At the core, the function of a stock market is to help companies to raise cash.
The benefit of being a listed company is that you get to tap on the equity market to raise money beyond what was raised during the initial public offering (IPO).
There are two main methods that companies use when raising money from the markets.
They can either do a private placement or a rights issue.
A private placement involves the sale of shares by the company to an external investor who is not an existing shareholder of the company.
The placement shares are often priced at a discount to the last traded price to entice the investor to purchase a large block of shares.
Such sales have the effect of diluting the earnings per share of the business as the total net profit of the company is now divided by a larger issued share capital base.
Rights issues, on the other hand, involve the sale of shares to existing shareholders.
They differ from private placements in that current shareholders have a chance to subscribe for their proportional stake in the company, thereby avoiding dilution.
However, the big question is whether you should allocate money to such rights issues.
Let’s take a look at the pros and cons surrounding such corporate exercises.
The mechanics of a rights issue
First off, let’s look at what a rights issue involves.
A company will declare a specific ratio of a certain number of rights shares for each share held by the shareholder.
A rights issue price will also be stated upfront that is the price per rights share should the shareholder choose to subscribe to his entitlement.
To provide an example, let’s say company A announces a rights issue of 1:4 at S$1.00 per rights share.
If you currently own say 4,000 shares of company A, then you will be entitled to subscribe for 1,000 rights shares (4,000 divided by 4).
Should you choose to exercise your full entitlement, you need to cough up S$1,000 in cash to purchase the rights shares.
Upon the completion of the entire exercise, you end up with 5,000 shares of company A.
Note that some rights issues are renounceable, meaning the entitlement to subscribe for the rights shares can be bought and sold on the stock market.
Shareholders who do not wish to take up their rights entitlement can then sell their entitlement to recoup some of their original investment but have to suffer from dilution as a result.
Different names, same purpose
Many REITs undertake rights issues to fund acquisitions during the normal course of business.
However, such fund-raising exercises are usually termed “preferential offers” and not rights issues.
The mechanics of such preferential offers are similar to those of rights issues, though.
Although companies and REITs use different terms when it comes to raising money, the purpose remains the same.
An example of a preferential offer is the 5-for-100 offer by Mapletree Industrial Trust (SGX: ME8U) at S$2.65 per unit.
Examining the rationale
Investors need to look at the rationale of each rights issue when evaluating if it’s wise to sink money into it.
There may be a plethora of reasons used by companies to justify each rights issue, but it all generally boils down to two key reasons.
One is to pay down debt to strengthen the company’s balance sheet and boost its cash balance.
Such a situation could arise from challenging conditions the company is facing that drains most of its cash.
Without an urgent cash infusion, the company will be left floundering and shareholders may end up with a bankrupt business.
The other key reason is to acquire another business or asset as part of the company’s business development efforts.
Access to debt may be restricted, thus compelling the company to tap on equity markets to fund the purchase.
Some recent examples of companies that conducted rights issues to shore up their balance sheets include beleaguered carrier Singapore Airlines Limited (SGX: C6L), or SIA, and distressed oil rig player Sembcorp Marine Ltd (SGX: S51), or SMM.
SIA announced a rights issue of 3-for-2 at S$3.00 per rights share back in March last year to bolster its balance sheet.
And SMM announced its second rights issue within a year comprising 3-for-2 at S$0.08 per rights share to replenish its cash kitty as the oil and gas industry remains mired in the doldrums.
A company that conducted a rights issue for an acquisition is commodities giant Olam International Limited (SGX: O32).
It announced a 3-for-20 renounceable rights issue with its rights shares priced at S$1.25.
The proceeds are intended to partially repay the debt taken up for the acquisition of Olde Thompson, a US private-label spices and seasoning manufacturer.
Get Smart: Review on a case by case basis
As can be seen, companies issue rights for a wide variety of reasons.
Investors need to assess each company’s rationale on a case by case basis.
If it’s determined that business deterioration will carry on despite the rights issue, then investors may want to think twice about throwing good money after bad.
But if the rights issue serves to help the company or REIT to grow and increase either its earnings per share or distribution per share, a case can be made for deploying some cash to subscribe for it.
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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.