(For more details, view the PDF here)
African Bank Limited (ABL) announced its intention to proceed with a rights issue of up to R4bn on 5 August. The terms of this rights issue were decided in early November: the company now plans to raise R5.48bn from its shareholders by issuing 685.28m shares at R8.00 in the ratio of 21 shares for every 25 shares held.
We will offer a method to measure the success of this rights issue for current ABL shareholders who may follow their rights or alternatively dispose of the shares that will carry these rights to their new owners.
Some detail
Shareholders or potential shareholders have until close of business on the JSE on Friday 8 November to qualify for these rights as registered shareholders. The rights will trade between 11 November and 29 November 2013. The last day to follow these rights, that is to pay R8 for the additional shares to be allotted, is 6 December.
The rights issue is fully underwritten and so it is certain the capital will be raised and the extra number of shares issued as intended. That is whatever happens to the share price of ABL between now and 6 December when all the shares can trade.
Some uncomfortable recent ABL history
The recent history of the ABL share price and its market value (share price multiplied by the number of shares in issue) is shown in the following chart. The bad news on 2 May took the form of a trading statement that indicated that earnings per share were expected to decline by between 25% and 29%.
The share price then immediately declined by 19.3% on the news. By the end of May the share price had declined still further to R16, reducing the market value of ABL by more than half of its pre-trading statement value, that is by nearly R13bn, over the month. Thereafter the share price varied from the R16 of 31 May to a high of R19 on 10 October. Clearly the company had grossly underestimated its bad debts, making a call on its shareholders to recapitalise the bank inevitable.
If the rights to subscribe new equity capital are taken up by established shareholders in the same proportion they currently hold shares, their share of the company is unaltered. They will be entitled to exactly the same share of dividends or the company (if liquidated) as before. In the case of a rights issue, established shareholders may however elect to sell all or part of their rights to subscribe to additional shares should these rights prove valuable, in which case they are giving up a share of the company but are fully compensated for doing so.
The key questions for shareholders and the market place are the following:
How well will the extra capital raised be employed by the managers of the company raising additional capital? Will the capital raised from old or new shareholders earn a return in excess of its opportunity costs? Will it earn a return in excess of the returns shareholders or potential shareholders might expect from the same amount of capital they could invest in businesses with a similar risk character?
Doing the numbers for the ABL rights issue
In the case of the ABL rights issue, the essential judgment to be made by the market place is whether or ABL will be worth more than the extra R5.482bn shareholders will have subscribed for in additional share capital, after 6 December. ABL had a market value of R12.33bn on 5 August when the rights issue was first announced. It would need to enjoy a market value of more than R17.88bn on 6 December (R12.34bn + R5.482bn = R17.88bn).
Given that 15.01m shares will have been issued by then, (the sum of the 685.28m new shares plus the 815.811m shares previously issued) the break even share price for the established shareholders would have to be approximately R11.88. A share price of more than this would confirm the success of the rights issue when the process has been finally concluded.
It is possible to infer the value of the rights implicit in the current R17.29 share price. R17.29 multipled by the 815m shares in issue gives a value of R14.09bn. If we add the additional capital of R5.5bn to this, we get an implicit post rights issue value for the company of R19.59bn. Dividing the R19.59bn by the 1501m shares gives an implicit post rights issue share price of R13.05. This is R1.17 ahead of the break even of R11.88. Hence the ABL capital raising exercise value has been value adding for shareholders.
Another way of measuring the value add is to compare the post rights value of ABL at R13.05 per share (R19.58bn) with the pre-rights issue value of R12.33bn to which the R5.5bn capital injection must be added. This amounts to R17.83bn and so the value add is R19.59bn – R17.83bn = R1.76bn.
The dilution factor – best to be ignored
The common notion is that issuing additional shares will “dilute” the stake of established shareholders, because more shares in issue reduces earnings per share. This assumes implicitly that the additional capital raised will not be used productively enough to cover the costs of the capital raised or earn more than the required risk adjusted return. But this is not necessarily so. Additional capital can be productively employed and can add, rather than reduce, value for shareholders.
