Pills or puts?

Change-of-control clauses — allowing the holder to put the bond back to its issuer at par — have been a feature of the high yield market since before Michael Milken went to prison. The rationale is pretty straightforward: they are supposed to protect bondholders from the terrible returns that come when they hold debt of firms subject to leveraged buyouts.

But around the mid-2000s, these so-called ‘poison puts’ suddenly took off for investment grade (IG) issuers. A newish paper from Rex Wang Renjie and Shuo Xia that’s due to be discussed at Cambridge university’s Judge Business School at the end of the month looks at the rationale and impact of this development, drawing some interesting conclusions.

Looking at the first chart above, which plots the percentage of new bond issues with poison put covenants from 1990 to 2021, it’s easy to project a mental model of IG bondholders pushing for the kind of protection that had become commonplace in the high yield market, and the Overton Window shifting in their direction.

But the second chart tells a different story — not about bondholder protection as much as senior-management job protection. It plots the percentage of firms with change of control put-at-par covenants outstanding (that the authors call ‘poison bonds’) and the percentage with poison pills (dashed) from 1990 to 2021, using all industrial IG firms with ISS governance data.

Poison pills are no longer massively common, so may require some explanation to the uninitiated. To be honest, they’re a bit bonkers.

Fundamentally, they’re mechanisms that boards of directors can use to fend off hostile takeovers. As the Corporate Finance Institute explains, a common type is the ‘flip in’, which:

. . . entitles existing shareholders to acquire shares of the company at a significant discount. However, the flip-in option is only triggered when a potential acquirer purchases a specific percentage of the target company’s stock. Once that threshold is reached, then the poison pill becomes effective for all target shareholders, excluding the potential acquirer. Therefore, the potential acquirer’s ownership will be diluted to unacceptable levels.

Twitter tried this when Elon Musk came for them, and Netflix used one to fend off Carl Icahn in 2012.

And as the authors of the poison bonds paper explain:

. . . poison pills are widely viewed as one of the most effective strategies to deter unsolicited takeover bids (Coates, 2000), previous research has generally argued that managers adopt poison pills to entrench themselves and engage in actions that destroy shareholder value.

Maybe enlightened management teams independently sought out best practice in abandoning poison pills? Not quite:

. . . on December 8th 2004, one of the most influential proxy advisory firms, the Institutional Investor Service (ISS), announced that it would recommend its clients to “withhold” or “against” the entire board of directors at companies that adopt or renew a poison pill plan without shareholder approval. Following the persistent governance reform efforts by proxy advisors and other stakeholders, the use of poison pills among large firms declined significantly from 55% in 2004 to just 2% in 2021.

But scrapping poison pills has helped shareholder returns, right?

In the long-term, a portfolio strategy that holds firms issuing poison bonds after removing poison pills earns significant negative abnormal returns of −5.1% to −7.3% per year, suggesting significant value-destruction for shareholders.

The poor stock-performance statistics above are for companies that issued a poison bond within a year of removing their poison-pill provisions. That’s compelling because it probably captures a set of companies that were acting defensively (to protect management).

Bottom line:

When firms are under pressure to remove poison pills, they are more likely to issue poison bonds as a substitute. This practice destroys shareholder value both in the short- and long-term.

It’s hard to imagine them losing much sleep over this. Equity holders and governance folk, on the other hand, might want to take a look.