How To Deal With Rights Issues

With many companies currently seeking to raise fresh funds from shareholders, Tony Boden takes a look at what you need to consider before parting with your cash.

In the current climate there seem to no end of companies seeking to raise new cash from shareholders, through rights issues and open offers (it comes with the territory of the current 'lenders strike'). Here I attempt to steer a path through the emotions that these can generate to guide shareholders to making the best decision based on the future.

1. Why the Fundraising?

Obviously the objective is to raise extra cash for the company.

In good times the cash will often be used to fund growth or acquisitions and it is likely to be the case that raising cash from shareholders is cheaper than raising new debt. The company will no doubt have a compelling growth story, encouraging investors that they will get a good return on their newly invested capital. Shareholders will in turn be well disposed to this in the belief/hope that their newly purchased shares will quickly appreciate in value.

Currently, however, most fundraisings are to "strengthen the balance sheet", (in a lot of cases this means that the existing lenders want some of their money back). The negative connotations of this make the offer seem far less compelling to shareholders, however, the logic of the fundraising may be far more powerful in these circumstances. 

The stark choice may be between a company at a strong risk of going bust, with probably zero return for shareholders, and a company sufficiently funded to trade through the credit crunch and go on to prosper. This does not of course mean that the shareholders choice is between backing the fundraising or writing off the entire investment. Your shares remain tradable and selling, even at a loss, is always an option.

As ever, the trick for investors is to take a step back and rationally assess the current situation, put aside regret that the shares once traded at a multiple of their current value and also regret that the dilution of earnings (by virtue of more shares being in issue) reduces the chance of past highs being reached in the near future.

First off, one needs to assess what the company will look like post-fundraising.

2. Post Fundraising

Let us take a simple example of company X. Here's the current situation:

To cover debt issue company X announces a '1 for 2' fundraising at 25p. This mean you have the option to buy 1 additional share for each 2 currently held:

So after the fundraising the company will look like this:

The actual share price after the announcement may be higher or lower than this dependent on how the market now views the company. By reducing the debt and therefore interest payable the fundraising will increase earnings by (say) £0.5m pa, so:

A P/E ratio of 7.6 at face value looks less attractive than 6 (as a result of the dilution), but this is compensated for by the reduction of risk (the stronger balance sheet). Also don't forget that as an existing shareholder you have the option to buy new shares at 25p, an effective P/E of 6.8.

So forgetting the past, you need to make an assessment on what you consider the refinanced company to be worth. That will obviously dependent on your view of the prospects of the company. 

Essentially, you have three options:

• Increase your shareholding by taking part in the fundraising (and even potentially buying additional shares in the market)
• Maintain your shareholding as it is.
• Reduce your shareholding (perhaps even to zero).

3. Decided? -- Now act!

Having made your decision you just need to act upon it and I would just offer a couple of pointers here :

Don't forget the deadline!

This sounds obvious, but having done all the hard work of making your decision it is easy to do, particularly given that your broker's deadline for acceptances may be up to a week before the company deadline, check with them as soon as possible.

Understand what the offer is

Two of the commonest methods of fundraising are "Rights Issues" and "Open Offers", there is an important difference between the two.

A Rights Issue gives you the right to buy X shares in the company at the offer price and these rights are tradable. The price of the 'rights' should be the difference between the new share price and the value at which the rights are exercised -- 3p in the case above. If you do not wish to take them up, you can sell the rights in the market or if you do nothing by the deadline they will be sold for you and you will receive the proceeds.

In an Open Offer, you are offered the chance to buy the shares at the discounted price, but, importantly you cannot sell on these entitlements and if you do nothing they expire at zero value. That's a bit perverse as the entitlements do have the same 'intrinsic' value (3p) as they would in the case of the Rights Issue.

The important thing to recognise here then is that for an open offer, if you do not take wish to take up your entitlement in full, it may still be worth buying the full entitlement and then selling directly. This will depend on how big the value is and whether you hold sufficient shares for this to justify the dealing costs of the sale (no dealing costs apply to exercising your entitlement), also you need to consider the risk that the share price will between you exercising and being able to sell. If the value is small you may decide not to take this risk, but it is always worth considering, don't pass up the chance of "free money" through indolence!

There is never an easy 'right' answer to these situations, but hopefully I've guided towards making a rational decision and ensuring you act upon it. Assuming we are not at the end of the fundraising season I hope over the coming weeks to give some pointers on fundraisings as they happen.

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