Underwriting of Rights Issues
A comparison of underwriting cost versus value in S&P/ASX300 company r ights issues, 2010 - 2012
Jun e 2014
Underwriting of rights issues, cost versus value: June 2014
Author and Acknowledgements
2
Author
This research was prepared by Mike Harut, Governance and Engagement Analyst at the Australian Council
of Superannuation Investors ("ACSI").
Acknowledgments
ACSI gratefully acknowledges the assistance of Dr John Handley, Associate Professor of Finance at the
University of Melbourne. The framework on which this research is based was originally developed in the
Australian context by Dr Handley almost twenty years ago. Dr Handley was also generous in providing
assistance through informal discussions with ACSI on the current research. The final research was not
formally reviewed or verified by Dr Handley.
ACSI also acknowledges the assistance of Ownership Matters which generously provided their proprietary
data on capital raisings that formed the basis of this research. Thanks in particular to Simon Connal and
Dean Paatsch who provided feedback and assistance.
Mike acknowledges the valuable input of fellow ACSI staff.
Australian Council of Superannuation Investors
The Australian Council of Superannuation Investors (“ACSI”) was established in 2001 to represent the
collective interests of profit-to-member superannuation funds regarding the management of
environmental, social and corporate governance (ESG) investment risk.
ACSI has 33 Australian superannuation fund members, who collectively manage over AUD$400 billion in
assets on behalf of over eight million Australian superannuation fund members and retirees, along with
five international members.
Australian Council of Superannuation Investors
Ground Floor
215 Spring Street
Melbourne VIC 3000
Australia
Tel: (03) 8677 3890
Fax: (03) 8677 3889
Email: [email protected]
Website: www.acsi.org.au
Underwriting of rights issues, cost versus value: June 2014
Table of Contents
3
1. Executive Summary 4
Key Points 4
Background 4
Comparing actual cost with the value of the shortfall risk 5
Study outcomes 6
Recommendations 6
2. Introduction 8
ACSI’s motivation for undertaking this research 8
Background to underwriting of rights issues in Australia 8
Past research 9
3. Methodology and Data 10
Underwriting is a financial option 10
Factors that determine the value of underwriting 11
Adaptions to the framework 13
Data 13
4. Results 14
Aggregate result 14
Consistency of individual outcomes 14
Comparison with 20 years ago 16
Potential drivers of underwriting premiums: size, liquidity, market conditions, reputation and purpose
17
Other potential drivers of underwriting premiums that were not examined 20
5. Recommendations 24
The role of company directors 24
The role of investors 24
The role of regulators and rule makers 25
Appendices 27
Appendix A: Adaptions to the framework 27
Appendix B: Variations to factor inputs 33
Appendix C: Bibliography 34
Underwriting of rights issues, cost versus value: June 2014
1. Executive Summary
4
Key Points
This study analyses 63 underwritten rights issues conducted by S&P/ASX300 member companies
between 2010 and 2012 and compares the amount they paid for underwriting against a benchmark
value.
In aggregate, companies appear to be paying more than twice as much in rights issue underwriting
fees than the benchmark value of those underwriting services. On a simple average, companies
appear to be paying a premium of almost 50% over the value of the underwriting service.
This suggests that companies have paid underwriters (typically investment banks and stockbroking
groups) a premium of more than $170 million, or an average of around $2.7 million per raising,
above the benchmark value.
Average underwriting fees are more than 60% higher than they were 20 years ago. This is despite
innovations that, in particular, have dramatically reduced the time required to complete a rights
issue thereby decreasing underwriting risk.
Background
One of the prime reasons that companies list on a stock exchange is for access to equity capital for
purposes such as pursuing an acquisition, commencing a new project, expanding an existing business or
repaying debt. In Australia, a key mechanism for raising that capital is the rights issue1 - where existing
shareholders are offered new shares on a pro-rata basis (e.g. a company may offer one new share for every
10 existing shares held – known as a “1-for-10” offer).
Shareholders are not, though, obligated to purchase these new shares and can elect to forfeit their rights
by not participating (in some cases, investors are compensated for giving up those rights, usually through a
renounceable issue where the rights to the offering can be traded on a market or cleared through a
bookbuild).
This means that in any raising there is an inherent risk that the amount of capital sought will not be
achieved: the shortfall risk. Such a shortfall may leave the company in a precarious position if, say, the
additional capital is urgently required to repay debt and remain solvent.
Companies commonly mitigate that risk by underwriting the rights issue – having a third party, the
underwriter, guarantee that the full amount will be raised by agreeing to purchase, or arranging the
purchase, of any unallocated shares. In exchange for this guarantee, companies pay an underwriting fee,
typically around 2 per cent of the amount being raised to the underwriter. In effect, this agreement
transfers the shortfall risk from the company to the underwriter (who may then pass on that risk to a sub-
underwriter).
1 Sometimes rights issues are called entitlement offers. There are different sub-categories of rights issue which can be either renounceable or non-renounceable. Practitioners also
use terms like AREOs, NREOs, REOs etc. This research considers all sub-categories of underwritten rights issues.
Underwriting of rights issues, cost versus value: June 2014
5
Underwriting fees are a direct cost to investors, including ACSI member funds, as the ultimate owners of
the entities raising capital. For example, if the company pays 2 per cent of the amount raised in
underwriting fees then, at best, only 98 cents in each dollar raised from the share sale actually reaches the
company.
ACSI’s view, reflected in its Governance Guidelines2, is that boards should seek to minimise the costs of
raising new equity, and to ensure that the fees paid to advisors, including underwriters, reflect the actual
value delivered and the risks incurred.
Comparing actual cost with the value of the shortfall risk
This study values (or prices) that shortfall risk using a benchmark model, first developed and applied in the
UK by Paul Marsh and, later, in Australia by John Handley3, and then compare it with actual prices paid to
underwriters. The benchmark model is based on the premise that, since underwriting agreements give the
company the right to sell its shares to the underwriter at a predetermined price, they are akin to a put
option bought by a company.
As such, an option pricing model (specifically, the Black Scholes Merton model4) can be used to price the
shortfall risk.5 The four key drivers of the benchmark model value are the discount between the share
price and issue price, volatility of returns, the length of the offer and dilution.6
The value from the benchmark model is then compared to the actual underwriting fees paid by companies
to determine if there is a premium relative to the benchmark model value. If this is the case, it suggests
that on average companies are paying too much relative to the actual risk inherent in the underwriting.
Only rights issues are considered because, under the ASX Listing Rules, underwriting fee disclosure is not
required to be disclosed for other types of underwritten equity raisings like placements.
Care is taken in selecting the inputs into this model, with several modifications being applied in an effort to
make the most accurate (and conservative) assumptions. The robustness of the results is also checked
using different inputs.
The study covers 63 rights issues conducted by S&P/ASX300 member companies between 2010 and 2012,
split into three components:
understanding the average underwriting premium being paid (if any)
analysing whether there is a relationship between amounts paid and risks incurred; and
incorporating some other possible risks that may be being considered, but which the benchmark
model does not capture.
2 The ACSI Governance Guidelines are available here. 3 Marsh (1980) (Marsh is currently at Emeritus Professor of Finance at London Business School) Handley (1995) (Handley is currently Associate Professor of Finance at the University of Melbourne) 4 More commonly called the Black-Scholes model. Robert C. Merton was also instrumental in developing the model, so modern academic texts typically include his name as well. 5 As explained in the body of the research, there are modifications applied to the standard option pricing model in particular to take into account the fact that the underlying shares are newly issued. Dilution is an additional factor that is not relevant for standard options traded on the secondary market (i.e. when the company itself is not a party to the contract). 6 As explained in the body of the research, the other (less material) drivers are the risk free interest rate and the actual cost paid.
Underwriting of rights issues, cost versus value: June 2014
6
Study outcomes
On average there is a statistically significant underwriting premium of 46% relative to the benchmark model value. Equivalently, in dollar terms there is an aggregate premium of around $172m over the three years, or an average $2.7m per capital raising. In aggregate, the total fees across the market are more than
double the benchmark model value. This premium is not generally observed in options traded on the ASX.
The current cost of underwriting a rights issue is around 60% more than it was 20 years ago when the Handley study was done. This is despite innovations that, in particular, have dramatically reduced the time
required to complete a rights issue (and therefore the risk borne by the underwriter).
