Lloyds Rights Issue: A Reason to Buy?

I’m rather surprised by the number of hits I’m still getting on a previous post, which noted the unnecessary complexity of the upcoming Lloyds rights issue and the way it’s been presented. I rather thought the weekend papers would clear the matter up, so was unsurprised to read the Guardian Money front page headline “Buddy, can you spare me £13.5bn?”. I immediately followed the injunction “>>Pages 4-5″ and fast-forwarded to read Jill Treanor’s examination of the “implications for small shareholders” and Patrick Collinson’s suggested “plan of action”.

I have to say I was rather disappointed.

Collinson suggests that:

“You got some Halifax shares when it floated. Now we at Lloyds want you to cough up a couple of hundred quid (we won’t tell you the exact sum till later)…”

[my stress]

Treanor also sheds considerable darkness on the point.

Now it simply isn’t true that Lloyds haven’t advised the exact sum investors will have to “cough up” (though they could have been clearer). As I pointed out last time, it’s quite simple: Lloyds wants £13.5bn, which will be divided equally amongst the ~27bn shares in circulation. That’s ~50p a share. If you own 1000 shares you’re going to be asked to put in £500. How many new shares you’ll get and at what price each is yet to be determined.

This is actually a step forward in the organisation of rights issues. The problem is that when a company announces it is going to sell a lot of shares, the price tends to fall – supply and demand – since not every share owner will be able to and want to put more cash into Lloyds equity. By delaying the announcement of the price of the new shares until the last minute, Lloyds has somewhat reduced the risk of the share price falling below the rights issue price, which would be a disaster, since, if you could just buy shares in the market for a lower price, there would be no point taking up the rights issue. The under-writers would end up with all the new shares.

What worries me most about Collinson’s comment piece and Treanor’s Q&A is that they omit part of the case for participating in the rights issue. What I’m about to say should not be construed as financial advice, but there are obvious reasons why a company’s share price might be depressed ahead of a rights issue and that in general a rights issue may be a good opportunity to invest.

The key point is supply and demand for the shares, that is, precisely what Lloyds is worrying about and the reason for the confusion about the offer price for the new shares. Many investors – funds or individuals – may simply be unable to put more money into Lloyds shares. They may just not have the cash. Or, especially if they’re a fund, they may not want Lloyds shares to rise as a proportion of their portfolio. This could even be against the rules of the fund.

Of course, some investors, such as index tracker funds, may be compelled to increase their holding in Lloyds in line with the increase in volume of its equity. But it’s difficult to think of a fund that would be compelled to take up more than its share of rights.

Therefore, it’s often argued, a rights issue is a good time to buy, because there is a surplus of sellers of the stock.

As Jill Treanor points out, you can sell some or all of your rights in the market, for example, to raise enough cash to take up the rest of your rights, a practice known as “tail-swallowing”. Such selling activity will tend to make the rights cheaper. But it’s important to understand that if the price of the rights falls, then so does the price of the existing shares. The reason is the (arbitrage) opportunity to simply sell shares and buy the rights.

Example: To simplify a little, say Lloyds shares fall to 60p when rights have been given to all the shareholders. The rights might entitle you to buy new Lloyds shares for 40p each (so you’d get 5 for every 4 shares you held at the qualifying date for the rights issue) so should sell for about 20p each (since once you’d put in the 40p you’d receive a new share exactly equivalent to the existing shares). If so many people sell their rights that the price is not 20p but drops to (say) 18p, then someone could sell shares for 60p, buy rights for 18p, subscribe to the issue for 40p and make (60 – 18 – 40)p = 2p a share. Do this for a few million shares and you’re building up a tasty bonus pot! What happens when people sell the shares to buy the rights, of course, is that the share price tends to fall until the price of the shares and the price of the rights are aligned again.

So, according to this argument, it may be a good time to buy Lloyds shares, e.g. by subscribing to the rights issue.

It might also be worth noting that Lloyds stated that it will not pay a dividend for 2 years. This may be another reason why some investors (income funds) will not want to hold the shares, though they may already have sold their holdings in the stock.

