Shares of enterprise identity management specialist Okta (NASDAQ:OKTA) are down today despite the broader market's gains. The company had announced a private offering of $1 billion worth of convertible senior notes earlier this week, and subsequently confirmed the pricing of that deal this morning. The notes will carry an interest rate of 0.125% per year and be convertible into 5.2991 shares starting in 2025, representing a conversion price of $188.71 per share, or about 48% higher than yesterday's closing price.

Here's why Okta stock is down on the offering.

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Exchanging notes

Related to the notes offering, Okta is entering into capped call transactions with institutional investors, a common maneuver intended to mitigate potential dilution should the notes ultimately convert into more shares. The total cost of the capped call transactions will be about $70 million, which will come out of the $981.8 million in net proceeds that the company expects to receive from the offering.

More importantly, Okta has gotten holders of existing 2023 convertible notes to agree to exchange those debt instruments for the new 2025 notes. The company had issued $345 million worth of 2023 converts back in February 2018, which had a conversion price of $48.36 -- well below current share prices. Convertible notes can often be converted prior to maturity under certain conditions, usually if the stock price is above the conversion price for a sustained period of time. In this case, the 2023 notes are convertible because Okta shares have been on a tear so far this year.

Facing potential conversions en masse that would require Okta to issue more shares and dilute existing shareholders, the software-as-a-service (SaaS) company persuaded investors holding $224.4 million worth of the 2023 converts to exchange that paper for the new 2025 notes, effectively raising the price where Okta would have to confront a wave of potential conversions. Okta pitched in 3 million shares (worth $384 million at yesterday's close) as part of the deal, which is better than the 4.6 million shares it would have had to issue if all $224.4 million were converted.

Establishing arbitrage positions

That also means that the bulk -- over 75% -- of the $1 billion worth of 2025 notes went to new institutional investors, which would predominantly be hedge funds implementing a convertible arbitrage investment strategy that entails buying convertible notes while simultaneously short-selling the underlying stock.

"Okta expects that holders of 2023 Notes that exchange their 2023 Notes may enter into or unwind various derivatives with respect to Okta's Class A common stock (including entering into derivatives with one or more of the initial purchasers or their respective affiliates) and/or purchase or sell shares of Okta's Class A common stock concurrently with or shortly after the pricing of the notes," the company warns.

In other words, many of the buyers of the 2025 notes are creating considerable selling pressure today as they construct their positions. Conversely, any 2023 bondholder that is unwinding their position would be buying shares to cover short positions. Since there are more investors establishing positions with the 2025 notes, the selling activity today is greater.