Rights issues: should you play the dash for cash?

"Desperate times require desperate measures," says Richard Steiner in the Daily Mail. For cash-strapped companies "first it was the banks, then the miners and now property firms" that means rights issues, in which new shares are issued to existing shareholders. The property sector alone has raised around £2bn in the last two weeks, and the same again is expected next month. Land Securities has gone cap in hand to its shareholders for a planned £755m, just as British Land tries to raise £740m and Hammerson £584m. In total, Goldman Sachs estimates that €300bn of new equity will be raised across European stockmarkets this year, excluding the financial sector. In Britain alone, we could see up to £70bn raised in 2009, equivalent to 7% of the value of the FTSE 100, says Nick Hassell in The Times. So why the rush and how should investors respond?

Why rights issues are back

As Hassell notes, over most of the last decade, firms have handed back cash to shareholders through share buybacks and special dividends. But the recession has reversed that. Companies now have little alternative to raising fresh capital via rights issues. Organic growth generating your own profits and cash flow is tough in a recession. Investec predicts a 20% fall in UK profitability this year, then a further 5% in 2010. Borrowing money is also hard. Because debt ranks higher than equity in the event of insolvency, it's usually popular. But the recent turmoil has driven up borrowing costs, leaving cash-poor firms facing crippling interest bills. Selling assets is also difficult due to a lack of buyers. That leaves rights issues.

How rights issues work

In a rights issue, new shares are offered to existing shareholders, who have a legal right to buy in before anyone else, unless these 'pre-emption rights' have been waived by prior agreement. To attract buyers, the shares must be discounted. For example, Land Securities is to issue new shares at 270p, a deep discount of just over 50% to the current share price. Existing shareholders can choose to 'take up their rights' and buy the new shares, or they can sell them to another shareholder 'nil paid' (see below) for cash.

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So should you buy in?

Investors should be wary of using rights issues as a buy signal, reckons Goldman Sachs. On average, says the bank, companies that raised equity capital during the last downturn in 1991 and 1992 underperformed the stockmarket before and after the issue. However, firms that raised capital in 1993, as the market was recovering, outperformed (in share price terms) by 5%-10% the next year, while the market as a whole rose 40%. So "there is little correlation between a replenished balance sheet and share-price gains". Indeed, a first rights issue may be a classic "bear trap". Many companies needed more than one rights issue to stop the rot, with no share-price rally seen until after the third cash call.

But Graham Secker at Morgan Stanley, who has studied over 100 British rights issues across 15 years, believes there is merit in buying after rights issues if you are selective. The important thing, he says, is the reason for raising fresh capital. Of most interest is a firm raising emergency funds and the more it needs, the greater the potential gains. He found that firms which needed to raise capital equivalent to more than 75% of their market value outperformed the market by 45% over the next two years, and sector rivals by 58%. On the other hand, those raising less than 25% of their market value through a rights issue perhaps to buy a rival on the cheap, or restructure their balance sheets by swapping debt for new equity lagged by 20% over the same period. This suggests that a big rights issue from a distressed seller is the one to watch.

So should you buy property and bank shares now? Sadly, not yet it's too early. JP Morgan's study of rights issues between 1989 and 1994 suggests that re-equitisation (as analysts call it) is only a buy signal if the economy has started to recover, which chimes with Goldman's findings. Given the current state of the global economy, we're some way off that point. So we'd advise holding onto your cash for now.

What 'nil paid' means

If a shareholder fails to respond to a rights issue letter from a firm within three weeks, most brokers will sell their 'nil paid' rights for cash. Say you have 900 shares at £9 and a firm has offered you the chance to buy new ones on a 1 for 9 ratio at a discounted rights price of £6. Buy the shares and your portfolio should be worth £8,700 (900 x £9) + (100 x £6). As you would then have 1,000 shares, the price per share the 'theoretical ex-rights price' is £8.70. So, if the share price doesn't change, your 100 rights should sell for £270 (£8.70-£6) x 100 before dealing costs.