Contingent Capital: Options on Capital When You Need It Most
Book: Structured Finance and Insurance: The ART of Managing Capital and Risk Author: Christopher L. Culp Publisher: Wiley Finance, 2006 ISBN: 978-0-471-70631-1
Chapter 15 covers one of the more creative corners of Part 3’s structured finance world. Contingent capital is the right to issue new securities during a specified period at a predetermined price. Usually something bad has to happen first before you can exercise that right.
Think of it this way: you negotiate a deal today that lets you raise money tomorrow, on terms locked in today, but only if specific conditions are met.
Contingent Capital as Options
Culp frames contingent capital as compound options. A regular corporate security can be viewed as an option (we covered that earlier in the book). Contingent capital is an option on that option. But for practical purposes, let’s just treat it as an option to issue a security.
Like any option, you can describe it using six features:
Underlying asset: The security you get to issue. Usually deeply subordinated debt or preferred stock. So most contingent capital facilities are closer to contingent equity than contingent debt.
Tenor: How long you have to exercise. A three-month facility on five-year debt has a three-month option life, even though the underlying security lasts five years.
Strike price: The predetermined issue terms. Usually set at-the-money when the deal is negotiated. The intrinsic value at exercise is the difference between what you’d pay in the open market versus the pre-locked terms.
Exercisability: Usually American-style (exercise anytime). But there’s often a second trigger. The first trigger is that the option has to be in-the-money (capital is cheaper through the facility than in the open market). The second trigger is usually some specific loss event. Both conditions must be met.
The second trigger is important for moral hazard. You don’t want the company to be able to draw on the facility just because it’s a good deal. The loss event makes sure the facility is available only when genuinely needed. And smart structures tie the second trigger to something the company can’t easily manipulate, like industry-wide earnings rather than the firm’s own earnings.
Type: Most are puts. The company gets the right to sell (issue) new securities to the counterparty. This is different from warrants, where the investor has the right to buy.
Option writer(s): Usually one or two firms, sometimes leading a syndicate. These aren’t public market deals. They’re contingent private placements.
Insurance Company Applications
Insurance companies were the early adopters. Their regulatory capital (surplus) has minimums that can trigger severe penalties, including mandatory shutdown. So protecting surplus from catastrophic events was critical.
Contingent Surplus Notes
Insurance companies can issue surplus notes, which are debt instruments treated as capital for regulatory purposes. In the 1990s, several insurers (Hannover Re, Nationwide, Arkwright) set up contingent versions.
Here’s how it worked: Investors bought bonds from an SPE. The proceeds went into high-quality collateral like Treasuries. The insurance company bought a put option from the SPE that allowed it to issue surplus notes if a catastrophic loss hit. The premium was deposited into the collateral account.
If nothing happened, investors earned the Treasury rate plus the commitment fee. If the catastrophe struck, the insurer issued surplus notes to the trust, the trust liquidated the collateral to buy them, and from that point forward investors held insurance company credit risk instead of Treasury risk.
CatEPuts
Catastrophe Equity Puts. Designed by Aon working with Centre Re. The company gets to issue equity (usually convertible preferred) at prenegotiated terms if a specific catastrophic loss occurs.
The first CatEPut was placed in 1996 for RLI Corporation, a specialty insurer that got hammered by the Northridge earthquake. RLI got the ability to issue up to $50 million in convertible preferred shares following a massive property and casualty loss. This meant RLI wouldn’t have to scramble for capital on terrible postloss terms.
Horace Mann Educators Corp. also used CatEPuts, purchasing $100 million in coverage. The loss event serving as the second trigger was highly correlated with expected stock price declines, which helps ensure the option is genuinely in-the-money when triggered.
Committed Capital Facilities
Similar to contingent surplus notes but less conditional. The Anchorage Finance structure for Ambac Assurance is a good example. Four sub-trusts, each issuing $100 million in securities backed by commercial paper. Each sub-trust wrote a contingent equity put to Ambac. If exercised, commercial paper gets liquidated, preferred stock gets purchased, and investors end up holding Ambac preferred instead of CP.
Several monoline insurers set up similar facilities in the 2001-2004 period. These structures are really fully prefunded reinsurance programs in disguise.
