There is an old principle, enshrined in British company law, that when a company issues new shares to raise cash, those shares should be offered first to the existing shareholders – the owners of the business – traditionally in the form of a rights issue. This is the principle of pre-emption rights.
The principle still holds to a certain extent, but in recent years it has been eroded at the edges. The rights issue process is lengthy and cumbersome, some companies and their banking advisers argue. Companies should be free to take advantage of temporary windows of opportunity in the financial markets by issuing shares as and where they see an opening. Companies in America have considerably more freedom in this respect and the principle of pre-emption rights counts for little. American companies may issue shares en bloc to a securities house, which subsequently sells them through its marketing network. This, it is claimed, is faster and cheaper for the company. And the people who make these claims are frequently the banks and securities houses that would earn most from this method of share distribution.
But there is a paradox here. How can a procedure be good for a company if it is not good for the existing shareholders who own the company? Echoes of this debate surface from time to time in the financial columns of the press. Generally the big investors – the insurance companies and pension funds – will argue strongly for a system which gives existing investors the first right to new shares. But they have compromised by allowing companies to make small issues of shares for cash without going through the pre-emption procedure. You will frequently see in companies’ annual reports that they ask investors to vote them the powers to make limited share issues to buyers other than existing shareholders. It may be described as ‘disapplication of the statutory pre-emption rights’.
Thus, anything we say about traditional methods of issuing new shares for cash must be read with a note of caution. Rights issues are no longer as common as they once were and placings, open offers and vendor placings are frequently encountered. It is the rights issue, however, that we need to look at first to grasp the principles.
The rights issue procedure – ‘rights’ because existing shareholders have the first right to put up the new money – goes like this. The company announces that it intends to raise a particular amount by creating and selling new shares. The new shares will be offered to the shareholders in proportion to their existing holdings. And they will virtually always be offered at a price below that of the existing shares in the market, to give shareholders an incentive to put up money for the new shares. If they are offered at a price way below the existing price – say, at half the market value – the issue would be described as a deep discounted rights issue or as having a very large scrip element (see below under ‘The scrip issue’). But this is the exception rather than the rule. Discounts of 20 per cent or so are more common.
This is a point that often causes confusion. You will come across phrases in the press like: ‘XYZ Holdings is offering shareholders one new share for every five held at the very favourable price of 200p against a market price of 400p’ or ‘XYZ Holdings is making a rights issue on very attractive terms to investors’.
This is usually sheer nonsense. The shareholders already own the company. The company cannot offer them anything that is not theirs already. The price at which the new shares are offered is a technicality, provided they are offered to existing holders. Investors are not getting anything on the cheap. An example illustrates the point.
Suppose XYZ Holdings, whose shares are quoted in the stockmarket at 260p, decides to raise £40m by creating and selling 20m new shares at 200p each. The shares are offered to shareholders in the ratio of two new shares for every five existing shares they hold (a ‘two-for-five’ rights issue). For an investor who decides to take up his rights, this is how the sums go. For every five shares worth 260p each that he holds, he buys two new shares at 200p each. The average value of his shares after the issue would be 242.9p:
|
p |
|
5 existing shares at a market price of 260p |
= |
1,300.0 |
2 new shares for cash at 200p |
= |
400.0 |
Total for 7 shares |
= |
1,700.0 |
Value of 1 share (l,700p / 7) |
= |
242.9 |
If all else were equal, 242.9p (call it 243p for simplicity) would be the price at which the XYZ shares would stand in the market after the rights issue. In other words, the market price would adjust down from 260p to 243p to reflect the fact that new shares had been offered below the previous market price. In practice, the general level of the stockmarket and the prices of individual companies are constantly moving up or down, so the sums may not be quite so clear cut. But the principle holds good.
It follows from this that the right to buy new shares at below market price has a value in itself, which is why it needs to be offered first to existing shareholders. A shareholder who simply ignored the rights issue would start with 5 shares at 260p worth l,300p in total and end with 5 shares at 243p after the price adjustment, worth only l,215p. In practice, when the shareholder does nothing the company will normally sell his entitlement to the new shares on his behalf and send the proceeds to him.
