Simulated Reverse Dilution

We are all aware of dilution of EPS in common shares by the conversion of preferred shares to common and I've previously written about what affects the dilution decision for those holding convertible options. However, although this is a one way conversion, is it possible to simulate the reverse in a virtual reverse conversion?

While I suggest one possible alternative and it's reasoning, I think it becomes quite obvious why this doesn't happen (at least not directly).

First of all, a dilution conversion is taken in the circumstance when a company seems to be about to reach a tipping point of success as those holding the convertible options of preferred shares decide to convert to common shares. Until these conversion options expire, holders of the preferred shares would probably prefer to take their dividends (cash in pocket) until the last minute, maximizing the value of their options and reducing the risk of the company crashing in the interim. When the decision for the dilution decision is reached (depending on a variety of criteria) it is essentially based on the maturity and stability of the company.

This means that to take the reverse action is to bet against the maturity of the company. In the reverse analysis of the decision criteria, it assumes that EPS is weaker than dividends. In the scenario of an established company, this comes as a major red flag that the company is in distress if it is struggling to generate the necessary revenue to sustain it's cash payment obligations.

To simulate the reverse of a conversion, this would essentially mean shorting the common equity position and picking up preferred shares. However, assuming all preferred shares are converted and unless more preferred shares are issued, this is incredibly difficult (because there is nothing to buy to simulate the reverse conversion). Usually, the only comparable option is to pick up debt (short equity and go long on the companies bonds - a similar concept to the flight of quality).

However, if you are looking and manuevering solely in one company (rather than the entire market) and your only move is to reallocate your assets from equity to debt holdings, you are essentially burning down the house to get the insurance money. The corellation between these two assets (despite being in different asset classes) is extremely high. After all, a company experiencing distress won't only feel it in it's equity prices but probably also in it's solvency ratios (possibly reflecting a downgrade in it's credit rating).

As is unfortunately common practice in todays market, companies in distress are experiencing financial difficulties in both its debt ratings and equity value meaning that it will struggle to raise additional financing.

Vulture funds who see this coming will dump financial support of companies (perhaps even shorting them) in the hopes of picking up distressed funds for pennies on the dollar and looking for upside on the turn around and restructuring of the company. Obviously, this is incredibly risky as even distressed assets are cheap for a reason. Financial gravity is such that recoveries in such scenarios are often unlikely.

Although similar to deleveraging in many respects, focusing on distressed companies is different in that in the toughest times, everyone gets a "hair cut". Except for bankrupcy liquidation (Chapter 7) where senior debt has priority claim (and which is rarely used seeing as companies generally hate admitting defeat), restructuring (Chapter 11) is such that everyone who owns a stake, bond holders, mezzanine financing and even equity holders make concessions. Usually, this comes in the form of bond holders and mezz financing to take reduced claims while equity holders and other stakeholders (employees) make covenents (reduced wages, selling off non-performing divisions etc).