Comparisons were also made between rights issues where all of the four key drivers (discount, volatility,
time and dilution) of one issue suggested that it was more risky than the other. Clearly, when each key risk
driver suggests greater shortfall risk, that company should pay more. Among the sample, however, there were 37 cases where companies paid the same - or less - than their apparently less risky comparators. This suggests that some companies are not adequately informed about some key aspects of the shortfall risk
that they are transferring, or about how much other companies have recently paid and, therefore, how much they should pay. In other words, there appears to be inconsistency in amounts paid compared to risks incurred. Companies
appear to be relying on a roughly 2 per cent fee heuristic, rather than a theoretical understanding of the risk they are seeking to mitigate. The result is companies paying similar fees even though the underlying
risks vary markedly between rights issues.
Obviously, the benchmark model may not capture all the risks that underwriters could potentially face during a particular rights issue. As such, further analysis is done on other potential explanations for the
underwriting premium, relative to the benchmark model value. Specifically, analysis evaluates the dollar size of the raising, liquidity, market conditions, underwriter reputation and the purpose of the raising. The
results suggest that none of these factors sufficiently explain the premium. Instead, the additional analysis suggests that two of the four key risk factors already part of the benchmark
model may be mispriced. Specifically, the underwriting premium is largest for companies that undertake
deeply-discounted rights issues over a relatively shorter period.
Recommendations
A 2011 review by the Office of Fair Trading in the UK, on excess in underwriting fees, found that it “can be
tackled most effectively by companies and shareholders doing more to achieve more cost-effective outcomes”. In a similar vein, this study makes recommendations for three groups of market participants who can help companies achieve more cost-effective outcomes in this area.
1. Company directors should appropriately oversee the capital raising process. They should understand the model used by the underwriter to determine its fee, the assumptions that go into this model and whether the premium (if any) is appropriate. Directors should also be aware that
previous research has suggested that past relationships with underwriters are associated with higher premiums and, so, should consider offering others the opportunity to tender for underwriting.
Underwriting of rights issues, cost versus value: June 2014
7
2. Investors should first understand the potential loss of value from poorly negotiated underwriting
agreements. They should develop a policy on capital raisings and query the board oversight of the
capital raising process, as well as underwriter selection and fee negotiation. Where relevant, they
should also consider underwriting fees when deciding on proxy voting resolutions regarding capital
raisings. Some may also consider opposing director elections if they believe overall board oversight
of capital raisings to be poor.
3. Rule makers can have a role to play in both enhancing disclosure and continuing to improve the
efficiency of the rights issue process. First, the ASX Listing Rules should be modified to require
disclosure of underwriting fees for share placements in the same way as currently applies to rights
issues. This improved transparency will allow analysis (such as this study) to be applied to
placements, not just rights issues. Second, ASX should continue in its efforts of shortening the
rights issue timetable, since shorter timetables should mean less costly underwriting.
Underwriting of rights issues, cost versus value: June 2014
2. Introduction
8
ACSI’s motivation for undertaking this research
The project has its genesis in the 2013 ACSI Governance Guidelines, which state:
“Boards should seek to minimise the costs of raising new equity and to ensure the fees paid to
advisors, including investment banks and underwriters, reflect the actual value delivered and
the risks incurred.”
The project’s primary aim is to see whether this occurs in practice.
Background to underwriting of rights issues in Australia
As noted in the executive summary, when conducting rights issue companies commonly mitigate shortfall
risk by underwriting the issue. In exchange for the underwriter guaranteeing to buy any unallocated
shares, the company pays an underwriting fee of typically around 2 per cent of the amount being raised. In
effect, this agreement transfers the shortfall risk from the company to the underwriter.
Management fees are also paid to external advisors (typically the same party as the underwriter) for
services including determining the appropriate pricing, timing and administration of the rights issue and
finding investors willing to participate in the case of placements and rights that have been forfeited. This
research focuses on underwriting, and so only the underwriting fees are considered henceforth.
Underwriting fees are expressed as a percentage of the funds to be raised. For example, a 2% underwriting
fee for a $100m rights issue means the dollar cost of underwriting is $2m.
The following graph shows the underwriting fees paid among the sample of 63 ASX300 rights issues
between 2010 and 2012, split into buckets (with a ±0.2% catchment for each bucket).
The aggregate cost of underwriting the 63 rights issues was just over $300m.
0
5
10
15
20
1.2% 1.6% 2.0% 2.4% 2.8% 3.2% 3.6% 4.0% 4.4% 4.8% 5.2%
Nu
mb
er
of
rais
ings
Underwriting costs (±0.2%)
Underwriting of rights issues, cost versus value: June 2014
9
Past research
As explained below, past research in Australia, New Zealand and the UK suggests that companies are paying underwriting fees significantly in excess of the value of the risk borne by the underwriters. A recent investigation in the UK, discussed below, suggests better company and investor oversight as the most effective tools to achieve a fairer, more cost-effective outcome. ”The Pricing of Underwriting Risk in Australian Rights Issues”
The foundation of this research is from a 1995 Australian study by John Handley.7 Handley’s research was based on a 1980 study in the UK context by Paul Marsh.8 Handley used a benchmark model to estimate the value of underwriting agreements and compared this to what companies actually paid. Handley found there was a premium on average of around 49% above the model value. Marsh’s UK study found a 100% premium on average. A similar study found that in New Zealand the premium was 900% on average.9 In the Australian study, the rights issues with higher underwriting premiums include those:
using leading10 underwriting firms that had prior relationships with the company lower volatility companies; and those that undertook raisings at deeper discounts to the prevailing share price.11
“Equity capital raisings in Australia during 2008 and 2009” and “Equity Capital Raising by the ASX300 post-GFC”
Research conducted by Martin Lawrence and Simon Connal12 (who are currently Ownership Matters principals) in 2010 found that through the global financial crisis equity capital raisings cost companies around 2% of the amount of equity capital raised in underwriting and advice fees. While these results may appear intuitively high, this study did not explicitly value the underwriting agreement to make a comparison. In 2013, Ownership Matters released a follow up study13 which found that although more companies are choosing rights issues they are paying even more in fees than during the uncertain conditions of the GFC.
Investigation by UK competition regulator
In 2011, the UK’s Office of Fair Trading (the country’s competition authority/regulator) investigated underwriting fees in the UK.14 It found there was little effective competition on fees, but that this did not result from poor competition or a lack of providers. Rather, the OFT suggested that buyers of underwriting services (i.e. companies) were allowing themselves to be overcharged. Its suggestion was that shareholders could help in providing the solution:
“[the issue] can be tackled most effectively by companies and shareholders doing more to achieve more cost-effective outcomes.”
7 John C. Handley (1995) “The Pricing of Underwriting Risk in Relation to Australian Rights Issues”, Australian Journal of Management, 20, 1, 1995, June.
8 Paul Marsh (1980) “Valuation of underwriting agreements for UK rights issues”, Journal of Finance, 35, 3, June, 693-716. 9 RJ MacCulloch and DM Emanuel (1994) “The valuation of New Zealand Underwriting Agreements”, Accounting and Finance, 34, 2, November 21-34.
10 In terms of market share.
11 Subsequent critiques have questioned the validity of these results because of the model inputs used. The present research takes all known critiques into account. 12 Martin Lawrence and Simon Connal (2010) “Equity capital raising in Australia during 2008 and 2009”, ISS 13 Simon Connal (2013) “Equity Capital Raising by the ASX300 post-GFC: Too much is never enough”, Ownership Matters 14 Office of Fair Trading (UK) (2011) “Equity underwriting and associated services: an OFT market study”
Underwriting of rights issues, cost versus value: June 2014
3. Methodology and Data
10
Underwriting is a financial option
The theoretical foundation of this research is from a 1995 Australian study by John Handley, who estimated
a value of the underwriting agreement using a model based on option pricing theory.15
The academic literature discussed above recognises that an underwriting agreement is like a put option
bought by the company from the underwriter. If there is a shortfall, the company has the option to
exercise the put and sell the shares (i.e. any shortfall) to the underwriter at the issue price (in options
language: the exercise price).16
The Black Scholes Merton option pricing model, adjusted for the fact that the underlying asset is a newly-
issued share, can be used to determine the benchmark model value. This can then be compared to the
actual price to determine if there is a premium.
