Raising Capital by Rights Issue – What to Make Out of It?

We have all heard a lot about initial public offer (IPOs), follow-on public offer (FPO), Bonds, VC, Angel investors, etc. Right issues is one method (among many other) that is not widely discussed in open financial media. One the reason is it is an option available to existing shareholders only. By definition, the significance seems to the titled towards existing majority shareholders.


The essence of raising capital through rights issues is very simple. It allows existing shareholder an option to invest more money into business. It gives them that benefit as an existing shareholder.  Here, the company board of directors decides to sell new shares, at a pre-defined price, in order to raise capital. In general, but not necessarily always, the shares are offered at a discounted price than the prevailing market price at that point in time. It gives existing shareholders an option to buy new shares proportional to their existing shareholding. It gives them an opportunity to maintain their existing percentage shareholding and hence, not dilute their ownership.


If shareholders (majority or minority holders) does not chose that option to invest more, then company may decide to sell those proportional shares to somebody else. I have observed that minority shareholders, i.e. general public, tend to avoid rights issue. They do not exercise their options and hence company tends to sell those to others.


What happens to company performance?

This is subjective and depends upon the objectives behind raising the capital. On many occasions, rights issue is for raising capital for future growth and/or future expansion. These growth could be merger & acquisitions, organic investments in new businesses, new markets, new products, capacity expansion, etc. This future growth proposals needs to be considered independently of right issue. Many times, rights issues for raising capital is done to shore up balance sheet such as debt payment, improving cash position, short term interest payments, etc. Also, many times is merely an issue of controlling stakes in the company. I will not go into discussing the merits of what is good or bad. That would take the discussion off the track.


The rights issues will likely revise the price of the shares in market. It will depend upon how the shares of rights issues are priced and proportional changes to the capital base. For example a 1:1 rights issue, priced at 50% discount, is likely to revise the market price of shares by 25% reduction.


The rights issues will also likely reduce all per share performance matrices for the company such as EPS, dividends, etc. Let us consider few examples.


EIH: Since these are subjective, you will find different interpretations of this event. To me, EIH rights issue boils down to struggle for ownership between existing promoter and other large shareholder(s). The current promoter, Oberoi’s, seems to have engineered this event of rights issue to use it for change the shareholder structure (read avoid ITC interference), and maintain their say in the business. It sold some percentage of their holdings to RIL, to bring them it as large shareholder. Now, the rights issue will allow a path for RIL to increase its holding and keep ITC at bay. Knowing RIL, I am sure it sees an long term opportunity. For RIL, with the cash flow it has with petrochemical and oil business, few thousand crore is chum change. Deploying few single digit thousands is not going to break their balance sheet. Globalization is one aspect that RIL has been unsuccessful (similar to TATA). May be RIL will provide funds to EIH for expanding into global market – think Branding? Or may be it just remains and ownership exercise?  We can only speculate.


REI Agro: Earlier, in my screening post, I mentioned this company is planning for rights issue for Rs 1245 crore. This is purely for reducing its existing debt. A debt of Rs 4400 crore that has been accumulated over a period of time. Approximately, with the capital of Rs 5400 crore (Rs 4400 debt + Rs 1000 equity), the company generates only Rs 3500 crore revenue and only Rs 155 crore odd profits. The interest it pays is Rs 350 crore. So every year, it pays more interest and it can make profits. Kudos to management for running such a great business (!). I will get fired for running my department in negative budget (?) What is REI Agro board of directors doing? Asking for more money? Saying there is future potential is not an excuse?


UB Group (including its subsidiaries): It has accumulated total debt of Rs 15000 crore, of which approximately Rs 7500 is for Kingfisher airlines. It is on a debt restricting spree and looking for raising capital through GDRs, new share sale in domestic markets, rights issue, etc. Would this be considered as raising capital for future growth? You be the judge?


What should I do as small shareholder?

Again, its subjective. Each individual has to understand such events in a given context.

  • In situation like EIH, assuming I was planning to buy new position, I would wait it out to see how it pans out. I would wait to see the impact on capital base and share price. Assuming I was an existing shareholder, I would sell and cash it out. I would not throw more money in new shares. And hence, I will get squeezed on dividends and market price. One could argue about the wisdom of selling because there could be some arbitrage permutation or combination (by exercising your option to buy more), but as I have mentioned in past, event driven situations have never been my cup of tea. OR there could be an argument that RIL is investing so its price will increase of overtime, so be it. If you think a rationale and confident about it, then you should go for it.

  • In situation like REI Agro and UB Group, run as fast as possible. Remember the cockroach theory. There is never one alone in a closet.


Majority of the time, (if not always), rights issue is used for shoring of the balance sheets. However, I am sure there are good examples of rights issue for future growth! Can you share such examples?


Note: There is much more technical details behind rights issues. e.g. how it affects share price. The intend here is to be simple in layman terms and hence, I expect the fundamental meaning to be correct i.e. raising capital – reasons for raising capital – dilution effect – impact on small shareholders.


The post was inspired by a question asked by one of the readers, Raja. The question was,”If you are following the EIH-Reliance deal, and the announcement of rights issue from EIH and all the speculation following that, you would probably understand the reason for my curiosity“.









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27 Responses to “Raising Capital by Rights Issue – What to Make Out of It?”

