Andrew Clark is the CEO of Bridgepoint Education (BPI), a leader in the postsecondary online education sector. As one of the co-founders, he's been with the company since inception and through its IPO. During that time he's amassed a personal war chest of 790,996 shares, not including options, valued today at just under $16 million. In mid-September Mr. Clark entered into a 23-month variable prepaid forward contract (VPFC) for the sale of up to 150,000 of those shares, or just under 19% of his total holdings. Although the move is not exactly an outright sale of stock, it's probably not a very bullish indicator either. What is a VPFC you ask? The following is an overview of how his contract works.
Variable Prepaid Forward Contract - How It Works
1. Andrew Clark (the Seller) decides he wants to sell/hedge 150,000 of his BPI shares.
2. Since he's not interested in triggering an immediate capital gains tax obligation, a loss of voting rights, or an avalanche of negative publicity that comes with material insider selling, he calls his investment banker (the Buyer) and enters into a VPFC for the future sale of 150,000 shares 23 months from that day.
3. The Buyer pays the Seller $2,069,363 immediately (the Payment). The Payment is simply the value of the 150,000 shares, times the market price at the date of purchase ($17.44/share) less a discount ($3.65/share).
150,000 shares x ($17.4409/share - $3.6451/share) = $2,069,362.79
Thankfully for the Seller the discount can be partially offset by reinvesting the Payment in some other return generating assets.
4. If the price of the shares is at or below $17.44/share (the Floor) on the maturity date (23 months after the opening of the contract), the Seller is obligated to hand over 150,000 shares of stock, or settle in cash.
5. If the price is above $17.44/share at maturity, the Seller can actually keep some of the 150,000 shares he/she was expected to sell. The amount of shares the Seller can hold on to depends on the share price at the time of contract settlement. The higher the share price is at the time of maturity, the more shares the Seller keeps, up to a point.
6. If the share price is at or above $26.16/share (the Cap) at maturity, the amount of shares kept by the Seller will start to decrease as share price increases.
Note: Mr. Clark's contract splits up the share settlement into 50,000 blocks to be exchanged on 3 consecutive maturity days. For simplicity we are assuming 150,000 shares and one maturity date.
This variability in the amount of shares that the Seller can keep at maturity creates a net payout similar to that of a "costless collar". It gives protection on the downside while still allowing for upward appreciation, albeit at a cost. The net payout diagram is shown below.
Figure 1-Andrew Clark's VPFC-Net Payout (Generated by Author)
The payout diagram in Figure 1 assumes a 0% return on the investment of the Payment. The contract effectively gives the Seller a Floor at $2,069,363, or the amount prepaid to the Seller at the initiation of the contract. Above $17.44/share, the Seller's net payout increases because the value of the shares kept by the Seller is added to the initial Payment. The number of shares the Seller can keep will increase between $17.44 and $26.16, giving them upside potential that tracks the unhedged position. A cap of $3,377,437 is created at 26.16/share, where the amount of shares the Seller keeps declines at a rate designed to maintain a constant payout value. Wealth of the seller stays constant above the CAP.
Assuming no return on the Payment, the "cost" of the contact is approximately $547,000, or a 20% discount to the aggregate share value at purchase, assuming the share price closes between the Cap and Floor. Any interest made on the Payment will partially offset this cost. A compounded return of approximately 12.4% from investment of the Payment will cover the discount entirely. Assuming no investment return however, it's not until the share price falls below $13.98 does the contract start to make sense vis-à-vis the unhedged position.
What Does It All Mean?
A March 2009 study by Carr Bettis et al. looked at a large sample of VPFCs and similar types of derivatives contracts designed to help top management sell or hedge large personal stock positions. They found that the performance of a company's shares generally tends to do poorly after the initiation of these types of contracts. The study also looked at the terms of many of the VPFCs in the sample. Relative to the Bettis sample set, the length of Mr. Clark's contract (just under 2 years) is significantly less than the mean of 1025 days. However, the spread between the Cap and Floor (50%) is slightly above their measured average of 43%. At a 20% discount, Mr. Clark is essentially paying more for a larger potential upside.
I think an obvious question arises from all of this. Mainly, why pay a half million dollars on $2.6 million of stock for upside potential you already had from an unhedged position? Is Mr. Clark really just looking to diversify his portfolio, or is the move more revealing about the near-term performance of BPI? The truth is, it's hard to tell.
Last week's earnings announcement from Bridgepoint's competitor Apollo Group (APOL) might shed some light on the matter. Although the company beat estimates and advanced double digits, the announcement of a continued year-on-year decline in new enrollments was not encouraging for the industry as a whole. If the decline in Ashford University's new student enrollments continues into 2014, Bridgepoint's bottom line may well turn from black to red absent aggressive cost cutting by the company. You can read my analysis of BPI and Ashford University here. If there is bad earnings news on the horizon, new litigation against the company, or something else unforeseen by the market, hedging by the CEO may be the canary in the coal mine. With that said, it's certainly possible that BPI will announce an earnings beat next Tuesday similar to Apollo's. But if that's the case, then why is Andrew Clark hedging….and why now???