As a small company specialist, I’m getting increasingly annoyed by the way a lot of Aim stocks go about raising money. This isn’t a minor moan – it’s an important issue.
I say it’s important, because it gets to the very heart of why we have a stock market in the first place. The market’s main purpose is to connect the providers of capital – that’s the pensions and savings industry and individual investors like you and me – with companies who need that risk capital to fund their activities.
It’s utterly fundamental. And we’ve got to get it right.
Let’s have a quick look at how things have changed for the worse over the years.
The old system was much better
When I began my investment career over thirty years ago, the standard method of raising new equity was via a rights issue. These ‘pre-emption rights’ gave existing shareholders the opportunity to buy the new shares before other investors. This helped ensure fair play for all investors.
The crucial point was that you were able to sell your rights if you didn’t want to take them up. The proceeds of this rights sale compensated you for the dilution which comes from issuing new shares at a discount to the market price. You could also avoid dilution by simply buying the new shares you were entitled to. So either way, you didn’t lose out.
Rights issues are still around, but, sadly, are a lot rarer than they used to be. Aim had more relaxed rules when it started in 1995; but even then, the rules on the main market had already changed, allowing shares to be placed at a discount while not being offered to all shareholders.
With small-cap shares, they can often end up being bought by only a few institutions, and the private investor only hears about the deal after it’s been done.
This needn’t be a disaster if the process is managed well. If the placing is done very close to the market price, and the news of the deal is well received, then the price won’t be damaged much at all.
A good example of an Aim stock that successfully managed this is EKF Diagnostics (EKF).
Management communication is crucial
Back in March, EKF raised £22m, which was almost a quarter of the size of the company. The price was struck at a discount of only 2.8%. EKF was doing a deal that investors liked and were keen to support. So it managed to create enough demand to avoid damaging its share price. Therefore, it didn’t matter that all existing shareholders weren’t given the opportunity to take part.
Just as importantly, the shares were stable beforehand. There was no suspicious-looking decline in the stock price ahead of the deal being announced.
A successful fundraising like that, which avoids wrecking the share price, doesn’t happen by chance. The deal itself has to make sense. Whether it’s to pay for an acquisition, or just cash for organic growth, the story needs to hang together. An effective investor-relations effort is important – management need to communicate well all the time, not just when they want more money. This leads to supportive shareholders who are keen to buy more shares. Good advice is also crucial from the company’s brokers to get the timing and market conditions right.
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The wrong kind of fundraising
Unfortunately, a lot of Aim stocks just don’t generate the same healthy demand levels for their stock that EKF was able to do. If the news has been patchy and the story isn’t a strong one, investors need to be ‘bribed’ to take part.
In the days of the rights issue, this couldn’t happen. There was no guarantee shareholders would take up their rights, so the deal would be underwritten beforehand by the banks. They promised to pick up any stock that was left unsold – so they had to be sure the deal was fundamentally OK.
All an investment bank does now is try to ‘build a book’ of institutions who will subscribe – it doesn’t put its own capital at risk.
This means that a company in a weak position with limited institutional support only has one bargaining chip – the price the new shares will come at.
In the worst cases, this might mean a 40%-plus discount to the prevailing price. Great for the lucky institution that holds all the aces, but a disaster for existing holders. Usually the shares will settle around the placing price or just above it – the institution has a good chance of making money from there, but small shareholders have been sandbagged.
The Aim market might argue that at least the company has raised its money, which is better than not having access to capital.
Weak companies need the discipline of a tight capital market to force them to raise their game and improve. If there’s always that last resort of the ‘institutional bribe’, which stuffs small shareholders, then they can avoid making the tough decisions that might be needed to run their business better.
This is the best protection
I always try to judge what a company’s requirement for capital is likely to be – and whether it will be able to drive a hard bargain when the time comes. But I’ve found your best protection is investing in companies where management holds a big stake. If their shareholding is significant, they will want to look after their own interests as well as yours.
One of my Red Hot recommendations recently raised some fresh capital at the prevailing market price. The two main directors owned about a third of the equity, and if raising the new money had meant trashing the share price, I’m confident they wouldn’t have gone ahead.
Without the protection of the rights issue or the ability for shareholders to vote on these transactions, shareholders are vulnerable. As with most things in investment, it comes down to backing good management.
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