4.1 What is a seasoned equity offering
4.1.2 Rights offers
While this paper, as noted, is concerned with public offering it is relevant to elaborate briefly on the topic of rights offers. This is done to highlight the problems that arise from directly comparing the two – something which not all previous studies seem to acknowledge.
As noted, in a rights offer, the new shares are initially only offered to existing shareholders.
Moreover, the offering is arranged in a fundamentally different way than an SPO. In a rights offering, existing shareholders are offered a right to buy new shares on a pro rata basis at a discount relative to the current market price (see e.g. Bøhren et al., 1997, p223). This essentially implies that existing shareholders are offered an in the money call option on new shares. The shareholders are typically allowed to sell the option, should they not wish to participate in the offering. The idea behind the rights offer is that the value of the right should financially offset the non-subscribing shareholders for the fall in the share price ex-post issuance. This ex-post share price is more commonly known as the Theoretical Ex-Rights Price (TERP), which is calculated as the weighted average of the price of new and existing shares.
Whereas the execution of an SPO is rather swift (see section 4.3), the process of a rights offer is somewhat more time-consuming. According to, for instance, German law, the offer period has to be a minimum of 2 weeks for rights issues (Bühner and Kaserer, 2002, p323). Another example is in the United Kingdom, where the offer period has to be at least 3 weeks (Armitage, 2000, p58).
These offer periods affect the TERP, as it is exposed to changes in the share price, which in turn influences the value of the right. If the price of the underlying stock falls below the sum of, the cost of buying a right and the cost of subsequently subscribing to the new share at the offer price, no rational investor would exercise his right. This would be equal to exercising a call option which is out of the money. This risk can be mitigated through underwriting. It is, thus common to distinguish between two types of rights offerings: uninsured rights and rights with standby underwriting. Issuers who use rights with standby underwriting are guaranteed that the underwriter will exercise the rights if the issuance is not subscribed in full by the end of the offer
period. On the contrary, an uninsured right is solely dependent on the subscription of existing shareholders and is as such comparable to the best efforts type of public offering.
As noted, the right can be seen as a call option on additional shares at a given price. In addition the option is only exercisable at maturity and the right, thus, specifically compares to a European call option. The intuition is that the value of the right is approximately equal to the difference between the TERP and the price at which the new shares are offered, i.e. the offer price.
If the shareholder receiving this right does not want to participate in the offering, he incurs on dilution as he should be able to sell the right at a price equal to the TERP and the offer price.
However, if the right trades this price, the non-subscribing investor would incur an indirect cost from a wealth transfer much like the case of an SPO. One may expect that the right would trade below its theoretical value for three main reasons; firstly, for several of the same reasons that the SPO is offered at a discount, see section 6. This is supported by Eckbo and Masulis (1992) who note that from an outside investor’s view, a rights issue, to which current shareholders decide not to subscribe, is informationally equivalent to a direct sale of shares to the public, i.e. as SPOs.
Secondly, the right will likely be less liquid than the underlying asset in the offer period, which should lead investors to require a discount. Thirdly, depending on the particular regulatory system, the investor may incur a period of non-tradability in the time span between buying the right, and until the shares are allocated. Somewhat surprisingly, it has not been possible to find papers that try to determine the ‘actual’ incurred rights offer discount. The insight from this discussion is that as long as the right has a value, the discount on the rights offer is not comparable with the SEO discount on the SPO.
While as noted, indirect costs between public offerings and rights offerings are at best difficult to compare, the direct costs are quite comparable. Empirical evidence suggests that the direct costs associated with a rights offer are generally lower than those of an SPO. This is a long time well documented fact and as noted by Smith (1977) “…the subscription price for a rights offer can be set low enough so that the probability of failure of the rights offering becomes arbitrarily close to zero” (Smith, 1977, p289). From this he reasons that the ‘insurance policy’ associated with underwritten issue must be of small value.
This lower direct cost should intuitively encourage an issuer to choose rights offers when issuing seasoned equity. However, empirical evidence shows that issuers, in particular US issuers, favor underwritten SPOs when making an SEO. This favoring of underwritten SPOs over rights issues, despite its higher direct cost has received much attention in academia and is known as ‘the rights
offer paradox’. Ursel (2006a) summarizes the rights offer paradox as the paradox that
“...American firms raise seasoned equity via underwritten public offerings despite the lower cost alternatives of non-underwritten or underwritten rights issues” (Ursel, 2006a, p31).
