Banco Popolare: the trade-off between dilution and egregious payout, an example of risky ?tick-boxing? approach

On January 2010 Banco Popolare launched a rights issue allowing its existing shareholder to subscribe to Banco Popolare’s convertible bonds with the following conditions: nominal value of € 6.15, fixed interest rate at 4.75%, maturity March 2014. Starting from November 2011, bondholders are able to redeem the convertible bonds receiving an amount of shares equivalent to note’s nominal value plus 10% premium. The bank is able to reimburse bonds through Banco Popolare’s shares and/or in cash. Therefore, shareholders approved the issuance of approximately 277 million new shares to service the convertible bonds. Banco Popolare’s convertible bondholders were in some way protected by an equity market value drop…or that seems to be on January 2010.
Now things have dramatically changed for Italian banks: FTSE Italy Banks’ Index felt 58% since March 24th 2010 (the convertible bonds’ listing date) and European banks are forced to find new capital on the market (106 billion Euros of which at least 15 billion will regard Italian banks, according to EBA). To keep it short, Banco Popolare might be forced to refund bondholders mostly in cash, as the market price will in all likelihood be lower than bonds’ nominal value, with a prohibitive payout for the bank.
Shareholders are now requested to approve the authorization to increase the number of shares to be issued to cover the convertible bond up to 1.5 billion, almost doubling the current 1.8 billion shares outstanding: much more than 20% generally considered as acceptable by our voting guidelines! But is this really affecting existing shareholders? We estimate that, at the current share market price, Banco Popolare risks to be forced to refund bondholders with more than € 800 million additional cash, together with the 277 million new shares.
Many advisors will probably oppose the issuance of new shares and the changes to bonds’ conditions, as it is clearly contrary to their internal guidelines. But that’s the typical mistake of a “tick-boxing” approach, that brings guidelines sometimes far from specific realities.
We consider that in many situations flexibility might be vital to protect shareholders’ interests. When third quarter’s net incomes fall 30.7% (versus third quarter 2010) and the EBA estimates € 2.8 billion new capital needed by the bank, a potential egregious refund to bondholders risks to be a hard blow to Banco Popolare’s financials and, consequently, to shareholders’ revenues. Finally, we should consider that the convertible bonds have been offered to shareholders first, via a rights issue: in that case the entire deal would just result in a technical change, with no real changes between shareholders and bondholders interests.