What is Hybrid Financing?
In the modern-day and age, obtaining finances at an effective rate is paramount to the success of the business. In this regard, it is important to realize the fact that there are numerous different mechanisms that the organization has pertaining to sourcing finance for various purposes.
In the recent past, hybrid financing has grown in popularity because of the relative advantages it has to offer to organizations. However, it has been around for a considerable period of time and has continued to help organizations raise finance to fuel their objectives.
Hybrid Financing can be defined as sources of finance that have characteristics of both equities, as well as debt. The major element of hybrid financing is referred to as hybrid security. As a matter of fact, it can be seen that hybrid financing combines the features of both pure typical equities, as well as pure typical bonds.
Therefore, these types of securities are considered to have virtues of both types. There are several different sorts of hybrid financing, which are discussed in the next part of the document.
The main rationale behind hybrid financing is to provide organizations with the virtues of both, debt financing, as well as equity financing. Debt and equity financing tend to be the two extreme points and in this regard, hybrid financing tends to be the exact midpoint between both of them. Therefore, hybrid financing mainly attempts to provide financial instruments that are a fair mixture of both.
Returns from Hybrid Financing
The returns that are generated from hybrid financing can be broadly classified into two components, which are the Fixed Component, and the Variable Income Component. The Fixed Income Component is somewhat similar to the Bond Part, whereas the Variable Income Component is similar to the Equity Part. They are subsequently explained in detail below:
- Fixed Income Part: Hybrid securities, just like other fixed income instruments, pay a certain proportion of the face value of the security in form of return in each of the time periods involved. This time period is usually annual.
- Variable Income Part: Once the hybrid securities mature, the value of hybrid securities mostly depends on the price of underlying securities or the given set of securities. Unlike bonds that return their face value at maturity, hybrid securities offer a rate, which differs from the initial offering.
Types of Hybrid Financing
The main types of hybrid financing are given below:
Subsequent description for all these types of hybrid financing is given below:
Holders of preference stocks are meant to receive dividends before the holders of the common stocks. In this regard, it is important to highlight the fact that preferred stocks are considered to be a mixture of both, fixed income streams as well as variable income streams.
Preference Stocks tend to be similar to Fixed Income Components in the sense that upon maturity, the share price might not necessarily be equivalent to the price that they initially paid for the share.
In the same manner, they also include a variable component, because they are entitled to a fixed rate of dividend every year. Regardless of the volume of profit that the company generates, Preference Stocks are entitled to the fixed rate of dividend that they receive.
Therefore, preference stocks are considered to be a classic example (and type) of hybrid financing, because they include both the relevant components.
Convertible Debentures can be termed as another example of hybrid financing. In addition to the normal debenture features, it can be seen that convertible debentures tend to include the option to convert debentures into equity, contingent on certain terms and conditions.
Up till the point where these debentures are converted into equity, they continue to be treated as debt instruments, and therefore, they incur a periodic, agreed-upon interest rate. However, after they have converted into equity shares, the return rate of the equity shares then changes.
Warrants are considered a type of hybrid security that gives the right to buy and sell shares at a particular price on or before a particular date. However, they do not obligate him to do the same. Warrants are similar to the call options in the manner in which they function.
However, they are different because warrants are sold between investors and the company issuing the warrant. This is different from the call option because the call option involves options being exchanged between investors. In the same manner, they are also cheaper as compared to other call options.
They are considered as a source of hybrid financing because they constitute of both, the fixed component, and the variable component.
In-Toggle Notes are defined as hybrid financing instruments that enable companies to meet their short-term cash flow issues. Therefore, it is considered to be a very efficient resource for cash-strapped companies.
An in-toggle note gives the option to the company to pay interest in the form of additional debt. This implies that the company that is issuing the in-toggle note is able to provide the note holder more debt other than interest payment. Therefore, it mainly comprises of using this finance in order to finance payments to the debt holders.
Therefore, it is considered as a midway between both, equity and debt because it strikes a perfect balance between both of these components.
As mentioned earlier, hybrid securities tend to be one of the broadest categories of hybrid financing. It is further broken down into different areas that include commodity risk, foreign exchange risk, interest rate risk, as well as a seniority disparity between bondholders as well as stockholders. As far as returns for hybrid securities are concerned, they are mostly tied with common economic variables.
Examples include commodity price, interest rate, as well as foreign exchange rate. However, these are fairly complex, and hence, they are mostly utilized by organizations that have very specific requirements pertaining to the risk and reward structure they are looking forward to including in their portfolio.
Advantages and Risks of Hybrid Financing
It must realize that for each of the different types of convertible bonds, there are different, and very specific risk and reward characteristics. For example, convertible bonds offer higher capital appreciation but offer lower interest as compared to traditional bonds.
Other than getting the best of both worlds (i.e. equity financing and debt financing), hybrid financing also has some very specific advantages, from the perspective of the organization, as well as the investors which are enlisted below:
- Higher Yields: Hybrid Securities are mostly placed subordinate in the capital structure. Therefore, they are likely to offer a higher rate of return as compared to senior debt.
- Lesser Volatility as Compared to other instruments: They are subject to lesser volatility in the market. This is because they are expected to pay regular and pre-determined market returns.
- Diversity: They offer a greater degree of diversity to the company. Therefore, once the overall portfolio of the company diversifies, it helps in improving the overall risk profile of the company.
However, it must not be ignored that hybrid financing (or hybrid securities) are relatively complex in nature, and therefore, they need to be properly planned out in order to get the best possible advantages of this particular method of raising finance.
Additionally, there are also several other risks involved with hybrid securities that mainly include deferred interest payments, insolvency, market price volatility, early repayment, as well as illiquidity.