Equity Issues by Listed Companies: Rights Issues and Other Methods

Executive Summary

• A rights issue is a method by which a listed company can issue new shares. The principle of a rights issue is that stockholders are offered new shares in proportion to their existing holdings. If stockholders do not want to buy the new shares, they can sell their rights on the stock market.

• The main alternative issue methods are the firm-commitment offer, the private placement or placing, and the open offer. These methods have been replacing rights issues in several countries.

• The average reaction of a company’s share price to firm commitments is negative, but it is positive for placements and open offers. The reaction to rights issues varies by country.

• The aim for a company is to have a smooth issue that raises the intended amount of capital for a competitive fee and at a minimum discount.

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Introduction

This article is about issues of shares to investors by companies that are already listed on a stock exchange. Such issues are often called rights issues, although in fact the rights issue is only one of several issue methods used. Other methods will also be discussed here. A generic term for issues by listed companies is seasoned equity offers (SEOs).

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Types of Offer

Rights Issue

The principle of a rights issue is that the company offers the new shares to its existing stockholders in proportion (pro rata) to the number of shares owned by each stockholder. In most countries this is a requirement of company law. The stockholder’s right of first refusal over the new shares is known as the preemption right. If a stockholder does not want to buy some or all of the new shares to which he or she is entitled, he or she can sell the rights to them on the stock market during a prescribed offer period. In the United Kingdom this period is three weeks.

The offer price of the new shares is usually set at a large discount to the market price of the existing shares just before the issue is announced. This discount means that the rights are likely to be worth something during the offer period. A numerical example is helpful in understanding the rights issue mechanism:

In this example, Company X is issuing one new share for every two existing shares in what is known as a “one-for-two” issue. The new equity to be raised is $45 million. The offer period starts on the ex-rights date, when the existing shares cease to carry the one-for-two entitlement to the new shares. If the underlying value of the company does not change, the share price will fall to the theoretical ex-rights price (TERP) on the ex-rights date. The TERP is the weighted average value of the old and the new shares. In the example, the TERP is $11:

(10 million × $12 + 5 million × $9) ÷ 15 million = $11

At this market price, each right to one new share will be worth $2; that is, $11 − $9.

An important point about rights issues is that a stockholder is as well off whether or not he sells the rights. If he does not sell, and he buys the new shares, he loses $10 per old share when they go ex-rights, but gains $2 per new share because the offer price is $2 below the market price ex-rights. If he sells the rights, he still loses $10 per old share but gains $2 in cash per new share. However, this ignores the cost of selling rights, which can be substantial if the company’s shares are illiquid.

The majority of rights issues are underwritten. This means that the investment bank arranging the issue will find sub-underwriters, usually investing institutions, to buy the shares at the offer price, or will buy them itself if necessary. The deeper the discount, the less likely it is that the underwriters will be called upon.

Firm-Commitment or Public Offer

In the United States, rights issues by commercial companies (as opposed to investment companies) have been rare since the 1970s. The standard method for larger issues is the firm-commitment offer. After the issue is announced, there is a book-building period of about one month, during which a syndicate of investment banks invites applications for the new shares and the share registration document is finalized. With a shelf offering, the new shares will already have been registered with the Securities and Exchange Commission. There is no pro rata offer to existing stockholders.

The offer price is set the day before the shares are issued. The offer price used to be the same as, or very close to, the prevailing market price. But, during the 1990s, it became common to set the offer price at a discount to the market price of about 2.5%. Firm-commitment offers are underwritten by the syndicate of investment banks that market the issue. Non-underwritten public offers are known as “best efforts” offers. Both rights issues and firm commitments are accompanied by a prospectus—a marketing document and memorandum that contains information required by the relevant regulatory authority.

In recent years, a variant known as the accelerated bookbuilt offer has become more common. The offer is announced and bids from investors are invited very quickly, often by the end of the same day. Accelerated bookbuilding tends to be used by large companies to raise small amounts in relation to their size.

Private Placement or Placing

A third type of offer is the private placement. In the United States, private placement refers to the sale of a block of shares by private negotiation, usually to one or two investors only and for a fairly small amount (a few million dollars). Placements are less onerous to arrange than firm commitments, because the shares are not offered to investors in general and no prospectus is required. Most placements are made at a discount, the average being around 15% in the United States. Many placements are now private investment in public equity (PIPE) issues, in which the shares placed can be resold more quickly than in a conventional placement. In the United Kingdom the term “placing” is used for any sale of shares that does not involve a pro rata offer to existing stockholders. Larger placings will have 20 or 30 placees.

Open Offer

An open offer combines a pro rata offer to existing stockholders with a private placing. Although stockholders retain their preemption rights, the rights cannot be traded and are therefore worthless unless the stockholder chooses to buy new shares. This type of offer is now standard in the United Kingdom but appears to be unique to that country.

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Aspects of Practice

Market Reaction to SEOs

The share price of US industrial companies falls by around 3% on average when a firm-commitment offer is announced. The stock market reaction to rights issues is mixed; it is negative in some countries and positive in others. A negative reaction is surprising on the face of it, since a company would not be expected to go to the expense of a share issue unless it had a good use for the money, i.e. a positive net present value investment.