When a company announces a rights issue, it says that the new shares will be offered to all shareholders on the company’s register of shareholders at such-and-such a date. But since it can take time for purchases and sales to be reflected on the register, the stock exchange adopts its own different cut-off date. Anybody buying existing shares in the market before this date buys them with the right to subscribe for the new shares (cum-rights). Anyone buying on or after this date does not have the right to the new shares – this remains with the seller. The date is the day on which the shares go ex-rights for stock exchange dealing purposes, and it is therefore the day on which the market price will adjust downwards – from 260p to 243p in the example. After this date the share price in the Stock Exchange Official List and in newspapers will be marked for a time with an xr to tell buyers that they are not acquiring the right to subscribe for the new shares.
The rights to subscribe for new shares can be bought and sold in the market in much the same way as shares, and the value of the rights will be roughly equivalent to the ex-rights price (the price that has been adjusted downwards to take account of the issue) less the subscription price for the new shares. In the example, the right to buy for 200p a new share which will be quoted in the market at 243p ex-rights will be worth about 43p (243p minus 200p), though technical considerations can affect this a little. Shareholders who do not want to put up money for new shares will sell their rights and thus end up with some cash plus a smaller proportionate stake in the company.
|
|
p |
Shareholder has 5 shares at 260p |
= |
1,300 |
Sells rights to 2 new shares at 43p |
= |
86 |
Retains 5 shares at adjusted price of 243p |
= |
1,215 |
Has shares and cash of (adjusting for rounding-up errors) |
= |
1,300 |
The rights themselves are a short-life high-geared investment rather like an option or warrant (see Chapter 18), and often appeal to gamblers. Suppose XYZ’s ex-rights share price rose 10p from 243p to 253p: an increase of 4 per cent. The value of the nil paid rights (the subscription price for the shares has not been paid) might be expected to rise from around 43p to around 53p: an increase of 23 per cent. Like all gearing, it works in reverse and the value of the rights can disappear entirely if the XYZ share price suffers a sharp fall.
The Financial Times carries in its ‘Companies and Markets’ section a table of rights offers showing the prices (technically the premiums) quoted for rights to buy new shares. It also gives the price at which the new shares are being issued (which would be 200p for XYZ), the proportion of this price which has already been paid (if any – see Chapter 8) and the highest and lowest price at which the rights have traded. You can see that the percentage swings can be very large. The pm after the price simply means that the price is actually a premium which the buyer pays for the right to subscribe to a new share.
The price for the new shares in a rights issue is normally pitched sufficiently far below the market price to allow a bit of leeway in case the share price falls in the interim – investors will not put up money for the new shares if they can buy existing shares more cheaply in the market. Nevertheless, to make sure the company gets its money, the issue will normally be underwritten – institutions agree for a fee to put up the money for any shares the company cannot sell (see Chapter 8).
Example 9.1 Stockmarket prices for ‘rights’. Source: Financial Times.
To XYZ Holdings it makes little difference if it issues 20m new shares at 200p each or 40m at 100p each. It still raises the £40m it needs. And if it pitches the subscription price at 100p against a market price of 260p for the existing shares, there is very little risk that the market price might fall below the subscription price and prevent the new shares from being taken up. A deep-discounted rights issue such as this would therefore not need to be underwritten – a considerable cost saving. In practice, very few companies follow the deep-discounted route. The reason usually given is that there is a slight tax disadvantage for some shareholders in the deep discount process. The City, for which underwriting fees are a useful and normally an easily-earned perk, does not encourage deep-discounters.
When XYZ’s market price is 260p the company is being no more and no less ‘generous’ if it offers new shares at 100p than at 200p. Remember the principle. The company belongs to the shareholders and there is nothing they can be given that they do not already own. The only benefit they may derive is if the dividend per share is maintained on the increased capital, which has the same effect as a dividend increase. This is a totally different decision, but it is often confused with the rights issue itself. If XYZ was paying a 10p per share gross dividend before the issue, the yield on the shares at 260p would have been 3.8 per cent. If it paid the same dividend per share after a two-for-five rights issue at 200p, the yield at the ex-rights price of 243p would rise to 4.1 per cent.
