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When I was in practice, I was proud of the way that my old flyover state law firm managed to more than hold its own when it came to capital markets transactions. My colleagues and I were involved in some pretty complex offerings and knew our way around a bunch of different financing structures. That being said, whenever I worked on a “modern” convert deal, I felt like a complete rube. One reason for my discomfort was that I cut my teeth on traditional converts back in the 80s and 90s, and those straightforward deals bear little resemblance to the masterpieces of financial engineering that converts have morphed into over the past couple of decades.

If you feel the same discomfort with these deals that I did, this Latham memo on “Demystifying Modern Converts” may be helpful to you. Here’s an excerpt from the memo’s discussion of one of the more complex features of a modern convert – the fundamental change make-whole provision:

Make-whole fundamental changes include the classic example of a cash merger, but they also include other events, such as the delisting of the underlying common stock, which reduces time value by decreasing liquidity and, accordingly, the ability to quickly sell the stock at fair value. As described below, calling the notes for redemption can also trigger make-whole fundamental change provisions. Importantly, a business combination event pursuant to which the notes become convertible into consideration 90% or more of which consists of listed stock of another issuer is usually excluded from the definition of make-whole fundamental change.

The theory behind this exclusion is that the convertible notes will continue to have meaningful time value following the business combination because a substantial part of the consideration due upon conversion will be based on the value of a price-volatile asset — listed stock. This is rough justice, obviously, since the new underlying security could be significantly more or less volatile than the original underlying security. Nonetheless, this is the current market compromise on the issue.

The temporary increase to the conversion rate is usually designed to result in the consideration due upon conversion having a value that, except as described below, approximates the theoretical value of the notes immediately before the make-whole fundamental change. Accordingly, converting noteholders that are entitled to the increased conversion rate will, in theory, be “made whole” for the loss of time value resulting from the make-whole fundamental change. The amount of the increase is determined by reference to a table and is based on the effective date of the make-whole fundamental change and a measure of the value of the underlying common stock as of that effective date.

The memo goes on to describe how the pricing information in the “make-whole table” is determined. I triple-dog dare you to read that discussion once and tell me with a straight face that you understand it. If you can’t do that, don’t feel bad, because my experiences with make-whole tables were what made me realize that I wasn’t the only rube on the deal team. For instance, we once priced a deal right after the market closed and then waited until almost 10:00 pm for the pricing term sheet to be completed, because none of the Wall Street bankers on the deal could figure out the make-whole table either.

– John Jenkins