Convertible preference shares

[hubertd]

Hi Everyone,

We're planning to invest in a rare earths extraction project via convertible preference shares. They will convert into ordinary shares at x price at either of:
- successful commissioning of the project
- change of ownership
- IPO or sale to 3rd party

The preference shares will pay a variable coupon (SOFR + 5% margin) - PIK dividend - which will be capitalised and converted into ordinary shares upon exit.

What kind of instrument is it? Just an equity holding? If so, how would one fair value this? Any idea? What's the accounting for the coupon/dividends?

Thanks

[DJP]

Hello,

When you say "convert into ordinary shares at x price", what do you mean? Is the price and quantity of the shares fixed? Or is the quantity of shares variable depending on the share price upon conversion?

[hubertd]

x price is a fixed price given upfront

[DJP]

so the quantity of shares is variable?

[hubertd]

We invest fixed amount and the conversion price is fixed so it's know upfront how many ordinary shares we're going to receive. Besides, it doesn't really matter if we receive fixed or variable number of shares. We're a holder not an issuer so this distinction is meaningless.

[DJP]

Sorry, I first understood that you were being funded via convertible pref shares.

In any case, it does matter to know what kind of instrument you're investing in. It looks like that you are getting a fixed number of shares for a fixed price and, therefore, there is an equity component in here. Hence the contractual cash flows are not SPPI because the return is linked to the value of the equity of the issuer. The investment should be carried at FVTPL. The coupons/dividends are accrued and part of the full fair value of the instrument. You should consult with a valuations expert to determine the fair value of this investment.

[hubertd]

Sorry DJP. My fault. I created a bit of a confusion but I was confused myself by the draft of the instrument terms where things were mixed up.

So in a more detail, we invest initially $30m at a pre-money valuation of 20p per preference share so getting 150m of preference shares. Then the dividends in kind will be added to our investment and increasing the number of preference shares we hold. Let's say right before conversion we would have 170m of preference shares. Then the preference shares will convert into ordinary shares at a ratio of 1 to 1 upon the successful commissioning of the project.

Thanks for suggesting we should consult a valuation expert. This was indeed my first thought. One clarification - saying dividends are accrued you mean adding them to fair value of the investment on balance sheet against dividend income in PnL, right?

[DJP]

No worries. The entire instrument should be carried at fair value on the balance sheet and its fair value changes should be recorded on the same line item in P&L (including the coupons/dividends accruals), i.e. I don't think it would be appropriate to record coupons/dividends accruals separate from the rest of the investment's fair value changes in the income statement.

[hubertd]

I think you're right about the coupons/dividends - thanks for pointing that out. Just for the avoidance of doubt, this is an equity instrument in my books in terms of classification, do you agree?

[DJP]

well, that is not an IFRS classification. you don't have to differentiate equity investments from the rest on your balance sheet. It is simply an investment at FVPL. You can then (and perhaps should) provide more information in the notes.

[hubertd]

Ok, I should have been more specific. Is this the equity instrument so that I can consider the OCI option? You're obviously right there's no distinction on the face of the balance sheet between equity instruments and debt held at FVPNL.

[DJP]

I don't think you can designate this instrument at FVOCI. Even though it has characteristics of equity, it is not equity (it does not represent yet a residual interest in the net assets of an entity). Plus, it also has a liabiity component -- the coupons/dividends. The entire instrument should be carried at FVTPL.

[hubertd]

Thanks DJP. Makes sense however I don't think there's a liability component on the part of the issuer. The coupons are capitalised and turned into preference shares which will be converted into ordinary shares. At no point does the issuer have an obligation to deliver cash.

[DJP]

Not so sure about that last point. There may be no obligation to deliver cash, but there is an obligation to deliver another financial asset. In any case, I don't think this is relevant for the matter in question.

[hubertd]

I was thinking about equity by exception as per para 16A-16D of IAS 32 but the Terms of the deal do not help me much. They state:

“In the event of any liquidation, dissolution or winding up of the Company, distributions shall be made with each Preference Share receiving a preference to holders of any of the Company’s other class of equity shares, equal to 1.5x the purchase price (plus accrued but unpaid dividends) per Preference Share. Investor shall have the right to convert its Preference Shares immediately prior to the effectiveness of any voluntary liquidation, dissolution or winding up”

It seems anything we do in such a case would depend on the economics of the transaction at the time of liquidation. Nothing I can know in advance.

Still no wiser if that would be debt via FVPnL or equity by exception instrument.

[Leo]

Just picking that up out of interest and also wanted to follow up with another question (related).

I think, if you conclude that the preference shares are equity instruments, as DJP said, it clearly fails SPPI test. However, I think provided the instrument is not held for trading, the company can still make an irrevocable election to present FV movements in OCI (recycling not allowed) because I think it's simply an equity instrument (I can't think of anything else belonging to liability).

I know that in this case, the prefs don't give the company any voting rights (which is often the case), but is there a chance still to account it as an investment at cost? (considering it as an investment in sub, JV or associate?)

Or, will it be reclassified into investment at cost upon conversion into ordinary shares? Even the conversion in a future date is mandatory?

I guess my question is does the accounting of the prefs as an investment in subs JV or associate at cost hinge on the prefs qualification as an equity instrument or on whether the prefs bears voting rights that make the holder a shareholder (now, not in the future when they are converted into ordinary shares).

Thanks

[Leo]

Any thoughts?

[Ketan Marwah]

Couldn't resist but to share my laughter on your interest in the archives…happy learning!! Since it is a long thread therefore maybe will try to mutter up the courage to read at a later time..