Strategy’s STRC gives hedge funds a new reason to short MSTR

Every new share of STRC by Strategy (formerly MicroStrategy) creates a perpetual claim on the company’s cash flow, and this might give institutions a reason to short the company’s MSTR common stock.

Strategy is a bitcoin (BTC) acquisition company that uses most of the proceeds of all types of its share sales to buy BTC.

Although MSTR has no upside limit and has unlimited price appreciation potential to penalize short-sellers, plenty of traders already short MSTR. Specifically, short interest exceeds 35 million shares of MSTR, equivalent to an alarming 11% of the float.

Yet few people understand that a small portion of this MSTR short interest might be the result of its interplay with STRC.

STRC is Strategy’s quasi-pegged stock that pays a variable, 11.5% annualized dividend and is supposed to trade near $100.

It’s fluctuated within 10% of that band during its lifespan.

The company’s common stock, MSTR, pays no dividends and fluctuates in price with no regard for any peg. Indeed, it’s fluctuated mostly, over the last 18 months, in a very downward direction and has halved over the past year.

There are $5.3 billion worth of STRC outstanding paying an 11.5% annual dividend in cash USD. Unfortunately, the company cannot fund those $609 million in annual payouts from regular business profits, which have been in decline for years.

Moreover, the company’s management, rather than focusing on fixing their software business, are “laser focused” on selling more STRC, according to founder Michael Saylor.

Indeed, CEO Phong Le has admitted that the company intends to pivot away from at the market (ATM) MSTR issuances in favor of perpetual preferred offerings.

Unfortunately, those preferred shares like STRC create obligations on the assets owned by MSTR.

Read more: STRC could be funding more Strategy bitcoin buys than ever

How STRC dividends actually work

Again, each new STRC issuance perpetually siphons dollars from Strategy which is collectively owned by MSTR, after STRC’s more senior claims. Yes, STRC is called a perpetual preferred for a reason.

Strategy owes $609 million per year in STRC dividends, and that cash has to come from somewhere. For years, it’s mostly been coming from MSTR ATMs.

In other words, each new STRC share increases Strategy’s annual cash dividend obligations.

Since the company generates negligible to negative earnings, the market expects those obligations to be funded by MSTR share dilution as a last resort, given the preeminence of MSTR as the most popular, liquid, and indexed security of the company.

Thus, STRC creates an expectation of predictable MSTR dilution that short sellers can front-run.

Moreover, the success of STRC at attracting capital is somewhat at the expense of demand that might otherwise bid for MSTR.

Rather than shareholders bidding for MSTR because they believe in Strategy, if they buy STRC instead, they benefit MSTR only in a one-time purchase of BTC yet then siphon out cash from the company forever.

STRC dividends at the discretion of the board

Even though short-sellers might be correct about their prediction about ongoing MSTR dilution, STRC dividends aren’t a fixed obligation to literally guarantee this dilution.

Strategy’s board declares dividends at its sole discretion. Moreover, the dividend rate of STRC is variable. Although it has only gone higher since inception, the board of directors can technically reduce it by 25 basis points plus certain declines in the one-month US Treasury secured overnight financing rate (SOFR).

Strategy can also fund dividends from any legally available cash, not just MSTR sales.

For example, the company might fund dividends through further STRC issuances, sales of other preferred shares, traditional debt, or other capital raises.

Read more: Saylor continues to liken STRC to a money market as risks mount

Buying converts, shorting commons

Before Strategy sold non-convertible preferred shares like STRC, it sold convertible bond notes. 

A less exotic asset type than Strategy’s perpetual preferreds, and therefore with a longer history for academic studies, the short-selling of common stock by companies that have issued convertible notes is a well-documented phenomenon.

Hedge funds frequently buy convertible notes, short the common stock to delta-hedge their position, and profit from volatility. Academic research confirms that convertible bond arbitrageurs drive significant increases in short-selling near issuance dates. 

As of Friday, Strategy held 766,970 BTC at an average cost basis of $75,644 per coin. Over the weekend, BTC was below $71,000, well below Strategy’s cost basis.

Strategy still has more than $22 billion in remaining STRC ATM capacity. Each $1 billion more of STRC means another $115 million in annual obligations in perpetuity.

Protos has previously documented how Strategy has hiked STRC’s dividend seven times since launch, from 9% to 11.5%, to encourage optimism after STRC traded as low as $90.52 in November and $93.10 in February.

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