In our first article, Introduction to Private Equity, we discussed that private equity funds, to realise the return on their investment, must find an exit route. One of the most common methods is to float the equity on the stock market through an initial public offering (IPO). Nonetheless, the IPO process is a universal method for any private company, regardless of whether the company is part of the private equity fund’s portfolio or not. It is important to remember that the listing process is separate from the registration of a public limited company (‘plc’). Many plcs decide not to trade their shares on the stock exchange. Therefore, the term ‘going public’ does not always refer to a company changing its status from private to public. It simply means that a company is willing to offer its shares traded on a stock exchange to the public.
''An IPO is the first sale of a company’s share to the public and the listing of shares on a stock exchange''.
EY Guide to Going Public, 2018
However, public companies, whose shares are already traded on the stock exchange, may still require raising even more capital needed to fund further expansion or refinance their debt. This could be done via rights issues when existing shareholders are offered to purchase a new tranche of shares. In some cases, companies can also increase the number of shares in the issue without raising new money (The Chartered Institute for Securities & Investment, 2020). This process is described as capitalisation issues, also known as bonus issues or scrip issues.
Rights issues
In a rights issue existing shareholders are given the opportunity to buy a set number of new shares in the company they own (Hargreaves & Lansdown, 2021). This is very popular and relatively cheap method of raising new funds (Arnold, 2020). The Chartered Institute for Securities & Investment (CISI) suggests that a company might want to issue more shares to:
· pay off existing borrowings
· fund expansion
· acquire funding to make new acquisitions
To ensure that the issue of new shares does not dilute existing shareholders' rights, the Companies Act 2006 requires that each shareholder must be offered a number of shares that will maintain that shareholder's proportionate holding in the company. The shareholders are said to have pre-emption rights (French et al., 2018). The company owners are entitled to subscribe to the new shares in proportion to their existing holding (Arnold, 2020). In practice, it means that each shareholder may be eligible to purchase one share for every two existing shares they own (a 1-for-2 rights issue) or one share for every four existing shares (1:4), etc. Shareholders can also sell the right to buy to another investor if they are not interested in purchasing those shares.
Companies tend to have their rights issue underwritten by an appropriate institution. It means that the underwriting organisation commits to take up the unwanted new shares at a set price and will hold the shares in its own name. It will then try to sell them in the market, preferably for a profit (CISI, 2020). This process prevents an issuing company from failing to raise the capital if there is insufficient interest from investors, often caused by unfavourable or unexpected conditions in the market.
New shares are offered at a discount, i.e., below the current market value of a share. Arnold (2020) says that the discount is typically 10-40%. For instance, a company may offer its existing shareholders to buy a new tranche of shares at 100p per share while the share's market value is, in fact, 120p. At first, it seems like a bargain, and that an owner can acquire new shares at a lower cost and immediately sell those at market value. The reality, however, is different.
The theoretical ex-rights price (TERP) is a concept which represents the price at which both old and new shares are expected to start trading once the rights issue has been completed and the new shares are fully paid. Let’s consider an example provided by Glen Arnold in his book The Financial Times Guide to Investing to understand the TERP concept in practice.
Figure 1. Calculations of theoretical ex-rights price (TERP). Source: www.perlego.com
Although the investor now owns one more share than before, each share lost 4p in value. The new level at which all the shares in issue are expected to trade from this point is 116p per share. The loss in value of the share price is exactly offset by the gain in share value on the new rights issue shares due to the discounted price. For instance, if an existing shareholder were eligible to buy additional 25 shares, he would save £4 compared to a new investor who wanted to acquire the same amount of shares but at the new price (116p). The example can be illustrated as follows:
Cost of rights shares (25 x £1) £25
Ex-rights value (25 x £1.16) £29
Gain £4
Case study
On 15 December 2020, the Financial Times article reported that shares of AirAsia – Malaysian’s low-cost airline- fell as much as 9.5% in response to an RM500m ($123m) rights and share issuance. The new capital was intended to win creditor backing for a proposed debt restructuring. The struggling Malaysian carrier had to liquidate a part of its assets to prevent the company from going bankrupt. Paul Yong, an equity analyst at DBS, said… the share price drop was not surprising because of the dilution effect of a rights issue.
On 7 January 2021, Phillip Stafford reported in the FT articles that TP ICAP launched a 2-for-5 rights issue equal to 40 percent of its existing share capital to help pay for the interdealer broker’s planned $575m acquisition of Liquidnet.