The following gives a brief overview of the six parameters (alternatively called “risk factors” and “inputs” in
this paper) that should drive the model value of the option. While the language used is specific to
underwriting, the principles are those of standard Black Scholes Merton option pricing model.
The methodology is explained below using a fictitious, simplified example. Suppose ABC Co’s shares were
trading at $11 and they decide to undertake a 1-for-2 renounceable rights issue for $10 per share. The
announcement is made on 1 January and the offer closes on 31 January. The stock returns 12% per annum
(1% per month) and the volatility of returns on the company’s shares is 26%, which means that there is a
95% chance that on 31 January the share price will be between $9.46 and $12.76.17 There are one million
shares on issue. The underwriter will receive 1% of the offer proceeds as a fee for underwriting the issue.
A visual representation of this example is:
15
Note some research in this area uses “fair value”. To avoid any connotations associated with the word “fair”, the more neutral terms “value” and “benchmark model value” are
used throughout. 16
In contrast to options between two investors, the underwriting agreement involves newly issued shares and the company itself as one of the counterparties. This type of option is typically called a “warrant”. This research uses the more generic and familiar term “option”. 17 Assuming a Normal distribution, there is roughly a 95% chance of the return falling between two standard deviations of the mean. In this example, the volatility (aka standard
deviation) of returns is 26% (or 7.5% per month) and the mean is 1%. Therefore, the so-called 95% confidence interval is between -6.5% and 8.5%.
$9
$10
$11
$12
$13
Start (1 Jan) End (31 Jan)
Pri
ce
Time
Issue price
Current share price Expected share price at offer close
There is a 95% chance that the share price will be in this range.
Shortfall area
Discount
Underwriting of rights issues, cost versus value: June 2014
11
The risk from the underwriter’s perspective is that the share price at the end of the period is in the
‘shortfall area’, where the current share price is less than the issue price. In this circumstance, it would be
cheaper to simply buy more shares in the secondary market from other sellers than to buy them from the
company by participating in the rights issue. Investors will not subscribe to the issue and the underwriter
will have to buy the shares at the issue (and then try to sell them at the lower market price). In short, the
larger the shortfall area the more valuable the underwriting to the company (and the more they should
be willing to pay).
Factors that determine the value of underwriting
As stated above, there are four general risk factors that determine the risk of a shortfall (two of which
apply specifically when the new shares are being issued from the company). The following tables state
these and outlines situations where underwriting should be more valuable to companies.
All else equal, underwriting is more valuable to the company when the…
Explanation
…discount is smaller.
Using the graph on the previous page, the discount is the size of the blue bracket. It is a function of the current share price and the issue price.
Companies can decrease the discount by offering shares at a higher issue price, which is the equivalent to the red square moving up on the graph. Clearly this would increase the shortfall area.
…volatility is higher.
Volatility is a measure of how much the share prices and returns change. A high volatility share has a high probability of large swings in returns over a given period.
In the previous graph, increasing volatility is the equivalent of the orange bracket becoming larger, which also causes the shortfall area to become larger.
…length of the offer is longer.
The longer the rights issue is on offer, the more uncertainty there is about the future share prices. In other words, the range of possible share prices is bigger, and so too is the possibility of a shortfall.
In the previous graph, this would again be equivalent to the orange bracket becoming larger but it is caused by the end date moving from 31 January to a later date.
…(risk free) interest rate is lower.
The potential payment of the issue price by the underwriter is a payment in the future. If the risk free (or government backed) interest rate is high, the underwriter would have to set less money aside at the Start to make the payment of the issue price at the End. If this is the case, companies should pay less.
This is a relatively unimportant parameter generally because the offer period is typically relatively short.
Underwriting of rights issues, cost versus value: June 2014
12
Handley shows that in underwriting two further parameters determine the value of the model. They are important because unlike typical options trading, the company itself is a party to an options transaction on its own shares and the shares are newly issued.
All else equal, underwriting is more valuable when the…
Explanation
…dilution is low.
Dilution is the proportion of shares issued to the proportion of shares currently outstanding. In the example above, dilution is 50% (1 new share for every 2 shares held).
Recall that the underwriter will potentially receive new shares in the company. The more new shares the company issues, the more dilution and hence less that each share represents in terms of proportionate ownership of the company’s equity. The lower the proportionate ownership that the underwriter may ultimately receive per share (i.e. the more dilution), the less the underwriter values each underlying share that they may get. If the company is aware of this, they should pay less for the option.
…total transaction costs are higher.
If the underwriter takes up any shortfall, the newly issued shares that they receive will reflect ownership in a company that has just had a cash outflow, namely of the transaction costs. This includes the actual underwriting cost itself.
Typical options trading (i.e. between parties that are not the underlying company itself) do not have this issue because trading options does not affect the company’s own cash flows.
This is a relatively unimportant parameter generally because the cost is typically small relative to the company’s overall size.
The preceding section has only presented the directional (up or down) changes in the underwriting cost given a change in one of the six parameters. More precisely, the formula used by Handley to calculate the value is:18
( ( ) )
( )
(1)
where:
is the value suggested by the benchmark model ( ) is a put option calculated using the Black Scholes Merton model is share price is issue price is the actual underwriting cost paid by the company is dilution (the new shares issued divided by the number of current outstanding shares) is volatility is the length of the offer period19 is the risk free interest rate.
18
For further technical insights on how to calculate the benchmark model value or further theoretical background, assumptions and proofs should consult the primary sources. 19
Note that there are two versions of time used in the formula (taking into account the trading days and calendar days). This is done in the same was as in Handley. See that paper
for further details. Also, when the rights issue was “accelerated” – where it had a separate institutional and retail component – the dollar value of underwriting for each component
was calculated separately then added. See Appendix A for further details.
Underwriting of rights issues, cost versus value: June 2014
13
Adaptations to the framework
Subsequent academic papers have generally accepted the overall validity of the framework, instead
focussing critiques on the key risk factor measures used. Based on these critiques, three adaptations were
made to the risk factors before running the benchmark model. The detail of these adaptations is in
Appendix A. Based on the discussion in Appendix A, the following parameters were used as inputs into
formula (1) above:
is the actual share price on the first trading day after the announcement, adjusted for dividends
(see Appendix A)
is the issue price
is the actual underwriting cost paid by the company
is dilution (the new shares issued divided by the number of current outstanding shares)
is 180 day historical return volatility, increased/adjusted for “volatility skew” (see Appendix A)
is the time between the announcement of the offer and offer close (see Appendix A)
is the 30 day20 bank accepted bill rate.
At the outset it should be noted that the methodology was run on a variety of parameter inputs and the
results from using different inputs are presented in Appendix B.
Data
Ownership Matters generously provided data on rights issues among the ASX300; including underwriting
cost (using ASX Appendix 3B announcements), announcement dates, close dates, dilution, issue price,
purpose and underwriter. This was supplemented with additional data collection directly from ASX
announcements.
Share price and dividend data was obtained through Yahoo! Finance, uses Capital IQ and Commodity
Systems Inc. (CSI). Underwriter market share data was obtained from the Bloomberg 2012 Global Equity,
Equity Linked & Rights League Tables survey. Implied volatility and exchange traded option data was
obtained from the share tables at afr.com. Bank accepted bills data were obtained from the Reserve Bank
of Australia website.
20 Handley uses a 90 day rate, noting that this is most aligned with the typical rights issue. Given contemporary rights issues are done over a shorter time horizon (as discussed), the
30 day rate was favoured.
Underwriting of rights issues, cost versus value: June 2014
4. Results
14
Aggregate result
There were 63 underwritten rights issues in total, each involving rights issues by ASX300 companies between 2010 and 2012. The results are as follows:
Actual cost (α) Value (αFV) Difference (%) Premium (%)
Simple average 2.4% 1.7% 0.8% A 46%
Weighted average percentage * 2.1% 0.9% 1.2% A 127%
Aggregate dollar amounts $308m $136m $172m A 127%
* weighted by the total amount raised A
Statistically significant at the 1% confidence level.
