Are rights issues worth it?

The Covid-19 outbreak hasn’t had many helpful side effects – but one might be that it has reminded public companies of the value of a stockmarket listing. Several big names have had to ask shareholders for fresh funds to get through the disruption caused by coronavirus. Companies who have successfully raised money fast via rights issues (defined below) include aerospace giant Rolls-Royce, hospitality chain The Restaurant Group and estate agent Foxtons.

But what about investors? Does piling into a rights issue (assuming you can) make sense? The good news is that Duncan Lamont at investment manager Schroders has dug into more than 20 years of data to see what history can tell us. 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 this year. They then looked at how these companies’ share prices performed, up to 30 June this year.

The first point to note is that today’s situation is unusual. Most companies raise funds from a position of strength, not weakness, with share prices typically rising in the year ahead of the fund raising. The second point is that 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%.

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Thirdly, the size of discount (see below) 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. Lamont argues that this is where an active fund manager can prove their worth versus a passive fund. It’s a fair point (though it doesn’t make it easier to find an active manager who can actually achieve this). As for those who invest in shares directly, 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?

I wish I knew what a rights issue was, but I’m too embarrassed to ask

When a listed company wants to raise more money, one of the options open to it is a rights issue. This involves the company going to its existing shareholders and offering them the opportunity – the right – to buy new shares in proportion to their existing holding. So for example, the recent rights issue by Rolls-Royce saw its shareholders offered the rights to buy ten shares for every three they already owned.

If a shareholder takes up their rights, they will end up owning the same proportion of the company as they did before the rights issue. If they decide to pass up on the chance to buy, they can sell the right to do so on to other investors, although their existing holding will end up being “diluted”.

Usually the new shares will be issued at a discount (ie, at a lower price) to the prevailing share price, to encourage investors to take up their rights. The size of discount will vary, though clearly if a company is raising funds because it’s in trouble, it’s likely to have to offer a more significant discount than a successful firm. Also remember that more shares are being issued, so you need to consider this when calculating how big a discount you’re getting. For example, in the Rolls-Royce rights issue, the share price was 130p when investors were given the chance to buy new shares at 32p each, a 75% discount. But taking dilution into account, the “theoretical ex-rights” share price was 55p – so the “real” discount was 42%.

A controversial aspect of the recent Covid-19 fund raisings is that not all investors had the chance to take part. From April, regulators allowed listed companies to issue up to 20% of their share capital (up from 5%) without giving existing investors first refusal (ie, pre-emption rights). In practice, that meant companies went direct to institutions to raise emergency funds fast, while private investors just had to put up with their holdings being diluted. The exemption expires later this month.