Merrill's Death Spiral Financing?

When cash strapped companies raise money by issuing securities where the number of shares issued increase as the the share price falls, the transaction is occasionally referred to as a "death spiral convertible".

Last week, no more than 23 days into John Thain's tenure, Merrill Lynch became the latest bank to arrange a capital infusion from a Sovereign Wealth Fund. Temasek of Singapore is purchasing $4.4bn of stock at $48/share with an option to purchase a further $600m of stock for up to 3 months from the date of the initial purchase. Davis Selected Advisors, a US money manager is chipping in with a $1.2bn stock purchase at $48.

At the September 2007 quarter end Merrill had 855.4m shares outstanding. Including 25m shares for the Davis investment and 91.7m shares for the initial Temasek investment results in 972.1m shares outstanding. The two initial sale transactions thus represent 12% (Temasek9.4%, Davis 2.6%) of the enlarged share capital issued at a 13% discount to the pre-deal price of around $55 . That in itself is decent dilution at considerable cost. But there are other peculiarities relating to the transaction:

1: Another fund raising is needed before Temasek can exercise its $600m option:

Unless there has been an increase in the number of shares outstanding since the September 28 period end of which this author is unaware (1), if Temasek exercise their option on 12.5m shares, they breach the 10% ownership limit forbidden under the terms of the deal. To receive the full Temasek capital infusion, Merrill must issue a further 57m shares or over 5% (for $2.5-3bn) to another party before March 28, 2008 . Either John Thain isn't done diluting existing shareholders, or Temasek's option to purchase a further $600m of stock is not all it seems. No wonder Goldman Sachs' analyst is able to forecast a kitchen-sinked quarter if there is another capital injection on the way.

2: Anti-dilution provisions look unfavourable for Merrill:

The term sheet also references a price "reset". The specific language is:

If Company sells or agrees to sell any common stock (or equity securities convertible into common stock) within one year of closing at a purchase, conversion or reference price per share less than $48, then the Company must make a payment to Purchaser to compensate Purchaser for the aggregate excess amount per share paid by Purchaser. At the Company’s option, the Company may issue additional shares of common stock in lieu of cash to Purchaser with a market value equal to such excess amount.

Translation: Temasek has a put option of sorts on its investment. If Merrill goes cap in hand for more capital later in 2008, it ain't going to be above $48. Temasek are immunised against this risk for 12 months. For example, if some unforeseen credit writedown in Q3 2008 casues Merrill to require another $8bn at a perfectly conceivable $30/share, Temasek will have to be repaid $1.875bn ($18 * 104.2m shares), or be issued a further 62.5m shares. Combine this with maintaining the 10% threshold and we are talking some serious potential dilution. Just when Merrill might need to raise capital more than ever, it will have to give it back to Temasek or dilute existing shareholders even further.

Is this a death spiral transaction then? Although the principle is similar, the answer is probably a qualified "no". Temasek are only entitled to their make-whole payment if Merrill go ahead and raise capital later in 2008. Surely a major reason these dangerous looking terms are embedded in the deal is that Merrill's management want to make a significant statement to the market that this will not be the case.

What Merrill are signalling, quite simply, is that they believe the worst is over. They must think that this transaction, plus the possibility of another $2-3bn infusion before March 2008, is enough to see off the rest of 2008 and beyond. Merrill shareholders, more than those of any other investment bank, need their management to be right with their call. If they are wrong, Merrill has compounded its downside with this transaction.

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(1) Merrill had not responded to queries on the transaction (specifically, that the pre-transaction number of common shares outstanding was indeed 855.4m) at the time of posting.
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Disclosure: Long MER options (from old employment)

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