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26/11/2024

Convertibles

This Toolkit item relates to Part 2 - Investment Governance, Funding and Financing of the Commonwealth Investments Resource Management Guide.


What is a convertible?

Convertibles are hybrid financial instruments that contain debt and equity features. The debt feature yields fixed-interest payments, and the equity feature provides the holder of the convertible the right but not the obligation to convert the convertible into a predetermined number of shares.


When should I use a convertible?

There a number of considerations to be balanced in determining the most appropriate non-grant financing options (or blend of options).

Due to their debt and equity characteristics, convertibles could be used where the Government is seeking financing optionality in the investment. The debt and equity features of convertibles provide Government characteristics similar to a commercial loan, and equity (where exercised). The hybrid nature of convertibles brings additional complexity in their establishment and ongoing management compared to loans and equity, thus convertibles require appropriate expertise and oversight. Convertibles are complex financial instruments and care should be exercised in their use. 
 

Characteristics of convertibles

Characteristic Details

Ability to influence financed objective


Medium-High

 Depends on whether the equity feature of the convertible is exercised. If exercised, the ability to influence is similar to equity characteristics. If not exercised, the ability to influence may be limited to the debt conditions of the convertible.

Level of market intervention


Medium-High

 The use of convertibles provides optionality to Government. Exercising the equity feature of the convertible, provides the Government a higher degree of ability to influence the strategic delivery of policy objectives of the investment. 

Commercial discipline incentive


High

 The debt feature of the convertible encourages commercial discipline through commitment to predetermined debt obligations. The equity option of the convertible provides the Government the option to undertake an ownership stake in the investment.

Certainty of financial return


Low-High

 The debt feature provides certainty of return with a known repayment period and interest requirement. If the equity feature is exercised, the convertible inherits equity return characteristics (i.e., uncertainty in timing and value of returns).

Opportunity to realise upside gain


High

 The equity feature of the convertible provides optionality for Government to benefit from upside gain in the investment (i.e., where Government exercises the equity option, as a shareholder, it inherits the upside equivalent to holding equity).

Level of financial risk


Medium-High

 The level of financial risk is dependent on whether the equity feature of the convertible is exercised. If exercised, as a shareholder, the Government holds high financial risk as its security to the investments underlying assets is subordinated to all of the investment’s creditors. If the equity feature is not exercised, the Government’s claim to assets is subordinated to secured creditors. Where the shares are worth more than the debt the conversion is likely to be exercised. Alternatively, exercise of the conversion could be driven by the Government's financial risk appetite as well as policy objectives.

Security of asset


Medium

 The convertible can be secured over assets similarly to a loan; however, convertibles are usually unsecured. If the equity feature is exercised, as a shareholder the Commonwealth’s claim on assets is subordinated to all creditors. 

Administration costs


Medium-High

 Initially administration costs are at a medium level because the costs to the Commonwealth of establishing a convertible are similar to the costs of establishing a loan. However, if the equity feature of the convertible is exercised, the Commonwealth becomes a shareholder in the investment and subsequently the administration costs are high as the Government takes an active role in the oversight of the investment.


Accounting and budget classification and reporting of convertibles

As a holder of convertibles, accounting standards classify convertibles as financial assets. Convertibles are held at fair value with all movements feeding through profit and loss. In addition to Annual Reporting requirements in accordance with the relevant accounting standards, convertibles that exceed a quantifiable value of $20 million in any one year or $50 million over the forward estimates, and if its impact were not otherwise captured within the Budget estimates are subject to additional disclosure requirements in the Statement of Risks in Budget Paper 1 – Budget Strategy and Outlook.

More information on recognition in Budget aggregates is available here.

 

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