Following strong performance and record issuance of convertible bonds over the last several years, investors are beginning to take notice of the attractive characteristics of this unique asset class. The hybrid construction of convertibles can offer a compelling way to participate in risk-on markets while offering some downside support during market pullbacks. Pier 88’s Investment Team posits that convertibles are a defensive way to gain exposure to growth stocks with less volatility. The case study of next generation security vendor Proofpoint, Inc. (“PFPT”) is demonstrative.
Case Study Example: Proofpoint, Inc. (“PFPT”)
PFPT is a security software vendor that focuses on threats and attacks associated with email. The company went public several years ago and subsequently tapped the convertible bond market for additional growth financing. We believe fast growing, innovative companies like PFPT tend to be attracted to the convertible bond market as it allows them to raise capital at lower interest rates in a manner that is less dilutive than straight equity. Investors may be attracted to convertibles from companies like PFPT as the risk of default is generally low (especially for software companies) and provides the investor with a call option on the company’s future growth. Further, there is a potential benefit of M&A optionality. Pier 88’s investment process focusing on disruptive innovators identified PFPT as a company that would likely be deemed strategic to a larger industry player. And it was.
On April 26, 2021, PFPT announced that it had entered into a definitive agreement to be acquired by Thoma Bravo, a leading private equity investment firm, in an all-cash transaction that valued PFPT at approximately $12.3 billion. Under the terms of the agreement, PFPT shareholders will receive $176.00 per share in cash, representing a premium of approximately 34% percent over PFPT’s closing share price on April 23, 2021. As depicted below the stock jumped on the news of transaction and the convertible bond had a sharp positive move as well.
Bondholders were rewarded as the market price for the convertible bond played offense following the equity move up and jumped from approximately $105 to $124.81 (+19% move).
What may be actually more interesting about this PFPT bond was how it protected during the Q1 growth sell-off. Despite positive returns of the S&P, Q1 saw a pronounced drawdown in high growth names, particularly in technology and healthcare, as investors sold last year winners to fund the value rotation. Many software and biotech names sold off in Q1 delivering negative returns. The downdraft helps illustrate the defensive nature of the convertible bond. As the above graph illustrates, the convertible bond outperformed the underlying equity as the equity declined. At the nadir, PFPT’s equity declined 17.56% while the convertible declined 8.86% or roughly half of the stock’s move. An investor owning the PFPT convertible bond from January 1st to April 26th when news of the deal hit, would have made ~+12.5% in a little under 4 months and beating the S&P, NASDAQ, and Russell 2000 Growth indices.
Pier 88’s Investment Team believes the sharp pullback in small and midcap growth stocks this year will be a catalyst for more corporate M&A and private equity transactions. We view the convertible bond asset class as providing an interesting opportunity for investors to generate better returns from his or her fixed income investments without taking on excessive credit or duration risks. PFPT’s convertible makes the point. We believe that getting access to great secular growth companies through investing higher in the capital structure seems to be a creative and more defensive way to own growth stocks.
This case study is a proprietary publication and the property of Pier 88 Investment Partners, LLC (“Pier 88”). The publication is written to express our view of the market and to explain our investment philosophy. It is not intended to provide specific investment advice or to guarantee that any past performance will be indicative of future performance results; investments may lose money. Certain statements contained in this newsletter (such as those that contain words like “may,” “will,” should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe”) are “forward-looking” insofar as they attempt to describe beliefs or future events. No representation or warranty is made as to future performance or such forward-looking statements. Any reproduction or other unauthorized use is strictly prohibited. All information contained in the case study was obtained from sources deemed qualified and reliable; however Pier 88 makes no representation or warranty as to the accuracy of the information contained herein. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
Performance results of convertible bonds is presented for information purposes only and reflect the impact that material economic and market factors had on the manager’s decision-making process. No representation is being made that any investor or portfolio will or is likely to achieve profits or losses similar to those shown. References to market or composite indices, benchmarks, or other measures of relative market performance over a specified period of time are provided for information only. Reference or comparison to an index does not imply that the portfolio will be constructed in the same way as the index or achieve returns, volatility, or other results similar to the index. Indices are unmanaged, include the reinvestment of dividends and do not reflect transaction costs or any performance fees. Unlike indices, the Fund will be actively managed and may include substantially fewer and different securities than those comprising each index.
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Not all acquisitions are profitable. The positions can be acquired at a price that is less than the price at which the Firm purchased its interest for the funds it manages. Not all acquired companies were purchased by Pier 88 for any specific fund. The information is being presented to reflect the manager’s ability to select investments that are likely to be acquisition targets and not to reflect any positive investment experience.