INSIGHTS

IPO, private placement, rights issue, share purchase plan, dividend reinvestment plan. While these names may be different, they serve the same key purpose – to provide additional capital to a business. The structure, timing, and pricing of a capital raise can all vary depending on what a company will ultimately be using the capital for. In this article we focus on one form of capital raising - a rights issue.

One of the primary reasons for being listed on a stock exchange is that it allows companies to easily access additional capital when required. The way this is typically achieved is through the issue of new shares to existing (and sometimes new) shareholders via a private placement, share purchase plan or rights issue.

The proceeds may be used to fund future growth, acquire another business, expanding existing operations, purchase new assets or technology, repay existing debt, or in some cases fund the day-to-day operations of the business. From an investor’s perspective, it is important to always understand why a company is raising new capital as this may influence your decision to participate in the offer.

Rights issues – 101

As the name suggests, a rights issue provides existing shareholders with the right (but not the obligation) to purchase newly issued shares in the company.

The number of shares that you are entitled to purchase is based on the existing number of shares you currently hold. This makes rights issues one of the most equitable ways for a company to raise capital, as all shareholders are treated equally.

The purchase price of the new shares is typically set at a discount to the prevailing market price. This is a key benefit for shareholders, as they have opportunity to purchase additional shares in the company at a discount to market.

Renounceable versus non-renounceable

Rights issues can either be renounceable or non-renounceable.

Given the price to purchase new shares via a rights issue is typically set at a discount to the prevailing market price, these rights have a value.

For example, prior to announcing a rights issue, Company A had 1 million shares on issue and the shares were trading at $5.00 per share. The company announced a 1 for 4 rights issue (1 new share for every 4 shares held) at $4.00 per share.

When a company announces they are doing a rights issue, market participants quickly calculate the theoretical share price (or TERP) that the company should trade at after the completion of the rights (Implied market cap following rights issue / shares on issue following rights issue).

In the case of the above example, assuming all the rights are taken up, this would see the company issue 250,000 new shares and raise $1,000,000 of new capital. The TERP or theoretical ex rights price would be $4.80. The value of a renounceable right is the difference between the offer price ($4.00) and the TERP ($4.80), so $0.80 per right.

A renounceable rights issue provides shareholders with the ability to sell all or part of their rights on market if they decide not to participate in the offer. Any rights not taken up by an eligible shareholder are usually sold on their behalf at the end of the offer period, and the proceeds returned to the shareholder.

However, if a rights issue is non-renounceable, the right to purchase new shares is not transferable and cannot be sold on market to someone else.

In this case, if an existing shareholder does not participate in the rights issue, their shareholding in the company will be diluted and they will not receive any compensation to offset this dilution from the sale of the rights.

The dilutionary impact of rights issues

A word that tends to go hand in hand with rights issues is dilution. There are two ways that dilution can occur as a result of a rights issue.

Firstly, and most importantly in our view, a shareholder will be diluted if they do nothing. If a shareholder has made the decision not to participate, and the rights are renounceable, then selling the rights will help to compensate for this dilution.

A shareholder who elects to take up their rights in full will not face any dilution in this regard. They will still hold the same percentage of shares in the company that they held prior to the offer. They will still hold the same voting rights, and they will still be entitled to the same share of the company’s earnings and dividends.

However, what does change following a rights issue, and the issue of new shares, is the ‘per share’ amount of earnings, book value, dividends and other ‘per share’ metrics.

Unless the equity raised via the rights issue is used to acquire a business that is earnings accretive from day one, then these per share metrics will be diluted since there are now more shares on issue. Typically, what we find is that while the rights issue may be dilutive on day one, if the company can use the proceeds effectively to grow the business, this should deliver growth to the shareholder over time.