MARCH 2011 THE TREASURER 13

news and comment RIGHTS ISSUES

Martin O’Donovan, assistant director fortechnical and policy, ACTRight issues have been attracting steadilyincreasing fees from the banks – both forunderwriting and for the whole package,including advice – over the past decade. Tenyears ago a figure of 1.5% or 2% of proceedswas typical; today 3% and even 4% is common.

Another development has been for the rightsissue to be priced well below current marketvalue. This gives shareholders more of anincentive to take up the issue and preventdilution, and there is less risk of the share pricesliding towards the rights issue level. There havealso been cases of rights issue being launchedinto a weak market, with the share price fallingbelow the rights issue level as a result.

Although underwriting fees have risen, thelevel of risk taken on by underwriters has fallen.Another development has been the increase inpre-marketing, also known as pre-sounding.Traditionally, a company would keep its plans fora rights issue confidential ahead of the launch, toprevent rumours from spreading – although itwould attempt to gauge likely demand.

The increasing use of pre-sounding has seenunderwriters approach investors much earlier, toget a more accurate indication of what take-upof the issue is likely to be. This means they can

be fairly confident in advance that the rightsissue will be successful, which in turn furtherreduces the degree of risk they are assuming.The greater degree of confidence would seem tomerit lower fees; the fact this hasn’t happenedsuggests that companies are being overcharged.

These trends have been noticed, though –hence the Institutional Shareholders’ Committeereport on right issues in December, which urgedcompanies to be more alert and to demand agreater degree of competition.

It was followed by an Office of Fair Tradingreport in January. Since the OFT stopped short ofdescribing the banks’ fees as anti-competitive,the inference is that buyers are failing tochallenge underwriters on whether their workmerits such high charges.

As issuers don’t usually engage in rightsissues very often, they rely on the expertise oftheir advisers as to whether a rights issue isactually needed, when the best timing is, etc. Yetthey often use the same bank for both theadvisory work and the underwriting – surelythere is a conflict here even if it’s different unitsof the bank divided by Chinese walls.

The size of the rights issue and the size of thediscount rest to some extent on the adviser’srecommendations. The underwriter wants aneasy life, so will tend to set both at a cautionarylevel. This might have been prudent whenmarkets were very volatile, but despite a fewjitters during 2010 the underlying trend has beena return to more normal conditions. Also, althoughadvisers would probably caution against goingahead with a rights issue if they felt the timing tobe completely disastrous, they might be mindedto recommend going ahead when conditions are“iffy” to avoid missing out on their fee.

Yet a rights issue is a big deal for a company.If it doesn’t work out, the outcome can be veryserious, so companies must proceed cautiously.

Treasurers would be well advised to hold acompetitive tender for the underwriting contractinstead of simply using their house bank. They

should also ask for an itemised breakdown whenthe advisory and underwriting fees are bundledtogether. Bear in mind that any bundling of chargesusually works to the benefit of the provider.

So the message is:g treat the rights issue as a serious transaction,

which means putting it out to competitivetender;

g question whether the rights issue actuallyneeds to be fully underwritten; and

g be aware that networking is still prevalent –the prospect of a rights issue often seesinvestment banks buttering up the CEO andbypassing both the treasurer and CFO.

It’s good to see that shareholders have begunquestioning the levels of fees charged. However,while they can put pressure on managementand raise the public debate they can’t actuallytake action themselves.

A concluding thought: given that underwritinga rights issue is a major strategic activity,companies and their treasury teams mightconsider working through the various issues wellin advance of commencing any rights issue – ona “how would we organise it if we went aheadwith one?” basis. This process would involve thelegal team and consider at what point to put itout to competition. Now that two recent reportshave publicised the issue of fees, companieshave more ammunition to question pricing andeven whether underwriting is needed.

The ACT has worked with other bodies onguidance to rights issues – suggesting, forexample, that they didn’t always need to beunderwritten. However, we have found it impossibleto agree a wording acceptable to everyone; theprojected guidance was continually redrafted orour radical proposals were watered down.

The ACT is now considering reviving theproject to issue guidance, perhaps in conjunctionwith investors. ACT’s technical and policy directorJohn Grout has just issued a blog on this topicand posted it on the ACT website atwww.treasurers.org/node/6750

Ask the experts:

Are underwriting feesexcessive?THREE EXPERTS – ONE FROM THE ACT, ALONG WITH A CONSULTANT AND A BANKER – DEBATE THE RIGHTSAND WRONGS OF FEES, WHILE A TREASURER RECOUNTS HIS RECENT EXPERIENCE OF A RIGHTS ISSUE.