As we have seen, the rights issue is not dead, but other methods of issuing new shares for cash have become increasingly common. The ones you are likely to read about include the following.
• The placing. This works in much the same way as a placing used as a method of bringing a new company to market (see Chapter 8). New shares are created and the company’s financial adviser will sell them direct to a range of investors. The shares will probably be offered at a price a little below the market price, but not as far below as in a rights issue. Sometimes, all the new shares might be offered to investors on an overseas stockmarket. In the 1980s companies and their advisers frequently presented this as a way of gaining a wider geographical range of shareholders – useful to a company’s international standing, they claimed. In practice, the overseas buyers who acquired shares below the market price frequently sold them to UK investors rapidly and at a profit (a process known as flow-back). The guidelines imposed by institutional investors would normally allow a placing of only a small proportion of the company’s capital unless there were clawback arrangements for existing shareholders (see below).
• Placing and open offer. This is a process which, up to a point, preserves the pre-emption principle and is increasingly commonly used instead of a rights issue. It can be described in slightly different ways. Essentially, new shares are created and sold conditionally (usually at a small discount) to large investors, mainly the institutions. But existing shareholders have the right to take up the new shares at the same price instead (this is the clawback feature). So the new shares will end up with the purchasing institutions only to the extent that existing shareholders decide not to take them up. Thus far, the result from the company’s point of view is much the same as with an underwritten rights issue. The arrangement for the institutions to purchase the shares serves the same purpose as a conventional underwriting agreement: the company knows that it will get its money. But note that this does not produce the same result as a conventional rights issue for all shareholders. A holder who does not take up his entitlement under the clawback has no rights to sell for cash. The benefit of new shares at below market price goes to somebody else.
• The vendor placing. Suppose Company A wants to buy a division of Company B, and wants to use its own shares to pay. Company B, on the other hand, wants cash, not shares in Company A. Company A could, of course, make a conventional rights issue to raise the cash to pay Company B. But it might be quicker and simpler to issue new shares to the required value to Company B and at the same time make arrangements for all these new shares to be bought by institutional investors for cash. This would be a vendor placing (the shares are placed with institutions on behalf of the vendor). The purchaser thus pays in shares but the vendor receives cash. Again, the institutional shareholder rules place an upper limit on the size of transaction that can be undertaken in this way without the new shares being offered to existing shareholders by way of clawback.
• The euroequity issue. A company uses a securities house or a number of securities houses to market the new shares that it creates to investors in a range of overseas countries via the international market mechanisms (see Chapter 17). Such operations by UK companies will tend to be limited by the pre-emption rules.
• The bought deal. Instead of placing shares with a number of investors, a company can invite bids for all the shares from the securities houses. The securities house offering the highest price gets the business and pays cash for the shares, hoping to make a profit by selling them via its distribution network to a range of investors. This might be described as a ‘primary’ bought deal, and in Britain its application is limited by the pre-emption rules. But the principle of the bought deal is not limited to new shares a company creates. A company which held a large investment portfolio of other companies’ shares that it wanted to dispose of could invite offers for the lot (a ‘secondary’ bought deal). Both types of business can be very profitable for the securities houses, though they are also very high risk – the buyer could lose heavily if the share price dropped between its buying the shares en bloc and selling them to the final purchasers. The operation requires large amounts of capital – one of the reasons why British securities houses need big financial backing to be able to compete with their American counterparts. Equally important, it demands a large efficient marketing department with a wide spread of investor contacts. The dangers of the bought deal procedure were underlined in 1990 when merchant bank Kleinwort Benson paid £138m (or 99p per share) to Burmah Castrol for its 29 per cent stake in Premier Consolidated Oilfields, hoping to distribute the shares quickly at a profit. Instead, the price fell heavily and Kleinwort eventually got out at 78p for a loss of £34m on the operation.
