What it means
A PERC is a type of convertible preferred stock, which means it ranks ahead of common shares for dividends and converts into common shares later. It was designed for investors who want more income than the common stock pays but are willing to give up part of the upside.
The issuer offers the extra dividend in return for the cap. Most PERCS are issued with a fixed life, often around three years.
At the end the stock is converted into common shares according to a ratio, usually one preferred share for one common share, but if the common price has risen beyond a cap price the holder receives fewer shares so that their value is limited to the cap. The issuer may also be able to call (redeem) the stock early at a price that falls over time.
For the company, a PERC is a way of raising equity capital while paying a modest dividend and, in effect, selling its own upside above the cap. It can be attractive when management expects the share price to be flat or rise slowly and wants to avoid issuing common shares at a low price.
The company's debt does not increase, so its borrowing capacity is unaffected. For the investor, the trade-off is clear.
The holder receives higher dividends than ordinary shareholders and some protection if the price falls modestly, but gives up the gains above the cap and still bears the risk of a large fall. The structure suits investors who think the share price will move sideways.
The nuance is that PERCS are now rare and have been replaced by other mandatory convertible designs. Anyone meeting the term should check the prospectus for the exact conversion ratio, cap price, call terms and tax treatment, since these differ between issues.
In practice
Real-world examples.
Example
A utility company wants to raise $200,000,000 of equity without selling common shares at a depressed price. It issues PERCS paying a higher dividend, and the cap gives it the benefit of any big rise in its share price.
Example
A pension fund manager expects a bank's shares to trade in a narrow range for several years. She buys the bank's PERCS to collect the higher dividend and accepts the cap on gains.
Example
A corporate treasurer reviews a prospectus for a PERC issue by a technology company. She checks the conversion ratio, the cap and the call schedule before advising the investment committee.
Formula
Calculation
Value at conversion = lesser of (common share price at conversion) and (cap price)
Total return = value at conversion + dividends received
Suppose a PERC is issued when the common stock trades at $50. It pays a dividend of $3.00 a year compared with $1.00 on the common, converts after three years and has a cap price of $65. If the common price is $70 at conversion, the holder's value is limited to $65, and dividends are 3.00 x 3 = $9, so total value is 65 + 9 = $74. A common shareholder would have 70 + (1.00 x 3) = $73. If the common price is $80, the PERC holder still gets 65 + 9 = $74 while the common holder gets 80 + 3 = $83. If the price is $40, the PERC holder gets 40 + 9 = $49 and the common holder 40 + 3 = $43.Case study
Seen in the real world.
Falconridge Energy is an illustrative, fictional company whose common stock trades at $40. The board wants to raise $120,000,000 but believes the shares are undervalued and does not want to sell them cheaply.
It issues 3,000,000 PERCS at $40 each, paying an annual dividend of $2.80 against $1.20 on the common stock, with a cap price of $52. If the share price stays at $40, the company will simply convert the PERCS into common shares at the end of three years.
When the share price later climbs to $60, holders receive shares worth only $52 each, and Falconridge keeps the difference by issuing fewer shares. The illustrative lesson is that the company paid for its capital with a higher dividend and with the upside above the cap.
Watch out
Common mistakes.
- Assuming the acronym PERC always means the same thing, when it is also used by unrelated bodies and the meaning depends on context.
- Believing a PERC offers unlimited upside like common stock, when the cap limits the gain.
- Ignoring the call feature, which lets the issuer redeem the stock early and cut the holder's expected income.
Questions
People also ask.
How does a PERC differ from ordinary convertible preferred stock?
Ordinary convertible preferred stock lets the holder convert when they choose and share fully in gains, while a PERC has a mandatory conversion date and a cap.
Why would a company issue PERCS?
It raises equity-like capital at a time when it prefers not to issue common shares, and it pays for the capital with a higher dividend and a limit on the holder's upside.
Are PERCS the same as mandatory convertibles?
They are an early form of mandatory convertible, and later designs have built on the idea with different caps and conversion terms.
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