Rights (said Fred?) may not be dead

The UK’s banking sector is certainly providing the entertainment missing from this year’s Wimbledon women’s singles non-tournament. After the Rock it’s now the turn of the Bradford Bungley bank. The Guardian includes a brief synopsis of events in its report of the latest stage of the fiasco. The basic problem is that rights issues aren’t working for the banks because the share price keeps falling below the issue price. This has happened to HBoS as well as B&B. There may be some technical reasons contributing to these mishaps, but the main reason is that the prices of the rights issues were set before the extent of the car crash that is the UK housing market (and economy in general) became fully apparent. When commenting on a piece by WIll Hutton last week it occurred to me to wonder why such rights issue accidents are allowed to happen.

Cutting to the chase, my suggestion is that instead of setting the price of the shares to be issued 2 months (say) before the issue date, and thereby becoming a hostage to fortune, companies could simply set the percentage discount to the share price at which the new rights issue shares will be issued. That is, if I was HBoS and my shares were around 500p, but I wanted to raise another £4bn to cover the possibilities implied by the possible UK housing meltdown scenario my strategists have identified, instead of announcing:

(1) as now, that shareholders will be able to purchase 1.5bn (approx.) of new shares at 275p in 8 weeks time, at a ratio of 2 new shares for every 5 shares held;

I would say:

(2) that shareholders will be able to subscribe to rights in new shares at a rate of 55p (a guesstimate of what HBoS are raising) for each share held. The new shares would be issued at a price 20% (say) below the closing price on the day of issue. For example, in the HBoS case, the shares could have risen to 550p by the rights issue date. In this case, putting in 55p for each share I already hold, I would receive one share for every 8 pre-rights issue shares I had (i.e. my new shares would be at a cost of 440p each). Alternatively, and closer to reality, the shares might have fallen to 275p. I would still have put in 55p for every share for which I had received the rights. But this time I would receive one new share (at 220p each) for every 4 shares I held before the issue.

I thought I’d work through this proposition a little more. In a rights issue we want to achieve 3 things:

– we want to raise a predetermined amount of money. In both case (1) and (2) we raise (say) 55p per existing share.

– we need to provide an incentive for shareholders to stump up the dosh. This is only true in case (1) if the share price stays above the offer price. Because it might not we shell out a fortune to underwriters. In case (2) shareholders always have an incentive to subscribe to the rights issue, otherwise they face being diluted by shares sold at a discount, equivalent to if a placing had occurred. But placings have the drawback that existing shareholders can lose out, i.e. lose their pre-emption rights. Much of the point of rights issues is to avoid this.

– we can protect shareholders who don’t want to or are unable to subscribe to the issue, allow other investors to buy in and reduce under-writing costs by allowing the rights to be transferable – i.e. bought and sold. The market price of the rights would converge on 20% of the value of a share after the rights are purchased (some recursive arithmetic is needed). [no it isn’t – the rights price will not vary simply because the share price changes – see Postscript.]. For example, in my HBoS example, it’s rational to buy the rights for up to about 10p (another guesstimate) if you think the value of HBoS shares after the issue of new shares will be more than £2.50. Obviously there are other factors to consider – e.g. the effect of the additional capital on the credit rating and hence cost of capital for the organisation.

[More accurately, in the example above, 1 share at 220p would be issued for every 4 existing shares if the HBoS share price is 275p on the rights issue date. If HBoS was worth 275p just before the rights issue, it should be worth ((4*275)+220)/5 = 1320/5 = 264p immediately after the rights issue, reflecting the 1 for 4 issue at 220p, so the rights to a share should have been worth (264-220)/4 = 11p.]. *

It would be irrational not to at least sell your rights (as it is now), but some shareholders are bound to let them lapse. The underwriters could be required to purchase the new shares corresponding to these rights, though in theory would make an instant profit (or companies could just ask for a bit more money than they need).

The threat of an overhang of unsold rights issue stock would be much reduced. Since such an overhang is one cause of share price declines ahead of rights issues, the current way of issuing rights at a deeply discounted share price falls into the self-fulfilling prediction category.

Existing practices could still take place. Rights could still be treated as pseudo-options, albeit a little differently than at present. You could still “tail swallow” by selling enough shares to cover your rights, because you are still being asked for a certain amount of money per existing share, though may end up selling a few more shares than necessary (since the price of the new shares is not known beforehand).

