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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