Key things to note in a Rights Issue
A rights issue is an offering of securities to all existing shareholders of a particular company. The securities offered are not limited to shares and may be in other forms including warrants, plain vanilla bonds, convertible bonds, preference shares or a combination of any of these. Here we shall examine the most common type of rights issue, that of shares.
What happens during a rights issue of shares
In a rights issue, shareholders are offered new common shares issued by the company in direct proportion to their shareholdings. These rights shares are usually priced at a discount to the prevailing market price of the underlying shares. As these shares are offered to existing shareholders on a pro-rata basis, there is usually no limitation on the quantum of discount that can be given as opposed to a private placement. Companies will have to take into account factors such as amount to be raised, prevailing market price and existing outstanding shares in order to make a decision on the pricing and number of shares to offer.
As an illustration, Company A with 10 million total outstanding shares and a market price of $10 per share will have market capitalisation of $100 million. In order to raise $20 million via a rights issue of shares, it can opt to offer, say:
Scenario 1: 5 million rights shares at a ratio of 1 rights share for every 2 existing shares (5 million:10 million = 1:2) at a price of $4 per rights share, in which case the amount raised will be:
$4 x 5 million rights shares = $20 million; or
Scenario 2: 2.5 million rights shares at a ratio of 1 rights share for every 4 existing shares (2.5:10 = 1:4) at a price of $8 per rights share, in which case the amount raised will still be:
$8 x 2.5 million rights shares = $20 million
While the company raises exactly the same amount of funds under both scenarios, the company will have more shares in issue and a lower theoretical trading price per share (see below) after completion under Scenario 1.
Calculation of TERP and the attractiveness of the rights issue price
As a company issues rights shares, its share price should adjust to a new level post-rights entitlement date. This new price is commonly known as Theoretical Ex-Rights Price or simply TERP. The TERP is calculated based on the basic principle that the value of shares you hold on the last day of cum-rights trading must be equal to the value of shares plus the rights you hold immediately on the next trading day, i.e. first day the shares trade ex-rights. It also makes the assumption that entire rights issue is fully subscribed by shareholders. Mathematically, TERP is represented by the following formula:
In a rights issue, shareholders are offered new common shares issued by the company in direct proportion to their shareholdings. These rights shares are usually priced at a discount to the prevailing market price of the underlying shares. As these shares are offered to existing shareholders on a pro-rata basis, there is usually no limitation on the quantum of discount that can be given as opposed to a private placement. Companies will have to take into account factors such as amount to be raised, prevailing market price and existing outstanding shares in order to make a decision on the pricing and number of shares to offer.
As an illustration, Company A with 10 million total outstanding shares and a market price of $10 per share will have market capitalisation of $100 million. In order to raise $20 million via a rights issue of shares, it can opt to offer, say:
Scenario 1: 5 million rights shares at a ratio of 1 rights share for every 2 existing shares (5 million:10 million = 1:2) at a price of $4 per rights share, in which case the amount raised will be:
$4 x 5 million rights shares = $20 million; or
Scenario 2: 2.5 million rights shares at a ratio of 1 rights share for every 4 existing shares (2.5:10 = 1:4) at a price of $8 per rights share, in which case the amount raised will still be:
$8 x 2.5 million rights shares = $20 million
While the company raises exactly the same amount of funds under both scenarios, the company will have more shares in issue and a lower theoretical trading price per share (see below) after completion under Scenario 1.
Calculation of TERP and the attractiveness of the rights issue price
As a company issues rights shares, its share price should adjust to a new level post-rights entitlement date. This new price is commonly known as Theoretical Ex-Rights Price or simply TERP. The TERP is calculated based on the basic principle that the value of shares you hold on the last day of cum-rights trading must be equal to the value of shares plus the rights you hold immediately on the next trading day, i.e. first day the shares trade ex-rights. It also makes the assumption that entire rights issue is fully subscribed by shareholders. Mathematically, TERP is represented by the following formula:
giving the company a post rights issue market capitalisation of $120 million ($8 x 15 million shares) and pricing the rights shares at a discount of 50% to TERP.
again giving the company a post rights issue market capitalisation of $120 million ($9.60 x 12.5 million shares) but pricing the rights shares at a discount of 16.7% to TERP.
Clearly, the rights issue is priced more attractively under Scenario 1 than 2. This is an important consideration for companies as share prices can fluctuate wildly during the trading sessions between the first day of ex-rights up till the actual subscription of the rights shares. As it only makes sense for shareholders to subscribe to the rights shares when the rights issue price is at a discount to the prevailing price of the underlying shares, the bigger discount to TERP usually helps to reduce the chances of under-subscription and gives the company more certainty that it can raise the desired amount of funds.
What are nil-paid rights?
A rights issue is normally renounceable, meaning if you do not want to exercise your rights to acquire the new shares, you can transfer and sell the “rights” to others. The rights that are traded in this case are “nil-paid” because as a shareholder, you do not pay to acquire the rights. Shareholders who wish to dispose of their nil-paid rights would normally be given a week during which these can be traded. The intrinsic value of the nil paid rights is simply the difference between the prevailing underlying share price and the rights issue price i.e. $4 ($8-$4) per nil paid under Scenario 1 and $1.60 under Scenario 2.