The company willing to issue new shares must provide an investor with a provisional letter of allotment detailing the extra shares investors are entitled to receive under the terms of the rights issue. A shareholder will then have ten working days (two weeks) to respond to an offer. An investor will have three options: i. to take upon rights to purchase shares, ii. to sell the right to buy to another investor, iii. to take no action. In this case, the rights will lapse and become worthless. Also, it is typical that the rights issue might have been underwritten by a bank whereby it buys any shares that go unbought by shareholders (Hargreaves & Lansdown, 2021).
Capitalisation issues
Capitalisation issues occur when a company increases the number of shares in issue without raising new money. Thus, shareholders are given more shares in proportion to their existing holdings (pro-rata basis). Arnold (2020) suggests the value of each shareholding does not change in theory because the share price drops in proportion to the additional shares. This is also known as scrip issues or bonus issues. Companies may be willing to have more shares in issue (without raising more capital) to improve their marketability and to make their balance sheet simpler and cleaner (CISI, 2020) or to make the share more attractive by bringing the price down (Arnold, 2020). Bonus issues can often be distributed from its retained profits or share premium reserve account. Thus it can indicate a company’s success since there are plenty of undistributed profits to reallocate (CISI, 2020).
Case study
In 2018, the Board of Directors of Oxley Holdings Limited announced that the company is proposing a bonus issue of new ordinary shares in the share capital of the company to the shareholders on the basis of one (1) bonus share for every five (5) existing ordinary shares in the share capital of the company at a date and time to be determined by the directors. The rational for proposed action was described with the following passage:
‘‘The Company is undertaking the Proposed Bonus Issue to further increase the issued share capital base of the Company, to recognise and reward the Shareholders for their continuing support of the Company and to further improve the trading liquidity of the Shares, allowing for greater participation by investors and broadening the Company’s shareholder base.’’
In 2008, the Board of the Royal Bank of Scotland announced a capitalisation issue in place of the 2008 interim dividend and reasoned the decision with the following passage:
‘‘As indicated in the press announcement dated 22 April 2008 and following our Rights Issue earlier this year, the Board considers that it is prudent to issue new ordinary shares in the Company (the Capitalisation Issue Shares) instead of paying the 2008 interim dividend in cash. This is intended to accelerate the strengthening of the Group's capital position. The Capitalisation Issue was approved by Shareholders at the General Meeting on 14 May 2008.’’
NEPI Rockcastle plc provided the rational for its capitalisation issue as a step to ensure that the company ‘‘maintains a strong balance sheet and ample liquidity while also returning value to shareholders during the present operating environment.’’
The Chartered Institute for Securities & Investment provides an example of an X company whose shares’ market value after the capitalisation issue (the ex-cap price), with all things being equal, fell in direct proportion to the increase in share capital.
In this example, a firm’s shares were priced at 250p each before the 1-for-3 bonus issue with a total of 400,000 issued shares. The bonus issue increased the share capital by additional 100,000 shares and caused the share price to fall by 50p.
Figure 2. Bonus issue of an X company. Source: The CISI
Share splits
Share splits, also known as stock splits, is the increase in the number of outstanding shares while making no changes in shareholder’s equity. Arnold (2020) defines the share splits as a decrease of a share’s nominal value in proportion to the increase in the number of shares so that the total book value of shares remains the same. He also states that share splits are a sign of confidence that the company will perform well in the future.
We can illustrate the concept of share splits with the following example:
Sausage Roll Ltd. has a total of 100 in issue with a nominal value of 100p of each. The management of the company decides to issue further 100 shares with the nominal value of each reducing to 50p.
100 shares x 100p = £100
200 shares x 50p = £100
In theory, the price of each share halved. However, the total share capital remained constant. In 2020, Apple and Tesla announced stock splits, which James Powell explains more in his article for the Financial Times: ‘‘Stock splits: playing devil’s advocate’’.
Any thoughts?
Capitalisation issues, bonus issues, stock splits, and dividend payments are considered the most common corporate actions, described as the collective term for a range of actions a company can take, affecting the holdings, benefits, or rights of its shareholders (CISI, 2020). Such actions can directly impact the share capital of a company, including the number and value of shares in issue.
Bibliography
Arnold, G. (2020). The Financial Times Guide to Investing. 4th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/1365862/the-financial-times-guide-to-investing-pdf
The Chartered Institute for Securities & Investment (2020).Investment, Risk & Taxation. 11th edition. CISI: London
Hargreaves & Lansdown (2021). What’s a Rights Issue and Why Do Companies Do Them? [online]. Available at: https://www.hl.co.uk/news/articles/whats-a-rights-issue-and-why-do-companies-do-them
Palma, S. (2020). Financial Times: AirAsia X Shares Fall 9.5% on Rights Issue Plan [online]. Available at https://www.ft.com/content/a0057bc5-c215-448a-a66a-0fcd7e17681f