What to consider when buying a rights issue
In the past few weeks, several companies have approached the Nigerian capital market with rights issue. A rights issue are shares of a listed company offered only to existing shareholders to take up additional shares in a company.
It can also be considered an invitation to existing shareholders to show that they have confidence in how a company is being managed. A fully subscribed rights issue would be considered as a vote of confidence in the management of a company, while an undersubscribed rights issue would be considered as a vote of no confidence in the management of a company.
Only last week, Union Bank on 30 October closed its application for a N50 billion rights issue, which actually opened for subscription on 20 September. The bank offered about 12 billion ordinary shares at a price of N4.10 per share, which represented a N1.95 or 32 percent discount on its current market price of N6.05 per share. Rights issues are always offered at a discount and targeted at existing shareholders in the company.
In the case of the Union Bank rights issue, existing shareholders were offered five ordinary shares for every seven ordinary shares that they already held in the bank. The fact that rights issues are only open to existing shareholders ensures that the ownership structure of the company remains the same at the conclusion of the offer. But this will not be the case where some shareholders decline to take up their offer.
Where a shareholder is unable to take up a rights issue, he or she is allowed to trade it on the floor of the Nigerian Stock Exchange to other interested shareholders who may want to take it up. The fact that existing shareholders are allowed to trade their rights on the floor of the exchange means that the ownership structure of a company can actually change after a rights issue. Majority shareholders can and often use a rights offering to increase their ownership stake in a company knowing fully well that minority shareholders may not be in a position to pick up their rights or would likely trade it.
There are several reasons company’s issue rights. In a high interest rate environment like Nigeria, companies can use rights issues to raise cheap money from existing shareholders rather than go to the banks to borrow. Money can also be raised through a rights issue to pay down debts that have become too cumbersome on the books of a company. Recently, many firms that have raised rights issues have done so to pay down their dollar denominated debts so that they can reduce or eliminate interest payments on such debts. Money can also be raised through rights for expansion, acquisition or just for working capital purposes.
In order to decide whether to buy into a rights issue or not, it is very important to find out from the rights issue circular what the existing management plans to use the money raised from the rights issue for. If the rights issue is being used to pay down a loan, it is important to find out what that loan was used for in the first place. Was the loan well managed? If the loan was mismanaged, then the proceeds on the rights issue would almost likely also be mismanaged and the company will soon be in trouble again.
Perhaps, it is the pressure from bankers that is forcing management do a rights issue. As soon as they get the money from shareholders to pay down the loan from the banks, they will return to their poor management practices. So it is important that as an investor, you ask the management the right questions before giving them money that may go into covering up the outcome of past bad management decisions.
Where the proceeds of the rights issue will be used to acquire new firms, it is also important to find out if proper due diligence has been done on the proposed acquisition. Do not help managers fund ego-fuelled acquisitions that will damage the company’s long term value. Even where the proceeds are to be used for working capital purposes, find out why the company is having working capital issues. Have they spread themselves too thin? Are they carrying too much overheads? Do they need to downsize? All these are issues that money can’t be thrown at. It must be resolved internally, or else the proceeds of the rights issue will run dry again in the face of the challenges forcing the management to seek for more funds.
Whatever decision you eventually make about a rights issue, whether you decide to pick up your rights or sell or ignore, you will still be impacted by the outcome of the rights issue. The new issued shares will eventually dilute your shareholding in the company and affect the returns that are due to you. If the money raised through the rights issue are utilised properly, it would raise the company’s long term value and compensate you for the short term loss in value. But if the money raised is not properly utilised, then the immediate dilution in value from a rights issue would only get worse. The bottom line is that as an existing shareholder, you cannot afford to ignore a rights issue. At the minimum sell your rights to get some value.