Of course, there are many reasons why it could turn out to be a bad time to buy Lloyds. They might screw up. Or we might experience the dreaded double-dip recession. And if so many people decide it’s a good time to buy Lloyds, this will push up the price and make it a bad time to buy! Though it is the largest rights issue in the UK to date…

At the end of the day, investors must make up their own minds, and, as I say, I’m not providing financial advice. Patrick Collinson (or his editors) are bold enough to allow themselves a headline “Lloyds looking unattractive” (or “Lloyds rights issue looks distinctly unattractive” in the online version). I just feel investors might also want to take into account the argument that rights issues can be a good time to invest.

Disclaimer: I worked for Lloyds in the early 1990s and own some Lloyds shares.

Lloyds Rights Issue complexity: Um, why don’t we just change the rules?

The upcoming Lloyds rights issue is in fact quite simple. They are giving shareholders the right to buy ~50p worth of new shares for each of the currently existing shares they hold. The new shares will be offered at a discount, but their price has not yet been set, so, obviously, you cannot yet determine how many new shares you can buy. But you’ve been told, albeit somewhat cryptically, what you need to know right now: if you want to take up your rights, you’re going to need to find 50p for each share you own when the rights issue process starts on 20th November. [Summary paragraph added 8:45am 4/11/09].

But is it just me or is the organisation and presentation of this rights issue more complicated than it needs to be? [Reworded 8:45am 4/11/09].

I quote in full section 10 of Lloyds’ announcement of its rights issue:

“10 Share Subdivision

Under the Companies Act, it is not permissible for a company to issue shares at a discount to their nominal value, which, in respect of the Existing Ordinary Shares is currently 25 pence per share. It is proposed that the Company carries out the Share Subdivision which will reduce the nominal value to 10 pence per share. This provides the Company and the Joint Bookrunners with greater certainty that the Issue Price will be able to be set at a 38 per cent. to 42 per cent. discount to TERP [the Theoretical Ex-rights Price, which itself depends on the number of new shares being issued, so a bit of algebra is needed to determine the issue price for 38-40% discount based on the current trading price of the existing shares] irrespective of market conditions. The Board believes that the Share Subdivision also provides the Company access to the best available underwriting structure and terms. Although no decision has currently been made as to the Issue Price, in no circumstances will the Issue Price be below 15 pence. As noted in paragraph 8 of this letter, the Issue Price is expected to be announced on 24 November 2009, two days before the General Meeting. The Proposals are conditional on, amongst other things, the completion of the Share Subdivision.

It is proposed that, pursuant to the Share Subdivision, each existing Ordinary Share of 25 pence in issue at the close of business on the date of the General Meeting will be subdivided into one ordinary share of 10 pence in the capital of the Company (a “10p Ordinary Share”) and one deferred share of 15 pence in the capital of the company (a “Deferred Share”). The purpose of the issue of Deferred Shares is to ensure that the reduction in the nominal value of the Ordinary Shares does not result in a reduction in the capital of the Company.

Each Ordinary Shareholder’s proportionate interest in the Company’s issued ordinary share capital will remain unchanged as a result of the Share Subdivision. Aside from the change in nominal value, the rights attaching to 10p Ordinary Shares (including voting and dividend rights and rights on a return of capital) will be identical in all respects to those of existing Ordinary Shares. No new share certificates will be issued in respect of the 10p Ordinary Shares as existing share certificates for existing Ordinary Shares will remain valid in respect of the same number of 10p Ordinary Shares arising from the Share Subdivision. The number of Ordinary Shares of the Company listed on the Official List and admitted to trading on the London Stock Exchange’s main market for listed securities shall not change as a result of the Share Subdivision. The Share Subdivision will not affect the Group’s or the Company’s net assets. Consequently, the market price of a 10p Ordinary Share immediately after completion of the Share Subdivision should, theoretically, be the same as the market price of an Ordinary Share immediately prior to the Share Subdivision.

In addition, it is proposed that, pursuant to the Share Subdivision and as required by Article 3.1.4(i) of the Articles of Association, each existing Limited Voting Share of 25 pence in issue at the close of business on the date of the General Meeting will be subdivided into one limited voting share of 10 pence (a “10p Limited Voting Share”) and one Deferred Share. Aside from the change in nominal value, the rights attaching to 10p Limited Voting Shares will be identical in all respects to those of existing Limited Voting Shares. No new share certificates will be issued in respect of the 10p Limited Voting Shares as existing share certificates for existing Limited Voting Shares will remain valid in respect of the same number of 10p Limited Voting Shares arising from the Share Subdivision.