However, as noted by Eckbo and Masulis (1992) this paradox is not seen across all markets.
Eckbo and Masulis (1992) note that “…the rarity of rights issues in the U.S. contrasts with the situation in Canada, where in recent years almost half of all equity issues have been sold through rights offers, and in Europe and the Pacific Basin, where the majority of equity issues are sold through rights, though a trend toward a greater use of underwritten offers is evident in a number of countries” (Eckbo and Masulis, 1992, p294). Bøhren et al. (1997) generalize this by linking smaller capital markets with a higher frequency of rights offers and vice versa for larger capital markets and SPOs.
As the rights offer paradox has received a significant amount of attention within academia, many possible explanations on its existence have been proposed. While this is not directly the topic for this present study, a very brief and non-exhaustive overview of the findings is relevant. This is in order to access the different motives for choosing between rights offers and SPOs, which in turn sheds light on the decision itself to issue equity via an underwritten public offering. Hansen (1989) finds that “…firms making underwritten rights offerings paid lower underwriting fees but incurred significantly larger price drops just prior to the offering than did firms making underwritten public offerings” (Hansen, 1989, p291). Hansen’s (1989) findings suggest that if shareholders are expected to resell their new shares, after subscribing to the proposed rights offer, an SPO may be a preferred flotation method, even if it entails larger underwriting fees.
Moreover, Hansen (1989) argues that underwriters are able to place new common stock at a higher price than the existing shareholders. This partly follows on from the argument made by Smith (1977), that shareholders not subscribing to the issue must sell their rights (or subscribe and sell the new shares) to avoid losing and foregoing the value of the right. These transactions will then create profits that are subject to capital gain tax, which increases with the subscription-price discount, hereby discouraging large discounts (Smith, 1977, p279).
Solely focusing on rights offers on the Oslo Stock Exchange, Bøhren et al. (1997), find that
“…the probability that a rights offer is underwritten is negatively related to expected shareholder take-up” (Bøhren et al., 1997, p258). Gajewski and Ginglinger (2002) add to this relation in their French study as they find “…that the percentage of shares held by the main shareholder in France is significantly greater for rights offers.” This indicates that rights offers are used by
companies with high shareholder concentration and high expected shareholders take-up. Bøhren et al. (1997) further note that “…an analysis based on direct flotation costs alone, which underlines the so-called ‘rights offer paradox’, misses important indirect costs of uninsured rights” (Bøhren et al., 1997, p259), hereby building on Hansen’s (1989) abovementioned findings.
The above arguments may indicate that the apparent, clever idea of issuing new capital via rights offerings may not be favorable for the existing shareholders as they, rather than the investment bank, carry much of the risk. In practice they may do so less efficiently than the investment bank.
In addition, after controlling for endogeneity in the choice of flotation method, Ginglinger et al.
(2010) find that “…public offerings are less expensive and improve liquidity more than standby rights whereas uninsured rights are still the best choice for low liquidity, closely held firms.”
(Ginglinger et al., 2010, p2). This suggests a bias in terms of which companies choose to undertake a public offering, namely that stock liquidity seems to be an important determinant in the choice of issuance method. Ginglinger et al. (2010), base their findings on a French dataset consisting of 178 SEOs, including public offerings, uninsured rights offerings and standby right offerings, during the period of 1995 to 2006.
Based on the discussion in the two prior subsections, it should be clear that comparing the cost, of issuing capital in the form of an SPO or as rights, is not simple. The direct cost (i.e. the gross fee) paid to the investment bank is not directly comparable, as the investment bank is faced with profoundly different risks and responsibilities under the two issuance types. What is furthermore important to note is that the SEO discount associated with public offerings and that of rights offers are fundamentally different in nature, and as such incomparable when assessing the indirect cost incurred when issuing equity. Finally, the two types of issuance seem to be incomparable in the sense that there is a bias in the nature of companies that choose to make an SPO and a rights offer respectively.
Knowing the fundamental difference of how SPOs and rights offers are organized, and why they cannot be directly compared in a meaningful way, the paper will continue with a discussion of the direct cost associated with underwritten public offerings in the next section. It should be noted that only the above section differentiates between SEOs and SPOs, henceforth the term SEO is used to describe the event of an SPO. The term rights offering will be applied specifically when relevant.