This is the second of a two part article addressing the United Kingdom's securities, mergers and acquisitions regimes and it focuses on an overview of the methods, both public and private, of raising equity finance in the United Kingdom. Part One, which described the principal UK capital markets and their regulation, was published in our Q2 2010 Securities and M&A Newsletter.
Public Equity Finance
When raising equity finance through the issue of shares to the equity markets, relevant considerations in determining which method of finance will be most suitable for the company include:
- The purpose of the fund raising;
- The time available to raise funds; and
- The anticipated reaction of the market to the fund raising.
There are four main methods that a public company customarily uses to raise capital in the UK equity markets:
- Rights issue;
- Open offer;
- Placing/Cash box placing; and
- Vendor placing.
A private company may seek to raise finance on the equity markets during its initial public offer (IPO) process, i.e. at the same time as it obtains a first listing for its securities on an equity market and offers securities to the public for the first time, by means of an offer for sale or subscription of shares, or by a placing. The IPO process in the UK is a complicated process and is beyond the scope of this article. We will provide a review of the IPO process in the UK in a future article.
Historically the most common method of raising finance (but now for regulatory reasons, far less common), a rights issue is an offer of new shares or other securities made on a pre-emptive basis to existing shareholders in proportion to their shareholdings.
A rights issue is subscribed for in cash (in most cases at a discount to the market value of the company's shares). This enables shareholders in a listed company to realise the value of their right to subscribe for new shares by selling them in the market nil paid .without the need for the shareholders to first pay up the sum required on allotment. Historically, a discount of 15 to 20 per cent was usual and it was mainly companies with financial difficulties who offered 'deep discounts' of 30 to 50 per cent. Because of the uncertain markets in the UK in recent years, deep discounting has become more common, most likely to allow greater liquidity in the nil paid rights and more flexibility.
On an underwritten rights issue, arrangements are made for the sale of shares not taken up by shareholders. Therefore, a shareholder retains the right to receive any value in excess of the subscription price, if the shares which were provisionally allotted to him in a provisional allotment letter (PAL) are sold at a premium in the market, even if no action is taken.
A rights issue by a public company will almost always constitute an "offer to the public", requiring the preparation of a prospectus, described below.
An open offer is similar to a rights issue to the extent that it is also an offer of new shares to shareholders on a pre-emptive basis. As a result, the existing shareholders of a company are faced with the choice of either taking up the offer or allowing the shares to be taken up by others.
Although an open offer is similar to a rights issue, there are a number of key differences:
- Application forms are used which cannot be traded in the market nil paid in the way that PALs can;
- Shareholders are generally offered a guaranteed minimum allocation of shares (equivalent to their entitlement under a rights issue) but can apply for additional shares;
- Shares are offered at a lesser discount than on a rights issue (not more than 10 per cent if the Listing Rules apply), which makes them attractive from a company's perspective as the discounts are generally finer; and
- For a fully listed company, if a general meeting is required (for example, to grant the directors authority to allot shares), application forms can be posted with the notice of the general meeting. On a rights issue, PALs can only be posted after the general meeting has taken place as the UK Listing Authority does not allow shares which can be traded to be allotted provisionally on a conditional basis. As the notice of the general meeting and offer period run at the same time on an open offer, the company will receive the proceeds of the offer sooner.
Once again, a prospectus is generally required (see below).
A placing involves the issue of new shares for cash to selected subscribers rather than to shareholders as a whole and is therefore a form of non-pre-emptive offer. The recipients of shares are usually institutional shareholders who are likely to hold the shares as a long-term investment.
Placings are generally used for relatively small issues as it is unlikely that shareholders would approve a large non-pre-emptive issue. Shareholder approval is required to disapply statutory pre-emption rights. Typically, a placing would be of shares representing less than 5 per cent of the company's issued share capital in any one year (or 7.5 per cent in any three year period) and placed at a discount (including commission) of not more than 5 per cent, in accordance with Investor Protection Committee guidelines.
Cash Box Placing
As described below (see below under Companies Act 2006), UK companies are restricted to the number of equity securities they can issue for cash otherwise than on a pre-emptive basis to existing shareholders. These restrictions do not apply to the issue of shares for a non-cash consideration. A cash box placing provides a legal mechanism to enable a company to issue new ordinary shares (or rights to acquire new ordinary shares) in return for the transfer to it of shares in a newly incorporated company, the assets of which comprise entirely of cash in circumstances where seeking shareholders' approval to the disapplication of the statutory pre-emption rights is impractical or undesirable.