The Deferred Shares created on the Share Subdivision becoming effective will have no voting or dividend rights and, on a return of capital on a winding up of the Company, will have the right to receive the amount paid up thereon only after Ordinary Shareholders have received, in aggregate, any amounts paid up thereon plus £10 million per Ordinary Share.

No share certificates will be issued in respect of the Deferred Shares, nor will CREST accounts of shareholders be credited in respect of any entitlement to Deferred Shares, nor will they be admitted to the Official List or to trading on the London Stock Exchange or any other investment exchange. The Deferred Shares shall not be transferable at any time, other than with the prior written consent of the Directors. The rights attaching to, and restrictions upon, the Deferred Shares are set out in Resolution 6.

At the appropriate time, the Company may repurchase the Deferred Shares, make an application to the High Court for the Deferred Shares to be cancelled, or cancel, or seek the surrender of the Deferred Shares using such other lawful means as the Directors may determine.”

Got that? You’ll be tested on it later!

In fact, all section 10 says is that to get round some stupid rule, and in case Lloyds shares fall before the rights issue completes, we’re all going to be issued with “deferred shares”. These are totally worthless. I just hope they don’t actually show on my trading account, cluttering up the screen and statements.

Frankly, who cares about the nominal value of shares? And, if the rule that companies can’t issue new shares at below the nominal value of existing shares is so easily circumvented, does it really have any point? Maybe the law could simply be changed to add “unless approved at an AGM”.

I’d rather the army of accountants and company lawyers running large companies were employed making sure the business doesn’t screw up, not worrying about worthless deferred shares. Someone was obviously paid to write the paragraph that ensures the deferred shares are worthless. On the other hand, maybe it was worth it for the amusement value. I like it so much I’ll quote it again, this time with a bit of emphasis:

“The Deferred Shares created on the Share Subdivision becoming effective will have no voting or dividend rights and, on a return of capital on a winding up of the Company, will have the right to receive the amount paid up thereon only after Ordinary Shareholders have received, in aggregate, any amounts paid up thereon plus £10 million per Ordinary Share.”

Perhaps they should index that £10 million to RPI. We might experience hyperinflation.

Lloyds is also waiting till the last minute before telling us what the issue price of the new shares will be, in case the short-sellers get their teeth into the situation. Actually I don’t care very much. What I want to know is how much I’m going to have to put in for each share I own. Then I can calculate the total amount I need to find. Shareholders are being asked for about 50p per share they own at the record date for the issue (20th November), calculated by dividing the amount to be raised (£13.5bn) by the number of shares in circulation at the moment (just over 27bn, a number which won’t change materially over the next couple of weeks). Lloyds’ announcement could easily have included the exact amount as a headline (I haven’t read all 200,000 pages of the documents they’ve issued today).

Rights issues remain dysfunctional as I explored here, here and here around 18 months ago (when HBoS was passing a hat around, ironically enough). All that’s been done is to try to speed the rights issue process up, which introduces new problems: the regulators haven’t speeded up the process of moving money about, and the post, for obvious reasons, is even less reliable right now (let’s hope we can all exercise our rights online or by telephone, eh?). As I said in my previous posts on this topic, it must be possible to devise a way of raising funds from shareholders that isn’t vulnerable to attack by short-sellers. Such a scheme would surely save on underwriting fees, for starters. Lloyds will only raise £13bn net from its £13.5bn rights issue. I can live with putting money into basically sound companies that need it, but it sticks in the craw that so much disappears in transaction costs (and in this case, a windfall tax in all but name). Especially when I’m not going to get any dividends for another 2 years!

The Grandmother Of All Stealth Taxes

As the nights were drawing in this time last year I detailed how the UK’s “bailout” of the banks is in fact the Mother Of All Stealth Taxes. Well, I underestimated the greed of our politicians.

In March this year the government had obviously not yet done a good enough job of convincing the world’s speculators that the UK financial system was safe. They therefore proposed an insurance scheme in case Lloyds’ losses on specific assets (some £260bn worth, mostly commercial property and mostly acquired when Lloyds took over HBoS) amounted to more than £25bn. For this insurance scheme Lloyds would be required to pay a notional amount of £15.6bn in shares as I described at the time.