  1. Ali says:

    Dear Tip Guy

    What an excellent Article.You explained Rights issue in a sweet and simple manner. This post is worth of filing in my personal doccument Folder.

    Million Thanks

    Ali

  2. Biren Gorkhab says:

    hi tipguy,

    I also agree with Ali. This post is super duper awesome.

    once again, i thank you.

  3. Raja says:

    That’s a fabulous post. Loved reading it.

    One point: in your example you mentioned ‘is likely to revise the market price of shares to 25%’ you probably meant ‘by 25%’ isn’t it ??

    On the EIH-RIL topic. The market rumor is, following the rights issue, EIH will be able to to allot the unsubscribed(public, and may be ITC) portion to Reliance hence taking the reliance holding above 15% and that would make it necessary for Reliance to go for an 20% open offer from market.

    What I fail to understand is if this was indeed the intent why didn’t EIH give reliance directly a 15% instead of 14.8%. Is .2% that important for EIH or is there something more to it ?

    Also one confusion I have after reading your post is: Suppose an existing shareholder in your example doesn’t subscribe to the rights issue, then his holding value will be probably be reduced by 25% for no fault of his own, isn’t it ??

    Regards
    Raja

    • TIP Guy says:

      Hello Raja,

      Thanks for pointing the error. Yes, it is “by 25%”. I updated the post.

      On 20% open offer…. Not necessarily. The non-subscribed portion could be distributed equally between EIH and RIL. Or they could bring in third party (from RIL or EIH enclave). That way RIL can still remain below threshold.

      On why leaving short by 0.2%….. Anything that is discussed about EIH-RIL topic would be permutations and combination. Out of many of these, one of them will be right. Unless the players come up and make an announcement or do it, it is all speculation. So my speculation is; reason for making it short by 0.2% would be to see how it pans out. The fact that deep pocketed RIL comes on board would likely act as a deterrent to other party (ITC?).

      Yes, the existing shareholder who does not subscribe will get squeezed for no fault of his own.

      Question for you: Independent of rights issue, is there any equity investment in which retail investor does not net squeezed (without fault)?

      Best Wishes,

      • Raja says:

        Hi TIP Guy,

        I had bonus issue in mind. Here also the equity base gets increased but at least the existing shareholder gets a proportionate share, am i right ?
        But probably am wrong here in treating bonus issue as equity investment, as in bonus there is no new money which comes in, its only a conversion from reserve to equity.

        Regards
        Raja

        • TIP Guy says:

          Hello Raja,

          For existing shareholder, bonus issues does not have an impact on % shareholding or dividends. He/she receives the proportionate shares. While individual share price will get affected (reduced), but theoretically, total value will remain same. However, in markets total value is likely to be higher, perception driven. It also dilutes capital structure.

          Best Wishes,

  4. neet says:

    Hi TipGuy,
    Thank you for expalining the dynamics of rights issue.What is your opinion of the rights issue being brought out by Karur Vyasa bank?

  5. Praveen says:

    Can you throw light on Suzlon issuing rights at 65/- when the market price of its share is ranging between 45 & 50.

  6. Erika Roach says:

    Hi TIP Guy,

    I have been a silent reader or follower of your blog for more than a year. I always look forward to your sensible & thoughtful & common sense views on welath creation.

    I haven’t commented much, but today, I wanted to drop few lines to say THANK YOU. There is no way I can pay you back for all your efforts. As a token, I will tweet your posts, as my thank you.

    Warm Regards.
    ER

  7. grm says:

    Hi,

    I came across your blog today and am impressed with the content. You really seem to have done and are doing true fundamental analysis. I will follow your blog.

    I had a question on your list of companies paying dividends. Is this Rs per share?

    Thanks.

  8. GRN says:

    Hi,

    I subscribed to you blog and was waiting for your ebook but it has not shown up yet in my mail. Is there anything else I need to do other than subscribe to the blog and click the confirmation link in the email that was sent? its been about 4 days.

    cheers,
    GRM

  9. GRM says:

    Hi,

    I subscribed to your blog and was waiting for your ebook but it has not shown up yet in my mail. Is there anything else I need to do other than subscribe to the blog and click the confirmation link in the email that was sent? its been about 4 days.

    cheers,
    GRM

  10. GRM says:

    Hi,

    I see you have not been responding to comments for about two days. I hope its just work that’s kept you away from your blog.

    Would you mind comparing investments in stocks versus investments in tax saving Govt schemes like National Savings Certificate etc with examples if possible please. Considering inflation, tax, brokerage fees, trading fees etc in comparison.

    Cheers,
    GRM

    • TIP Guy says:

      Hello GRM,

      Yes, I do mind. Both are designed for different objectives and hence it is apples to oranges comparison. You want safety and low risk (or no risk), then go for NSC type purchase. Simple. I do not consider NSC type vehicles as “investments”. They do not provide real growth in wealth. They are safe way to park your cash which keeps up with inflation. If you want capital appreciation, then equity type investments should be preferred choice.

      Both have a role to play in your portfolio.

      Best Wishes,

  11. ethiraj says:

    sir,
    i am new to ur blog.the thought process is impressive. i have purchased kvb shares at rs
    860 thinking about bonus shares and the rights issue.now the share price is low.rights issue nit yet commenced.plz advise.

  12. Hi,
    A very nice explaination.

    But for an investor what importance the right issue has in his portfolio? and if so how should he decides which right issue should he subscribe to.

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