Rights issue of shares lead to no dilution of shareholding if fully subscribed
Under our example, if a shareholder owns 100,000 shares of Company A and subscribes fully to the rights issue under Scenario 1, he should end up with the same percentage shareholding of the company before and after the rights issue. We can easily verify this below:
Before rights issue, percentage ownership of shares in Company A = 100,000/10,000,000 = 1%
Post rights issue, percentage ownership of shares in Company A = 150,000/15,000,000 = 1%
Therefore, a rights issue of shares leads to no dilution of shareholding if fully subscribed.
A quick calculation for Scenario 2 will lead you to the same conclusion.
Options for shareholders during a rights issue
As a shareholder, you have a number of options when the company you own shares in announces a rights issue. You can either:
Conclusion
So what should a shareholder do when faced with all these options? Well, it really depends on your desired exposure to the company, financial position and why the company called for the rights issue in the first place. If it is to finance a fundamentally sound earnings accretive acquisition, for instance, it would be sensible to subscribe for your entitlement and more. On the other hand, if the main purpose is more generic, such as to repay bank loans and/or for working capital, then you should closely scrutinize whether the investment case for buying into the company is still valid and make a decision based on that.
Clearly, the rights issue is priced more attractively under Scenario 1 than 2. This is an important consideration for companies as share prices can fluctuate wildly during the trading sessions between the first day of ex-rights up till the actual subscription of the rights shares. As it only makes sense for shareholders to subscribe to the rights shares when the rights issue price is at a discount to the prevailing price of the underlying shares, the bigger discount to TERP usually helps to reduce the chances of under-subscription and gives the company more certainty that it can raise the desired amount of funds.
What are nil-paid rights?
A rights issue is normally renounceable, meaning if you do not want to exercise your rights to acquire the new shares, you can transfer and sell the “rights” to others. The rights that are traded in this case are “nil-paid” because as a shareholder, you do not pay to acquire the rights. Shareholders who wish to dispose of their nil-paid rights would normally be given a week during which these can be traded. The intrinsic value of the nil paid rights is simply the difference between the prevailing underlying share price and the rights issue price i.e. $4 ($8-$4) per nil paid under Scenario 1 and $1.60 under Scenario 2.
Rights issue of shares lead to no dilution of shareholding if fully subscribed
Under our example, if a shareholder owns 100,000 shares of Company A and subscribes fully to the rights issue under Scenario 1, he should end up with the same percentage shareholding of the company before and after the rights issue. We can easily verify this below:
Before rights issue, percentage ownership of shares in Company A = 100,000/10,000,000 = 1%
Post rights issue, percentage ownership of shares in Company A = 150,000/15,000,000 = 1%
Therefore, a rights issue of shares leads to no dilution of shareholding if fully subscribed.
A quick calculation for Scenario 2 will lead you to the same conclusion.
Options for shareholders during a rights issue
As a shareholder, you have a number of options when the company you own shares in announces a rights issue. You can either:
- Subscribe for the rights shares and increase your existing capital exposure to the company if you wish to avoid dilution of your percentage shareholding due to the rights issue. This is illustrated in the preceding section. On top of this, if you can afford it and the rights issue is priced attractively enough, you should always consider subscribing for excess rights shares beyond your entitlement.
- Sell your nil-paid rights and reduce your exposure to the company in both capital allocated and percentage shareholding. As an illustration under Scenario A, this means that you would sell all 50,000 nil paid rights for a sum of $200,000. Your capital exposure would then go from $1,000,000 (100,000 x $10) at the beginning to $800,000 (100,000 x $8) and your percentage shareholding in the company diluted to 0.67% (100,000/15,000,000) from 1%.
- Sell some shares after the shares trade ex-rights but before the subscription deadline and use the sales proceeds to subscribe to your entitlement. Doing this allows you to retain the same capital exposure to the company while diluting some of your percentage shareholding in the company. Continuing our example, this means that you would sell say 25,000 shares at the TERP price of $8 and use the sale proceeds to subscribe for your full entitlement of 50,000 rights shares. Post rights, you would end up with 125,000 shares (100,000 - 25,000 + 50,000) at $8 a share giving the same capital exposure of $1,000,000 you began with. However, your shareholding in the company would now reduce to 0.83% from 1%
- Do nothing and let the rights expire. Realistically, this is only viable if the prevailing share price in the run-up to the subscription deadline is below the rights issue price and you could not dispose of your nil-paid rights because of its negative intrinsic value. This situation is not common and happens most frequently under the following conditions:
- The rights issue is deliberately priced with an insignificant or no discount to market price of underlying shares possibly to consolidate majority shareholdings. An example of a rights issue priced at close to the market price would be the Shangri-la Asia Ltd rights issue announced on 23 October 2014 where the rights shares were priced the same as the market price of HK11.10 (link) although we are not implying that the desire to consolidate shareholdings was the main reason for the rights issue.
- General market conditions took a turn for the worse and the price of the underlying shares dived below the rights issue price. This is one reason why some companies opt for a higher discount to TERP to provide sufficient buffer against market conditions.
- The rights issue is not well-received and investors sold the price of the underlying shares down to below rights issue price.
Conclusion
So what should a shareholder do when faced with all these options? Well, it really depends on your desired exposure to the company, financial position and why the company called for the rights issue in the first place. If it is to finance a fundamentally sound earnings accretive acquisition, for instance, it would be sensible to subscribe for your entitlement and more. On the other hand, if the main purpose is more generic, such as to repay bank loans and/or for working capital, then you should closely scrutinize whether the investment case for buying into the company is still valid and make a decision based on that.
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