I say the amount is notional, because no-one knows what the shares would have been worth in the future. Presumably existing shareholders think the shares are worth more than their current price or they would sell them. Furthermore, the price of the shares granted for the insurance scheme was set when the bank was in difficulty. Since pre-emption rights of existing shareholders (i.e. their right to buy shares on the same terms as the new investment in the bank) were not respected we have no way of knowing how many would have bought shares on the same terms as the UK’s Treasury was offering.

Since Lloyds would have to incur losses of £(25+15.6) = £40bn or so before it even broke even on the deal, their executives started looking into ways to make themselves strong enough to insure themselves against these potential losses. The situation is not straightforward, but Lloyds’ management must have considered that they could manage the assets to incur less than £40bn in losses.

Lloyds now believes it can raise enough money by selling new shares to existing shareholders and issuing some bonds (mandatorily convertible to shares in certain circumstances, I gather) to insure itself, which is, after all, a large part of what banks do.

But as is being widely reported, the Government is demanding a £2.5bn break fee. This has no logical justification whatsoever.

The febrile media reaction to the banks is typified by Dan Roberts in the Guardian. His commentary begins:

“Another day, another few billion pounds of our money is on its way to cheer up Britain’s banks. Today it was the turn of Lloyds to stick its hand out – indicating it wants an estimated £5bn to support its latest restructuring wheeze.”

and which descends into complete incoherence by the end:

“All in all, it’s like taking out house insurance during a fire, refusing to pay for it once the fire is out and sending the insurance company a bill for a new sprinkler system. The real irony is that behind all the complexity, the APS and this associated exit strategy boil down to something very recognisable to bankers by now: a credit derivative, the most toxic yet invented.”

In actual fact a capital raising by Lloyds is a welcome simplification of what looked like becoming a labyrinthinely complex relationship with the UK government. It’s not the role of the taxpayer to guarantee the dodgy property loans Lloyds inherited when it took over HBoS – when, we shouldn’t forget, the bank’s executives were denied the right to conduct thorough due diligence on behalf of Lloyds’ shareholders – so Lloyds raising capital itself so that it is strong enough to bear the potential losses of the assets now on its books represents a return to normality which pundits like Roberts should be welcoming.

What Roberts seems to object to is the government’s participation in the rights issue. But this is what happens when you’re a shareholder. The government will be better off compared to underwriting the losses on a £250bn dodgy loan portfolio. The cost to the Treasury of keeping its/our shareholding to 43% will be around £5bn whereas they could otherwise have had to pay out, we have to assume, perhaps somewhere around £25bn in insurance in return for increasing their holding in Lloyds from 43% to 62% according to calculations done back in March. Let’s be generous and assume ~20% of Lloyds raises £15bn when the taxpayers’ stake is eventually sold (valuing the whole bank at £75bn). Even then the taxpayer is at least £25bn – £5bn – £15bn = £5bn better off under the rights issue plan than writing the APS insurance, assuming £25bn losses, after excess.

The reader may ask why a deal being done at all. The answer is that obviously Lloyds’ management think they can keep losses somewhat lower, but the Treasury surely has to take a more cautious view – note that because of moral hazard, the level of losses could depend on whether or not they’re insured by the Treasury! Since the sensational news has just come through this morning that RBS is to exit the scheme as well, I suspect that all involved – particularly in government – have realised that the scheme is in fact unworkable. It distorts the two banks’ incentives so much that it is impossible for them to do their job of managing the bad debts.

But what of this £2.5bn fee? There are two sorts of justification. One is that the government “saved” Lloyds by proposing the APS. But if the government had done nothing either the whole banking system would have collapsed in March or the banks would have faced down the short-selling speculators and recovered (as Barclays did, its shares having risen 6-fold since then). I would have thought it was part of the normal responsibility of government paid for by all our taxes, not an optional extra, to ensure the existence of an orderly banking system.

Then there is the financial justification. Roberts suggests in his fire insurance analogy that:

“The catch here is that we haven’t been paid yet for providing this insurance when it was needed most (ie, during the crisis) and are having to haggle to get the premium paid retrospectively.”