These results show that on average there is a significant difference between the actual cost paid and the value derived from the model. From the table above, between 2010 and 2012 ASX300 companies paid around $172m more in underwriting fees than the model value, or around $2.7m per raising on average. Results with alternative model parameters are presented in the appendices. While obviously the size of the premium changes, each of these results are still statistically significant and positive. Note that the premium in the simple average is 46%, which is lower than the 49% premium found by Handley (1995). This may reflect the more conservative assumptions on the appropriate discount and volatility.
Consistency of individual outcomes
When each individual rights issue is considered, there are a wide variety of outcomes. The following graph plots each rights issue as a dot, with the underwriting fee paid as the horizontal x axis and the model value as the vertical y axis. The dots above the red line represent good value for money underwriting and the dots below represent poor value for money underwriting, according to the model.
This graph shows that while there is a clustering of actual underwriting fees (around 2%) there is a lot of divergence from value. In fact, value exhibited three times the variability of the actual costs paid. The most extreme cases involved companies that paid the same amount or less in underwriting but one company was more risky for the underwriter based on each key risk factor: specifically a smaller discount21, higher volatility, longer maturity and smaller dilution. In fact, in the data there were 37 such instances where one raising was more risky in each of the four key ways but they either paid the same amount or the less risky company paid more.
21 To the TERP and announcement factor adjusted share price.
0%
2%
4%
6%
8%
10%
0% 2% 4% 6% 8% 10%
Val
ue
of
be
nch
mar
k m
od
el
Actual underwriting fee paid
poor value for money
good value for money
Underwriting of rights issues, cost versus value: June 2014
15
To illustrate, consider the following two companies in the ASX200 which both paid 2% in underwriting. Recall
the discussion above regarding the effect of changes in the risk factors.
Parameter/risk factor
Raising A
Raising Z
All else equal, underwriting should cost more for…
Which should cost
more?
Discount (adjusted as above) 15% 7% smaller discount Raising Z
Volatility (adjusted as above) 47% 49% larger volatility Raising Z
Time to maturity (weighted
average between institutional
and retail)
6 days 21 days longer time Raising Z
Dilution 1 for 12 1 for 16 lower dilution Raising Z
Risk free interest rate 5% 4% lower interest rate Raising Z
In each of these ways, Raising A should be cheaper than the Raising Z but in fact both companies paid the same
amount. Both raisings provided poor value for money according to the model.22
As an even stronger example, consider the following two companies. The company undertaking Raising B paid
more, but had an underwriting agreement that was lower risk in every way.
Parameter/risk factor
Raising B
Raising Z
All else equal, underwriting should cost more for…
Which should cost
more?
Actual cost 2.5% 2%
Discount (adjusted as above) 9% 7% smaller discount Raising Z
Volatility (adjusted as above) 35% 49% larger volatility Raising Z
Time to maturity (weighted
average between institutional
and retail)
7 days 21 days longer time Raising Z
Dilution 1 for 7.2 1 for 16 lower dilution Raising Z
Risk free interest rate 5% 4% lower interest rate Raising Z
22
Interestingly, the underwriter of the relatively less risky rights issue was also a substantial shareholder. See “Information asymmetry between company and underwriter and prior relationships” below for further analysis.
Underwriting of rights issues, cost versus value: June 2014
16
Comparison with 20 years ago
As a check of this result, the following compares the prevailing circumstances in relevant to the current
research (“Now”) versus when the original research was done (“Then”). The following table shows that the
time frames, number of rights issues considered and the amount raised are broadly similar and that the
amount paid is around 60% more now compared to twenty years ago.
Parameter Then Now
Time frame 3 years ending June 1993 3 years ending December 2012
Number of rights issues 60 63
Amount raised (inflation adjusted to 2012)23 $12.2bn $14.9bn
Average actual underwriting fee paid 1.56% 2.50%
The table below shows the average of each of the key parameters during the two time periods.
Parameter/risk factor Then Now
All else equal, underwriting should cost more for…
Which should cost more?
Average discount (pre-
announcement)24
20.6% 17% smaller discount Now
Volatility (adjusted as above) N/A 63% larger volatility ?
Time to maturity (weighted
average between institutional
and retail)
60 days
15 days
longer time
Then
Dilution N/A 29% lower dilution ?
Average risk free interest rate25 8.9% 4.4% lower interest rate Then
Premium to value26 49% 203% lower interest rate Then
The table shows that while the average discount is slightly lower now, the typical offer is now four times
shorter than 20 years ago. In other words, the “at risk” period has reduced by a factor of four. Interest
rates also suggest underwriting should be cheaper now. Unfortunately, however, given a lack of data on
volatility and dilution it is difficult to draw conclusive results from this analysis.
However, using the same risk factor inputs as in the Handley research yields a premium of just over 200%
as compared to 49% in 1993 (see Appendix B for further details). This suggests that underwriting is even
more expensive relative to the risks transferred as compared to the 20 years ago.
23 Using inflation data from the Australian Tax Office and comparing June 1993 with December 2012. The data is available here. 24 To ensure consistency with Handley, the discount off the dividend adjusted pre-announcement price is taken rather than the approach which takes into account the
announcement factor and TERP. 25 Risk free is not as important as the others when the option expiry is so short. 26 This uses identical inputs to the original Handley research; see Appendix B for further details.
Underwriting of rights issues, cost versus value: June 2014
17
Potential drivers of underwriting premiums: size, liquidity, market conditions, reputation and purpose
Obviously, a relatively simple theoretical model may not capture all the particular circumstances facing
companies and factors other than discount, volatility, time and dilution may be important. As such, this
research considers the following additional factors:
Size of raising
Liquidity of underlying stock
Market conditions
Underwriter reputation
Purpose of raising
The discussion also considers whether these are legitimate costs to be included as part of the underwriting
component of the fee, remembering that companies also pay a management fee.
Size of raising
According to Handley, underwriters find it more difficult to underwrite a larger capital raising because it
becomes more difficult to reduce the risk through sub-underwriting. As such there may be an entirely
legitimate “size of raising” factor whereby larger raisings cost more on a proportional basis. This suggests a
positive relationship with the level of excess.
On the other hand, larger companies have a higher profile among investors and if they are included in
indices they may be within the investable universe of more fund managers.
Of course, rights issues by definition offer shares first to existing shareholders, who should know the
company. However, the bookbuild process for forfeited rights would involve new shareholders and it may
well be more difficult to find other investors at smaller companies.
Additionally, since larger raisings are typically done by larger, better resourced companies potentially they
may be better able to negotiate a lower fee.
In summary, the size of the raising may be important but it is difficult to say in which direction.
Liquidity of underlying stock
If the rights issue fails, the underwriter has to take up a large proportion of the company’s shares which,
presumably, it does not want. The ability and speed with which the underwriter can then sell shares in this
situation depends on the liquidity of the underlying stock.
In the analysis, the 30 day liquidity prior to the raising is used. It is calculated as the turnover of the
company’s stock (total dollar volume of shares traded divided by the average market capitalisation during
that time).27 The expectation is that underwriters of lower liquidity companies would recognise the
additional difficulty of selling shares in an illiquid stock and would price that in. This suggests a negative
relationship between liquidity and excess returns.
27 This assumes that liquidity does not change, or a uniform change occurs along all companies, after the raising.
Underwriting of rights issues, cost versus value: June 2014
18
Market conditions
Handley suggests that market conditions (whether bullish or bearish) may have an effect. Specifically, in bearish
markets where investors are more cautious about committing additional funds there is a greater risk for the
underwriter for which they should be compensated.
However, recall that the model (as previously specified) potentially already captures this risk because of the
impact of volatility. In bearish markets, volatility would be higher and so too would the benchmark model value.
In this analysis, the recent (30 day) historical returns and the volatility of the ASX200 are included. If these are
important, excess returns would be greater during low recent returns and high recent volatility.
Purpose of raising
Each of the rights issues considered can be roughly split into two underlying purposes , namely to fund a new
project or acquisition or to pay down debt or fund working capital. If, for example, the company is seeking to
undertake a large equity raising to pay down debt, particularly where there is a covenant breach, this is likely to
be less favoured by the market. As such the underwriting risk may be greater when the rights issue is to pay
down debt. With the variable specified with 1 being assigned to new projects/acquisitions and 0 otherwise, this
would suggest a negative relationship.
However, again it is worth noting that the model previously specified took the share price after the
announcement and so should already incorporate any market reaction to the news.