• Euromarket convertible issues. Companies may issue ‘deferred equity’ to international as well as domestic investors by issuing a convertible bond via the euromarket mechanisms (see Chapter 17). In the past, some companies used this route as a way of avoiding the institutional rules for new share issues. But the limits on the amount of new capital that could be offered to investors other than existing shareholders now apply to convertible issues as well as to direct issues of shares.
In the case of a placing, a vendor placing or, particularly, a bought deal, the price for the new XYZ shares would probably be far closer to the market price than in the case of a conventional rights issue. But it will still normally be at some discount to the ruling market price. And this is where the controversy arises. It makes no odds, as we’ve seen, whether XYZ choses to offer its new shares at 200p or 100p as long as they are offered first to existing shareholders. But if they are offered below market price to investors who are not already shareholders in XYZ, there is a transfer of value from existing shareholders to the new buyers, which is a totally different matter.
The pension funds and insurance companies are the major existing shareholders in most larger companies, and they have not taken kindly to seeing their birthright eroded. They have therefore argued that most or all of the new shares sold via these techniques should be offered to existing shareholders as a clawback – the process we have already looked at.
In practice, as we have seen, they have had to compromise. Their rules – which are reinforced by the authority of the stock exchange – lay down that a company may not issue new shares for cash, without offering them first to existing shareholders, if the new shares represent more than a certain proportion of existing capital or are issued at a discount of more than a certain amount. In 2000 the rule was that new shares issued for cash, and bypassing existing shareholders, must not add more than 5 per cent to the company’s capital in a single year or more than 7.5 per cent over a rolling three-year period, or be issued at a discount of more than 5 per cent to the market price. For vendor placings the institutions have their own slightly less restrictive guidelines. Here, in 1999 the limit on issues without clawback was 10 per cent in a year and at a discount of no more than 5 per cent. Even at these levels, issues over a period of years to non-shareholders can significantly dilute the existing shareholders’ interest and the institutions are not entirely happy with the situation.
From the new, back to the old. There is one further type of share issue that any reader of the financial press has to understand: the scrip issue or capitalization issue. It arises almost by historical accident, but poses a pitfall for the unwary. It is sometimes referred to in the press (and, even less excusably, by companies themselves) as a free issue or a bonus issue – again conjuring the vision of shareholders receiving something for nothing. In the case of the traditional scrip issue, this is misleading nonsense.
The historical accident is the fact that the nominal value of the share capital of British companies is distinguished from other funds belonging to shareholders and that the shares themselves therefore have a par value: 5p, 10p, 20p, 25p, 50p, £1 or whatever. The equivalent unit of common stock in American companies may not need to have a par value.
A scrip or capitalization issue in the UK is the process whereby a company turns part of its accumulated reserves into new shares. Suppose ABC Company’s shares stand in the market at 800p and its shareholders’ funds look like this:
|
|
|
£m |
ORDINARY SHARE CAPITAL (in 20p shares) |
100 |
PROFIT AND LOSS ACCOUNT RESERVES |
600 |
REVALUATION RESERVES |
300 |
SHAREHOLDERS’ FUNDS |
1,000 |
Because the company has accumulated considerable profit and loss account reserves (also known as revenue reserves) by ploughing back profits over the years, the £100m of share capital gives little indication of the total size of the shareholders’ interest in the company. Also, as profits have risen so the share price has risen, to the point where – at 800p – it is heavy by British standards. In many other countries, shares which each cost the equivalent of tens or hundreds of pounds are common. Britain has the tradition of units with a smaller value, and shares are considered to become less easily marketable (less easy to buy and sell in the stockmarket) when the price pushes up towards £10 or so.
