What’s the significance of May 29th? For fans of Shake Shack, it means only two months remain until the post-IPO lockup period ends and insiders are free to sell shares. If you don’t think those shares will hit the market like a ton of bricks, I’ve got a burger joint valued like a biotech to sell you.
Although insiders would surely be happy to sell a lot of stock anywhere close to today’s appreciated levels (nearly a quadruple from the IPO), it probably will be necessary for the next stock deal to be a mix of new stock, with proceeds going to the company for its ambitious expansion plans, and insider stock. If Shake Shack wants to maximize the proceeds it can raise while allowing insiders to cash in, it should seriously consider issuing a convertible bond at the same time it makes the next stock offering.
Why? The demand would surely be there. The restaurant group is underrepresented in the convertible market. Plus, let’s not kid ourselves. Shake Shack, based in New York, would surely get a familiarity boost from the local money-management community. More importantly, convertibles are powerful capital-raising tools for companies with high-flying stocks. They enable issuers to monetize their stock price while effectively issuing far fewer shares than from a direct stock issuance.
Shake Shack’s wild gyrations have doubtless come largely from the travails of short-sellers, who have been paying a usurious effective interest rate (between 50% and 100% annually) to borrow the shares and bet against the wild “valuation.” Their thought process clearly involves a willingness to “eat” the interest cost, which could translate to 10 points or more in the stock between now and the lockup’s expiration, because of the overwhelming likelihood that the stock will come under massive selling pressure as the lockup approaches. The trouble is that nothing stops the stock from rising now as some of the weaker shorts decide they cannot take the near-term pain.
It is very difficult to issue a cost-effective convertible bond if the underlying shares are overly expensive to borrow. For this reason, Shake Shack would be well advised to make sure enough shares hit the market (between insiders and new stock) to make hedging activities more feasible. Convertible-bond math dictates that hedgers need to sell roughly 50% of the value of a new convertible to protect themselves. However, much of a new Shake Shack convertible would probably go to investors willing to bet, unhedged, on Shake Shack’s prospects, assuming the stock price has fallen enough by then to have some meaningful relationship with the underlying business. With hedgers taking only a fraction—say 40%--of a new issue, it would only take around 20% of the value of the convertible to hedge a convertible. So a $250 million convertible issue would probably only need about $50 million in stock available for borrow, at least initially.
That being said, continued interest from fundamental short-sellers is a near-certainty. While the laws of supply and demand dictate that borrowing Shake Shack shares will become far less expensive following the next stock offering, demand from short-sellers may keep the price high enough to impair convertible valuation. After all, hedgers need to factor this cost into what they can pay for the convertible bond.
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