraged-loan-in-almost-a-month] Who the hell lends to a restaurant now? they don't want to lend to the people who own the space much less those who lease it.. CAKE increases the probability of survival by taking Roark's money vs a less friendly party. Roark has a long history of working with/owning restaurants (it is the premier multi-unit private equity firm with an emphasis but not sole focus on restaurants). There is value to teaming up with Roark beyond the money. A debt fund/ bank just gives you money. this is a very small deal for Roark. If i had to guess, they're dipping their toes in tepid fashion, perhaps anticipating more pain at CAKE and across their empire. 

 

2. unsure but I wouldn't worry about a common dividend at this time, they need to pay their rent and new PE loan sharks partners first.

 

3. $1000  Par Value / $22.23 Conversion Price = 45 shares per preferred, potential of 9 million shares or about 20% of the company. these transactions usually get 20% of the company because above 20% requires a shareholder vote and presents uncertainty to the transaction. CAKE has a bunch of closed operations and it needs cash now! Call Roark, 877 cash now! Note the language that conversion can't result in Roark owning more than 20% of CAKE. I believe (based on other companies where this structure takes place) that's to avoid a transaction in which over 20% of shares change hands, which would require a shareholder vote.

 

Think about it from Roark's perspective. If CAKE is successful, they want to own 45 shares. If CAKE isn't successful, they want to lend to it at 9.5% and grow their liquidation preference.

 

4. the company is not allowed to pay this back until the 5th anniversary. Between years 5 and 6, they may pay it back at 120% of par, but Roark can convert just before conversion. After year 6, they may pay back at par but again Roark may convert. This is to protect Roark's re-investment risk. They are extracting value from CAKE and don't want to be called on their high cost paper in the event of a quick recovery, likewise they want to benefit if CAKE is at $50 and their pref's are better off as common equity.

 

EDIT: it looks like after 90 month's Roark can demand they pay it back. this is longer duration than they'd get from a loan, offering CAKE some runway. and it doesn't show up as a scary maturity in the traditional sense.

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I'll try answer your questions. All from a  very quick read, errors are very possible.

 

1. this is not equal to borrowing at 9.5%, this is equal to borrowing at a higher percentage, because the instrument has significant option value to a recovery at Cheesecake Factory. CAKE would take this because this is a flexible piece of paper with the ability to pay in kind (which is valuable to a closed restaurant company). A real "lender" would require cash interest and shorter effective maturity. It is in CAKE's interest to sell some upside to Roark and effectively raise this financing instead of a higher cost, cash-pay paper which is what the debt market would require [landry's just raised 1st lien loans at like 15%...https://www.bloomberg.com/news/articles/2020-04-06/landry-s-brings-first-u-s-leveraged-loan-in-almost-a-month] Who the hell lends to a restaurant now? they don't want to lend to the people who own the space much less those who lease it.. CAKE increases the probability of survival by taking Roark's money vs a less friendly party. Roark has a long history of working with/owning restaurants (it is the premier multi-unit private equity firm with an emphasis but not sole focus on restaurants). There is value to teaming up with Roark beyond the money. A debt fund/ bank just gives you money. this is a very small deal for Roark. If i had to guess, they're dipping their toes in tepid fashion, perhaps anticipating more pain at CAKE and across their empire. 

 

2. unsure but I wouldn't worry about a common dividend at this time, they need to pay their rent and new PE loan sharks partners first.

 

3. $1000  Par Value / $22.23 Conversion Price = 45 shares per preferred, potential of 9 million shares or about 20% of the company. these transactions usually get 20% of the company because above 20% requires a shareholder vote and presents uncertainty to the transaction. CAKE has a bunch of closed operations and it needs cash now! Call Roark, 877 cash now! Note the language that conversion can't result in Roark owning more than 20% of CAKE. I believe (based on other companies where this structure takes place) that's to avoid a transaction in which over 20% of shares change hands, which would require a shareholder vote.

 

Think about it from Roark's perspective. If CAKE is successful, they want to own 45 shares. If CAKE isn't successful, they want to lend to it at 9.5% and grow their liquidation preference.

 

4. the company is not allowed to pay this back until the 5th anniversary. Between years 5 and 6, they may pay it back at 120% of par, but Roark can convert just before conversion. After year 6, they may pay back at par but again Roark may convert. This is to protect Roark's re-investment risk. They are extracting value from CAKE and don't want to be called on their high cost paper in the event of a quick recovery, likewise they want to benefit if CAKE is at $50 and their pref's are better off as common equity.

 

EDIT: it looks like after 90 month's Roark can demand they pay it back. this is longer duration than they'd get from a loan, offering CAKE some runway. and it doesn't show up as a scary maturity in the traditional sense.

 

Thanks for such a good explanation.

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A 9.5% equivalent to yearly interest rate is very high for current market rates.

 

The current credit market rate is pretty bad for companies that are shut and not paying their rents. These companies, like CCL are raising money at very high rates. CCL paid about 11.5% as an investment grade company. 9.5% isn't too bad in this environment, although they had to give part of the upside to secure this rate.

 

https://www.barrons.com/articles/carnival-pays-steep-rates-for-nearly-6-billion-in-new-debt-51585834262

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There’s an article on Bloomberg today about PIPEs (Private Investment in Public Equity) and that there’s a lot of competition between PE firms to do them because they have so much dry powder.

 

It says that CAKE spoke to 20 different parties and chose Roark’s deal, which gives some credibility to the idea that CAKE sees Roark as a value-add/partner or at the very least found their terms less objectionable than others.

 

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I'll try answer your questions. All from a  very quick read, errors are very possible.

 

1. this is not equal to borrowing at 9.5%, this is equal to borrowing at a higher percentage, because the instrument has significant option value to a recovery at Cheesecake Factory. CAKE would take this because this is a flexible piece of paper with the ability to pay in kind (which is valuable to a closed restaurant company). A real "lender" would require cash interest and shorter effective maturity. It is in CAKE's interest to sell some upside to Roark and effectively raise this financing instead of a higher cost, cash-pay paper which is what the debt market would require [landry's just raised 1st lien loans at like 15%...https://www.bloomberg.com/news/articles/2020-04-06/landry-s-brings-first-u-s-leveraged-loan-in-almost-a-month]

 

 

As you suggest, the real interest rate on this is higher than 9.5%.  CAKE essentially sold a PIK bond and something like a six-year call option on 9 million shares with a $22.23 strike.  If you assume $19.50 stock price at exercise, 1% risk-free rate, and 27% volatility (from 2019 10-K, but too low now), Black-Scholes would value the option at $4.55/share * 9 million shares = $41 million.  That leaves $159 million in principal for the PIK bond.  It's paying 9.5%*200 million = $19 million annually in interest, which is ~12% interest on $159 million in principal.  For various reasons, the B/S value of the option is probably too low, so the true interest rate here is likely higher.  In addition, the right to participate in common dividends pre-conversion has some value, which would also increase the implied interest rate.  Bottom line:  It looks to me like CAKE is borrowing in the low teens.

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Great answers from everyone.  One thing I will also add is that, in my experience with convertible prefs, management teams view this (ever optimistically) as a way to essentially issue equity at above market prices.  CAKE might have not issued equity because they believe their current stock price to be too low or secondaries are hard in this market so they looked to a structured deal to issue a lot of equity a bit above their current price.

 

 

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