Rights issues: The hidden dangers

Would you like to buy shares at 40% below the trading price? It sounds like a bargain, but it's what companies have been offering their investors regularly over recent months in a spate of rights issues. However, as with all irresistible offers, it is wise to investigate them carefully before you accept.

Investors in Royal Bank of Scotland (RBS) and HBOS found that accepting their rights issue invitations meant losing their money as surely as if they had put it on a 500/1 shot in the 2.10pm at Ascot, without the enjoyment of watching an exciting race.

In June 2008, RBS persuaded more than 90% of its shareholders to stump up 200p a share, which was 46% below its share price at the time, to support a record-breaking £12 billion rights issue.

Since then, it has raised a further £20 billion - most of it from the government - at 65.5p and 31.75p, and is now offering the government a further £8 billion of shares at 50p each. Investors who subscribed for that initial £12 billion will end up owning little more than 15% of the bank, worth less than £5 billion.

Big letdown

It's a similar story with the Lloyds Banking Group - the new name for the merged LloydsTSB and HBOS - which is in the process of raising £13.5 billion in a new rights issue. Less than 18 months ago, HBOS was asking its shareholders for £4 billion in a rights issue priced at 275p a share.

The two banks have since raised a further £14 billion between them - again, much of that came from the government - and are currently asking for a further £13.5 billion at a price likely to be well below the current 85p share price.
However, two other UK banks have fared rather better. In March 2009, HSBC launched a record-breaking £12.5 billion rights issue at 254p a share; a 47% discount on its share price at the time. The bank's shares are now changing hands for almost 700p, providing a handsome profit to anyone who supported its cash call.

Standard Chartered raised £1.8 billion just over a year ago in a rights issue priced at 390p. Now you would have to pay more than four times that for a stake in the bank.

One major reason companies ask their shareholders for extra funds is to repair balance sheets damaged by poor business decisions and excessive borrowing. The HBOS and RBS rights issues are prime examples of that. They have been forced to write off billions of bad loans and ill-judged acquisitions.
HSBC and Standard Chartered were also guilty of embracing the culture of thin capital ratios prevalent in the banking industry until the credit crunch shattered confidence.

But their underlying businesses are robust enough for them to ague that their finance raising was undertaken to take advantage of opportunities to expand the business, whether by acquisition or through organic growth.

This has been a bumper year for rights issues. According to figures from Dealogic, which analyses capital markets, $92 billion (£55 billion) had been raised by the end of October, compared with $85 billion in the whole of 2008.

Even excluding the banks, most of these have been for repair rather than expansion and to help refinance the borrowing that hard-pressed banks were unwilling to extend further.

Mining company Rio Tinto asked its shareholders for $15.2 billion in the summer to help cut borrowing for the extravagant purchase of Alcan Aluminium. Housebuilders such as Barratt Developments, Taylor Wimpey and Redrow have protested that they are raising money to build more homes, but in truth, most of the money has been used to pay down debt.

Property companies such as Land Securities and British Land have been forced to plug holes in their balance sheets caused by the plunging price of offices and retail centres. Retailers JJB and DSG International, owner of Currys and Dixons, have been forced to bolster their defences against the fall in consumer spending.

Holding back

The rally in the stock market since March has certainly improved the climate for raising capital. This time last year, investors were reluctant to buy shares in anything, never mind to rescue a company struggling with large debts and under pressure on sales.

But as the threat of a prolonged recession has receded and interest rates have fallen - so low that holding cash is deeply unattractive - investors have been willing to take a bit more risk.

But that's no reason to back any old rights issue. The vast majority of Lloyds and RBS shareholders have ignored the recent rights issues, leaving the government to stump up the cash.
Investors are getting more discriminating. Harry Nimmo, small companies manager at Standard Life Investments, says he does not back rescue rights issues, but focuses instead on fund-raising efforts by companies that will use the funds to expand.

Robin Geffen, fund manager and managing director at Neptune Investment Management, says he will shun the cash calls from RBS and Lloyds.

"The size and scope of this capital raising should remind people of the scale of the problem. The banks are actually raising more cash than their current market capitalisations, as they are looking for £54 billion with a current market cap of £23 billion for Lloyds and £20 billion for RBS.

"We are not looking to participate in either company, given that this is a rescue operation rather than an investment opportunity," he notes.

Retail investors, however, have to carefully weigh up the advantages and disadvantages of a rights issue before deciding whether to back it.

John Hatherly, a consultant for Seven Investment Management, says: "The first question to ask is whether you want to put more money into the company. If you do, the second question to consider is whether you support the reason the company is raising the funds. The third thing to ponder is whether you like the terms of the rights issue."

Discount warning

In general, a big discount to the current share price indicates the company's - and its advisers' - concern that investors will not support it either because it is very large or it is intended to extricate the company from problems rather than to secure future growth opportunities.

The company is generally guaranteed the money, regardless of whether or not investors take up their rights, because issues are usually underwritten by its City advisers and other investment banks.

They will guarantee to buy any shares not subscribed for, in exchange for a fee. But the underwriters do not want to be left with large tranches of shares that they might have to sell on, so they will demand a hefty discount on the rights.

Yell, the directory services group, took months to negotiate a refinancing deal with its bankers and investors.

When it was finally able to agree terms, it ended up having to pay £75 million in fees to raise £660 million through a placing and open offer, although the fact it managed to issue the new shares at a discount of just 12.5% to its share price before the rights issue was some compensation for that high charge.

If investors decide not to take up their rights they can sell them, either through the stockmarket when the rights are traded as 'nil paid' in the weeks before the offer closes, or by letting their entitlement lapse, in which case the company will sell on behalf of shareholders and send them a cheque for the amount due.

That cheque is likely to offer only a small compensation for the dilution that investors will face by not taking up their rights. Any dividend the company pays will be divided between a larger number of shares, so your total income could fall if you do not subscribe.

Nick Raynor, an investment adviser at the Share Centre, warns that the impact of dilution will be particularly severe for Lloyds shareholders because the issue is so large - £13.5 billion accounts for more than half its market capitalisation, which, given that Lloyds will have to offer a substantial discount to the existing share price, means it could have to increase the shares in issue by 60% or more.

Rayner believes those who have stuck with Lloyds this long may as well take up their entitlement. Otherwise, he warns: "The growth going forward will be significantly lower."

Many Share Centre clients were keen to buy Lloyds shares now to get access to the rights, but Rayner thinks that is ill-advised. "Buy after the rights issue has closed. Then you will know what the shares have settled at and be confident that you will not be asked for more money."

This article was originally published in Money Observer - Moneywise's sister publication - in December 2009