Swiss Re’s CLOCS
Committed Long-Term Capital Solutions. One of the most successful contingent capital products. Can be structured as contingent debt or equity.
MBIA Insurance Corporation used a $150 million CLOCS with Swiss Re in December 2001. For a monoline insurer, the nightmare scenario isn’t insolvency. It’s losing the AAA rating. Without AAA, their entire business model collapses. The CLOCS gave MBIA access to capital on pre-loss terms after taking a big hit on its guarantee business. Swiss Re would purchase subordinated debt that converts to perpetual preferred stock over time.
Corporate Applications
Insurance companies use contingent capital mainly for capital preservation. Corporate users have broader motivations.
Committed Lines of Credit
The oldest and most common form of contingent capital. A bank agrees to lend you up to a certain amount for a specific period. You pay a commitment fee on undrawn balances. If you draw, it becomes a real loan.
No explicit second trigger, but companies typically draw after a significant liquidity hit. This is pure contingent financing, not risk transfer. The bank gets its money back. It’s useful for the underinvestment problems we covered in Part 1.
Royal Bank of Canada CLOCS
In October 2000, Swiss Re provided a C$200 million facility to RBC for preferred stock at pre-locked terms. Banks hold excess reserves over Basel minimums to avoid having to replenish on bad terms. But excess reserves are expensive because they divert earnings from investments.
RBC used CLOCS to maintain its buffer without actually holding the capital. As RBC executive David McKay explained: “It costs the same to fund your reserves whether they’re geared for the first amount of credit loss or the last amount of loss. What is different is the probability of using the first loss amounts versus the last loss amounts. Keeping capital on the balance sheet for a last loss amount is not very efficient.”
This improved RBC’s return on equity while still providing protection for extreme scenarios.
Michelin CLOCS
One of the most celebrated deals. Swiss Re and Societe Generale structured a facility for Compagnie Financiere Michelin. The bank piece was a committed line of credit. The CLOCS piece was a five-year put option on subordinated debt, with a second trigger: the combined average GDP growth rate in European and US markets had to fall below a threshold.
Tying the trigger to GDP was clever. Michelin’s earnings are highly correlated with GDP growth, so the facility activates when Michelin genuinely needs it. But GDP is beyond Michelin’s control, so moral hazard is minimal. The commitment fee was five basis points below the bank piece, partly because of this second trigger.
Michelin used CLOCS as financial slack to fund investments that might arise during downturns. During good times, finance expansions from internal funds. During bad times, exercise the facility instead of passing up opportunities.
Reverse Convertibles and Trombones
Trombone convertibles emerged for M&A financing. Two call dates at two different prices. The second call is contingent on an M&A event (like antitrust approval). Allied-Lyons used one for its 1994 acquisition of Pedro Domecq. If the EC Commission approved the merger, investors got full participation. If not, investors paid less but got fewer shares. This solved the problem of raising acquisition capital before knowing if the deal would close.
Reverse convertibles are bonds plus a put option on the issuer’s stock. If the stock price drops below the strike at maturity, the bonds are redeemed in shares instead of cash. Popular in Germany and Switzerland. Coupons are high to compensate investors for the equity downside risk. Some include a barrier (down-and-in reverse convertibles) to limit investor risk and reduce the coupon.
The Cephalon Story
My favorite example in the chapter. Biotech firm Cephalon needed cash to buy back a drug license from a research partnership if the FDA approved its flagship drug, Myotrophin. Management estimated an $80-100 million external funding gap.
Working with SBC Warburg, Cephalon purchased European-style call options on its own stock. If FDA approval came and the stock rallied, the options would generate roughly $45 million in cash. If approval didn’t come, the options would expire worthless.
Elegant. The cash inflow would arrive precisely when needed and from precisely the event that created the need.
As it turned out, the FDA didn’t approve Myotrophin. The options expired worthless. But Culp rightly notes that on an ex ante basis, this was a well-designed contingent capital program. Sometimes good decisions lead to bad outcomes.
My Take
Contingent capital is one of those topics that sounds obscure but is genuinely useful. The core insight is that access to capital matters most when it’s hardest to get. Locking in terms before disaster strikes is valuable for the same reason insurance is valuable. You’re paying a small premium now to avoid a potentially devastating cost later.
The variety of structures here also shows how creative financial engineering can get when there’s a real problem to solve.