Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper. Read more opinion LISTEN TO ARTICLE 3:02 SHARE THIS ARTICLE Share Tweet Post Email

Photographer: Antonio Heredia/Bloomberg Photographer: Antonio Heredia/Bloomberg

Even a company the size of Vodafone Group Plc can’t just write a check for 18.4 billion euros ($22 billion) to buy a heap of European telecom assets from Liberty Global Plc. The size of the transaction creates a financing dilemma.

Borrowing the whole sum would damage Vodafone’s credit rating. But selling new shares to support the purchase would go down like a lead balloon. The British company has found an ingenious third way.

The deal will transform Vodafone’s position in Europe, making it one half of a new German telecoms duopoly while expanding its presence in eastern Europe — assuming regulators say yes. It also brings together cable and mobile. This should create a more stable company as customers taking multiple services are less prone to switch, Vodafone argues.

These benefits mean the group can support higher levels of net borrowings, of up to 3 times Ebitda, while retaining a “solid” investment-grade rating. The snag is that this deal would puncture even that raised ceiling if it was funded entirely in debt.

In theory, Vodafone could have placed 5 percent of its share count yesterday to raise some cash. At a 5 percent discount to the closing share price, the proceeds would have been 3 billion euros, keeping leverage inside the limit. In reality, a share price already 13 percent off its year high would probably have cratered.

Crossed Wires Vodafone stock has underperformed this year amid concern it might overpay in M&A Source: Bloomberg

So Vodafone is effectively borrowing equity instead. It is to raise 3 billion euros in so-called mandatory convertible bonds. These get redeemed not in cash but new shares after three years. Simultaneously, it is making arrangements to buy back all that freshly hatched stock at the same price as the bond issue — whatever happens to the share price.

The upshot is that the credit rating agencies will treat the bonds as equity from the get-go, while Vodafone avoids a dilutive equity issue.

Too good to be true? Investors in the bond looks set to experience the usual economics of these instruments. If the Vodafone share price falls, they would typically get repaid less than their initial investment, having at least enjoyed some juicy interest payments in the meantime. If the share price rises, they make a gain, although not as much as if they’d just bought Vodafone shares.

Vodafone, however, can pick and choose. It could let the bond convert into stock with the resulting dilution. Or it could buy back the new stock and keep the share count steady. This would make sense if the shares shoot up, as Vodafone will have fixed the purchase price at a lower level.

Keeping its choices open like this will come at a cost, though. The coupon on the bonds will be higher than ordinary bonds. The wildcard is the expense of the stock options that Vodafone requires to hedge the cost of such a chunky buyback in three years’ time. Long-dated options on single stocks don’t usually come cheap.

Bosses will always try to avoid diluting shareholders if they can. That’s a good thing as investors can suffer for a long time before earnings per share grow back to their old level. The structure for the Liberty deal is cunning. But if investors are spared dilution, they will have paid away some of the saving in a bonanza for the options market.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.