What is not right about rights sharesMoney that should have gone to the corporate coffers is going to the shareholders’ pockets.
There are many sources of funding available for a public company. It can tap into retained earnings. It can issue shares in the secondary market, or issue debt or take on bank loans. If it is adopting the secondary route, management will try to price the shares as expensive as possible, but not prohibitively so. If it is borrowing money, the goal will be to negotiate as favourable terms as possible, including low rates. Companies can also avail themselves of rights shares. In Nepal, where the history of the capital market is young, companies often issue a rights offering to raise additional capital. Shareholders adore these, as they benefit at the cost of companies issuing these shares.
When a company goes public, it issues shares to the public for the first time in an initial public offering (IPO). In a rights offering, shares are not issued to the public, rather to the existing shareholders in proportion to their holdings. Shareholders have choices. They can subscribe to the offer partly or fully, let it lapse or transfer their rights to others; rights can be transferable. In general, companies that are levered up to the gills can have trouble securing additional loans and hence look toward rights. There are times when companies resort to this to stop someone from raising ownership; this tactic is known as a poison pill, and companies use these to discourage hostile takeover attempts.
From the shareholders’ perspective, there are at least a couple of things they may need to consider before taking up on the offer. In normal circumstances, rights shares are not the first choice of corporate treasurers looking to raise capital. Often, cash-strapped companies go down this path, in which case managements can use the funds to right the distressed balance sheet; but there is no guarantee, as the balance sheet may have been impaired for a reason to begin with. Then, there is the issue of dilution. As more shares are issued to the market, the issuing company’s net profit is spread over a larger number of shares. Ordinarily, it is because of this fact that as soon as a rights offering is announced, the stock price goes down.
In Nepal, it is the other way around. Stocks go up when rights are announced. The Nepal Stock Exchange (NEPSE) only began trading in January 1994. There are 225 companies listed on the exchange, and these are dominated by banks and insurance companies. The corporate bond market hardly exists; companies rather rely on bank loans. In this environment, rights shares are a frequently used tool. These companies are not necessarily cash-strapped either. In 2015, Nepal Rastra Bank, the nation’s central bank, gave commercial banks two years to raise their paid-up capital from Rs2 billion to Rs8 billion, hoping this would encourage mergers and acquisitions. Banks instead bulked up by issuing rights and bonus shares.
Typically, if the rights are offered near the current market price, existing shareholders may not view it as a compelling buy. This is particularly so if the issuing company has its back against the wall. For this reason, these shares are issued at a discount. In mature markets, the discount is not that deep, so shareholders also consider growth prospects, valuations and management’s track record. Shareholders obviously would not want to see their investment go down the drain. Customarily, investors benefit in two ways–dividends, which can be in cash or shares–and/or capital appreciation. Rights shares offer another opportunity for the existing shareholders to benefit financially.
In Nepal, rights shares are popular among listed companies. In the current Nepali calendar year 2021-22 that began mid-April this year, the Securities Board of Nepal (SEBON), which regulates the securities industry, gave approval to one company to issue rights shares. In 2020-21, seven companies received approval, and there were 11 in 2019-20. Besides SEBON’s approval, company managements also need the go-ahead from their boards. Similarly, as a regulator of the financial sector, Nepal Rastra Bank in the 2020-21 monetary policy, which was announced in July last year, prohibited microfinance institutions from issuing rights shares, as these companies used these to raise capital, but not mergers and acquisitions which the bank wanted.
Money at the table
Here is the biggest irony of all. Companies in Nepal are not required by law to issue rights shares at par, which is the price at which a company goes public in its IPO, but this is what happens in practice. With a few exceptions, NEPSE-listed companies have all gone public at Rs100. Thus, irrespective of where a company’s shares are traded–Rs100, Rs1,000 or whatever–rights issues are offered at Rs100. On NEPSE currently, only one of the listed companies has market prices below Rs100, with Unilever Nepal going for as much as Rs20,000 per share. The higher the share price, the higher the guaranteed profit. This explains why prices are bid up immediately after rights shares are announced.
It is a big loophole and needs to be plugged. As rights shares are offered at deep discounts, money that could–and should–have gone to the corporate coffers is going to the shareholders’ pockets. Managements do not seem to mind this, as in all probability they, too, own company shares. Without a doubt, discounts should be there to ignite shareholder interest, but not to the extent of benefiting one at the expense of the other. This is particularly important in Nepal’s case as odds are the stock market will be a lot higher in 10-20 years; share prices’ path of least resistance is up in the long run. That is, companies offering rights shares at par will continue to leave money at the table.
In the event a rights offer is not fully subscribed, a company will sell the unsubscribed shares in an auction. Unlike rights shares, the auction is open to all investors; the highest bid is accepted. In essence, the higher the buyer interest, the higher the price. Accordingly, the company stands to gain more–more than it would have banked if the rights shares were fully subscribed. Absurdly, management probably hopes for exactly that outcome–so the shares can be auctioned off. Something is not right in the prevailing system here. Companies should be encouraged–or even required–not to offer rights shares at absurdly deep discounts. This creates misallocation of capital.