The Strategic Use of Convertible Debt in "Deep Pocket" Predatory Games

A model is developed to argue that an entrant can use noncallable convertible debt to avoid predation in a "deep pocket" predatory game. Adverse-selection problems force the entrant to enter the market heavily leveraged compared to the incumbent monopolist. The model demonstrates that there exist conversion ratios for which creditors only have incentive to convert if the entrant is high quality. The entrant can therefore issue convertible debt to signal quality to investors. Before production decisions are made, the creditors convert, preventing predation. The conclusions are relevant to both the convertible debt literature and the product market competition literature.