January 28, 2021

GameStop(ped) Out

BY Alessio Farhadi

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( 3 mins)

Objective: To prevent a significant loss that will undermine the financial system, crystallize a loss (gain) for the hedge funds (redditors) short  (long) GME stocks without resorting to new and extraordinary measures.

SOLUTION: Issue a convertible/hybrid instrument to counterbalance the sky high (~700%) demand for call-options on GME shares.

What we know to begin with:

  1. In its simplest form, Modigliani-Miller (M&M) theory says that the value of a firm is not affected by how it is financed – whether by debt or equity. Taxation, and market inefficiencies are primary reasons this would not be the case. This forms the foundation of modern financial economic theory.
  2. Robert Merton extended on M&M theorem (also from the University of Chicago) to develop the Merton-model (or firm value model), or firm value model, which states that the equity value of a firm is the residual of Assets minus Liabilities. Merton represented the value of a companies equity (share price) as that of an option on the Asset Price of a firm; struck at the value of the liabilities. The Merton-model links a firm’s share price, volatility, and balance sheet to estimate the likelihood of debt defaulta novel approach to calculate the credit risk of a company (see Moody’s KMV model). The strategy of trading the dislocations in relative values of credit (bond) instruments versus equity, and equity derivatives, is commonly known as Capital Structure Arbitrage.
  3. Putting together the two Nobel-Prize winning theorems above, it is reasonable to assume a company’s decision to raise capital via debt or equity is motivated by whichever is the cheapest source of funding.
  4. Company’s management have a fiduciary duty to maximize shareholder value, which over the long term is reflected in the share price.
  5. A company has a social purpose in creating and maintaining jobs within the community, and provide a decent standard of living for its employees.
  6. A rights issue/offer is when a company asks the existing shareholders to put more equity in the company to safeguard the value of shareholders, or to pursue new business opportunities. A rights offering must be in the shareholders best interest according to the regulators.
  7. A regulator’s (SEC) role is to maintain confidence and integrity in financial markets, primarily to protect investors.
GameStop(ped) Out 1
Source: Credit Suisse Research

The figure above illustrates the value of a company issued convertible bond issued as a function of the stock price. Considering all the above points, we see a junior hybrid instrument issued by GameStop as the most amenable solution to ending the current stalemate with retail community.

A convertible/hybrid placement to the hedge funds short would:

  1. Allow the proceeds to be used to pay off the existing expensive debt through a bond at a significant premium to current levels.
  2. Provide a natural counterbalance (sell) to the sky high implied volatility levels of the stock. Options are for hedging, else speculation. i.e. Options traders are not investors.
  3. Enable the company to monetize the current market gains, which in turn benefits the shareholders.
  4. Cap the maximum potential losses at the financial institutions at a level comparable to the face value of the convertible/hybrid instruments. Thus, removing market uncertainty.
  5. Provide a private market solution which allows the hedge funds take a loss whilst not burning the retail investors.

Naturally, standard advisory and issuance fees shall apply on any hybrid instruments, and a couple of GameStop shorts will be happy buyers to cover their naked shorts.

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