Preferred Shares - Dilution Indicators and Decisions

Readers may recall my previous posts focusing on preferred shares as an interesting mezzanine equity alternative to real estate and an emerging popular trend to seek quality with the potential for capital gains with investors.

A quick review: preferred shares are between senior tranches (debt and bonds) and junior tranches (equity) and have similar characteristics of both. They are similar to convertible bonds with coupons: A preferred share usually comes with a regular dividend payment and can be converted into common shares later when your company takes off.

While these shares in themselves have their own unique characteristics, it is interesting to look at the fundamental mechanics of how they work (and what trading volume in them indicates to investors).

Background: If you are a company, your main sources of capital are usually to issue debt (bonds) or to seek equity (investors buying stocks). However, if you are growing, pre-IPO company, you might have trouble finding a market for your capital raising products (banks won't lend you the money you need because you've already borrowed a lot, and no one is interested in buying equity in your company - your not listed, no liquidity).

This is where a venture capitalist will come in at the mezzanine financing level. The VC firm will usually offer to provide you with additionally financing you need with the goal to bring you to an IPO ready state. They want their capital investment to be senior to equity, but they also want to get some of the potential upside if your company takes off in the IPO. They will usually create an arrangment where they hold preferred shares in your company, getting regular payments, but having the option to convert to common shares.

What can we learn about a company by watching this market?

Let's do a quick recap of fundamentals analysis:

Basic EPS is calculated as follows:

Basic EPS = [NI - PDIV] / WANS

NI - Net Income
PDIV - Preferred Dividends
WANS - Weighted Average Number of Shares outstanding

Analysts will be familiar with the concept of dilution. Dilution is what happens when preferred shares (or other options) are converted into common shares. The EPS can decrease because the same net income (NI) is spread over a larger base of shares.

Diluted EPS = NI / [WANS + NCS]

NCS = New Common Shares issued on conversion
*Note that because the preferred shares are converted, there is no need to reduce the numerator by the preferred dividend because it is not paid out

However, an observant analyst will note that not all conversions result in dilutions. When does this happen? If you do the math, you can see the condition for this is true iff (if and only if):

Basic EPS >= Total Preferred Dividend / Number of Preferred Shares

What does that mean? For a moment take taxation, speculation, liquidity and emotion out of the picture. If you hold a preferred share, you would consider it a good idea to convert your preferred share to common if:

You could get more value through EPS in a common share than
if you received the preferred dividend

Makes sense. In this case, you'd rather take the common share to gain it's EPS rather than be paid the dividend. It's a zero-sum game (the money and earnings are finite). You'll only participate in diluting the EPS if doing so allows you a larger chunk of the NI.

But also look at the larger implications: What does that mean for the company? Chances are that it is starting to grow (it's reporting positive EPS after all)! Risk (long run variation in returns) aside, it would be logical to take the larger earnings. Is this a tipping point for the company? Is it finally worth it to move from mezzanine finance into equity investing?

Now of course when we put the assumptions back in from above which we took out to illustrate the point, we suddenly see other factors come into play:

• Dividends are taxed differently than capital gains income
  
• Analysis of strength of earnings - affect PE ratio for common share market price
  
• Sharpe ratios of risk to reward - Investor risk tolerance
• Liquidity - Even though you have more equity on paper (EPS versus dividend) how much of it can easily be converted to cash is another topic all together

But this simply has to be a metric which private equity, venture capital and hedge funds watch for "up and coming" companies who have large mezzanine instruments in companies which are in a marginally post-IPO position.