For what the government deserves another £2.5bn (making them at least £7.5bn better off than before this latest deal) is not exactly clear. The point is the insurance scheme had a £25bn excess and was to run for 5 years, so Roberts’ fire insurance analogy is inappropriate – the insurance policy would have had to pay out nothing for at least the first couple of years. Logically, if there’s going to be a fee of this kind it should be offset against losses and writedowns to date against a scaled-back excess of ~£5bn, i.e. a fifth of £25bn, since about one of the 5 years will have passed since what I understand to be the baseline for the insurance policy of last December by the time the Lloyds fund-raising is complete. Furthermore, the FT this morning provides details of RBS’s losses to date on assets that would have entered the APS. I don’t know where such data for Lloyds could be found, but they are likely to be comparable. RBS has already absorbed losses of £23bn! Even if we take a figure of £15bn for Lloyds, then the loss after the excess is £10bn. The government pays 90%, so owe Lloyds £9bn. Fine. We’ll offset the £2.5bn against that amount!

The £2.5bn break fee is just an opportunistic tax, ultimately falling largely on UK pension funds. There’s no financial justification for this amount.

Lloyds shareholders are likely to be understandably aggrieved that the fee is much higher than the figure of £1-1.5bn that has been touted in the media for some time now. There has to be the suspicion that the government’s negotiators have ramped the price at the last minute. If so, this reeks – I would have thought government had a duty of fairness.

With another £13bn from a rights issue, Lloyds shares are in total worth around £40bn, tops, right now, so £2.5bn represents an arbitrary tax of at least (2.5/40)*100 = 6.25%. There is still an upside, but it’s not looking stellar. I gave a guesstimate earlier that, with a fair wind, Lloyds may eventually be worth £75bn or about double the value shares are currently trading at. But this might not be for 5-10 years. A lot of investors are going to consider that they can much more easily double their money in a “global return to growth” scenario by investing it in emerging markets – where the political risks these days seem no worse – instead of in the UK. Does the government want that to happen? Especially as they may want to sell a lot of bank shares in a few years!

I have owned Lloyds shares since I worked for the bank in the early 1990s. When I was given a few shares as part of my remuneration, I certainly wasn’t warned that the government would levy arbitrary taxes whenever the country’s finances hit a patch of turbulence.

Flogging the Black Horse: How Bad is it for Lloyds Shareholders?

CORRECTION (01:00 11/3): I made an assumption in this post (mentioned in section 5) that the Government would not have an entitlement to new ordinary shares at 38.43p each. In fact, they have stated that they DO have such an entitlement and intend to take it up. This point has been discussed on FT Alphaville, which notes that the minimum holding the Government will end up with in Lloyds is 62%, not the 51% I (and some others) arrived at. They will retain at least 43% of the ordinary shares, not the 26% I (and some others) arrived at, before the B shares are converted. I haven’t yet corrected this error in the text of this post. The discussion remains valid.

(10:00 11/3): Made corrections to some calculations in the text (in italics).

—–

It’s been incredibly frustrating over the last couple of days trying to determine exactly what the effect of the latest dodgy UK Government wheeze (its Asset Protection Scheme, APS) has been on the value of my modest Lloyds Group shareholding. On Sunday I complained, inter alia, about how the bank is being forced to lend not for business reasons, but because the UK Government seems to think this is a good idea. I have no idea whether or not such enforced lending will benefit the economy – it seems like just the latest fashionable economic thinking to me – but I presume that, if it turns out to be a big mistake, Brown, Darling and King will be disgraced and stripped of their pensions.

Nevertheless, I’m not too worried about the lending stipulation on Lloyds. After all, we’re a bank – that’s what we do!

I become a little more concerned (meaning my blood boils) when I read articles suggesting that the latest intervention – a “toxic asset” insurance scheme – may not in itself be entirely necessary (after all, we were told the UK banks were stress-tested last October – they are now just realising anticipated losses), but is being implemented in order to gain control of the banks in order to force them to implement ad hoc lending policies devised by politicians seeking re-election within 15 months.

I become very concerned (my blood curdles) when I subsequently discover that the UK Government appears to be making up the rules as it goes along, for example on capital adequacy, in order, it seems, to force the banks to participate in the APS, in order to force them to implement ad hoc government policies that may not be in their shareholders’ interests.

I am extremely concerned (blood clots block my veins) to read this morning that one of the few remaining independent UK banks – Barclays – may also be forced to become a tool of UK Government policy.

