Mezzanine Financing: Tools, Applications and Total Performance

4

The ‘Pricing’ Question and Further Financial Dynamics of Convertible Loans and Preferred Convertible Shares¹

The first part of this chapter will be devoted to the question of the mezzanine product group's pricing: we will build further on the discussion we started at the end of Chapter 3. The second part will be devoted to some of the intrinsic complexities of embedded optionalities as they can be found in convertible loans and preferred convertible shares.

4.1 PRICING GRID FOR MEZZANINE PRODUCTS

As indicated earlier, the pricing of these products is very fact dependent. However, basic logic with respect to debt pricing and the underlying debt still applies. As the creditworthiness of a firm deteriorates, the pricing of the instrument will go up. Often this process is, to a large degree, linked to the firm's credit rating which takes into account the subordination of the debtholders, the amount of (expected) FCF etc. For non-listed instruments or companies this is much more complicated.² In these situations there are basically two options with respect to structuring the pricing of subdebt, regardless of the category in which they fall.

The first option is to create a synthetic credit rating for the firm or instrument. The Damodaran chart below – which is taken from Chapter 3 – reflects the correlation between the S&P credit rating and the Interest Coverage ratio. The outcome can then be used to substantiate the spreads added to the basic funding cost. The chart indicates the ...