Underwriter reputation
Handley also considered whether the underwriter’s reputation determines the premium that they can extract
from companies. Attaching the offer to a more reputable underwriter may well enable the company to achieve
greater demand for its shares and may have benefits in terms of the quality of their share register and the ease
of underwriting. Companies know this and they are willing to pay more.
This aspect is an entirely legitimate additional cost for companies to consider paying, but it clearly falls within
the management aspect of the underwriter’s role, not the underwriting itself. In fact, if the underwriter’s
reputation makes the raising less risky as described above, it would be expected that more reputable
underwriters should charge less for underwriting (but more for management).
Market share of ECM (equity capital markets) business, as collated by Bloomberg, is used to proxy for the
underwriter’s reputation. A dummy variable was created where a “top underwriter” status is assigned for the
top 3 ECM firms by market share in any year. This provided a reasonable mix among the sample. (Unfortunately,
this data was only available for 2011 and 2012 so it is assumed that these top underwriters were the same in
2010.)
Original benchmark model variables
As in the Handley research, to check whether there is proper pricing of the core factors in the model (being the
discount, time, risk free rate and volatility), they are all included again in this analysis. If the market is properly
pricing each of these factors, they will not be statistically significant. (Note that dilution is not separately
included because, holding market capitalisation constant, the size of raising is a linear function of dilution.)
Underwriting of rights issues, cost versus value: June 2014
19
A regression was set up with the following specification:
In other words, this analysis tests whether the excess fee, or premium, can be explained by:
Parameter/risk factor Measurement
Purpose Dummy variable; 1 if purpose is to undertake a new project or acquisition, 0 otherwise
Underwriter reputation Dummy variable; 1 if underwriter was in the top 3 underwriters by market share during 2011 or 2012, 0 otherwise28
Size Dollar amount raised (transformed into a natural log)
Liquidity Dollar turnover of the company’s stock as a proportion of its market cap
Mkt Conditions Return Continuously compounded return on the ASX200 in the 30 trading days preceding the announcement
Mkt Conditions Risk Volatility (standard deviation of returns) of the ASX200 in the 30 trading days preceding the announcement
and/or the following factors, that have already been incorporated into the benchmark model:
Discount Percentage discount between issue price and share price immediately after
announcement (adjusting for dividends and TERP, as necessary)
Values are presented as negatives
Vol 180 day historical volatility of returns on the underlying stock
Time Days between announcement and offer close, weighted by the proportion
Risk free 30 day bank accepted bill rate at the time of announcement
A linear regression of these variables yields the following results:
Prediction Coefficient t-Stat29 p-value
Intercept None 0.025788 0.70 0.685
Purpose Negative 0.004001 1.03 0.308
Underwriter reputation Negative -0.002 -0.51 0.613
Size Positive -0.00028 -0.08 0.934
Liquidity Negative -0.0006 -0.81 0.420
Mkt Conditions Return Negative 0.058555 1.39 0.171
Mkt Conditions Risk Positive -0.02096 -0.51 0.609
Discount No relationship -0.12262 -3.35 0.002
Vol No relationship -0.0286 -1.75 0.087
Time No relationship -0.25759 -2.10 0.040
Risk free No relationship 0.167695 0.42 0.677
28 An interaction term between the purpose and underwriter’s reputation was also added and tested. This did not alter the outcomes. 29 These are calculated using robust standard errors to correct for heteroskedasticity in the data.
Underwriting of rights issues, cost versus value: June 2014
20
Note that there was little explanatory power any of the new factors proposed (i.e. each of purpose,
reputation, market capitalisation, liquidity and market conditions were statistically insignificant). The
statistically significant factors were the discount and time.
The additional insight from this analysis is that it can shed light on the specific characteristics of a rights
issue that are most prone to a large underwriting premium. Specifically, the characteristics are deep
discounts and rights issues with shorter timetables or (because time is weighted by the institutional and
retail components) larger institutional shareholdings.
The fact that discount and time to offer close are explaining the level of excess suggests first that they are
indeed the most important determinants of what companies actually pay. However, to repeat, these
factors have already been incorporated into the benchmark model.
It is worth noting that this result is similar to the Handley research, which found that “excess returns are
associated with lower volatility and deeper discount issues”. While volatility now appears to be properly
priced, the length of the offer is now not.
Other potential drivers of underwriting premiums that were not examined
Management costs
There are obviously many other important functions performed by underwriters. These include preparing
all the associated documentation, determining pricing, gauging market appetite and timing, finding new
investors, ensuring the stock trades well in the secondary market after the issue and many others.
However, the total fees paid are split between management and underwriting and all of the items
described above clearly fall into the management component of their service. As such, these are not
relevant considerations for the underwriting component of their service.
Disclosed versus actual costs
When the announcement of a rights issue is made, the underwriting fee is disclosed to the ASX according
to the ASX Listing Rules in a form called Appendix 3B. The final audited fee can then be determined from
the company’s annual report.
Comparing Ownership Matters’ data on the audited fees versus the fees disclosed at the time in Appendix
3B yields the following:
Average total fees as disclosed in Appendix 3B: 3.12%
Audited total fees as disclosed in annual report: 3.47%
Difference: 0.35% (this is significant at the 1% level)30
30 This analysis includes 53 raisings where data was available. Raisings where fees are not applied in a uniform way are excluded.
Underwriting of rights issues, cost versus value: June 2014
21
This suggests that underwriting and management together ends up costing around 11% more than what is
disclosed up front. If this is the case for the underwriting component then the results above are
understating the true premium to the benchmark model value.
However, it’s unclear which of those two components actually end up costing more than disclosed. Also,
the audited fees are aggregated in annual reports and do not provide the split between underwriting and
management required to perform analysis of just underwriting fees. They may also include other fees (such
as legal fees) but these are typically immaterial.
Termination clauses
Underwriting agreements typically include clauses that enable the underwriter to terminate the agreement
if certain adverse events occur throughout the underwriting period. The option to terminate clearly
reduces the risk for the underwriter.
As one example, the June 2012 capital raising by Ten Network Holdings included (among others) the
following termination triggers for its underwriter:
material disruptions in the financial, political or economic conditions in key markets
delays in the timetable without the underwriter’s consent
an adverse change to the business, operations, prospects, management, financial position,
earnings position or shareholder’s equity relative to the position as at announcement
a drop in the ASX200 by 10%.
This effectively shields the underwriter from having to take up a shortfall if there is a materially adverse
market or company specific event. It appears therefore that this would shield them from the most adverse
outcomes and as such, companies should pay less.
Although these termination triggers are noted as “customary” in the Ten Network Holdings disclosure and
others, the uniqueness or otherwise of the particulars of such arrangements was not studied further.
Information asymmetry between company and underwriter and prior relationships
Handley also suggests that the existence of a prior relationship with the underwriter may reduce
information asymmetry between the relatively uninformed underwriter and the company, which has
superior knowledge of its operations. As such, the prediction is that the existence of a past relationship
between the underwriter and the company reduces the premium or excess. However, Handley found the
opposite effect – specifically that excess fees were generated precisely when there were prior relationships
(although only in the case by ‘top underwriters’).
Given data collection and time constraints, this argument was not explored in detail.
However, the following case study provides evidence consistent with Handley’s results.
Underwriting of rights issues, cost versus value: June 2014
22
Recall the table at the top of page 15 where two companies paid the same for underwriting yet one was
less risky in four key ways. In the less risky raising, the underwriter was also a substantial shareholder and
had board representation. Clearly, information asymmetry would not be relevant in this case. However, as
the analysis above showed, this company paid in excess of benchmark model value. This case suggests that
when the underwriter is close to the company, it may be a situation of the underwriting premium being
even bigger than otherwise. The underwriter in this case was one of the ‘top underwriters’, which is
consistent with past results. Obviously, no firm generalisations can be made given this is one case study.
Expected take up and soft soundings
Adverse selection is a phenomenon where there is information asymmetry between (well informed)
companies and (poorly informed) potential new investors. If potential new investors subscribe to a “bad”
offer they may be disheartened by the experience and withdraw from the market altogether. Companies
know this and in order to induce new investors to subscribe may seek to use underwriting to certify the
offer/lease its brand name.
