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How to respond to a rights issue
How do rights issues work, are they good or bad news for shareholders and should you buy in if you are offered one? Tim Bennett explains.
Thanks to the sudden loss of confidence across the economy triggered by the credit crunch, everyone wants, or needs, cash. The result has been a series of rights issues the latest batch of names going cap in hand to shareholders to ask for more money includes banks such as RBS, HBoS and Bradford and Bingley, plus Carlsberg and Johnston Press.
In total, Morgan Stanley estimates that over $100bn of cash will be raised in Europe in the next few months. So how do rights issues work, are they good or bad news for share prices, and what choices do participating shareholders have?
How rights issues work
Rights issues are effectively new issues of shares, but ones that give existing shareholders the legal right to buy the new shares on offer before anyone else. That way, an existing equity stake is not diluted. Say you already own 100 shares in a company out of a total of 1,000 (so 10%), and you are then offered further shares on a "one for ten" basis. This means a total of another 100 shares are to be issued and you have the right to buy ten of them, bringing your holding to 110 shares, but leaving your stake in the firm at 10%.
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You are never obliged to take your rights (you can just let your percentage stake fall), but in order to encourage shareholders to open their chequebooks, new shares are offered at a discount to the current market price. In the case of the recent RBS £12bn issue, for example, the offer was made on an "11 for 18" basis, with the new shares available at 200p considerably lower than the open market price.
Given that existing, and other, investors may not be willing to buy shares in a cash-strapped firm, rights issues are normally guaranteed, or "underwritten". Bradford and Bingley's £300m issue, for example, is being guaranteed by Citigroup and UBS, who will take a fee in return for mopping up any unwanted shares.
Rights issues shouldn't be confused with "bonus issues". Here, a company issues free shares to existing shareholders simply to improve liquidity by reducing the average market price per share. Nor should they be confused with "scrip issues", where cash-strapped firms try to persuade their shareholders to accept shares in lieu of a cash dividend. American firms may also undertake "stock splits", which subdivide existing shares, reducing the existing share price without changing the firm's overall market capitalisation or raising any fresh capital.
Once a rights issue has been announced, it doesn't have to be dealt with immediately. For instance, RBS shareholders have until early June to decide what to do, the exact deadline depending on whether shares are held in "nominee" or "certificated" form. For the three main options, see below.
So should you buy in?
That depends on where you think share prices might go next. The rights issues and the discounts do not act, as Hugo Dixon puts it on Breakingviews.com, "like a gun to the head of existing shareholders" because any UK shareholder can opt out, sell rights "nil paid" and pocket cash instead. The bigger the discount, the more cash they get. They can also sell out entirely, which might not be the worst option. Since announcing their rights issues, shares in RBS and Bradford and Bingley have steadily drifted downhill.
A JP Morgan study of the period between 1989 and 1994 reveals that "re-equitisation is not a buy signal if the fundamental backdrop remains negative". The Bank of England's Mervyn King recently commented that "the nice decade is behind us", a warning that the current backdrop is pretty dire.
Options for existing RBS shareholders
1. Take up your rights
You could simply pay RBS the rights price of 200p per share. So if you own 1,800 shares, the 11 for 18 offer entitles you to another 1,100 shares (1800/18 is 100 and 100 x 11 is 1,100). At 200p each, that's a cash commitment of £2,200.
2. Sell your rights "nil paid"
You could sell your entire rights entitlement for the so-called "nil paid" price, currently 50p (the difference between the current "ex-rights" share price of 250p this changes daily and the fixed subscription price of 200p) and pocket £550 (1,100 x 50p).
3. Sell some rights to fund new shares
Good for shareholders who want to take up some rights but avoid dipping into their own pockets. From 1,100 rights, you could sell off 880 (200/250 x 1,100) for 50p each and raise £440. This will pay for 220 new rights shares at 200p each, without costing you a penny.
Don't panic if the numbers look horrible try the RBS calculator at h-l.co.uk.
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Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