The leading explanation (Myers and Majluf, 1984) is that news of an SEO indicates that the issuer is more likely to be overvalued than undervalued. An undervalued company is one in which the market value of the equity is less than the managers’ assessment of its value. If the managers are correct, issuing shares when the company is undervalued means that existing stockholders who do not buy will lose out to new investors, who will obtain shares at below the full-information price. Some undervalued companies will choose not to issue as a result, even if they need the money for a worthwhile investment. Therefore, companies that choose to issue are more likely to be overvalued, and the market price will fall as a result.

However, the market reaction to private placements, placings, and open offers is positive on average. These issue methods potentially involve detailed investigation of the issuer by placees or underwriters, who have access to private information about the company. So one explanation for the positive reaction is that the willingness of these well-informed agents to buy or underwrite certifies a minimum value for the issuer. Another explanation is that in some placements an active placee is introduced, i.e. an agent who brings know-how or an intention to intervene in the company, and the market reacts positively to news of a placement to such an investor.

Decline of the Rights Issue

The decline of rights issues in the United States, the United Kingdom, Japan, and elsewhere is somewhat puzzling. The firm-commitment method that replaced them in the United States is more expensive and does not offer an obvious advantage. Most placings are made at a sizeable discount, which means that stockholders who are not invited into the placing lose out. Possible disadvantages of rights issues include the cost of selling large blocks of rights, delays in the issue process compared with placings, and less effective certification of value than in an open offer or placing.

Rights issues work best when most of the new shares will be bought by existing stockholders willing to take up their rights. There is then little need to find other buyers. They are therefore frequently used by family-controlled firms. Rights issues also work well for the largest companies, with very liquid shares, because it is cheap and easy to sell rights on the market.

Long-Run Underperformance Following SEOs

Companies that raise new equity tend to underperform in relation to other companies matched by industry, size, and risk over a three- to five-year horizon. This underperformance occurs for both returns on the shares and operating profit. The same finding applies to companies that make or have made an initial public offer. One explanation is that, on average, companies successfully time their issue for when they are overvalued.

Issue Costs

The total cost of a firm-commitment offer in the United States is, on average, 7% of the amount raised, ignoring any discount. The cost of a rights issue or open offer in the United Kingdom is 6% on average. Much the largest components of the cost are the fees to the lead bank and to the underwriters. The cost is relatively more for smaller companies, partly because there are clear economies of scale and partly because they are riskier.

Discounts

Discounts to the market price are a cost to nonsubscribing stockholders, except in a rights issue. Why are discounts needed? First, investors tend to buy large blocks, which could be costly to sell in future. There is a strong empirical relationship between depth of discount and the bid–ask spread of the issuer’s shares. Second, the value of many issuers is rather uncertain; in the academic jargon, there is high information asymmetry. There was a major shift in the 1990s in the type of company listed on stock exchanges, away from well-established companies with a successful track record, toward smaller firms that are still in the product development stage. The discount could also provide compensation for costs of investigating the issuer, or for future costs of active monitoring.

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Case Study

Bradford and Bingley’s “Rights Reissue,” May–June 2008

The rights issue of Bradford and Bingley plc, a British mortgage bank, was among the most extraordinary in living memory. On May 14, 2008, Bradford and Bingley announced that it was to raise £300 million via a 19-for-25 issue at an offer price of 82p—a discount of 48% on the preannouncement share price. However, on June 4, 2008, while the offer period was still running, the bank unexpectedly announced a profit warning, the resignation of its chief executive, and a restructuring of the issue. In particular, the offer price was cut to 55p to avoid the share price dropping below the offer price after the profit warning. A price cut mid-offer is extremely rare, but without it the underwriters would have been left holding much of the issue at a loss, and they might have sought to escape their obligations by invoking the “material adverse change” clause in the underwriting agreement.

In a further twist, Bradford and Bingley arranged for Texas Pacific Group (TPG), a private equity investor, to buy shares at 55p via a placing, acquiring a 23% stake and two seats on the board. TPG’s shares were not offered to existing stockholders and were therefore not part of the rights issue proper. TPG’s involvement as a potentially active investor was generally welcomed. At the same time, some institutional stockholders were annoyed at not being given the chance to invest more at 55p. As one said, “If there was no TPG, the whole thing would have collapsed. But it comes at a huge price for investors.”¹

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Making It Happen

• An equity issue is an expensive process and time-consuming for senior management.

• Key practical aspects include the choice of lead investment bank and other professional-service firms (for example, lawyers), the type of issue, the size and timing of the issue, whether to have it underwritten, the content of the prospectus, the level of fee, the offer price discount, and who the main buyers (future stockholders) will be.

• Companies are largely in the hands of the lead investment bank once the issue process is under way, but they can (and do) shop around when selecting the lead bank. When making the choice and negotiating the terms of the issue, company managers should be aware of the terms on which recent SEOs have been made by companies of a similar size. The fees and discount should be competitive.

• The company should aim for a smooth issue that raises the intended amount and is sold to a group of investors who are, or plan to be, long-term holders of the shares.

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Notes

¹ Financial Times (June 6, 2008).

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