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Stephanie Maguire, professional supportconsultant, Herbert Smith During the banking crisis, many rights issuestook place in the UK under challenging marketconditions, and the level of fees charged byunderwriters was seen to reflect the increasedrisks at that time. However, as market conditionshave improved there has been no correspondingreduction in underwriting fees.

Given this, in July 2010 the InstitutionalInvestor Council (IIC) announced that it wasconducting an inquiry into underwriting practiceson rights issues in the UK. In the course of itsreview, it looked at the role and selection ofadvisers and underwriters, the pricing andstructure of capital raising, the level ofunderwriting fees relative to changing riskexposure, the transparency of underwriting fees,and sub-underwriting practices.

Following its review, the IIC inquiry issued adetailed report and made a number ofrecommendations to improve the equityunderwriting process for issuers. While some ofthe proposals would require regulatory changes(for example, the recommendation that theListing Rules require issuers to disclose in detailall fees paid on a rights issue, to whom they arepaid and for what services), there are some morestraightforward suggestions in the report thatissuers considering an equity capital raisingcould follow now. These include seekingindependent advice, not automatically assumingthat the rights issue must be fully underwritten,and always putting the primary underwritingcontract out to tender. Issuers concerned aboutthe expectations of their investors should look atthe draft generic guidance relating to theexpectations of institutional shareholders in anissuer conducting an equity capital raising.

The rights issue fees inquiry is not, however,the end of the story. Not long after the IIClaunched its inquiry into underwriting, the Officeof Fair Trading also launched a market study inthis area. It has recently published its findings,

which broadly indicate there is little competitivetension between investment banks during theequity raising process and that issuers raisingequity capital are not focused principally onreducing underwriting fees. It also found thatthere had been a significant increase in feessince the start of the financial crisis and thosefees have not since fallen in line with thereduction in risk.

However, the OFT has provisionally concludedthat it is not appropriate to refer the equityunderwriting market to the CompetitionCommission for investigation as the market hasjust been through an exceptional period followingthe credit crisis. Instead, it believes the issuescan be addressed most effectively by issuers andinstitutional shareholders negotiating harder overfees and taking other steps to help reduce fees.

At a practical level, the OFT report, like the IICinquiry, suggests that issuers should, amongother things, seek more advice about the processfrom their institutional shareholders, non-executive directors and legal advisers, and putgreater pressure on fees by asking for a costsbreakdown. It also recommends that issuersimprove the competitive tension for theunderwriting business by, for example, invitingbanks with which they have existing relationshipsto compete for different aspects of theunderwriting, and by increasing the number ofbanks they have relationships with.

The OFT believes that institutionalshareholders should put greater pressure onissuers to reduce fees. It suggests that theyshould discuss the principles for any futureequity raisings with the issuer and, wherepossible, commit to sub-underwriting before theannouncement of the rights issue, therebyreducing the underwriting risk and, potentially,the fees.

Looking forward it will be interesting to seehow market practice on these points develops.At the very least, issuers are likely to havefurther pressure placed on them by institutionalinvestors to negotiate underwriting fees andbanks should expect to be having more heateddebates on fees.

The British Bankers’ Association The argument persists across public debate thatfor there to be effective competition in bankingthere needs to be a significant number of playersin the market. Yet evidence abounds that thebanks remain in aggressive competition witheach other for customers, in internationalcommerce as in the high street. They only evercome together, with some reluctance, in times ofpressing need.

Lately we have seen several examples of thatkind of pressing need emerging, as the entirebanking industry has taken the reputational hitfor the high-profile failures of a few. ProjectMerlin was an attempt to provide reassurancethat the banks were committed to supporting theeconomic recovery. The Business FinanceTaskforce is the banks’ joint initiative to providefirm, deliverable commitments to businessesseeking financial support for the recovery.

Competition is a good thing – indeed, it is vitalto functioning markets – and the British Bankers’Association always welcomes the emergence ofnew entrants in the market (and not simplybecause they swell our membership). But themarket does not necessarily need an abundanceof different companies in order to work.Nevertheless, we have seen new entrants to theinvestment banking market in recent years andthere is increasing competition among the bigglobal investment banks in the world’s biggestfinancial markets, including our own.

The Office of Fair Trading’s recentinvestigation into investment banking feescharged by UK banks – which it ultimatelydecided not to refer to the CompetitionCommission – did level criticism at the industry,which is currently being discussed across theCity with a view to improving banking services tocustomers. But it also pressed customers to bemore alert to the deals available. Specifically, iturged companies and institutional shareholdersto push hard for the best deals in equityunderwriting fees – and correctly so. Competitionworks best when customers hold out for theoptimum deal.

