What is a rights issue?
A rights issue gives investors who already hold shares in a company the right to buy additional shares in a fixed proportion to their existing holding.
A rights issue is one of the ways in which listed companies (those which have already gone public) raise new money via the stock market. It gives any investors who already hold shares in the company the right – but not the obligation – to buy additional shares in proportion to their existing holding. This is so that their existing holding in the company is not “diluted” – they will still own the same-sized chunk of the company as long as they take up their rights.
For example, say you already own 100 shares in a company out of a total of 1,000 (so 10%). 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 (one for every ten you own), bringing your holding to 110 shares, but leaving your stake in the firm at 10%.
These new shares are priced at a discount to the current market value of the company's shares in order to encourage investors to take up the offer. A useful rule of thumb to remember is that the more desperate the company is to raise the cash, the bigger the discount is likely to be. Companies raising money from a position of strength may not have to offer much of a discount at all.
Rights issues: what happens if I don’t want to exercise my rights?
Shareholders who do not want to take up their rights to buy the discounted shares may sell them as “nil-paid rights”. Because investors don’t always want to sink more money into companies that might be struggling, rights issues are usually underwritten by an investment bank, who will mop up any unwanted shares left over.
The discount on new shares bought at a rights issue does not necessarily mean that they are cheap, as the new shares will “dilute” previous holdings: the market price of existing shares will fall to reflect the lower price of the new, so a large part of the “gain” on the new shares will be cancelled out.
For example, say a firm offers one new share priced at £1 for every four currently held – a “one for four” issue. Say the current share price is £2.50. After the new share has been issued you would expect the firm's shares to trade at around £2.20. This is the “theoretical ex-rights” price.
How did we calculate this? Simple. Take the price of the existing shares:
Four at £2.50 each = £10
Then take the price of the new shares:
One new shares at £1 = £1
Then add them together:
Five shares worth £11 in total
And divide to find the theoretical ex-rights price:
£11 / 5 = £2.20
So this is what the shares would be worth directly after the new rights issue has taken place, assuming the share price doesn’t change (which of course, it does, because markets are moving all the time).
Any shareholder can choose not to take up their rights, in which case they can often be sold. The “nil-paid” price is the difference between the issue price and the expected ex-rights price. Here that's £2.20 – £1 = £1.20. Another investor who was not invited to participate in the original rights issue might be interested in paying for nil-paid rights instead.
Should you invest in rights issues?
So as a shareholder, you have three options: you can take up the rights in full; you can sell the rights (or at least, get your broker to do so on your behalf); or you can sell some and take up the others.
When you decide whether you want to take up your rights, it's a good idea to focus on why the company wants to raise cash. Paying down debt can be a good idea, as it will make your shareholding less risky, which should be positive for its value. It's even better if the cash will be used to invest in a profitable new business.
However, on the downside, rights issues are often used to pay for restructuring a poorly performing part of a business. If this is the case, then check that the management's turnaround plan is credible and doable. If it isn't, then you may be throwing good money after bad.
In a recent study, Duncan Lamont at investment manager Schroders dug into more than 20 years of data to see what history has to say about whether rights issues are a useful “buy” signal or not. The bad news is that his findings won’t make your decision much easier.
In a paper entitled The good, the bad, and the ugly of secondary public equity offerings, Lamont and his team looked at 1,638 issues where more than £1m was raised – worth a total of £260bn – between January 1998 and March 2020. They then looked at how these companies’ share prices performed, up to 30 June 2020.
Historically speaking, most companies raise funds from a position of strength, not weakness, with share prices typically rising in the year ahead of the fund raising. However, in a majority of cases (57%), companies who raised funds then saw their share prices fall over three and five years. In about a fifth of cases, companies lost more than 90% of their value – although at the other end of the scale, about a fifth saw gains of more than 90%.
On top of all that, the size of the discount made no clear difference long term. So even the chance to buy shares at a big discount isn’t always a good bet – as Lamont notes, sometimes it just “shows how desperate a company is”. The one factor that does seem to matter is that profitable companies have better odds of outperforming after a rights issue than loss-making ones, with a mean average outperformance of 4% after five years, versus a 38% underperformance for loss-makers.
In all, the clearest takeaway is that while there are potentially big gains to be made from taking up rights issues, you have to be picky. Take the same approach to rights issues as you would any new investment – why are you buying? Is this the best use of your cash? And if you do decide against taking up the rights issue – should you still be holding the stock at all?