Righting Rights Issues: Further Reflections

It’s incredibly annoying when media organisations give the appearance of encouraging debate, but in fact simply don’t. The BBC’s “Have Your Say” is truly appalling: there is often a backlog of hundreds of comments over hours or days which have not been “approved”. Why pre-approval of comments is deemed necessary is beyond me (even the most innocuous subjects are “Fully Moderated”) – surely just permitting complaints (and if substantiated removing offending posts) is sufficient. After all, people can post what they like elsewhere on the internet. If the BBC can’t resource “Have Your Say” perhaps they shouldn’t bother – they’re drawing traffic away from other discussion forums and blogs. I recently complained to “Have Your Say” along these lines, but I’ve had no response. I guess they haven’t the resources to respond to complaints. Doh! I’ll be happy to respond to any sensible complaints here!

Anyway, this morning I spied a piece by Jeremy Warner at the Independent. I noticed that the Indy offers the opportunity to post a comment. Maybe this facility is new, as I don’t remember seeing it before. Anyway, at the end of my post I wanted to say “I told you so”, by linking to this blog. Specifically, my parting shot was going to be:

“The current problems were fairly predictable, e.g. see: http://unchartedterritory.wordpress.com/2008/03/19/how-to-play-dominoes/

Guess what? Of course, I couldn’t get the Indy’s robots to accept this. Presumably they want to control rather than encourage debate. I notice “JF” endorsed my comment. Perhaps (s)he would have liked to read my blog post too. This attitude is self-defeating. People prepared to increase the value of online articles and comment pieces will gravitate to less restrictive outlets, like the Guardian’s “Comment is Free” forum.

Anyway, I wanted to provide an update to my previous post, as I have become aware of a couple of nuances and thought some more about the rights issue process.

First, I mentioned underwriting costs, saying “I’ve read of 2-3% of the rights issue fee”. This looks like a cut and paste error, what I meant (obviously) was that the underwriting fee is typically 2-3% of the amount to be raised in the rights issue. But in distressed rights issues, which are the ones we’re concerned about here, it can be more. According to the Times, the B&B rights issue will cost £55m to raise £400m! We’re in rip-off City. There must be a better way.

Second, it’s been pointed out to me that there is yet another error in the Motley Fool article I quoted which purported to advise readers about the HBoS rights issue. They said:

“4. You do nothing and, at the end of the rights issue process, your rights are sold and you receive the proceeds.”

In fact, what HBoS would actually do according to their “Rights Issue Guide” is “arrange for the shares that your Rights entitled you to buy… to be offered for sale in the market” and buy more shares with the “premium obtained above the Rights Issue price”. So unless they can dump shares for all the lapsed rights at more than 275p (unlikely, now) you get nothing. When I looked earlier today, you could sell your rights for over 4p each, even though the share price is (just) under 275p. They were worth more last week, even when the HBoS share price was lower. The Rights are behaving like an option. In fact, they are an option. As we get nearer the rights issue date (July 18th) the less chance there is that the HBoS share price will shoot up to a level where it’s worth exercising the rights. So the Fool’s advice relating to points 2, 3 AND 4 is flawed (and in no circumstances would you get the “free money” the Guardian mentions – the best HBoS will offer if you let the rights lapse is HBoS shares to the value of the rights).

It seems more and more to me that the rights issue process as presently conducted is itself likely to drive a company’s share price towards the rights issue price. It’s very interesting to watch the HBoS share price. Today, for example, the stock markets snapped back. Lloyds TSB shares were up more than 6%, Barclays more than 5%, for example. But HBoS gained only just over 1% and closed under the rights issue price at 273.5p. The problems now, of course, are that:

– the market is swamped with options to buy at 275p. No-one holding these need pay more than a little over 275p for HBoS stock (they could try to do a little better by selling the right and simultaneously buying the share at less than 275p + the value of the right, but if enough people do this the rights price falls and the opportunity disappears).

– everyone knows that a huge number of shares are going to be dumped on the market in a couple of weeks and that the sellers (the banks underwriting the issue) will settle for anything over 275p. The Rights Issue Guide says so!

– people have been able to buy HBoS stock at less than 275p for some days (and may well be able to do so again before the rights issue date), which has satisfied many potential buyers of HBoS stock, including holders of the rights who are therefore able to sell them, depressing demand for HBoS stock further.