A cash box placing involves the incorporation of a new company (usually outside the UK for tax purposes) (Newco) in which the issuer's bank subscribes for redeemable preference shares and undertakes to pay the subscription price (a sum equal to the proceeds of the placing) for those shares. The bank identifies persons wishing to take up ordinary shares in the issuer (Placees) and shares are allotted to the Placees in consideration of the transfer of the redeemable preference shares in Newco from the bank to the Issuer. The Placees pay the subscription monies for the placing shares to the bank and the issuer allots the placing shares to the Placees. The bank uses the proceeds of the placing to discharge its undertaking to pay the subscription price for the preference shares.
There are a number of potential legal issues associated with cash box placings and concerns regarding this structure have been raised by some commentators, including the Association of British Insurers (an independent body representing the interests of large institutional investors). Views have been expressed that this structure could be challenged as a means of avoiding statutory pre-emption rights. However, the prevailing view is that the cash box structure is designed to fall within the exemption from the pre-emption rule afforded to the allotment of shares otherwise than for cash, and therefore it remains a mechanism for raising equity finance which is used successfully by some issuers.
In practice, a vendor placing is only used where the purchaser wants to issue shares to fund an acquisition, but the vendor wants to receive cash rather than shares in the purchaser as consideration. In a vendor placing, shares in the purchaser (Consideration Shares) are allotted to the vendor in exchange for the transfer of the shares in the target to the purchaser. The Consideration Shares are then placed by the purchaser's broker on behalf of the vendors who receive the proceeds of the sale of such shares in cash.
Regulation of the public equity markets
There are a number of regulations and guidelines, as detailed below, which govern the issue of shares by a company on the public equity markets.
Companies Act 2006
The two key provisions of the 2006 Act relate to the directors' authority to allot shares and the disapplication of pre-emption rights.
An ordinary resolution must be passed by the shareholders of the company in order to grant the directors authority to allot shares if such an authority sufficient for current requirements is not already in place.
Companies can disapply pre-emption rights by the shareholders passing a special resolution. The life of the disapplication will be limited to the length of the directors' authority to allot to which it relates.
In accordance with the Investor Protection Committee guidelines, the directors' authority to allot shares should not relate to more than one third of the existing issued ordinary share capital of the company or the amount of unissued but authorised ordinary share capital. However, on a pre-emptive rights issue, the guidelines issued by the Association of British Insurers permit companies to seek authorisation for the allotment of a further one third of share capital.
Financial Services and Markets Act 2000
The issue of shares by listed companies is regulated by the Financial Services and Markets Act 2000 (FSMA) and by the EU Prospectus Directive.
A prospectus, disclosing such information as to enable investors to make an informed assessment about the financial position and prospects of the issuer, approved by the relevant competent authority is required where a company offers shares to the public or applies for the admission of shares to a regulated market. There are, however, a number of exemptions to this requirement.
Financial Promotions Regulations
FSMA contains the basic financial promotion restriction which provides that a person must not:
- In the course of business;
- An invitation or inducement;
- To engage in investment activity;
unless he is an authorised person, or the content of the communication is approved by an authorised person, or the communication is covered by an exemption.
Each limb of the above restriction must be looked at carefully in determining whether a proposed communication will be caught by it. Similar careful consideration should be given to the exemptions from the restriction (which are stated in the secondary legislation). There are many exemptions to the restriction on financial promotion, some of which relate to all controlled activities and some relate only to deposits and insurance.
Some of the more commonly used exemptions can be divided into the following categories:
- Communications to certain recipients;
- Types of communication;
- Communications from certain persons;
- Communications relating to certain securities and listings;
- Company communications; and
- Communications relating to corporate transactions.
As referred to above, each of these categories is subject to detailed information and guidance within the legislation and therefore each proposed communication must be looked at on a case by case basis to ascertain whether an exemption applies. A commonly used exemption is that relating to communications to certain recipients (specifically, to (amongst others) investment professionals, self-certified high net worth individuals, high net worth companies and self-certified sophisticated investors), the main reason being because it is usually relatively straightforward to determine whether a company/individual falls into such a category.
The Financial Promotion Regime and its Territorial Scope
Whether the financial promotion rules apply to incoming and outgoing promotions to/from the UK will depend on various factors, such as the location of both the sender of the communication and the recipient of it. The general starting point is that any promotion with a UK link (whether an incoming or outgoing communication) will be caught. In general, the UK's financial promotions regime will apply to promotions to recipients located in the UK, subject to exemptions. FSMA states that promotions originating outside the UK will be caught if they are "capable of having an effect in the UK".
