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On March 5, 2024, SoFi Technologies (NASDAQ:SOFI) announced to the market a $750 million Convertible Senior Notes Offering (due 2029). The notes will pay interest at a rate of 1.25% and the conversion price is set at $9.45 (30% above SOFI closing price of $7.27).
To mitigate the potential dilution impact, SoFi has entered into so-called “capped calls” transactions. These are derivative transactions with institutional counterparties that effectively hedge out the dilution impact up until a share price of $14.54. SOFI is paying a premium of $78.8 million to purchase that “anti-dilution” protection.
SOFI will receive $735m after transaction costs and discounts and expect to use the funds to (1) pay the capped calls premium (2) redeem its expensive 12.5% Series 1 Preferred Stock and (3) for general corporate purposes. The transaction may also be upsized by an additional 112.5m at the option of investors.
Separately, on March 4, 2004, SOFI entered into exchange agreements with holders of its current 0% Convertible Senior Note due 2026 to exchange $600 million of these notes for an estimated 61.7m shares.
Curiously, these are two separate and independent transactions but they were reported in the same press release.
How should investors view this?
In my view, SOFI is raising a form of fresh equity capital.
The exchange agreements with the current convertible notes (due 2016) will result in an immediate increase in the shares outstanding.
Whereas, the newly issued Convertible Notes (due 2029) are a trade-off between the lower cost of funds (1.5% interest) and potential future dilution risk. There is of course the additional $78.8 million payment for the capped calls which serves to mitigate, to an extent, the dilution risk but is not cheap.
Why is SOFI doing this now?
In my opinion, this has all to do with SOFI’s capital position. In my previous articles (here as an example), I explained in great detail the risks in SOFI and why I believed it was going to be capital-constrained by the 1H-2024:
SOFI has been depleting its capital ratios quite rapidly. On the basis of the back-of-envelope calculation, SOFI will be capital-constrained somewhere around 1H of 2024. In other words, growth in lending has to slow down materially.
That is exactly what transpired. At the 2023 fourth-quarter earnings call, SOFI surprised investors by projecting that its Lending revenue is expected to decline by mid to high single digits in 2024 (year-on-year basis):
We are taking a conservative and pragmatic approach toward our Lending segment revenue, expecting to largely maintain it, given our concerns about the 2024 macro environment as it relates to uncertainty on rates, the economy, and industry liquidity. Therefore, we will manage the Lending segment revenue to be 92% to 95% of 2023 lending revenue. This very conservative view of lending, reflects our choice to limit lending growth below both the much higher level of demand we have had and expect to continue to see in 2024 and the capacity that we have.
This was especially surprising as their capital ratio (CET1) was at a seemingly healthy 15.3%, so investors were puzzled why SOFI was choosing to reduce lending.
The answer to this is of course SOFI’s Held For Sale (“HFS”) accounting treatment which differs from peers and as I covered in my prior articles, artificially inflates its capital ratios:
SOFI is recognizing a day 1 profit of ~4.3% (this is Gain On Sale Margin or “GOSM”) whereas peers are required to provide for loan losses of ~7% (this is in line with the CECL provisioning methodology for loans held to maturity). So the accounting difference is ~11.3% on day 1, for precisely the same loan and cashflows. This is merely a timing difference and it reverses over time but it is especially beneficial to SOFI during the ramp-up stage of lending. If I adjust SOFI accounting profits and capital to equalize to peers, this would result in a ~$800 million hit to the bottom line. The way I arrived at ~$800 was by multiplying SoFi personal loans balance as of Q3 (~$13 billion) by 6% reflecting a conservative loan loss provision (as an example, LendingClub recognized lifetime loan losses between 7% and 9%). In other words, there will be revenue headwinds for SOFI in 2024 and beyond as the loan portfolio matures.
So if you adjust the SOFI capital ratio like-for-like to other banks, it would likely result in a capital deficit at the end of 2023. Whilst it is important to highlight that SOFI’s accounting treatment is squarely in accordance with U.S. GAAP, still it results in the upfronting of accounting and capital benefits which reverse over time.
If you dispassionately consider recent actions by SOFI management, you will probably conclude that it is driven by the need to shore up its capital position. Why else would they deliberately reduce lending and dilute existing shareholders?
Final Thoughts
I suspect that SOFI management received a “friendly” nudge from regulators to increase their capital buffers. Actions taken including the reduction in lending and equity issuances certainly adversely impact the share price and come with a cost. There are cheaper ways to refinance the Preferred Shares other than by potential equity dilution.
Reading the tea leaves, these actions do not look like they were completely voluntary. Somebody probably forced the issue, most likely proactive regulators.
The good news, however, is that now SOFI’s capital position is much more secure and it is becoming a less risky proposition.
One reason to be bullish when it comes to SOFI is the Tech division which is a source of scalable, sticky, and capital-light revenue. The signs appear quite positive and if SOFI can generate 25%+ revenue CAGR in the next 3 to 5 years, this could potentially be a game changer to the stock.
At this juncture, I remain on the sidelines with a neutral rating.