But none of the articles I’ve read clearly explain the precise impact on Lloyds shareholders. I’ve had to download a PDF from Lloyds own website. Sack the journos. And take away their pensions!

Let me try to explain the deal:

1. Cost for participation in the APS
I wrote on Sunday that this would be £10bn (plus a £25bn excess). I’m not sure where I got this figure – TV or radio speculation, probably – because news sources were quoting £15.6bn.

But neither figure is really correct. The £15.6bn is an entirely notional amount. It is intrinsic to the deal that this is paid in new Lloyds B shares:

“…carrying a dividend of the greater of 7 per cent per annum and 125 per cent of the dividend on ordinary shares.”

The B shares will cost 42p each, the approximate closing price last Friday, the last trading day before the announcement.

Now, call me naive, but even if we say that Lloyds shares are “worth” 42p, the B shares are worth somewhat more than my ordinary shares. They have first call on dividends (so in the worst case for ordinary shareholders could receive 2.94p each – 7% of the notional £15.6bn, i.e. £1.092bn! – in a year when ordinary shareholders receive nothing!).

But even if the ordinary dividend exceeds 2.94p * 1.25, i.e. 3.675p per share, the B shares will receive 1.25 times the ordinary share dividend.

It seems to me the B shares are worth north of 1.25 times the ordinary shares, that is, at least 52.5p each or £19.5bn in total.

But there’s a twist in the tail.

2. Conversion of B shares
The B shares can be converted into ordinary shares, but only at a cost of 115p, i.e. about 2.74 B shares would be converted into one ordinary.

Furthermore, the government must convert the B shares if the ordinary share price rises above 150p.

This would result in the government increasing its holding by at least an additional 12% of the bank (the figure depends on how many shares the Government already holds, since it dilutes its own existing holding by taking new shares) of Lloyds (see below for explanation), in terms of both economic and voting interest (but see below).

This is very curious, since, before conversion (strictly, if never converted), the B shares increase the economic interest of the Government in Lloyds by (at least) 3.42 (1.25 times 115 pence/42 pence) times as much, that is 41.07%!!! [Actually, the calculation is not quite so simple - perhaps its easier to say that before conversion the B shares number more than the ordinaries, and get a higher dividend per share, so on their own represent an economic interest of well over half the bank!! And the Government owns 43% of the ordinaries already, and could own as much as 65%. It's total economic interest, i.e. share in dividends, before conversion of the B shares - which could be calculated exactly, maybe I will later - could be as much as around 90%].

Astonishing! As an ordinary shareholder, the Board of Lloyds will only be acting in my interests if it refuses to pay any dividends until the B shares have been converted into ordinaries. They will then have “merely” exchanged (approx.) 12% of the bank for the APS insurance. If the B shares are never converted, the insurance will have cost (approx.) 41% of the bank!!

3. APS insurance excess
I mentioned that the excess charge for the protected assets is £25bn. But this is on the assets after “historic impairments and writedowns”. So the cover is for £250bn of £260bn of loans. Maybe the excess should really be stated at £35bn, since it’s not clear that Lloyds would benefit were any individual loans that have been written down already to recover. This matters, as Lloyds has just declared a huge loss on the HBoS book. I understood at the time that this was done in order to get the bad news, or at least the worst of the bad news, out of the way.

If the £260bn of loans don’t make a further £25bn of losses, then Lloyds will have given the UK Government another 12% (or perhaps 41%) of the bank for nothing.

In fact, if the extra lending Lloyds is to undertake is given a value – say, several £bn – then, worst case, Lloyds will have given the Government 12% of the bank and several £bn, for nothing!!

4. Conversion of preference shares
I’m trying to be objective, here, so perhaps should cut out the exclamation marks and italic emphasis.

Even if Lloyds doesn’t lose another £25bn on the loan book, there is something in the deal for Lloyds shareholders. The Government is offering to underwrite a conversion of the 12% preference shares – albeit that these were outrageously expensive in the first place.

The £4bn of prefs are going to be converted at 38.43p per share, creating an additional 10.41bn shares.

There are currently about 16.34bn in circulation (calculated from Yahoo! data), so the new shares are 10.41/(16.34+10.41) or 38.92% of the increased pool of shares, or 63.71% of the shares already in circulation.

