The era of cash-rich companies and cheap debt now seems a distant memory. Throughout 2008, we saw a return to prominence of secondary equity offerings, as companies attempted to shore up their balance sheets and meet their increasingly pressing working capital needs.
This briefing looks at the main developments in secondary offerings since the start of the credit crisis, and what lies ahead in 2009. It seeks to provide some pointers to issuers and underwriters alike, to assist in the execution of capital raising transactions in difficult market conditions.
Trends in equity raisings
Last year saw over £40 billion raised in the UK in rights issues alone, which was an increase of 66 per cent on 2007. Commentators are predicting that around one-fifth of FTSE-250 companies will have gone to their shareholders for cash by the end of 2009. There are a number of emerging trends in the deals that have come to the market:
- Dash to cash: Rights issues have spread from industry sector to industry sector in waves. This started with financial institutions such as the UK banks. The need to raise cash spread to the mining sector (Xstrata, Rio Tinto, Peter Hambro), Lloyds companies (Beazley, Chaucer, Catlin, Omega) and to property companies (British Land, Hammerson, Workspace, Land Securities). In each sector, issuers have gone to the market in the hope that they will be able to access the limited demand for equity in each sector, before their peers get there first.
- Deep discounts: Issuers and underwriters have struggled to cope with the volatility in the market. Consequently they have set their offerings at deep discounts to the market price, typically around 40 per cent. Some “rescue” issues have seen discounts of up to 90 per cent (e.g. Paragon). We have seen the market price of shares dip below the rights issue price on a number of occasions, leading to extremely low take-up under the rights offering (as low as 8 per cent on the HBOS issue). This briefing comments on some of the ways the regulators and the market have responded to these difficulties.
- Anchor investors: Some issuers have sought to manage the uncertainty of raising equity by striking deals with significant investors. For example, in June 2008, Barclays placed 5 per cent of its share capital with Sumitomo in conjunction with a placing and open offer, and agreed that the Qatar Investment Authority would cover over half of the open offer as a conditional placee. Making special deals with anchor investors can result in a negative reaction from investor protection committees where pre-emption rights are not respected. However, issuers may consider the presence of strategic investors important to get the deal away. Anchor investors are not always the answer, though, as Bradford & Bingley discovered when Texas Pacific Group exercised a termination right to pull out of its rights issue.
Rights issues: the quicker, the better
Last year saw unprecedented volatility in the equity markets, particularly in the sectors engaged in rights issues. There is a widespread consensus that the lengthy timetable of rights issues has contributed to difficulties for equity raisings. This is not only because a longer timetable increases the risk of significant market shifts, but also because short sellers have time to put in a place a strategy on the stock. There has been both a regulatory and market response to the need to shorten the timetable:
- An extraordinary general meeting will lengthen the timetable considerably. The ABI now allows a company’s annual allotment authority to permit rights issues of up to two-thirds of issued share capital. This should mean that companies are less likely to require shareholder approval for a typical rights issue.
- The Listing Rules now permit rights issues to be conducted over a period of 10 business days (rather than 21 days as previously), provided the company disapplies statutory pre-emption rights.
- Rights issues require a full IPO-standard prospectus to be produced, which is a time-consuming task for the company. It is hoped that the FSA will encourage changes to European legislation to enable a shorter or simplified disclosure regime. Some issuers and their advisers are simply starting work on prospectuses earlier, in anticipation of a possible rights issue.
- For property companies, the FSA has shown some flexibility in the requirements for a current portfolio valuation, allowing issuers to utilise an existing valuation which is no more than seven weeks old.
Short-selling: issuers fight back
Short-selling has taken the blame in the press for some of the difficulties seen in rights issues last year. This led the FSA to adopt rules in June 2008 requiring public disclosure when a person acquires a net short position in stocks subject to rights issues, above certain thresholds. Although the subsequent ban on shorting financial institutions stock has now expired, the rights issue disclosure regime remains in place.
The FSA is currently consulting on the approach to be taken to short-selling. It has acknowledged that short-selling has an important role in the market, but that companies engaged in rights issues are particularly at risk from the practice, where short-sellers can be incentivised to drive down the market price.
When sub-underwriters engage in short-selling, this is seen as having a particularly destabilising effect. This is because sub-underwriters who also short-sell can lock in a guaranteed profit, without sharing the risk of the issue - which is the role that traditional “long-only” sub-underwriters have normally played. Such strategies are thought to increase the chances of a low take-up, and a significant “overhang” in the market.
It seems that the FSA is minded to maintain a disclosure regime for short-selling, but not to impose a ban on short-selling during rights issues. However, issuers are taking the initiative by imposing restrictions upon the underwriting syndicate - and in turn upon sub-underwriters.
Issuers are requiring that underwriters and sub-underwriters refrain from short selling whilst engaged on the rights issue. Market practice is developing in what exemptions are permitted to these restrictions - for instance, ordinary course market-making activity. Sub-underwriters will want to make sure that normal portfolio management activities are not unduly restricted.
The short-selling strategies developed up until last year meant that many sub-underwriters were not traditional “long-only” investors. It is thought that the increasing restrictions on short selling, the shorter timetable and the lower activity levels of hedge funds will mean that sub-underwriting will once again become the preserve of the traditional institutional investor.
Underwriting: back to basics?
After the significant take-ups by underwriters on the HBOS and Bradford & Bingley issues, the market is well aware that underwriters are taking on real risks in underwriting rights issues. After a period in which underwriters were willing to retain a large proportion of the risk themselves, we are now seeing a return to the traditional model where most of the issue is sub-underwritten - in some cases, by securing sub-underwriters at the outset in tandem with the entry into the underwriting.
There have been a number of developments in the underwriting of rights issues:
- Commissions have increased to reflect the higher perceived risk profile. In the last year, typical underwriting and sub-underwriting commissions have increased by around 1 per cent. On smaller issues in particular, we are now seeing total commissions of around 4 per cent.
- Step up clauses are being debated in the context of secondary offering underwritings. These clauses require underwriters to increase their underwriting commitment if one of the members of the underwriting syndicate defaults on its underwriting obligations. They are traditionally seen mainly on primary offerings and underwriters remain reluctant to see these obligations appearing in rights issues.
- Termination rights are being drafted more precisely. Underwriters would in practice often be unable or unwilling to withdraw from an underwriting based on a general “material adverse change” clause. It is now more common, for example, to include a right to terminate the underwriting in the event of a downgrade in the issuer’s credit rating.
- Set off rights are also being considered, in order to encourage existing shareholders to participate in sub-underwriting. “Set-off” rights enable existing shareholders who are also sub-underwriters to decrease their sub-underwriting commitment to the extent they take up their rights. However, on larger issues, the administrative burden of these is significant for the lead underwriter.
Pre-emption rights (and wrongs)
Many of the largest deals in the last twelve months have been conducted using one of the traditional pre-emptive structures - either rights issues (HSBC, RBS, HBOS, British Land, Centrica) or open offers (DTZ, 3i, Barclays). However, it is being questioned whether pre-emption rights may have assumed too great an importance in the structuring of transactions.
It is notable that pre-emption is a peculiarly European concept - in the US, for instance, shareholders do not have comparable pre-emption rights, but instead issuers come to the market more frequently for smaller equity raisings, using shelf registration statements.
A number of transactions in the last twelve months have thrown open the debate about the extent to which it is appropriate to protect pre-emption rights:
- Barclays placing: The last of the three placings carried out by Barclays in 2008 attracted particular criticism. Barclays placed Mandatorily Convertible Notes and Reserve Capital Instruments with a small number of Middle East investors, with limited clawback rights for existing shareholders. The transaction was “red-topped” by the ABI because, among other things, the warrants that were attached to the RCIs were not offered to other shareholders. However, despite a furore from some existing shareholders, the take-up of the instruments was relatively low - leading some to comment that the use of the strategic investors had in fact been critical in raising the funds.
- Xstrata rights issue: The recent Xstrata rights issue in some ways highlights the difficulties with the pre-emptive principle. Xstrata structured the deal so that Glencore, its 35 per cent shareholder, could effectively fund its rights issue participation out of the proceeds of the sale of an asset by Glencore to Xstrata. The asset sale has attracted a great deal of scrutiny, but since pre-emption rights were in substance protected, investor objections seem to have been managed.
- Rio Tinto / Chinalco deal: By contrast, the Rio Tinto deal has provoked a considerable degree of organised shareholder dissent. Rather than seeking a pre-emptive fundraising, Rio placed shares with Chinalco, one of its customers and clearly a strategic investor. Rio has also offered Chinalco minority stakes in a number of its subsidiaries. The investors’ principal objection was the failure to respect pre-emption rights and the chairman-designate Jim Leng resigned in protest over the deal.
A recent development has been the increasing focus on cash box structures. Investor protection committees have recently voiced their disapproval of the use of cash boxes on placings above 5 per cent, where they are used to avoid the need for a special resolution to disapply pre-emption rights.