Given rights issues are only offered to new investors if existing investors decline to participate, this effect is
larger (and the cost to underwrite should be greater) if current shareholders do not participate. Therefore,
underwriting should cost more for companies where there is lower expected current shareholder
participation.
Additionally, it is likely in modern capital raisings that the largest shareholders and potential new
shareholders were already contacted confidentially prior to the raising (so called ‘soft soundings’).
According to a recent investigation by the Australian Securities and Investments Commission (ASIC), this is
the usual practice and “involves a lower level of risk for the underwriter. In practice, this means that
investment banks and brokers will not usually sign an underwriting agreement unless they have sufficiently
sounded the market to their satisfaction.”31 As such, the underwriter may potentially have informal
agreements from the market for the full raising before they sign the underwriting agreement. In these
circumstances, their risk is negligible.
Finally, in many cases the participation of a major shareholder is announced as part of the market
announcement. Below is one such example from Ten Network Holdings’ June 2012 rights issue:
In Handley, the percentage of total shares held by the top 20 shareholders was used to proxy for the
expected take up. Given the increasing use of pooled nominee accounts by custodians which do not
disclose beneficial owners, this proxy was deemed insufficiently accurate and the issue was not explored
further.
31
Australian Securities and Investments Commission, (2014) “Report 393: handling of confidential information: briefings and unannounced corporate transactions” (available here – see paragraph 205)
TEN Managing Director and Chief Executive Officer, James Warburton, added: “[..] In a strong endorsement of our
turnaround strategy, four of our major shareholders accounting for approximately 43% of the shareholder register
have committed to take up their entitlements in the Entitlement Offer. Those shareholders are interests
associated with Bruce Gordon, Lachlan Murdoch, James Packer and Gina Rinehart.” (emphasis added)
Underwriting of rights issues, cost versus value: June 2014
23
Sub-underwriting
Sub-underwriting is where the head underwriter agrees with other institutions that they will take a portion
of the shares in case there is a shortfall. The underwriter pays a fee to the sub-underwriter for this service.
The existence of an active sub-underwriting community may affect the cost of underwriting for the
company. A large group of sub-underwriters collectively may be better able to withstand having to buy a
large amount of shares from a failed raising; therefore the cost should be lower if sub-underwriters are
used.
There is no data available to ACSI on sub-underwriting and as such it was not explored further.
Underwriting of rights issues, cost versus value: June 2014
5. Recommendations
24
This section highlights the role of three market participants in helping achieve a more cost effective
outcome for companies and their investors.
The role of company directors
Given the above results, the following questions may aid company directors in overseeing capital raisings:
What model does the underwriter use to determine the underwriting fee? What value does it
generate?
What inputs go into this model? Specifically, what assumptions are used regarding discount, time
to maturity and volatility? What other risks are being incorporated?
If there is a premium to what the model suggests as the value of the underwriting and the
proposed fee, is it reasonable?
Handley’s research found that the existence of prior relationships with underwriters on average meant that
premiums were larger.32 This suggests that directors should carefully scrutinise fees when there is a prior
relationship and suggests that, where possible33, affording others the opportunity to tender for
underwriting may lead to more cost effective outcomes because it will build competitive tension between
underwriters.
The role of investors
First, investors should be aware of value loss that can occur as a result of poorly negotiated underwriting
agreements and so should also develop policies outlining their expectations of company executives and
boards in this area.
The ACSI Governance Guidelines34 include a section on its expectations regarding “Capital Raisings and pre-
emptive rights of existing shareholders” (section 7) which may be a starting point for other investors.
There are two main mechanisms through which investors can exercise their ownership rights to ensure
more cost effective outcomes, namely company engagement and voting. These are discussed in turn
below.
Engagement
Directors of most last Australian companies engage meaningfully with investors and investor
representatives like ACSI. Where relevant, that the discussion should also include investors explaining their
policy on capital raisings.
32 As noted above, the current research did not consider this factor given a lack of readily available data. 33
Given the rights issue would be material non-public information, companies would clearly need to consider confidentiality of the information very carefully. In a similar vein, once an underwriter is selected directors should also be aware of ‘soft soundings’ where potential investors of the upcoming issue are contacted to gauge their interest (see ASIC report 393, cited above under the heading “Expected take up and soft soundings”, for further details). Putting the underwriting service to a tender process would also involve a more lengthy process. 34 Available here.
Underwriting of rights issues, cost versus value: June 2014
25
Where the company has recently conducted a capital raising, using the ACSI Governance Guidelines section
7.2 as a basis, potential questions for boards include:
How did the company35 oversee the capital raising process?
How did the company select the underwriter?
How did the company35 negotiate the fees paid to underwriters?
How was the issue price determined?
How was the shortfall allocated?
There are also important broader questions regarding the existing shareholders’ access to the capital
raising that are further explored in the Guidelines.
Timely and informed engagement with the board will demonstrate the importance of the issue from the
investor perspective and hold boards more accountable for their oversight in the area.
Voting
Shareholders do not vote on resolutions involving rights issues. However, under the current ASX Listing
Rules (Chapter 7), where companies undertake placements beyond specific thresholds they are required to
seek shareholder approval or subsequent ratification. Clearly, where the placement is underwritten, one
consideration in deciding whether to support the resolution should be the fees paid to underwriters.
Unfortunately, as discussed below, the current disclosure regime for placements does not sufficiently
enable shareholders to understand fees.
Some investors may also consider opposing director elections based on poor oversight of capital raisings.
The role of regulators and rule makers
ASX Listing Rule Disclosures for placements
This study only considers rights issues despite the fact that many more placements are done – and they can
present greater loss of value to existing shareholders given the discretion to allocate shares to any investor.
However, for underwritten placements there is no requirement to disclose the underwriting cost under the
ASX Listing Rules. For rights issues, the underwriting cost is required to be disclosed to ASX using the
Appendix 3B form. Part 2 of this form, which includes questions 20 and 21 regarding the underwriter and
cost, are only required for pro-rata raisings.
This is an anomalous regime because the capital raising mechanism that has more potential to undermine
existing shareholder rights (through the abandonment of pre-emptive rights) has lower disclosure
requirements. As such, ACSI recommends increasing the disclosure requirements for placements to at least
match those of rights issues. ACSI has advocated this policy position in the past with ASX.36
35 An earlier version of this report erroneously said “board” in these two places, rather than “company”. 36 For example, see point 7 of ACSI’s response to the ASX BookBuild Consultation Paper, available here and page 3 of ACSI’s response to the “Modernising the timetable for rights issues” paper available here.
Underwriting of rights issues, cost versus value: June 2014
26
Shortening the standard timetable for rights issues
In June 2012, ASX released a consultation paper entitled “Modernising the timetable for rights issues:
Facilitating efficient and timely rights issues”.37 The proposal to shorten the standard timetable from 26
days to as short as 18 days was generally supported by the market and has now been incorporated into the
ASX Listing Rules. In discussing the feedback received from stakeholders, ASX noted:
These comments sit comfortably within the theoretical framework used for this research, where the longer
the offer period the more expensive underwriting should be (see “Methodology and Data” above).
In its discussion, ASX noted that further shortening of the timetable is possible but there are barriers,
including the ability to make real-time payments and the current requirement of hard copy dissemination
of disclosure documentation. In its original response to the consultation, 38 ACSI was generally supportive
of both these developments as long term goals and continues to support these given they may also lower
underwriting costs.
37
ASX Consultation Paper (2012) “Modernising the timetable for rights issues: Facilitating efficient and timely rights issues” (available here) 38 ACSI’s response is available here.
There was strong in-principle support from almost all stakeholders for the objective of shortening the
standard timetable for rights issues to improve their relative attractiveness as a mechanism for raising
capital. Some saw the potential for market users to benefit from the expected process efficiencies and
for a reduction in the level of risk associated with possible changes in market conditions during the life
of a rights issue. Others also saw the potential for issuers to secure underwriting more easily and cost-
effectively. (emphasis added)
Underwriting of rights issues, cost versus value: June 2014
Appendices
27
Appendix A: Adaptations to the framework
The following section explains the three adaptations to the benchmark model as compared to Handley.
They are each inputs into the benchmark model formula or, in other words, key risk factors in valuing the
shortfall risk.
Share price
The share price used in the Handley research is the last closing price before the announcement of a rights
issue is made. As noted above, using a lower share price in the model would narrow the premium between
the actual cost and the benchmark model value.