Now, if the shareholders end up with all these 10.41bn new shares, the Government’s existing 43% in the bank will be diluted down to only about 43/1.6371 or 26.27%.
[An alternative way of carrying out the same calculation is to note that, in this scenario, the Government would end up owning 7.03bn of a total 26.75bn shares, that is 7.03/26.75 or 26.28% of the shares - obviously small rounding errors are creeping in].
CORRECTION (10:00 11/3): This won’t happen, as the Treasury will take up its 43% or 4.48bn of these shares, maintaining its minimum holding at 43% or a total of 11.50bn shares (actually the Treasury has 43.5%, but forgive me if I don’t go back and correct this everywhere).

It’s quite possible that the shareholders will take up their entitlement to new shares at 38.43p, since the Lloyds share price at this very moment is somewhat higher at 48.8p (i.e. I could subscribe for my shares and sell them immediately at a 10.37p profit per share, but, of course, this will tend to lower the share price, so not everyone can do it).

On the other hand, if the Government as underwriter ends up with the new shares instead of its prefs, it will own (43% of 16.34 bn) + 10.41bn of the total 26.75bn shares in Lloyds, that is (7.03 + 10.41)/26.75 = 17.44/26.75 = 65.20% of the shares, as quoted in the Press.

5. Conversion of B shares revisited
As I mentioned above, if and when the Government converts its B shares to ordinary shares, it will increase its holding by at least an additional 12% of the share base.

As detailed in section 4, above, when it converts the B shares, the Government may have as many as 17.44bn shares out of the total share base of 26.75bn ordinary shares.

The £15.6bn of B shares will convert at 115p per share, that is, into 15.56/1.15 = 13.53bn new shares.

Treating the B shares separately after conversion, they give an economic interest of 13.53/(26.75 + 13.53), that is 33.59% of the bank.

Before conversion, the B shares receive dividends equivalent to at least 1.25*13.53*115/42 = 46.31bn shares, that is 46.31/(26.75 + 46.31) or 63.21% of the dividends.

But the B shares dilute the Government’s own ordinary share holding, so it’s also interesting to see their effect on the Government’s total holding after conversion.

If the shareholders subscribe to no new shares at 38.43p, the Government would end up owning (17.44 +13.53)bn of (26.75 + 13.53)bn ordinary shares, i.e. 30.97/40.28 or 76.89% of the bank as quoted in the Press.

Note that the Government’s voting rights are capped at 75%, which may explain why this number has sometimes been reported for the Government’s Lloyds’ share.

On the other hand, if the shareholders take up all their rights to the new ordinary shares being exchanged for the preference shares, then, after converting the B shares, the Government would only hold (7.03 + 13.53)bn of 40.28bn shares, that is, 51.04%.
CORRECTION (10:00 11/3): Since the Treasury will take up its 43% or 4.48bn of the preference replacement ordinary shares, as noted in section 4, its minimum eventual holding is in fact (11.50 +13.53)bn of 40.28bn shares, that is 62.14%.

Since this is a bare majority, I am ashamed to say that I am inclined to wonder whether the numbers have been stacked to ensure that the Government will always be capable of becoming a majority shareholder in Lloyds (since it can convert its B shares at will).
CORRECTION (10:00 11/3): OK, it’s not a “bare majority”, but I still wonder whether the whole process has been, in part, designed to ensure the Treasury gains a controlling stake in Lloyds.

I note, also, that that there appears to be no provision for Lloyds to pay for the APS by raising more than the £4bn needed to redeem the preference shares when it offers existing shareholders (and new investors) new shares at 38.43p. [On the other hand, I've assumed the Government will not participate in this share offer, even pro rata to its existing 43%, given that it is under-writing it anyway, and that the full £4bn worth of shares will be available to outside investors].
CORRECTION (10:00 11/3): I was in fact mistaken to make assumption indicated in the square brackets.

But, of course, if the numbers have been stacked, this would be tantamount to expropriating Lloyds’ shareholders assets – seizing them without adequate compensation – and of course that would be against the European Convention on Human Rights. And, of course, the Government is always careful to respect the rights of its citizens!

And, after all, according to Lloyds:

“HM Treasury has confirmed to the Board that its objective in increasing its potential holding of ordinary shares in the Group is to provide financial support. In the event that HM Treasury increases its ownership of the ordinary shares, it does not envisage any change to the constructive relationship it currently enjoys with the Board.”

