Who Pays for This Hedge Fund Happy Meal?

(Bloomberg Opinion) -- Vodafone Group Plc's jumbo 3.4 billion-pound ($4.5 billion) fundraising this week offers stupendous returns for hedge funds and a fee bonanza for the banks involved. For the U.K. mobile phone company’s shareholders, value for money is harder to gauge.

The mandatory convertible bond is a rarified instrument that, to investors, looks unattractive at first glance. It gets repaid in Vodafone shares – not in cash. What's more, it pays a coupon of as little as 1.2 percent. Buy the shares outright and you can get a dividend yield of more than 9 percent.

Specialist convertible funds see things differently. Buy the bond and sell Vodafone shares short and you have a clean income stream. Apply leverage, and you have a much higher return. It’s likely some funds will have been able to obtain positions 50 times greater than the capital they put down. The coupons can be deferred at the company’s discretion, so investors would want to buy some protection against default. Leverage has funding costs too. These bring down the eventual return.

What’s more, to get all that leverage, the funds would need to show they can hold the bond to maturity and have plenty of liquid, low-risk, low-return investments elsewhere in their portfolio to meet unexpected redemptions without closing the trade. That's a hidden cost. Even so, investors could plausibly make a 25 percent internal rate of return on the instrument. Little wonder this kind of transaction is known as a happy meal for hedge funds.

For Vodafone shareholders, the pickings are less generous than first appear. The company has a cunning plan to protect them from dilution when the bond is repaid in new stock: it will buy back the same amount in shares, a move that, in effect, turns the whole operation into a cash-settled loan.

This insurance policy is cheaper than one might imagine. The company buys options that pay the gain on a notional 3.4 billion-pound holding of its own shares if the stock is trading higher when the bonds mature. The cost of these options is almost entirely covered by selling derivatives that force Vodafone to cover the losses if the stock goes down. Add the options payouts, and the cost of a buyback at the market price when the bond matures will be 3.4 billion pounds or thereabouts. All this for a small additional cost on top of the bond coupon.

Many of the investment banks arranging the transaction will be on the other side of the derivatives trades – another way for them to earn more from the deal. They are buying half the bonds, so could profit as investors, too. Then there's the marketing value of the league table credit. Shareholders will have their fingers crossed that the securities firms are being charitable on the headline fee.

It looks like Vodafone gets cheap financing that will neither lift leverage nor inflict dilution. But the deal exposes shareholders to some asymmetric risk. If the shares rally and the buyback proceeds, the company will have only succeeded in borrowing money more expensively than it can do right now in the bond market and deferring the inevitable increase in leverage.

If the shares fall, Vodafone loses money on the hedge – a real cash expense. What's more, in that scenario, the phone giant might not be able to spare the resources for a share buyback. Dilution would be inevitable. This outcome supposes the worst is past for the stock, which is already trading at a nine-year low. Investors can only hope.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

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