There are at least three reasons why the share price drops on announcement of the offer, namely:
theoretical Ex-Rights Price (TERP) effect
an announcement effect; and
dividends.
Theoretical Ex-Rights Price effect
First, there is the simple mathematical dilutive effect that occurs whenever new shares are issued at a
discount and each has the same proportional ownership of the equity. This new price is called the
Theoretical Ex-Rights Price (TERP) and is commonly quoted in announcements. For the fictitious example in
the section entitled “Underwriting is a financial option”, the TERP is $10.66 (a 3% drop).39
By way of a real example, in the announcement of its 2012 rights issue AGL Limited used the TERP when
discussing its issue price:
However, the model as specified already incorporates this effect through the denominator (1 + q) in the
formula (1). Nevertheless, given that accelerated rights issues do not have a cum-rights trading period (see
below), isolating this effect is now more difficult in practice. As such, the share price is decreased for the
TERP factor even though it is already factored into the model. Since decreasing the share price means
decreasing the discount, this approach yields more conservative results (i.e. increases the benchmark
model value).
39 Before, there were 1 million shares at $11 each (total equity value of $11m). The rights issue will add a further 0.5m shares at $10 each (total value of $5m) and will result in a total
of 1.5m shares. The total value of the company should be $11m plus $5m, so $16m. This equates to $10.67 per share ($16m divided by 1.5m).
The offer price of $11.60 per new share represents:
A 22.3% discount to last close; and A 19.7% discount to the theoretical ex-rights price (TERP).
1
1 The theoretical ex-rights price is the theoretical price at which AGL shares should trade immediately after the ex-
date for the Entitlement Officer. The theoretical ex-rights price is a theoretical calculation only and the actual price at which AGL shares trade immediately after the ex-date for the Entitlement Officer will depend on many factors and may not be equal to the theoretical ex-rights price.
Underwriting of rights issues, cost versus value: June 2014
28
Announcement effect
The second reason why the share price on average drops during a rights issue is because it is often a
negative signal. Investors may perceive a rights issue as symptomatic of an inability to generate cash
through operations or other sources such as debt according to the “pecking order theory”.
However, Hansen40 documents a share price drop on the announcement of a rights issue and further drop
in share price until the offer close. In the Australian context, Grundy41 suggests that firms and underwriters
generally know that the price will drop because of the announcement and therefore use a lower share
price to determine the appropriate underwriting fee.
Of course, the underlying purpose of the raising would also influence the magnitude of a share price drop
and operational announcements are often made at the same time as rights issue announcements. For
example, if the purpose of the raising is to pay down debt (especially if debt covenants may be breached
otherwise), the market impact would probably be more than if the purpose was to fund a new project that
investors agree is value adding.
These effects are known to the company and its underwriters and they will price the underwriting
agreement to take them into account.
To incorporate this into the model the closing share price on the first trading day after the announcement
is made is used rather than using the pre-announcement price. This is essentially assuming that the
company and underwriter can, on average, make an unbiased prediction/estimate of where the share price
will be after the offer and any associated news is announced.
An alternative would be to discount each price by the average price drop across all raisings, but it is not
preferred given the different discounts and purpose of each specific raising would be ignored.
For rights issues that are “accelerated”, there is typically no “cum-rights” market, which means that anyone
buying the shares after the announcement is not entitled to participate in the offer. For example, below is
a typical announcement made by ASX whenever a company announces a rights issue:
This means that the closing price on the next trading day after announcement incorporates both the price
drop from the dilution/TERP adjustment and the market’s assessment of the other news associated with
the raising. For traditional rights issues, the effects of the announcement and the TERP are added.
40 R Hansen (1988) “The demise of the rights issue”, The Review of Financial Studies, 1, 289-309. 41 B Grundy (2009) “A Note on the Costs of Equity Financing”, response to the Australian Energy Regulator’s draft decision for TransGrid. (available here)
Trading issues
ASX will not price a “cum” market with respect to trading in the Company’s securities. Persons who acquire the Company’s securities after the commencement of the trading halt on Thursday, 21 June 2012 are not entitled to participate in the Entitlement Offer. (emphasis added)
Underwriting of rights issues, cost versus value: June 2014
29
As one final point, Hansen’s research suggests a further drop in share price of around 4% between the
announcement and offer close. The actual price drop between these two dates in the current sample was
not significantly different from zero; nor was there any significant abnormal return after applying a simple
Market Model.42 As such, this effect was ignored.
Dividends
Finally, as is common in option pricing (and incorporated in Handley), the stock price was adjusted down if
dividends were payable throughout the offer period. The adjustment is necessary because, should a
shortfall occur, the underwriter would not receive the dividend.
Volatility
A second critique of the model proposed by Handley was around the volatility parameter. Volatility
assumptions are regarded as the most crucial to accurately pricing options because of its effect on option
values and that, of all the parameters, it is the only one that is not directly observable. The following
section outlines two adjustments that were considered.
Volatility prior to issue versus volatility during the issue
The volatility estimate used in Handley’s research was the volatility of returns in the 180 trading days prior
to the rights issue announcement. A subsequent paper found that the volatility of returns was materially
greater during the offer period rather than before.43 Using the volatility during the period (a higher value)
meant that there was no premium between cost and the benchmark model value. The argument is that
companies and underwriters know that stocks are more volatile during the period than in the more
tranquil period before so they price in this increase.
However, in the current sample this relationship does not hold. In fact, the volatility during the offer period
was slightly lower than in the 180 days before the announcement on average. This would mean that the
premium between cost and benchmark model value would be greater using the volatility during the period.
As such, volatility during the offer period was not used.44
Volatility “skew”
One further issue is the often observed effect of the “volatility smile” or “volatility skew”. Recall that the
underwriting agreement is like an option held by the company to sell shares, otherwise called a put option.
For put options where the issue price is much lower than the share price (i.e. “out of the money”, or in
underwriting language “heavily discounted”), the option price is higher than the Black Scholes Merton
model would predict.
42
In the present sample, there was no difference from zero at the 10% level using either the actual return between the announcement and offer close or the excess returns from the
market model (with parameters estimated using daily data from the sample). 43 Howard W. Chan (1997) “The effect of volatility estimates in the valuation of underwritten rights issues”, Applied Financial Economics, 7, 473-480. 44 Additionally, given many contemporary rights issues have an accelerated institutional component that is often done over one or two trading days or while the shares do not trade,
the volatility during the period is undefined. This means that the sample is heavily biased to only the retail portion of the offer.
Underwriting of rights issues, cost versus value: June 2014
30
The volatility input that would make the observed option price equal the Black Scholes Merton option price
at a given issue/exercise price is called implied volatility because it is implied/calculated from observed
prices.
(One explanation is that there is a relatively large demand of options as insurance against large falls in
share price, so these options attract a special premium. It could also be a reflection of returns not being
normally distributed, which is an assumption of the Black Scholes Merton model, and instead having a
greater chance of a more extreme outcome. This phenomenon is sometimes called “fat tails”. Regardless of
the underlying reason, what is clearly important is to take it into account.)
The important thing to note is that this phenomenon is relevant for precisely the type of rights issue that is
typically undertaken – a heavily discounted one. The error that can arise from not adjusting for the
volatility skew is underestimation of the value.
Unfortunately, for all but the largest ASX-listed companies there are no exchange traded options on the
ASX. This means that actual option price data are not available and nor can implied volatilities be
calculated. In the present sample, only seven (of 63) companies that undertook rights issues had exchange
traded options on the market at the time.
Instead, to establish the percentage increase in volatility given different discounts to the current share
price, weekly data for all exchange traded put options was collected. Where the options were actually
traded during the week, the average percentage increase between the volatility at a given discount
compared to equivalent at-the-money options was measured.
Graphically this produces the following:
Note: this graph excludes cases where there are fewer than 75 data points at a given discount and the buckets capture 1% either
side of the point. The x axis has negative numbers because these are all discounts to the share price.
