What Is Deferred Equity?
Deferred equity is a type of security, such as preferred shares or convertible bonds, that can be exchanged in the future at a predetermined price for shares of common stock. These securities, also known as convertibles, are named as such because of their equity component, and the expectation that they will eventually be converted into regular ownership stakes in a company.
- Deferred equity is a type of investment that can be exchanged in the future at a predetermined price for shares of common stock.
- Payouts on these income-paying securities are lower than normal because they offer the option to be converted into more profitable equity.
- The most common types of deferred equity are convertible preferred shares and convertible bonds.
- Companies that issue these securities will often use call features to maintain some control of the investment.
How Deferred Equity Works
Deferred equity is an investment vehicle that gives its owners the possibility to convert the income-paying securities they hold into common shares in a company at some point in the future. Payouts are usually lower than comparable securities without conversion features because they come with an option to acquire regular units of ownership in a company and all the associated benefits that come with this.
The date of conversion may be determined at the outset, left for investors decide or be at a company’s discretion — occasionally deferred equity will be issued with a call provision, meaning the company can force investors to convert the security into common stock, usually when the stock price rallies to a high level. In any case, if and when the conversion occurs, investors should find themselves acquiring securities with greater potential for appreciation, and all the associated risks, normally at a lower price than what they would have had to pay for them on the open market.
The price per share that deferred equity can be converted into common stock, otherwise known as the conversion price, is based on the conversion ratio, which is established at the time deferred equity is issued and can be found in the bond indenture, in the case of convertible bonds, or in the security prospectus, in the case of convertible preferred shares.
To calculate the price, it is necessary to divide the par value of the convertible security by the pre-determined conversion ratio indicating the number of common shares the investor receives for each convertible security.
Often, the conversion price will be set significantly higher than the current price of the common stock, making conversion desirable only if a company experiences a significant increase in value.
Example of Deferred Equity
A convertible bond, one of the most common forms of deferred equity, offers the features of a fixed-income corporate debt security, such as interest payments, alongside the possibility to one day trade this in for stock in a company. Typically, the bondholder will exercise the convertible option and transform the bond to shares of common stock if the price of the underlying shares rise to a profitable level, typically 25 percent higher than the price at issuance.
Selling convertible bonds presents companies with a way to raise money cheaply. Coupons, the annual interest paid on these fixed-income securities, are low because they come with a value-added component.
Each convertible bond has a conversion ratio that denotes the number of shares of common stock the bondholder can receive upon conversion. The ratio may be stable or it might change over the bond’s life, but it is always adjusted for stock splits and dividends. A conversion ratio of 50 means that for every $1,000 of par value, or face value of the bond, the bondholder converts, he or she will obtain 50 shares of common stock at a conversion price of $20 per share.
Most convertible bonds have intermediate-term maturities and contain a call provision, forcing investors who wish to convert to do so at that price, even if they would rather wait for a better opportunity. The upside is not unlimited. However, the investor will receive the par value of the bond at maturity, even if the share price falls dramatically, meaning that some downside protection is provided.
When deciding whether or not to make a deferred equity investment, it's important to be familiar with the specifics of not only the convertible features but also call features. If a company makes the convertible securities callable at or near the conversion price, interest expense is eliminated and the investor receives either return of capital or common stock equal to the initial investment.
Deferred equity can also be sold before conversion. If the stock price is way below the conversion price, the security is likely to trade as a straight bond or preferred share, since the prospects of conversion are viewed as remote. Should the stock price rise, however, the deferred equity becomes more valuable.