So ABC might decide to convert part of its reserves into new shares. Suppose it decides to use £100m of its profit and loss account reserves for this purpose. It creates £100m nominal of new shares (500 million shares, since they are 20p units) and uses £100m of the profit and loss account reserves to make them fully paid. The new shares are distributed to existing shareholders (in this case in a one-for-one ratio) and the shareholders’ funds after the operation look like this:
|
|
|
£m |
ORDINARY SHARE CAPITAL (in 20p shares) |
200 |
PROFIT AND LOSS ACCOUNT RESERVES |
500 |
REVALUATION RESERVES |
300 |
SHAREHOLDERS’ FUNDS |
1,000 |
All that has happened is that £100m has been deducted from one heading (profit and loss account reserves) and added to another (ordinary share capital). It is a book-keeping transaction, pure and simple, and in no way affects the value of the shareholders’ interest in the company nor does it raise money for the company. Shareholders’ funds remain unchanged at £l,000m.
In our example the shareholder now has two shares where he had one before. But since the value of the company has not changed, the market price will simply adjust to reflect the issue. Previously the shareholder had one share worth 800p. After the issue he has two shares worth 400p each. The greater number of shares in issue and the less heavy price may make them slightly more marketable.
A scrip issue need not be in the ratio of one-for-one (also referred to as a 100 per cent capitalization issue). It could be one-for-ten (a 10 per cent issue), two-for-five, two-for-one, and so on. The complication in each case is that the market price has to be adjusted for the issue. If the issue were one-for-ten, the market price would come back from 800p to 727.3p. The investor starts with 10 shares at 800p, worth 8,000p in total and he ends with 11 shares. Dividing the 8,000p by 11 shares gives a price of 727.3p.
As with a rights issue, the stock exchange sets a date after which a buyer of ABC’s shares in the market will not acquire the entitlement to the new shares resulting from the scrip issue, and that is the day the price adjusts downwards. After the adjustment the letters xc will appear after the price, meaning ex-capitalization.
If a scrip issue by itself is significant only in a technical sense it can, like a rights issue, have implications for the shareholder’s income. If ABC makes a one-for-one scrip issue and wants to pay out the same amount of money by way of dividend after the issue, it will have to halve the rate of dividend per share. The shareholder who received 10p on one share gets the same income from 5p on two shares after the issue. If ABC holds its dividend at 10p per share, it is effectively doubling the payment. Occasionally, companies increase their dividends by paying a constant amount per share, but making regular small scrip issues such as one-for-ten.
With a one-for-one scrip issue, when the market price halves, it is not easy to miss what is happening, though brokers still get calls from clients asking why their shares have performed so badly. A one-for-ten issue, with a comparatively minor downwards adjustment in the price, is far easier to miss. When tracking the performance of a share price over the years, the investment analyst or journalist has to adjust for every scrip issue. Not only must the price be adjusted. Previous years’ earnings and dividends per share will also need adjustment. Suppose ABC earned 25p per share and paid a 10p dividend for the year before it made its one-for-one scrip issue, at which time the share price was 800p. In the year after the scrip issue the earnings per share were 15p, the dividend was 6p and the share price has touched 550p. What has really happened?
All of the earlier year’s figures have to be adjusted for the issue:
One share at 800p |
= |
two shares at 400p |
25p earnings on one share |
= |
12.5p per share on two shares |
10p dividend on one share |
= |
5p dividend on two shares |
Therefore, in comparing the previous year’s performance with the latest one, we are comparing effective or adjusted earnings per share of 12.5p with the latest year’s 15p, and an effective or adjusted previous year’s dividend of 5p with a current one of 6p. The share price has risen from the equivalent of 400p to the current 550p. Net asset values must be adjusted in a similar way.
Discussions of company performance in the financial press are thus studded with words like ‘effective’, ‘adjusted’ and ‘equivalent’, and reflect this particularly irritating technicality of British company practice. In theory, all figures should also be adjusted for a rights issue at below market price, though practice varies. Certainly, a deep-discounted rights issue (which really contains strong elements of a scrip issue as well as a money-raising issue) requires adjustment.