-20%
0%
20%
40%
60%
80%
100%
-35% -30% -25% -20% -15% -10% -5% 0%Vo
lati
lity
pre
miu
m r
ela
tive
to
at-
the
-mo
ne
y o
pti
on
Discount
Volatility premium relative to at themoney option
Line of best fit
Underwriting of rights issues, cost versus value: June 2014
31
This confirms that there is indeed a volatility skew over the period. For example, if there was a rights issue
conducted at a 20% discount to the share price using the historical volatility would underestimate the value
of the option as it would be if it was trading in the market. Applying a 54% premium to the volatility input
should correct for this.
The percentage increases also did not exhibit any strong relationship with time – in other words there were
not, for example, a larger increases in any one period versus another. There were three ‘spikes’ in the data
although none of the rights issues to be tested fell on these times. Again, to be conservative, all the data
was retained (alternatively - if you removed the ‘spikes’, the volatility increase is smaller). Also, the data did
not exhibit any short term patterns (or, technically speaking, ‘serial autocorrelation’).45
Given these results, and to retain a simpler model, the same increases in volatility were applied regardless
of when the rights issue occurred. Finally, as stated above, to be conservative no reductions in volatility
were applied even when the results suggested doing so and the ‘spikes’ were not removed.
For the current data set, the formula that was applied was:
(2) 46
Note: ATM is “at the money”. Discount is always a negative number, so this formula yields positive numbers.
The discount between issue price and share price adjusted for the announcement factor, TERP and
dividends was used for these adjustments.
Time to maturity
The current research also raised questions on one other parameter – time to maturity.
Accelerated rights issues
Perhaps the most dramatic change in how rights issues are conducted is the so-called “accelerated” (or
“dual track”) rights issue where the institutional shareholders have a very short window in which to take up
the offer and the retail shareholders have a longer period. Until recently, accelerated rights issues have
been allowed through ASX granting waivers of the ASX Listing Rules although recently ASX has moved to
formalise an accelerated rights issue timetable alongside the “traditional” approach.47
Despite them not being formally within the ASX Listing Rules, accelerated rights issues are unequivocally
the norm in large Australian companies. Among the current sample of ASX300 companies between 2010
and 2012, only 16% were traditional rights issues.
As noted above, accelerated rights issues reduce the time to maturity dramatically – in the current sample,
the institutional component was completed three times faster (from announcement to settlement) than
the retail component on average.
45 A correlation of virtually zero between errors from one period to the next and p-value of 0.88. 46 This parameter (-2.4) was highly statistically significant (p-values were virtually zero). Where there was a premium to the price, volatility was left unchanged. 47 ASX Consultation Paper (2012) “Modernising the timetable for rights issues: Facilitating efficient and timely rights issues” (available here)
Underwriting of rights issues, cost versus value: June 2014
32
This development should not come as a surprise given the pricing framework introduced earlier because a
shorter time to maturity means less risk for the underwriter and (hopefully) lower direct underwriting
costs. Given the different settlement periods it can also have beneficial cash flow implications for the
company because they will receive the institutional component (on average) around 22 days before the
retail component. A successfully completed institutional component can also be a signal to retail
shareholders that the offer is attractive. This appears to be the at least part of the intent behind
documents sent to retail shareholders, which occurs after the institutional component is completed (see
above under “Expected take up and soft soundings”).
This research takes accelerated rights issues into account by splitting it into its two components, calculating
the model value of each component then taking the weighted average of the two. The weights are simply
the number of shares issued under the component divided by the total number of shares issued.
Offer close date versus settlement date
Handley used the offer close date as equivalent to the maturity date for the underwriting option. This
would be appropriate for exchange traded shares (or options), where the clearing and settlement system
effectively eliminates counterparty risk.
However, in primary market transactions like capital raisings the clearing and settlement risk is borne by
the company and its underwriter. In other words, if a party subscribes to a capital raising but does not have
sufficient funds, then the company simply does not get funds and the settlement fails. The ASX itself does
not bear any counterparty risk in primary market transactions.48
Nevertheless, it is assumed that the actual risk of failed settlement through uncleared funds is low because
it results from cheques failing to clear. First, it is assumed that only electronic payments were used among
institutional shareholders. Second, cheque use is also assumed to be low among retail shareholders.
According to the APCA (Australian Payments Clearing Association) cheques are widely used by around 5%
of the Australian population, with this demographic representing “the elderly, rurally isolated and the
unwaged”. 49 Outside of outright fraud (which occurs in less than 0.02% of transactions and 0.001% of
cheques according to the APCA website) cheques can be dishonoured.
Additionally, if a retail shareholder subscribes to a rights issue but the cheque is dishonoured this may
present a benefit to the underwriter because presumably by this point the rights issue would have clearly
succeeded, with the issue price remaining below the share price. The underwriter can take this (probably
small) parcel of shares at the issue price and sell in the market at a profit without affecting the price.
As such, it is assumed that this risk is negligible and, like Handley, the present research uses the offer close
date in determining the benchmark model value.
Residual issues
Some rights issues are only partly underwritten. In these cases, the non-underwritten component was
stripped out prior to completing the analysis. Also, where the full rights issue was not completed in the
time period, the whole issue was ignored. This occurred typically where the announcement was made in
late 2012 and the retail component was not finalised until 2013.
48 This point was confirmed with discussions between ACSI and ASX. 49 Australian Payments Clearing Association (2011) “The Role of Cheques in an Evolving Payments System” (available here)
Underwriting of rights issues, cost versus value: June 2014
33
Appendix B: Variations to factor inputs
To test the robustness of results, the methodology was run using different assumptions. These showed that
the headline result as presented were robust to sensible changes in methodology. Below is the outcome
using identical inputs to the original research conducted by Handley.
The following parameters were used as inputs into formula (1) in the original research:
is the actual share price on the last trading day before announcement, adjusted for dividends
is the issue price
is the actual underwriting cost paid by the company
is dilution (the new shares issued divided by the number of current outstanding shares)
is 180 day historical return volatility
is the time between the announcement of the offer and offer close
is the 30 day bank accepted bill rate.
As was discussed in Appendix A, the differences are an adjustment of the share price to factor in an
announcement effect and increasing volatility.50
Actual cost (α) Value (αFV) Difference (%) Premium (%)
Simple average 2.5% 0.80% 1.61% 203%
Weighted average percentage * 2.1% 0.29% 1.77% 608%
Aggregate amounts $308m $43m $264m 608%
The difference and premium are statistically significant.
50 The necessary changes were splitting the rights issue into the institutional and retail components for accelerated rights issues and using a 30 day, rather than a 60 day risk free rate.
Underwriting of rights issues, cost versus value: June 2014
34
Appendix C - Bibliography
ASX Consultation Paper (2012) “Modernising the timetable for rights issues: Facilitating efficient and timely
rights issues”
Australian Payments Clearing Association (2011) “The Role of Cheques in an Evolving Payments System”
(available here)
Australian Securities and Investments Commission, (2014) “Report 393: handling of confidential
information: briefings and unannounced corporate transactions” (available here)
Howard W. Chan (1997) “The effect of volatility estimates in the valuation of underwritten rights issues”,
Applied Financial Economics, 7, 473-480.
Simon Connal (2013) “Equity Capital Raising by the ASX300 post-GFC: Too much is never enough”, Ownership
Matters
Bruce Grundy (2009) “A Note on the Costs of Equity Financing”, response to the Australian Energy Regulator’s
draft decision for TransGrid (available here)
John C. Handley (1995) “The Pricing of Underwriting Risk in Relation to Australian Rights Issues”, Australian
Journal of Management, 20, 1, 1995, June.
Robert Hansen (1988) “The demise of the rights issue”, The Review of Financial Studies, 1, 289-309.
Martin Lawrence and Simon Connal (2010) “Equity capital raising in Australia during 2008 and 2009”, ISS
Robert MacCulloch and David Emanuel (1994) “The valuation of New Zealand Underwriting Agreements”,
Accounting and Finance, 34, 2, November 21-34.
Paul Marsh (1980) “Valuation of underwriting agreements for UK rights issues”, Journal of Finance, 35, 3, June,
693-716.
Office of Fair Trading (UK) (2011) “Equity underwriting and associated services: an OFT market study”
Cost of Capital Raisings: the costs of underwriting ASX300 rights issues 36
Ground Floor, 215 Spring Street, Melbourne VIC 3000 Australia I T: +61 (0)3 8677 3890 I F: +61 (0)3 8677 3889 I E: [email protected] I W: www.acsi.org.au