It seems to me for the third of these reasons in particular, that, once a share falls below the rights issue price for any length of time, it’s rather difficult for it to struggle much above it.

Now, how did we get into this mess?

When a company, such as HBoS, implements a rights issue, its shares are likely to drop in value somewhat, for two distinct reasons. The profits of the company’s business are simply going to be distributed among more shares (“dilution”). What’s more, some of the value of the shares is transferred to the rights, because the rights allow new shares to be purchased at a discount (in the HBoS case I calculate that the shares should have dropped around 10% in value when they went ex-rights on 27th June, so the discount was only “really” around 1/3, not 40% – the only problem is they’d already fallen close to the rights issue price!). Of course, if the market believes the money will be used to grow profits, e.g. develop a new aero-engine or acquire a rival software company, to allude to two issues I remember, there will be more profit to go round. This is not the case for distressed rights issues. The prime purpose is not to improve profits, but to bolster the balance sheet and address cashflow risks (so the 10% drop is a conservative estimate – I’d expect it to be more, though this would occur when the rights were announced or even rumoured, not on the ex-rights day).

The initial price drop will not help market sentiment. But it is the compounding of market sentiment with the mechanics of the rights issue that really causes a problem.

Let’s imagine that rights have been awarded to shareholders and shares in the company in question have dropped appreciably for the reasons just discussed. Now:

(1) Some shareholders will simply not be able to take up their rights. They might simply not have the cash (fairly predictable that much of the retail base of HBoS shareholders won’t right now, I’d have thought). Or, perhaps important in the case of HBoS, the shares could be in an ISA wrapper (HBoS provide one) to which cash cannot be added without incurring a penalty, i.e. the loss of the year’s entitlement to set up another ISA (including a cash ISA). Whatever the reason, shareholders unwilling to exercise their rights will either have to sell them or carry out a “tail swallow” (which involves a net sale of rights). This will depress the value of the right. E.g. in the case of HBoS the share price might be 300p, but the rights price 20p. [Actually, even at 25p the rights would be a bargain because of the value of the option to buy at 275p. This is worth something more than zero to represent the possibility that the share will fall below 275p before the rights issue date. This option value is ignored until point 3.].

(2) Now the “tail swallow” is not the whole story. It may be the only practical option for retail investors and is the only option provided on the HBoS form. But it would be daft for a fund manager who doesn’t want to exercise the rights to sell them at 20p and buy shares at 275p (by using the proceeds to take up the rights issue) if the shares were at 300p. They’d be much better off selling shares (and rights) at 300p to take up rights at 275p.

Consider: 100 rights at market value of 20p, 100 shares at market value of 300p.

a) Tail swallow: have to sell 13.75 rights to take up a share. Therefore can sell 94 rights raising 1880p. Exercise rights for 6 shares. Result 106 shares + £2.30 (+ use of £18.80 for some weeks).

b) Sell shares to exercise rights: sell 92 shares raising £276. Exercise rights for 100 shares for £275. Result 108 shares + £1 (+ use of £276 for some weeks).

Magic! Of course stamp duty (0.5%) and dealing costs need to be taken into account, but for a fund with, not 100 HBoS shares and rights, but 1,000,000, these would be negligible. So if the rights fall even 1% below “fair value” it would be better to carry out option b) rather than option a).

So if the value of the rights drops – because of supply and demand – it also drags the value of the shares down towards the rights issue price.

(3) Now we need to take the value of the right as an option into consideration. If the value of the share is above the rights issue price, it may still be worth buying the rights above fair value price, or holding them (in point 2(b)) for the option to buy HBoS at 275p (and to reflect the fact that they don’t have to put the money up for a while), hoping to in fact buy HBoS for less than 275p. The more likely the share price is to remain above 275p the less the rights are worth purely as an option, and the closer they should be to fair value. So our fund manager in 2b may prefer to sell the shares at 300p as described even if the rights price is (say) 26p, if the possibility of buying below 275p (see also point 4(c), below) is worth more than 1p, i.e. if the right simply represents a mispriced option.

Once the right has a high option value – say the shares are at 280p and the right is worth 10p in the market – then the incentive to “tail swallow” is greater. Selling the right yields 10p, exercising it a profit of only 5p.