In the case where balance sheets have been impaired, the ability to raise additional capital from shareholders in a rights issue adds value to the company by reducing its default risk. This would appear to be the main factor adding value to ABL. It is up to established shareholders in the first instance to approve any rights issue, on the presumption that it will add value to the stake they have in the company. If they approve and are willing to invest more it will be over to the market place to decide whether the gain in market value exceeds or falls short of the value of the additional capital subscribed.
In the case of a secondary issue of additional shares (rather than a rights issue) the answer is easily found by observing the share price after the capital raising. A gain in the share price would be evidence of a value adding capital raising exercise for both established shareholders who did not subscribe additional capital as well as for all those who did.
However to be a truly value adding exercise, these share price gains made after a secondary issue would have to be compared to market or sector wide gains or losses. If the share price gains were above market average, the success of the capital raising exercise would be unambiguous.
Estimating the impact of a rights issue is complicated; a lower share price may be compensated for by more shares owned.
Estimating the value add in the case of a rights issue is more complicated. This is because the rights are typically priced at a large discount to the prevailing share price before the announcement. The share price after a rights issue is likely to go down, but this will be compensated for by the fact that the shareholders, subject to a lower share price, will have received more shares at a discounted price, in exchange for additional capital subscribed.
The reason for pricing the rights at a discount to the prevailing share price is to attract attention to the offer and by so doing, to make sure that the rights to subscribe additional capital will have market value and so will be followed and the additional capital secured.
Making the comparison with a sole owner of a business investing more capital in it.
For any sole owner of a business enterprise injecting more capital into his or her business, the nominal price attached to the shares in issue would be irrelevant. He or she still owns all the shares.
When a sole owner decides to add capital to the private unlisted business, the test over time will be whether or not the business comes to be worth more than the extra capital invested – to which an opportunity cost should be added. That is what the same capital might have realised in an equivalently risky alternative investment.
The same is true of a rights issue in a listed company except, that if the shares are actively traded, the judgment of the market place on the wisdom in raising additional capital is immediate and continuous. Shares in a rights issue are being issued to shareholders in the same proportion to which they own them. As with a 100% owner, they would be issuing shares to themselves and their share of the company, after the rights issue, will remain the same should they follow their rights.
The rights issue price therefore is largely irrelevant to the established shareholders. What matters is the amount of capital the shareholders are called upon to subscribe to and what this capital they have subscribed for will come to be worth, when the rights issue and the capital raising exercise is concluded.
Why a large discount to the prevailing share price can be helpful to the success of the rights issue
This capital intended to be raised can be divided into a larger or smaller number of shares by adjusting the price at which the rights are offered without any important consequence for current shareholders – other than those who are financially constrained and therefore unwilling to come up with additional capital. They therefore would prefer not to take up their rights and to sell part or all of their rights to subscribe additional capital, presuming these rights had a positive value.
The same would be true for any underwriter that presumably would prefer not to have to take up their rights. For the underwriter the larger the discount the better; the larger the discount the less likely they will be called upon. One wonders if the underwriting commission properly reflects this trade off (as it should). For the underwriter, as for any shareholders less willing to follow rights, the larger the discount (and so the more additional shares issued) the better. A large discount to the prevailing share price will ensure an active market for the rights they wish to give up.
Conclusion
So far so good for shareholders in ABL following their rights issue. By agreeing to support the rights issue they have added value to the shares they owned. The market, as well as the shareholders, have so far voted in favour of the rights issue. Had the shareholders decided not to support the rights issue and proved unwilling to risk additional capital, the future of the bank might well have been regarded as much less certain and the share price damaged even more than it was. The market would have regarded any failure to support a rights issue as negative for the future of the Bank. The decision by shareholders to re-capitalise the bank was their vote of confidence in the management to realise good returns on capital in the future, even though they may have blotted their copy book. Forgiveness can be divine – but also value adding.