There are many sources of financing available for a public company. It can tap into retained earnings. It can issue shares on the secondary market, issue debt or contract bank loans. If it takes the secondary route, management will try to price the shares as expensive as possible, but not prohibitively. If it is a question of borrowing money, the goal will be to negotiate the most favorable terms possible, including low rates. Companies can also take advantage of rights actions. In Nepal, where the history of the capital market is young, companies often issue a rights offer to raise additional capital. Shareholders love them because they profit from them at the expense of the companies issuing these shares.
When a company goes public, it issues shares to the public for the first time as part of an initial public offering (IPO). In a rights offer, the shares are not issued to the public, but to existing shareholders in proportion to their holdings. Shareholders have a choice. They can subscribe to the offer in whole or in part, let it expire or assign their rights to third parties; rights may be transferable. In general, companies that are pushed to the gills may find it difficult to obtain additional loans and therefore seek rights. There are times when companies use this to prevent someone from increasing ownership; this tactic is known as the poison pill, and companies use it to deter hostile takeover attempts.
From a shareholders’ perspective, there are at least a few things they may need to consider before accepting the offer. Under normal circumstances, rights stocks are not the first choice of corporate treasurers looking to raise capital. Often, cash-strapped companies go this route, in which case management can use the funds to turn around a troubled balance sheet; but there is no guarantee, as the balance sheet may have been depreciated for some reason initially. Then there is the issue of dilution. As more shares are issued in the market, the net profit of the issuing company is spread over a greater number of shares. Usually, it is because of this fact that as soon as a rights offer is announced, the share price drops.
In Nepal, it is the other way around. Inventories go up when rights are announced. The Nepal Stock Exchange (NEPSE) only started operating in January 1994. There are 225 listed companies, and these are dominated by banks and insurance companies. The corporate bond market barely exists; companies rely more on bank loans. In this environment, rights shares are a frequently used tool. These companies are not necessarily strapped for cash either. In 2015, Nepal Rastra Bank, the country’s central bank, gave commercial banks two years to increase their paid-up capital from Rs2 billion to Rs8 billion, hoping this would encourage mergers and acquisitions. The banks have rather expanded by issuing rights and free shares.
As a general rule, if the rights are offered near the current market price, existing shareholders may not view it as a compelling buy. This is especially the case if the issuing company has its back to the wall. For this reason, these shares are issued at a discount. In mature markets, the discount is not that large, so shareholders also consider growth prospects, valuations and management track record. Shareholders would obviously not want their investment to collapse. Usually, investors benefit in two ways: dividends, which can be in cash or stocks, and / or capital appreciation. Equities with subscription rights offer another opportunity for existing shareholders to benefit financially.
In Nepal, rights stocks are popular among listed companies. During the Nepalese calendar year 2021-2022 which began in mid-April of this year, the Securities Board of Nepal (SEBON), which regulates the securities industry, authorized a company to issue shares with rights subscription. In 2020-2021, seven companies received accreditation, and there were 11 in 2019-20. In addition to SEBON’s approval, company directors also need the green light from their boards of directors. Likewise, as a regulator of the financial sector, the Nepal Rastra Bank in monetary policy 2020-21, which was announced in July of last year, banned microfinance institutions from issuing rights stocks because these companies used them to raise capital, but not for mergers and acquisitions desired by the bank.
Money at the table
Here is the greatest irony of all. Nepalese companies are not required by law to issue shares at par, which is the price at which a company goes public when it goes public, but this is what happens in practice. With a few exceptions, companies listed on NEPSE all went public at Rs100. Thus, regardless of where a company’s shares are traded, Rs 100, Rs 1,000 or any other rights, rights issues are offered at Rs 100. On NEPSE currently, only one of the listed companies has market prices below 100 rupees, Unilever Nepal up to 20,000 rupees per share. The higher the share price, the higher the guaranteed profit. This explains why the prices are increased immediately after the announcement of the subscription rights.
It is a big loophole and it must be closed. Since rights shares are offered at very low prices, money that could and should have gone into the company’s coffers goes into the pockets of shareholders. Executives don’t seem to care because in all likelihood they too own shares in the company. Without a doubt, the discounts should be there to ignite the interests of shareholders, but not to the point of benefiting one at the expense of the other. This is especially important in the case of Nepal, as there is a good chance that the stock market will be much higher in 10 to 20 years; The path of least resistance in stock prices is upward over the long term. That is, companies offering au pair rights shares will continue to leave money at the table.
In the event that a rights offering is not fully subscribed, a company will sell the unsubscribed shares in an auction. Unlike rights stocks, the auction is open to all investors; the highest bid is accepted. In essence, the higher the buyer’s interest, the higher the price. As a result, the company stands to gain more than it would have received had the subscription rights been fully subscribed. Absurdly, management is probably hoping for exactly that outcome – so the shares can be auctioned off. Something is wrong with the system that prevails here. Companies should be encouraged, if not forced, not to offer stocks at ridiculously low prices. This creates a misallocation of capital.