1.4 Seasoned equity offerings
The issuance of additional shares is called a seasoned or secondary equity offering (SEO). SEOs are common in the London market, but less common in the USA. In some countries, including the UK, one form of SEO is a rights issue. In such issues the existing shareholders are given the right to buy further shares, usually in an amount proportionate to their prevailing holdings. This is known as a pre-emption right.
While rights issues can support the need of a successful company to extend its capitalisation to accommodate further growth, such issues can be seen as a distress signal, reflecting weak performance and diminishing liquidity and hence the need to raise new funds. In contrast, financial companies such as banks and insurance companies, often resort to SEOs to provide additional capital to maintain their solvency ratios.
Offering these new shares at a discount to the prevailing price highlights a vicious circle that applies to rights issues. Given the normal three week period of acceptance that is required when offering a rights issue, it is usual to offer the shares at a discount to their prevailing market price. This ensures – as far as possible – that during this acceptance period the prevailing price of the company's shares does not fall below the offer price of the rights issue. If this were to happen no shareholders would logically take up their rights. Yet, offering the rights at a discount almost inevitably reduces the company's share price towards the level of the price of the rights issue.
As a shareholder, taking up the rights issue will mean that proportionately you still own as much of the company as you did before the issue although, initially at least, each share is likely to be worth less than before. The alternative is not to take up your rights and sell them at their market value. Under these circumstances, though, your share holding in the company is diluted: by not taking up your rights you will own a smaller proportion of the company than before the issue.
Rights issues are cheaper than other SEOs in respect of the fees that have to be paid to the lead banks and the other intermediaries involved in the transaction. Institutional investors also like rights issues since they ensure that investors maintain the same percentage holding of the companies' equities. This is important given that the performance benchmarks for these investors are usually stock market indices. On the other hand the nature of rights issues – issuing to existing shareholders – does not help to deepen or diversify a company's composition of shareholders.
In the USA, SEOs are sold like IPOs and there are no pre-emption rights.
Interestingly, Corwin (2003) found that like IPOs, SEOs are often underpriced. His research found underpricing by an average of 2.2 per cent during the 1980s and 1990s. Corwin provided a number of reasons for this finding – including ‘temporary price pressure’ (perhaps attributable to investors trying to influence the offer price ahead of the SEO) and the tendency of the lead banks to round down the offer price to the nearest dollar or $0.25.
Underpricing relative to the prevailing market price is always going to be likely, given that the company making the issue normally has to offer some incentive to the investors.
So far in this section we have looked at the various forms share issues can take; in the next section we will examine why a company may want to list its shares on more than one stock exchange.
Case Study 4: Pru's rights
The international insurance company Prudential launched a £1 billion rights issue in October 2004. Shareholders were offered one new share for each six already held. The issue followed the abandonment of the plans to sell its holding in the online bank, Egg.
A proportion of the proceeds from the issue – circa £100 million – were used to enhance Prudential's solvency ratio (in effect, their reserves of equity and debt capital) in readiness for the implementation of the new EU Financial Group Directive in January 2005.
The terms of the rights issue showed what usually has to be done to encourage existing shareholders to put up more cash – the 337 million new shares were offered at £3.08, a discount of one third of the then prevailing price of Prudential's shares. With rights issues, shareholders need to be incentivised to take the rights. Those who did take up their rights were rewarded by seeing Prudential's share price rise dramatically to £4.52 at the end of 2004. At least in the short term those investors who were prepared to put more cash into Prudential were handsomely rewarded.