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With investors spooked by junk bonds in this jittery market, more issuers are turning to a relatively rare security convertible preferred stock to raise capital, says Alex Cappello, chairman of Cappello Group Inc. in Santa Monica, an outfit that does nothing else but underwrite the unusual securities.

Convertible preferred is stock that has a guaranteed dividend as long as company finances hold up. It can also be converted into common stock, under certain conditions. Convertible preferred stock is similar to convertible bonds in that regard.

In general, says Cappello, convertible preferred stock offers a better dividend yield than a Treasury bill, but less than a high-yield bond.

“The high-yield bond market has disappeared,” declares Cappello, echoing the sentiments of many. “But companies need to raise money. We’ve never been busier.”

Cappello says that all public companies are having a tougher time raising capital, even if they go the convertible preferred stock route.

“Until just a few weeks ago, it was an issuer’s market. Virtually any decent public company could raise money through a convertible preferred. But now buyers are very selective,” he said.

Exactly how much convertible stock will pay in dividends depends upon the credit-worthiness of the company, prevailing credit conditions, the conversion features, and the market’s perception about the issuing company’s future fortunes on Wall Street.

Ironically, in this zig-zag market, it is the very uncertainty of convertible preferred stock that is working in its favor. There may be a big upside for buyers, if the common stock takes off.

Convertible preferred, when issued, generally carries a “premium,” or “spread” to common. For example, a convertible preferred share might be issued at $10 a share, and offer $1 a year in dividends. It might be exchangeable for one share of common, trading at $8 a share at the time the convertible was issued.

Of course, should the common go up in price say to $12 then the convertible preferred is “in the money.” The potential upside, in addition to the dividend, means investors are willing to part with their money for a lower yield, compared to when they buy a straight junk bond which they aren’t buying now anyway, says Cappello.

For issuers, that means the ability to raise capital.

“With high-yield bonds out and common stock very soft (from an issuer’s standpoint), the convertible preferred stock offers an option for issuers,” said Cappello. “Also, issuers can count the preferred as equity on their balance sheet, not debt.”

In general, Cappello underwrites mid-cap public companies, and places the securities with institutional investors. The securities are, however, registered with the SEC.

Not everybody in town is enamored with the use of convertible preferred stock. “If you own common (stock in a company), be sure you know how much convertible preferred is out there,” said one manager of a local investment shop. “When they convert, it can be incredibly dilutive.”

The beginning of the end?

With the Internet’s ability to post prices, and handle huge volumes of data, investors someday might trade stock directly, perhaps relying only on a stock transfer agency to verify and record trades a clerical, if important, function that should be dirt cheap.

That’s the direction being pursued by Santa Monica-based Direct Stock Market, which recently announced the creation of an Internet stock trading system.

“We will provide a marketplace for what I call sub-micro-cap, or nano-cap stocks,” said Clay Womack, founder, CEO and chairman of the company. “There needs to be a place that can match ordinary investors with start-up or nano-cap growth opportunities.”

The first company to trade shares on the exchange, also called a “bulletin board,” is Los Angeles based Internet Ventures Inc. which, appropriately enough, is a high-speed Internet access provider.

Internet bulletin boards are a marvel of simplicity. Would-be sellers and buyers merely list the stock they want to buy or sell, and at what price, on the DSM Web site. Traders can negotiate with each other, and eliminate the “spread” the difference between a Nasdaq-listed stock’s buy and sell price that some contend is merely a subsidy for the brokerage community.

“A trade will cost a flat $24 on each side,” said Womack, who said he expects to list 200 companies within a year.

Womack said he will only list companies that have approval from state authorities the Department of Corporations to be publicly offered. If investors prove willing to take a flier on a nano-cap growth stock listed on the Web, wouldn’t they even more readily buy IBM or Microsoft from each other, over the Internet? And won’t that ultimately spell doom for many brokerages?

“Well, I think there are too many people making too much money, with vested interests, to ever let that happen,” said Womack, describing the brokerage community. “But perhaps, over time, people will buy certain large-cap stocks over the Internet. It’s certainly technically feasible.”

Give up equity

What’s still the toughest part about raising money for growth companies in this market?

“The hardest thing to place is minority interest,” said Davis Blaine, founder and chairman of the Westlake Village-based Mentor Group, a corporate evaluation firm and boutique investment banker with 33 professionals on board.

By minority interest, Blaine refers to equity stakes of less than 50 percent. Many business owners do not want to give up majority control, but Blaine said it is “increasingly hard to find investor money for the minority position.”

And investors today know they have more leverage to get what they want. The initial public offering market is dead, junk bonds are dormant, and people with capital in general are pulling their horns in.

Additionally, from an evaluation standpoint, “the multiples being paid (a company’s price times its earnings, however defined) are down,” said Blaine. Nevertheless, Blaine still sees a good amount of deals getting done, which he surmises is an indicator that the local economy is not bordering on a recession.

“Before previous recessions, we saw the decision-making process on a deal get stretched. Deals got harder to close. Now, deals are getting done, just at lower prices,” he said.

Contributing Reporter Benjamin Mark Cole covers the local investment community for the Los Angeles Business Journal. He can be reached at [email protected].