The benefits and costs of deeply-discounted rights issues – practitioners viewpoints

Abstract

Deeply-discounted rights issues (DDRIs) remain rare on the world's largest stock markets, but the costs and benefits of such issues have attracted renewed attention in recent years as market regulators search for ways of driving down the cost of external fund raising. The relative scarcity of DDRIs presents a puzzle to researchers because the rationale normally suggested – concern about the diluting effect of a heavily discounted rights issue on earnings per share – is easily shown to be irrelevant in theory (Patterson and Ursel, Journal of Business Finance and Accounting, 20, 115–24, 1993). The present study therefore reports the results of a series of discussions with firms, investors and advisers in the UK regarding DDRIs and the extent to which concerns about the impact on earnings continue to hamper growth in their use. The results suggest that firms are fully aware of the potential cost savings associated with DDRIs, but concerns about investor reaction to any offer-induced earnings dilution continue to mitigate against any significant increase in their popularity.

Acknowledgements

The authors would like to thank the Association of Chartered Certified Accountants for supporting this project. Thanks are also due to participants at the Alternative Perspectives on Accounting and Finance Conference held in Dundee in July 2000 and the British Accounting Association Scottish Area Conference in Stirling in September 2000 and 2001.

Notes

¹Definitions of (DDRIs) vary, but it is typically considered to be any issue offered at a discount to market price of more than 30% (Armitage, 2000). In the UK, conventional rights issue are typically made at a discount to market price of approximately 15% (Burton and Power, 2003).

²Anecdotal evidence of the reductions in costs achievable through the use of DDRIs continues to emerge. For example, the Financial Times on 9 July 2002 (pp. 21–24), examines Kingfisher PLC's decision to raise £2bn through a one-for-one 50% discounted issue to facilitate a share purchase and indicates that the related underwriting costs were little more than 1%.

³ Two researchers attended each interview. All were taped except in two cases where the interviewees specifically asked that the discussions were not recorded; in these cases extensive notes were taken at the time.

⁴ See Slovin et al. (2000) and Barnes (2002). The study by Barnes details the issue methods used by UK-listed firms for SEOs made between 1989 and 1998. The study notes that rights issues were used in the majority of cases, peaking at 92.3% in 1989, until 1996 when rules restricting placings to issues worth less than £15 m were relaxed by market regulators.

⁵ UK-listed firms’ decisions on how to issue shares essentially involve making a choice between a rights issue to existing shareholders and a placing to financial institutions. Institutional investor convention is to vote down any proposed placing that (i) is made at a discount of more than 5% to market price and/or (ii) represents more than 5% of a particular class of share capital; a rolling three-year limit of 7.5% also applies (Burton and Power, 2003).

⁶ The only way in which UK-listed firms can place significant amounts of equity is to link the issue to a clawback, i.e. where the shares are placed provisional on existing shareholders not taking up their rights to the shares. These differ from rights issues (i) in that the discount is typically lower and (ii) that the rights to purchase the shares are not separately tradeable.

⁷ The greater discount associated with most rights issues in the UK (typically 15%) compared to placings (typically 5%) means that more shares must be issued under the rights method to raise a given sum.

⁸ In that gains from conventional rights issues tend to be tax exempt, whereas this would not be the case for the much larger gains likely to accrue from DDRIs.