In terms of communications into the UK, a person who carries on relevant investment activities outside the UK but who does not carry on any such activity from a permanent place of business maintained by him in the UK may be able to take advantage of certain exemptions to the financial promotion restriction. In summary, such exemptions depend on whether the communications are 'real time' or 'non-real time', solicited or unsolicited and whether a particular customer is an existing customer of the party making the promotion.
Consideration must also be given to applicable EU legislation. It is possible that more than one EU directive could apply to a particular financial promotion, in which case careful consideration must be given to the territorial scope. In particular, it should be noted that the exemptions referred to previously are not available to MiFID business carried on by an investment firm. MiFID is the Markets in Financial Instruments Directive and, very broadly, applies to investment banks, corporate finance firms, stockbrokers, portfolio managers, parts of the business of retail banks and building societies as well as other firms/institutions. It is possible for a firm to be a MiFID investment firm even if it does not provide investment services to others.
Careful consideration should be given to, and legal advice sought before, any promotion, or offer, which could be deemed to be a promotion, is communicated to ensure that there is no breach of the financial promotion restriction.
Prospectus Rules and Listing Rules
The Prospectus Rules govern the content of prospectuses and apply to all offers to the public by a company, whether the company is trading on the Official List, AIM or PLUS.
In establishing if a prospectus is required, it is important to consider the following questions.
- Is there an offer to the public? and
- Is there going to be an application for admission to trading on a regulated market?
In the event that a prospectus is not required, any documentation produced will need to comply with the general circular requirements detailed in the rules of the relevant market.
Listed companies are also subject to the pre-emption rules of the Financial Services Authority detailed in the Listing Rules. Under these rules, even overseas companies must generally get shareholder approval for a non-pre-emptive share issue, although overseas shareholders and fractional entitlements can often be ignored for these purposes.
A prospectus can only be issued with the approval of the Financial Services Authority following a thorough pre-vetting process. This can involve considerable time and expense, and many issuers will seek to structure their fundraising to avoid the need for a prospectus if at all possible, often by effecting an institutional private placing.
Private Equity Finance
In many situations, public methods of raising equity such as IPOs and rights issues will be inappropriate. This may be due to market conditions, unsuitable internal policies including improper corporate governance practices, or the often off-putting, onerous and ongoing obligations attached to public listings. In particular, the lacklustre IPO market in recent times has increased companies' drive to find alternate means of raising capital, with private equity often being a plausible solution. However, an IPO does, of course, remain a viable option for an unlisted company to raise equity finance in the UK, subject to it satisfying various requirements which are referred to in Part One of this article, as well as many of the regulations and legal requirements referred to herein.
Methods of raising finance most frequently adopted in public equity, such as rights issues and placings, can also be transposed into the realm of private equity, the difference being that in the latter case they are not tradable securities. March 2009 saw Aquarius Platinum Limited, the world's fourth largest primary platinum producer, combine a private placement of convertible bonds with a public rights issue and placing, raising £125 million in gross proceeds.
Private equity transactions cover a variety of arrangements including buyouts, which are a process by which management teams acquire a target with the help of external private equity funding and debt. Across Europe, the number of private equity buyouts has increased by 23 per cent in 2010 and recent announcements include the luxury shoe retailer Jimmy Choo which is considering a £500 million buyout of the business, and the fast food chain Burger King which recently agreed a buyout valued at just over two billion pounds.
The two main providers of private equity finance are venture capitalists and business angels.
A business angel investor is simply defined as an individual acting alone or in a formal or informal syndicate who invests their own money directly in an unquoted business in return for equity. It is in fact a significant source of equity for early stage businesses in the UK often providing the first significant injection of capital without which many ventures cannot grow. In the current economic climate, there has been a significant increase in demand from entrepreneurs seeking access to alternative sources of investment.
Many business angels make extensive use of the Enterprise Investment Scheme outlined below. According to a report published in May 2009 by the British Business Angels Association, an average of 82 per cent of business angels used EIS for at least one of their ventures with 53 per cent of investors saying that they would have made fewer investments were it not for the tax incentives. Together with the benefits of tax relief, business angel investments have the subjective benefit of limited regulation, which is restricted specifically to the control of Regulated Activities in accordance with the Financial Promotions Order.