But decisions on matters that can be vital to acompany’s future are rarely made solely on price.And that price must reflect the inherent risk inthe transaction. It is a regulatory obligation thatall banks must now seek to manage theirexposure to risk more carefully, and, as with allregulations, this has an impact on the widereconomy as well. Too often in public debate wehear banking regulation referred to as if it has noimpact on the economy beyond the way thatbanks conduct their business. In fact, capitaland risk controls in particular have afundamental impact on the availability of banksto support businesses.

The banks carry special responsibilities here,both in the wake of the economic crisis and asengines of the economy. We have all beenthrough very turbulent times and banks musttake their share of the responsibility for whathappened. We now need to work together toensure Britain’s businesses can be assured ofthe support and the services they need in orderto restore lasting stability to our economy.

14 THE TREASURER MARCH 2011

news and comment RIGHTS ISSUES

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MARCH 2011 THE TREASURER 15

news and comment RIGHTS ISSUES

One of the more unexpected stock marketannouncements of 2010 came in May, whenNational Grid used the release of its full-yearresults to launch a rights issue involving the saleof 990 million shares in a two-for-five placing at335p a share.

The plan by the UK’s largest utility groupcaught many investors off-guard, but appearsless surprising in retrospect. National Grid needsto upgrade the UK’s power infrastructure over thenext five years and estimates that the total costwill come in at £22bn. The news was alsosweetened by the group announcing a 12% risein pretax profits, and an 8% increase in thedividend, which it pledged to maintain over twofurther years.

National Grid’s rights issue also differed frommost others in being specifically allocated fororganic growth, rather than to fund an acquisitionor provide an injection of capital to a business introuble. Many of those announced during 2009and the early months of 2010 fell into the lattercategory, says its group tax and treasury directorMalcolm Cooper.

The group’s treasury team was informed earlyin the year of plans to step up its investmentprogramme and worked on the issue overseveral months, with progress periodicallyreviewed at board level, he says. “It was evidentthe sum involved meant that it wasn’t fundableinternally and we would need to seek equity fromthe outside.”

Cooper admits that choosing the right timingwas difficult, particularly when a general electionwas confirmed for early May. It was eventuallydecided that the rights issue announcement

would coincide with the release of the results forthe year to 31 March 2010, which werescheduled for release on 20 May.

“There was some concern that the newsmight leak ahead of this date, but fortunately itremained confidential and we avoided anyuncertainty caused by speculation and also anyshare overhang,” says Cooper.

National Grid announced that the issue wouldraise gross proceeds of £3.3bn and a net figureof £3.2bn, with the difference consisting ofthe fees for underwriters Morgan Stanley, Bankof America-Merrill Lynch and Deutsche Bank.

“Yes, it’s debatable whether such a level offees was justified,” Cooper says. “With NationalGrid behind the offering, you can argue thatthe degree of risk taken on by the underwriterswas minimal.

“But at the same time, it provided aninsurance policy against unexpected events; hadthe issue failed, then the fees would have beenworth every penny. And it was a tough marketlast May, with Greece’s sovereign debt crisiscreating uncertainty and much volatility in theequity markets.”

Fortunately, although the market’s initialresponse was unenthusiastic – the share pricefell 43p to 577p on the day of the announcement– the issue was highly subscribed, with a take-up rate of around 95%.

“We knew beforehand it wasinevitable that a rump ofshareholders, mainly our smallershareholders, wouldn’t be able totake up the rights,” says Cooper. “Soall in all we were very pleased withthe outcome.”

The share price also traded much in line withthe treasury team’s expectations, despite the factthat on 3 June – 12 days before trading in thenew shares commenced – the shares went ex-dividend. By 17 June, the share price was at514p and in line with the theoretical ex-rightsprice (TERP), which carried a discount of 35.7%.The other key metric, the bonus element fromthe dilution, was 1.1426.

“So in retrospect, the timing proved verysatisfactory,” Cooper says. “The transaction wentvery smoothly and we successfully got funding inplace towards our five-year plan. I also believethat it represented the largest rights issue todate designated for organic growth.”

Case study: National Grid MALCOLM COOPER, GROUP TAX AND TREASURY DIRECTOR OF NATIONAL GRID, RECOUNTS HIS RECENTEXPERIENCE OF A £3.3BN RIGHTS ISSUE TO GRAHAM BUCK.

“IT PROVIDED ANINSURANCE POLICY

AGAINST UNEXPECTEDEVENTS. HAD THE

ISSUE FAILED, THENTHE FEES WOULD

HAVE BEEN WORTHEVERY PENNY.”

Power points: some of NationalGrid’s electricity transmissioninfrastructure in the UK

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