Cash box placings originally evolved out of the “vendor placing” structure - a structure involving a placing to fund an acquisition, in which the shares are also treated as being offered for non-cash consideration and therefore exempt from pre-emption rights. Vendor placings have historically been accepted by investor protection committees, provided they did not exceed 10 per cent of share capital. For this reason, cash box placings of up to 10 per cent were also generally assumed to be acceptable provided they also involved an acquisition.
Recently, issuers have announced cash box placings of up to 10 per cent of share capital where no acquisition is involved (e.g. Logica, Tullow Oil). In February, the ABI circulated a letter expressing its preference that cash box placings of more than 5 per cent are not used to circumvent pre-emption rights. Whether this also affects cash box placings involving an acquisition, or even vendor placings, remains to be seen.
As we have seen in the Barclays, Xstrata and Rio Tinto deals, issuers are not always confined to the traditional equity structures in seeking to raise finance. There are a number of alternative mechanisms which companies may consider:
- Corporate bonds: Activity in the corporate bond markets has increased recently, particularly because the spreads between government gilts and corporate debt are becoming increasingly attractive for investors. Convertible debt, in particular, is likely to provide investors with both a level of security in relation to their investment, as well as exposure to an upside. Convertible debt deals are normally relatively easy for an issuer to execute due to the less onerous documentary requirements. As strategic investors are increasingly important in capital raisings, the instruments themselves are becoming increasingly tailored to their requirements.
- Convertible “rights offering”: Mapeley recently announced an innovative convertible bond issuance which was offered to its existing shareholders, but only to those holding a certain amount of shares. This effectively enabled a quasi pre-emptive offering to benefit from an exemption from prospectus rules.
- Warrants may also be considered. These are sometimes used to “sweeten” a deal -particularly for strategic investors - to give them significant exposure to potential upside (such as on the final Barclays placing in 2008). They may also be used in conjunction with corporate debt, which gives a similar economic effect to a convertible bond but enables the debt and equity elements to be traded separately.
- Preference shares are another structure that issuers are starting to consider. Certain types of preference shares may be efficiently used by financial institutions for regulatory capital purposes. But other issuers may consider preference share issues, because of the greater security they give to investors over straight equity, and some investors may be restricted by their investment mandates to invest in equity rather than debt. An example of the use of preference shares was the Berkshire Hathaway investment in Goldman Sachs last year.
- PIPE deals (private investments in public equity) have been quiet in recent years, as private equity funds have been less active. But as traditional leveraged buy-out deals are not as easy to execute, private equity houses may seek alternative investments such as taking significant equity stakes in listed companies. Premier Foods has recently been linked to a private equity deal coupled with a rights issue, which would be one of the first PIPE deals since the credit crunch.
- Finally, debt-for-equity swaps are likely to be a feature of the market, as some issuers find themselves unable to service their debt burden particularly in sectors with a high gearing. Cattles has recently been linked with a possible debt-for-equity swap and others are likely to follow suit.
Practical tips for issuers
We have seen that there are a number of difficulties in executing a rights issue or other equity offering. What should issuers be doing to try to minimise those difficulties?
- Plan ahead: it will be much easier for an issuer to launch a rights issue or open offer quickly if it has already done some of the ground work to prepare for a prospectus. This means gathering information early, possibly at the same time as preparing its annual report and accounts. It may also mean asking the accountants to do some of the preparatory work for a working capital report, or starting work on a property valuation. The company may also seek advice on how to deal with certain overseas jurisdictions where shareholders are resident.
- Seek appropriate authorities at your AGM: In order to take advantage of the new two-thirds limit to the allotment authority, companies will need to include it in the appropriate resolution in their AGM notice. In addition, companies who can currently hold an extraordinary general meeting on 14 days’ notice will need to seek an annual shareholder approval at their AGM to preserve this ability (as required by the Shareholder Rights Directive).
- Get the timing right: Companies in danger of breaching banking covenants or running short of cash may be well advised to raise capital early rather than be forced into a “rescue” situation. Seeking capital early also minimises the competition for cash from others in the same sector. As can be seen in the property sector, a number of issuers who have not yet come to market may find it difficult to do so now.
Above all, however they come to the market, issuers must maintain a dialogue with their institutional shareholders - particularly if the structure adopted is likely to lead to criticism from investor protection committees. For each issuer, it is critical to strike the right balance between respecting pre-emption rights and securing certainty of deal execution.