SCO and Baystar Strike a Deal

comforteagle writes "As you'll no doubt recall, SCO financier wanted to cash-in on its stock because of how SCO was being run. It appears they've struck a deal. 'The SCO Group, Inc. today announced it has entered into an agreement with BayStar Capital II LP to repurchase and retire all 40,000 shares of Series A-1 Convertible Preferred Stock currently held by BayStar.'" Summary: Baystar and the Royal Bank of Canada invested $50 million in SCO in October 2003. In 6 1/2 months, they've now converted their investment to $13 million in cash and $13.7 million of common stock, for a loss of almost half their investment.

Comments

You think it's funny, but actually ...

[mec]

When an investor such as Baystar does one of these convertible preferred deals, they can do something called "shorting against the convert".

Here's how it works. At the time Baystar bought their convertible preferred shares, SCOX was trading at about $15 (roughly ... I can't be arsed to hit Yahoo Finance right now). Well, Baystar can sell shares at $15. They can sell shares that they don't even own ... that is called "short selling", and is a normal transaction on the stock market.

You start with 0 shares, you sell (say) 10,000 shares at $15, now you have $150,000 cash and a position of -10,000 shares SCOX. (That's right, negative numbers!) Later, you buy those 10,000 shares back at $5 per share, leaving you with $100,000 profit and 0 shares of SCOX.

What if you short at $15 and the stock goes to $25? Then you lose $10 per share on every share that you shorted. Except ... if you've got a convertible ... you just pull out the convertible preferred shares and convert them, in order to have shares.

I'm not saying Baystar did this, but it's a common strategy for holders of convertibles. A convertible is really just a bond + a call option, and shorting against a call option is a common strategy.

In other words, you guys are laughing that Baystar is stuck with a bunch of $5 SCOX shares, but Baystar may have already sold them a few months ago at $15 or $20. They'll just use these conversion shares to deliver back on the shares that they borrowed+sold at $15 to $20.

Re:You think it's funny, but actually ...

[TheWizardOfCheese]

The parent is an excellent post, and deserves to be rated +5, informative. However, I would like to point out a technical error to those Slashdot readers who understand finance:

A convertible is really just a bond + a call option, and shorting against a call option is a common strategy.

No. Many, many tears have been shed over this fallacy. Most converts are like a bond + call, so long as the credit of the name remains good. The credit will be reflected in the underlying stock price, and in this region, the bond value acts as a floor, producing an option-like value profile with positive gamma. That means that since you are long the option, your delta hedge will be profitable even if you can't rebalance. However, when the name is close to default, the bond value itself will go to zero; this produces a region of negative gamma. A convert thus has both positive and negative gamma, quite unlike a vanilla option; it's definitely possible to lose your shirt even if you're delta hedged.

Re:Apparently not.

[alw53]

80 days in fact, today's volume was 262,879,
and 10% of that is only 26,000 shares.
They have 2,105,263 shares to dump!

Re:SubGenius fodder for sure

[Spruce Moose]

Stocks very often don't go to infinity so losses are hardly 'unlimited'.

Also read about stop -loss orders on how you can limit your losses.

"There is no such thing as a sure thing" is also a cool paradox. (-: