Of rights issue and REITs (Part 3 of 3)

After going through a rights issue by one of my investment (CapitaComm Trust) in June this year and a proposed rights issue by another of my investment (MacarthurCook Industrial REIT), I got exposed to the nitty gritty of rights issue.

What is rights issue?

Rights issue is an invitation by a company to it's shareholders or other investors to purchase more shares in the company at a discounted price to the current market price of it's shares (usually last closing price when rights issue was announced). Rights issue calls by companies are for raising funds for various reasons such as paying down debts, fund acqusition, or other growth plans. Sometimes, rights issue is underwritten by an investment bank. This means that the investment bank agrees to bear the risk of helping the company to raise funds through the rights issue by buying the rights and selling the rights at a marked up offer price to the public. Full underwritting of rights by an investment bank provides assurance that the company will still be able to obtain it's finances through the rights issue (since the investment bank bears the risk of buying and selling the rights for the company).

Theoretical ex-rights price

Rights issue offers shareholders rights to a discount on new shares purchase. However, the trade off is that there will be an increased number of shares of the company thus resulting in dilution of the shareholders' investment in the company. To check whether the rights issue offer is attractive, an existing shareholder needs to consider the theoretical ex-rights price. Theoretical ex-rights price is an estimated price of a stock after the rights issue has been exercised fully.

A typical example of calculation of theoretical ex-rights price:-
Imagine a company is offering 1-for-2 rights issue. This means that for every 2 existing shares held by a shareholder, he has the rights to purchase another 1 more share at the rights issue price. If the shareholder is offered the rights to purchase the new shares at $0.60 per share and the current market price of the stock is $1.00 per share, the calculation is as follows.

Value of existing shares = 2 X $1.00 = $2.00 per share

Value of new offered shares = 1 X $0.60 = $0.60 per share

Total value of existing shares and new offered shares = $2.00 + $0.60 = $2.60 per share

Theoretical ex-rights value per share = $2.60 / (1+2) = $0.867 per share , note that the denominator (1 + 2) consists of total of the number of new offered shares and existing shares in a simplified reduced ratio (1-for-2 rights issue implies a total number of 1 + 2 = 3)

As one can see, the calculation is merely a simple ratio calculation which an upper primary student can also do. Thus, we have the following share prices for comparison.

Last current market price for stock = $1.00 per share

New offered share price (through rights issue) = $0.60 per share

Theoretical ex-rights share price = $0.867 per share

The theoretical ex-rights share price is an estimated price the shares of a company will be traded after completion of the rights issue. An existing shareholder can choose to subscribe fully for the rights by purchasing new shares exercising his rights, renounce the rights, or choose to do nothing. Sometimes, if the shareholder sees no more future in investing in the company offering the rights, he may even sell off all his existing shares upon news of the rights issue.

An existing shareholder can calculate his average holding price after he purchase the new shares and compare his holding price with the theoretical ex-rights price to see whether he is getting a good bargain from the rights issue. For example, an existing shareholder owns 2000 shares of the above-mentioned company at $1.50 per share. He decides to exercise his rights to purchase new shares. He can only purchase 1000 new shares at $0.60 per share based on the terms of the rights issue. His new holding price will be $1.20 per share for 3000 shares after the rights issue. Comparing this with the theoretical ex-rights price of $0.867 per share, his new holding price of $1.20 per share is way above the theoretical ex-rights price and thus he is at a disadvantage by owning shares far above the theoretical ex-rights price. There are ways to overcome this, for example by applying for excess rights or buy rights entitlement from other shareholders during nil-paid rights period and eventually purchase more new shares using the additional rights entitlement.

Determining right response to rights issue

It is always easy to stereotype rights issue as a disadvantage to existing shareholders of a company. It is true that offering new shares to the market results in dilution of existing shareholders' investment in the company. However, rights issue does offer existing shareholders the rights to purchase new shares of a company at a discount price. Thus, existing shareholders receive rights entitlement to purchase new shares. Rights entitlement carries a value to compensate existing shareholders for the dilution of their investments. Existing shareholders can choose to sell their rights to others to exercise this value of compensation (by getting back some amount of money) should they not want to purchase the new shares eventually. As such, there are two types of rights entitlement namely, renounceable or non-renounceable rights.

Renounceable rights and non-renounceable rights

Renounceable rights offers an existing shareholder the choice to sell his rights over the stock market during the nil-paid rights trading period. This means the existing shareholder sold his rights entitlement to another investor. Thus, he has no more rights to purchase the new shares offered by the rights issue.

Non-renounceable rights means rights cannot be sold over the stock market. The existing shareholder is thus faced with the only option to either purchase the offered new shares or not to purchase the new shares eventually.

Usually, rights issue are offered with the means of renounceable rights and the existing shareholder should consider carefully whether to sell his rights entitlement to another investor during the nil-paid rights trading period. If the shareholder has no wish to purchase the new offered shares, then he may sell his rights to at least get a little bit of monetary compensation for the dilution of his investment in the company.

How much should one sell his rights entitlement over the nil-paid rights trading period?

To determine how much should one sell his rights entitlement over the nil-paid rights trading period, one should consider the difference between the theoretical ex-rights price and the rights issue price. In the above example, the difference is $0.867 - $0.60 = $0.267 per share. This means the rights entitlement is estimated to be worth only $0.267 per share. An existing shareholder that does not want to purchase new offered shares should seek to sell his rights entitlement to other investors at above $0.267 per share during the nil-paid rights period when there is usually another traded counter (e.g. company name-R; R represents rights trading counter) for this purpose of selling one's rights entitlement to another investor. Of course, the higher the rights entitlement sold above $0.267 per share, the more an existing shareholder will get back for his compensation for the dilution of his investment in the company. On the other hand, the lower a new investor can pay for the rights entitlement (below $0.267 per share), the more bargain he gets.

It is not difficult to appreciate the reasoning behind calculating rights entitlement value. Assuming as a new investor (not existing shareholder), I pay $0.267 per share for rights entitlement. I need to further pay $0.60 per share (fixed based on rights issue price) to purchase new shares using these rights entitlement I have obtained. I pay in total $0.867 per share for getting new shares in the company which is same as the theoretical ex-rights price (price in which shares of the company is estimated to be worth after rights issue). I thus get no bargain.

If I can pay $0.10 per share for rights entitlement, I will pay in total ($0.10 + $0.60 = $0.70 per share) for the new shares in the company. This now gives me a bargain since I pay less than what the shares should be worth ($0.867 per share) after factoring in the effect of the rights issue.

Similarly, if I pay $0.40 per share for the rights entitlement, I will end up paying a total of $0.40 + $0.60 = $1.00 per share for the new shares. I thus overpaid for the new shares at $1.00 per share which is above the theoretical ex-rights price ($0.867 per share; which is price in which shares of the company is estimated to be worth after rights issue).

Doing nothing is as good as gaining nothing!

Doing nothing at all is the most foolish thing an existing shareholder 'can do' when faced with a renounceable rights issue. If an existing shareholder wishes to purchase the new offered shares, he should keep his rights entitlement and later use all his entitlement to purchase the new shares at discounted price (by the acceptance deadline of payment for the rights issue). If he has no wish to purchase the new shares, he should sell off his rights entitlement during the nil-paid rights trading period to at least get back his compensation for the dilution of his investment in the company.

Doing nothing is often due to lack of understanding of the terms of a rights issue by existing shareholders or some shareholders may not even be aware that their invested company is offering a rights issue at a certain time. This goes to show that as investors, one ought to be serious to find out some basics about equity investment and monitor one's invested company periodically. Warren Buffet has stated an important investment mantra, "Risk comes from not understanding one's investment." If an investor is not serious at all, he may be better off not risking his money in stocks, but instead put his money into simpler investment products such as fixed income deposits offered by banks or just simply leave the money in bank savings account (though the meagre interest rate returns will not be enough to overcome inflation which erodes away the value of money over time). By doing so, at least he is practising the most important investment rule, that is never to lose money (capital preservation).

Is rights issue always a bad thing?

It all depends on the reason for raising funds by a company since they are diluting the investment of their existing shareholders in the company. Usually, it is preferred for a company to raise funds for acquisition and growth opportunities rather than paying down debts. Of course, if paying down debts is important to increase balance sheet health of a company, it may be still a justified cause. However, beware of companies that frequently raise rights issue so much so that it becomes a bad habit, especially that the funds raised from the frequent rights issue is to keep paying off debts. This leaves one thinking why the company is so good at frequently raising cash and then equally good or better at buring away cash for no better reason than just paying off debts upon debts. Sounds much like a ponzi scheme or a black hole suction effect for shareholders' money that goes to no where........

Discussion points:- Rights issue is an invitation by a company to it's shareholders or other investors to purchase more shares in the company at a discounted price to the current market price of it's shares. 

Look for rights issues that are supported by full underwritting from an investment bank. This ensures that the company / REIT raising the rights issue can obtain it's funding regardless of whether the rights shares/ units are eventually undersubscribed or oversubscribed.

Theoretical ex-rights price is an estimated stock price after factoring in the effect of the rights issue. One can use the theoretical ex-rights price to compare with one's eventual average holding price after purchasing new shares through the rights issue to make sure one's eventual average holding price is not too steep above the theoretical ex-rights price.

Check carefully whether a rights issue consists of renounceable or non-renounceable rights. Renounceable rights offer existing shareholders the choice to sell their rights entitlement to other investors during the nil-paid rights trading period should they not want to hold the rights to purchase the new offered shares. This is so that existing shareholders that do not want to exercise their rights to purchase new shares can receive some compensation for the eventual dilution of their investment in the company. As such, doing nothing is disadvantegous to an existing shareholder since he receives no compensation by not selling his rights to other investors (assuming the rights is renounceable) should he not want to exercise his rights to purchase new shares from the rights issue. 

To determine how much is the rights entitlement worth, take the difference between the theoretical ex-rights price per share and the rights issue price per share. An existing shareholder (who does not want to purchase new shares) should seek to sell his rights entitlement above this calculated rights entitlement value during the nil-paid rights trading period. On the other hand, a new investor (who wants to purchase new shares) should seek to buy at below the rights entitlement value for a bargain.

Be careful of companies that frequently raise rights issue only for paying down debts. This may signal problems with the financial health of the company. Rights issue is preferred for reasons such as fulfiling acquisition and growth plans. This ensures potentially increased future shareholders' earnings from yield accretive ventures.