The only instance in which there would be no market for a rights issue would, it seems to me, be if a company is worth less than zero, that is, if it is not a going concern (and everyone agrees that this is the case), in which case no amount of rights issues would save it. Otherwise, even if the share price and hence price of the nil-paid rights drop dramatically before the rights issue [see Postscript – actually the value of the nil-paid rights would be unaffected], there will eventually come a point where it makes sense to take up the rights, since, as the share price declines, the rights issue (which, remember, is per existing share) will buy a larger and larger proportion of the company.

There may be legal niceties to overcome. For example, it might be necessary to issue (or get permission to issue) more shares than needed (since e.g. an EGM might be necessary for this), so that the number sold can vary depending on the share price. Shares not sold could be cancelled.

Procedures would be needed to deal with the entitlements to fractions of a share that might arise in method (2), but this is already the case in method (1). It’s slightly worse in method (2), since the fractions are not known in advance. In this age of electronic payments, and online share-trading, giving people a small amount of change (or allowing them to elect for it to go to charity!) should not be an insurmountable problem.

Why wouldn’t such a system be workable? Wouldn’t it reduce the risk of rights issues failing, and hence underwriting costs? Answers, especially attempted debunkings, on a postcard, please.

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*[Postscript 18:00 4/7/08: The example above in square brackets isn’t quite right. If I knew the share price was going to drop to 264p I’d sell my shares at 275p and buy them back! We need to add the option price (11p) into the calculation (264 + 11 = 275), i.e. the share price + the value of the rights should be 275p, but this would mean the actual share price is 264p, so we’d issue a few too many shares. Rather, we have to reach the share price at the moment of the rights issue by doing the calculation the other way round. If we think the company plus new capital is worth a certain amount (in £bn) then we can create a formula for the option price (z), share price (x) and number of shares (y) to be issued at the moment of the rights issue.

We estimate V, the value of the company after the rights issue.

We know a, the number of shares before the rights issue, b the discount for the rights issue and C the amount of money to be raised.

We can solve for y, the number of new shares to be issued:

After the rights issue, the share price, x = V/(a+y) [1]

The money raised C = xy [2]

From [1] and [2]:

C/V = y/(a+y) [3]

That is, very simply, the number of new shares to be issued y, as a proportion of the total shares in the company after the rights issue, is given by the money to be raised as a proportion of the value of the company after the rights issue.

Doh! We can do this even more simply, from the known value, V, of the company after the rights issue and the known amount to be raised, C, and assuming the rights issue completes, the value of the existing shares x, after the issue is:

x = (V-C)/a [4]

We can then derive y straight away from [2].

Never mind, let’s do an example!

E.g. company value £100 after we raise £20. 100 shares before issue.

20/100 = y/(100+y) from [3]

100+y = 5y

y = 100/4 = 25 (we issue 25 new shares).

So x, the share price, at the issue is 80p (£20/25 shares).

Check: The 100 existing shares must also be worth 80p, so we now have shares worth 125 * 80p = £100.

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BUT what is the price worth paying for options (rights) to buy these shares that will be worth 80p?

The value of the rights must be the same if we subscribe ourselves or if we don’t.

If I subscribe to the rights issue I receive new shares so can imagine I am not diluted by 125/100 and still have the same proportion of the company afterwards as I did before. It costs me 20p per pre rights issue share to avoid being diluted by 25%. But this is 20*(100/125) = 16p per diluted post rights issue share (this may seem a strange line of reasoning, but this is what we’re comparing it with). With no dilution, my shares would be worth 100p each. For this option, that is, if I subscribe to the issue, each post rights issue share is therefore worth 100p -16p to me, that is 84p.

If I sell the right I only end up with a share worth 80p + the money I received for the rights issue. I should sell if I can get more than 4p.

You could derive this perhaps more simply, as the total discount for each of original shares. i.e. the total discount in this example was 5 shares (with no discount we’d have issued 20 rather than 25 new shares), which we’ve shown will be worth 400p, spread over 100 original shares, giving tradeable rights of 4p/share.

In general:

Undiluted share value – discount per original share = final share price + option/rights price (z), i.e.:

V/a – C(1-b)/a = (V-C)/a + z [4]

az = V – C(1-b) – V + C

z = Cb/a [5]

In this example,

z = £20 (0.2)/100

z = 20p * 0.2 = 4p. Bingo!

That is, the value of the nil paid rights (before supply/demand fluctuations) is simply the discount per share. We don’t need to know anything else to trade these babies. The amount of dilution, though, follows from the share price at the moment of the rights issue which itself is simply derived – everything depends solely on what you judge the company to be worth after the rights issue (taking into account any risks you identify) compared to the amount being raised in the rights issue.].