With regards to the investee companies, the advantage brought by 'angels' is that together with the financial benefit, they bring expertise in their particular field, as strategic investors will usually turn their attention to businesses related to their personal knowledge. A well balanced investor/investee relationship will inevitably increase the potential for success.
Enterprise Investment Scheme – EIS
The Enterprise Investment Scheme (EIS) is aimed at promoting investment in smaller, higher risk companies that have growth potential but often encounter difficulties in raising finance.
The decision by individuals to invest in qualifying EIS companies is often incentivised by the potential tax advantages affiliated with such a transaction, but as is customary, the reaping of benefits comes hand in hand with the meeting of certain conditions.
In order for a company to be a qualifying company and subsequently, for an investor to be eligible for tax relief, the company must be 'limited' at the time the shares are issued, i.e. not listed on the London Stock Exchange or any other recognised stock exchange. There are no restrictions on it later applying for listing so long as no arrangements to list were in place at the time the shares were issued, otherwise the investor would lose the benefit of tax relief. For the EIS rules, AIM and the PLUS-quoted and PLUS-traded Markets are not considered to be recognised exchanges, so a company listed on those markets can raise money under the EIS if it satisfies all other conditions. However, the PLUS-listed market is a recognised exchange and so a company listed on it cannot take advantage of EIS.
The company must exist wholly for the purpose of carrying out a qualifying trade. Most trades are qualifying trades provided that they are conducted on a commercial basis with a view to making profits. The investee company must also be independent in so far as it is not a 51 per cent subsidiary of another company or under the control of another company. Guidance to these and further requirements is provided by Her Majesty's Revenue and Customs (HMRC).
If these circumstances are met, investors may claim relief against income tax up to an annual investment limit, for funds used to subscribe for new ordinary shares issued by qualifying companies. An EIS investor who qualifies for income tax relief may also be entitled to exemption from capital gains tax (CGT) on a disposal of those shares. Additionally, CGT on the disposal of any asset can be deferred by reinvesting in EIS eligible shares. However, the subscription must be made for genuine commercial reasons and not purely for the purpose of tax avoidance.
Unlike business angels, venture capitalists focus their attention on high value investments, generally inputting a minimum capital injection of around £2 million. They provide a service and source of capital that neither bank lending nor mass shareholder equity (such as public shareholders) could provide.
Venture capitalists generally seek to invest in businesses with a large earning potential and a high return on investment within a specific timeframe. Although they do not tend to get involved in the day to day running of the business, they often help with a business' strategy.
Closing the Gap - Enterprise Capital
Funds Since 2005, the government has provided a multi-million pound equity finance scheme in the form of Enterprise Capital Funds (ECFs) to bridge the equity gap where businesses require greater funding than that which can be provided by a business angel but do not require the level of input which would attract a venture capitalist. These are a hybrid solution, investing a combination of private and public money in small, high growth businesses seeking up to £2 million in equity.
Regulation of the Private Equity Market
Private equity and venture capital funds have direct impacts on the real economy through their role as providers of capital to small businesses. The recent global crisis in the financial markets has led to concerns that the functioning of the real economy is being distorted. This is due to a buildup of leverage in the financial system, including private equity funds. The result has been a pressure build up at the European level for legislative measures to be taken to tighten regulation of the private equity industry.
In April 2009, the European Commission tabled its proposal for a Directive on Alternative Investment Fund Managers (AIFM), to regulate all alternative investment managers in the EU currently not covered by EU law, including private equity fund managers with a portfolio of over €500 million.
Private equity industry bodies have been highly critical of the proposed AIFM Directive. In a statement published by the BVCA, the Directive was described as being "irrational", "contradictory", "draconian" ,"manifestly unfair" and "especially counterproductive for Britain", on the basis that a percentage majority of the European private equity industry is located in the UK.
The Directive is not yet in force but consultations are taking place subject to which the Directive may come in force by late 2012 to mid 2013.
FSMA and the exemptions to the financial promotion restriction apply in similar ways to private companies wishing to seek investment, as well as to public companies, and therefore careful consideration to any form of promotion, or offer which could be deemed to be a promotion, should be given and legal advice sought, before it is communicated.
A company looking to raise finance has various options available to it. The difficulty lies in finding the right option which is both available and suited to its particular requirements.
Be it public or private, with the current difficulties in obtaining debt finance, the importance of equity finance in the current market cannot be overstated.