Two other quirks of the scrip issue process crop up from time to time. Sometimes, companies give their shareholders the option of receiving their dividend in the form of a scrip issue of new shares in place of cash (a scrip dividend). Originally the new shares would have been issued only to the value of the net dividend (the dividend after basic rate tax has been deducted). But later we saw the enhanced scrip dividend, where the company offered a larger value in shares than in cash to persuade shareholders to opt for the former. But there are objections to scrip dividends. In effect, a company that pays most of its dividend in shares rather than cash is making a smallish disguised rights issue – boosting its cash resources by avoiding a cash outflow – often without adequately explaining the reasons. It was sometimes felt that this encouraged companies towards laxity in their cash management by removing the need to ensure that the cash was there for the annual dividend.
Second, in some of the government privatization issues, shareholders who retained their shares for a specified period were promised a loyalty bonus in the form of a scrip issue of additional shares. In this case the issue does have a value since it does not go to all shareholders alike. Those who receive the extra ‘loyalty’ shares are increasing their proportionate stake in the company at the expense of the other shareholders who do not qualify.
As well as issuing new shares, companies sometimes buy back existing shares. And as well as raising money, they sometimes decide to return money to shareholders. The two operations are sometimes interconnected and have become a lot more common in recent years.
Take share buy-backs first. We said earlier that ordinary share capital – equity capital – is permanent capital. And so it usually is. Ordinary shares, unlike loans and some preference shares, do not have to be repaid. But a company may still decide that it is in its interests to reduce the number of shares in issue. And it can do this either by buying them in the market or by inviting shareholders to sell some of their holdings to the company. In Britain, the shares that are bought by the company will be cancelled, thus reducing the issued ordinary capital. In the United States, companies are allowed to buy their own shares and hold them as treasury shares, perhaps reissuing them again later. There has been talk of allowing British companies to do this, too, in the future.
Why would a company want to buy back its own shares? It may be simply that it thinks the shares are too cheap, and if it reduces the number of shares in issue the price will improve because investors will be chasing a smaller number of shares. It may be that the company has accumulated more cash than it needs and would like to return some of this to shareholders. This is often a good idea, because another way of getting rid of the excess cash would be to use it to make a takeover – and it is rarely sensible to make takeovers simply because you have cash burning a hole in your pocket. It may be that the company thinks its gearing ratios are wrong and it could operate more profitably with less equity and more debt. It may be that the company sees that it can improve its assets per share or earnings per share if it reduces the number of shares in issue.
Take an example of this last operation. A company has net assets of £13m and it has 10 million shares in issue. The net asset value per share is therefore 130p but the share price in the market is only 100p. So the company decides to use £lm of the cash it holds to buy back and cancel 1 million of its shares. The use of the cash reduces net assets to £12m, but the number of shares in issue reduces to 9 million. The £12m of net assets divided by the 9 million shares gives a new net asset value per share of 133.3p per share: a small but worthwhile improvement.
Because companies in Britain are not normally allowed to give financial assistance for the purchase of their own shares, they have to go through a fairly lengthy rigmarole to pave the way for a buy-back operation. You will notice in the annual reports of companies that a resolution is often proposed for the Annual General Meeting, asking shareholders to give the directors the authority to buy back the company’s own shares, probably up to a maximum of 10 per cent of the issued capital.
The problem with returning cash to shareholders is that there may be severe tax obstacles. The cash is likely to be treated as a distribution – in other words it may receive the same tax treatment as a dividend. With the abolition of Advance Corporation Tax (ACT) in 1999, this may be less of a problem in the future, But it has generated some very complex transactions to return cash to shareholders in the most tax-efficient manner. One variant involved making a scrip issue to all shareholders of a new class of share that carried no rights to dividends or votes. These shares were then redeemed for cash by the company and cancelled, putting the cash in the hands of the shareholders.
Far simpler is for a company to return cash to shareholders simply by paying a special dividend in addition to the normal interim and final dividends. This special dividend is likely to be a lot larger than the normal annual dividend and, because it is a one-off, it will not of course be taken into account in calculating the yield on the shares.
For statistical information on recent issues (both new companies that have come to the market and further issues by existing companies) you may download the monthly Primary Market Fact Sheet from the London Stock Exchange site at www.londonstockexchange.com. There is information on the institutions’ guidelines on share issues at www.ivis.computasoft.com/.