There have been a spate of rights issues by listed companies recently. And you can expect many more to come as SGX recently announced some changes that will make it easier for companies to raise capital through issuing rights. These changes are no doubt bought about by requests from companies.
So, what exactly are rights issues?
Rights are essentially a way for companies to raise capital (money). Fresh capital is essential for a company if they need more funds for their business operations. In the current economic climate, more and more companies find that they require more funds. There is also the problem of existing credit lines of companies being reduced, thus increasing their need to raise capital.
Traditionally, there are two main ways for companies to raise capital. Via debt or equity.
Debt can be raised through bank borrowings or the issuing of bonds. The problem with bank borrowings now is that banks are unwilling to lend money. And if they do agree to lend, the interest rates are higher than normal. For bonds, there might not be enough takers.
Equity can also be raised through issuing preferred shares, private placement of shares or rights issues.
In a private placement, shares are issued to a selected group of people at a particular price. The problem with this method is that the traded price of many companies are at very low levels now. Existing shareholders will be extremely unhappy if a private placement is done at low prices and their shareholdings get diluted. It would be like daylight robbery.
A rights issue overcomes the problem of a private placement by offering all shareholders an equal chance to subscribe to the new shares at the low price. While this might seem fairer than a private placement that would benefit only selected people, it does come with its disadvantages to existing shareholders.
This would be better illustrated with an example.
Lets say you own 1000 shares of company X and the shares were purchased at $1 each. The company has 100000 shares in circulation so you own 1% of the company.
Suppose you were only willing to commit $1000 of your capital when you purchased the shares. And that is the amount you will lose should the company go bust. Your liability is limited to your initial capital.
Now company X decides to issue a 1 for 1 rights at a price of $0.80. Assuming you subscribe to your entitlement, you would have paid an additional $800 to purchase 1000 shares.
While the number of shares you own has now increased to 2000, your percentage of shareholdings actually remain unchanged. 2000 out of 200000 shares is still 1%.
What this means is that you have been “forced” to pump in more of your money just to maintain your ownership of the company. Your capital at risk has also increased from $1000 to $1800.
This is like the reverse of issuing dividends.
You have the right to refuse to subscribe for the rights of course.
If you do nothing at all, your initial shareholdings of 1000 shares will become only 0.5% after all the new shares are issued. This would be a huge mistake as the very least you should have done is to sell off the rights to recover some capital if you are not going to subscribe for the new shares. This will help to compensate slightly for the dilution of shares.
I always find the term “rights” an irony. The rights of shareholders are these few options:
- Subscribe to the rights based on the amount of money needed by the company. You are at the mercy of the terms of subscription price as well as number of shares you can subscribe to.
- Sell off the rights, keep the shares and have your shareholdings diluted.
- Sell off the shares before they go ex-rights.
Sometimes, an investor could feel that he is having no rights as none of the options are attractive.
For example, an investor could be pretty positive about the company but he doesn’t have the cash on hand to subscribe to the new shares. Neither option 2 or 3 would be good for him.
Take my case where I was holding the shares of a particular company in my CPF OA. As my CPF stock limit was already maxed out, I can’t subscribe to the rights that was being offered.
The option given to me was to top up cash into my CPF investment account and use it to subscribe to the rights. This is not attractive to me at all as the money would basically be stuck inside CPF after the transfer.
So, faced with the prospect of a massive dilution of my shares, I had to decide whether to sell off my holdings (at firesale prices).
One way out (if I am positive about the company) is to sell the shares inside CPF, repurchase them using cash and subscribe to the rights. Very messy and it does incur additional transaction costs.
This is a case of “Damned if you do, and damned if you don’t“. Very bad timing also as I have only purchased the shares 2 days before the company announced the proposed rights issue!
More on some of the mathematical aspects of a rights issue in my next rights post.