This dumps still more rights on the market, depressing the value below what the option to buy at 275p should be worth.

(4) We also have to add into the equation the ability to sell short. If the right is worth less than fair value, i.e. share price (e.g. 300p) – rights price (275p) + rights value as an option to buy at 275p, then it is worth selling the share short and buying the right.

Say the right at this point costs 28p. I sell the share at 300p and buy the right. Net cash 272p. Now:

a) If the share stays above 275p I can exercise the right. I lose 3p (but see also point (c)).

b) But if the share falls below 275p I can close my position by buying the share. At 270p I make a 2p profit plus what I can sell the right for.

c) But it’s better than this. As long as the share price falls below 300p I can buy the share and sell the right. E.g. at 280p, the right may have relatively more value than when the shares were at 300p. Maybe it’s worth 10p. [Because of demand: instead of buying the share at 280p, some people will buy the right (or mispriced option) to lock in the price (effectively 285p) in the hope the share will rise before the issue date (in which case they can sell the share short and close the position by exercising the right).] If I’ve sold short, I might buy the share at 280p and sell the right for 10p. My closed position is worth 272p – 280p + 10p – a 2p profit again. [Or maybe I just change strategy, in which case I don’t sell the right but just close the short share position. I’ve now gained 20p (less taxes etc) on the share deals and have a right (that cost 28p) for a net 8p, which the market values at 10p, but which I might value at 12p, because its price is reduced by the excess of sellers of the rights over buyers].

So the conclusion so far must be that if there is any possibility whatsoever of a rights issue failing, the rights represent cheap options from which traders can profit.

(5) The more volatile the market, the more expensive options should be. I wrote earlier that LloydsTSB shares rose over 6% today and RBS over 5%. That’s a large movement. No-one has a clue whether the UK housing market will drop 10% or 40%. HBoS stock is likely to be volatile. Indeed it dropped dramatically in March after some rumours and bounced back the same day. Therefore options should be more expensive than usual. But a rights issue gives a cheap supply of options to buy (calls).

(6) Once the share price drops below the rights price, then, as we have seen, it’s unlikely to rise above it, because when its below the offer price people can simply buy shares in the market and sell the rights – increasing the supply of rights. The cheap option allows people to sell short even below the rights price, because their risk is limited by the ability to close the position by exercising the right.

(7) Then to complete the picture, we have short-sellers who anticipate all this happening (maybe not consciously, but based on experience). They can sell the shares short ahead of and at the start of the rights issue to get the price to the range where the share is vulnerable, possibly hedging their position with regular options.

Now, maybe all this is not conscious. The “evil hedgies” doing all this will, I presume, have software giving them a minute by minute update of their exposure, flagging opportunities and even trading automatically. In any case, they are worried only about their own position and not the market as a whole.

How could this happen? Perhaps rights issues are being carried out as they’ve always been, but insufficient modelling has been done to reflect the changed landscape. Maybe the game theorists need to be brought in. But of course the people who should do this – the investment banks – have a vested interest in the current method of carrying out rights issues: those massive underwriting fees. Even so, whoever decided that the HBoS rights issue should be at 275p has made a serious mistake (since even the underwriters don’t want the issue to fail), since the current problems were easily avoidable simply by choosing a lower price at which to offer the shares. £4bn worth of shares at 275p aren’t selling, but £4bn at (say) £1 each might have done. And if you’re going to put 1.5 billion options in circulation it might be best to be absolutely sure they’re worthless as hedges against short-selling!

Who’s lost and who’s gained? Well, the canny traders have gained – all those little gains per share we identified earlier. The main losers are HBoS shareholders who haven’t bought shares in the market at less than 275p. They’ve been diluted by 2 shares for every 5 for very little compensation. Of course, having said all this, HBoS shares may really be worth less than 275p! The market could be pricing them perfectly!!

I suggested back in March that the BoE/FSA should basically order banks to raise capital through rights issues (or otherwise), which is what seems to be happening. This presupposed a way of conducting orderly rights issues. I suggest now the authorities look at how rights issues are conducted and perhaps adopt my new method of discounting against the price on the day of the rights issue, not as at present against an arbitrary price some weeks before.