So that’s all right, then.

After all, now that they’re in the position of having to sell the deal to shareholders, the Lloyds Board are not exactly free to speak their minds. I’m sure there’s nothing in the various stories that have appeared claiming they are unhappy.

Note: 22:23 10/3 Corrected an embarrassing slip in this post – the minimum B share dividend is 7% (2.94p), not 7p which appeared in a couple of places!

Countercyclical Conundrums

Several agendas – or should that be “agendae”?; I told you there was a brave attempt to teach me Latin at school: in fact, I now recollect, so dedicated was my teacher, that, after watching me for a good 5 minutes, he once stopped me swapping stamps in the middle of a lesson! – anyway, let’s get on with it: several agendas were at play in shaping the UK Government’s bank recapitalisation plan.  I hesitate to call it a “bailout”, as it’s not really clear who is being bailed out by whom.  It rather seems to me that the banks, by agreeing to Brown’s plan, are bailing out the economy and the PM.

One influence that seems to have come to the fore during the week between the announcement of a £25bn capital injection (with another £25bn to follow if needed) is the idea of taking measures to encourage countercyclical availability of credit.  That is, it is argued, steps should be taken to discourage bank lending during an upturn and to encourage it during a downturn.  The point is that during the downturn banks have less money for new lending because of the bad debts they have to write off.  The idea I hope I’ve encapsulated – a sort of privatised Keynesianism – is that of the latest economic guru of those who hope to defeat the business cycle, Hyman Minsky.  Even as I write the BBC Sunday evening schedule is undoubtedly being cleared for a documentary on the guy.

The amount of lending a bank can undertake is determined in large part by the amount of surplus capital on its books.  The capital can be thought of as a cushion against loans failing to perform.  The amount that a bank can loan out at any given point in time in the form of mortgages, business loans and so on, against deposits or short-term borrowings, is many times its liquid capital.  It all gets rather technical, but a bank’s capital adequacy can be measured in one or more of a number of ratios under guidelines set by the Bank for International Settlements (BIS) which is based in Basel, Switzerland.  This is why banks report their compliance with the “Basel I” or new “Basel II” sets of rules. The “Tier 1″ capital ratio is the one banks most often refer to.  For example in the announcement about its fund-raising as part of Brown’s plan to save the world, RBS notes:

“The capital raising will increase RBS’s pro forma core tier 1 and tier 1 capital ratios by approximately 3 percentage points and 4 percentage points respectively, on a proportionally consolidated basis”.

One way to implement a countercyclic credit policy is therefore to stipulate that banks’ capital ratios must increase when you think credit has become too easy (during the boom) and relax the ratios during the downswing in the hope that banks will continue to lend.  The mechanism is analagous to the setting of interest rates by the Bank of England (and other central banks) but aimed at controlling credit rather than inflation.  I’m fairly sure at least China and India already implement such a policy already since I’ve seen announcements in the FT of adjustments.

It appears that the UK decided last weekend to introduce a countercyclical policy.  All very ad hoc.  And, since the banks were not ordered to increase their capital ratios during the boom years (which might have been a good idea), it’s all somewhat late in the day.  You could say that during one frantic weekend the UK took the decision to embark on an ad hoc, post hoc countercyclic credit management policy!

This policy shift is one reason why – despite having plenty of capital relative to existing regulatory requirements – the UK banks are having to raise £37bn (or more – I think this figure is just the government’s maximum commitment and doesn’t include fund-raisings by Barclays, HSBC, the Santander-owned mortgage banks and Nationwide).  The idea, it seems, is to get them to where they should have been at the end of the boom, i.e. with Tier 1 capital ratios of 9% or more.  The point is that they should then be able to continue lending without the worry that bad debts will send their ratios back down to the level (say less than 6%) where the market starts to lose confidence in them.

A real giveaway that the government is trying to do more than just free up the interbank money markets is the stipulation as part of the bailout that banks must “maintain the availability” of “competitively priced lending… at a level at least equivalent to that of 2007…” (this quote is from Lloyds TSB’s announcement).  The FT may have described the move as a “demented diktat” (curiously this phrasing was noted by various secondary sources on the web, and then apparently removed from the original article), and it may be impossible to enforce, but the banks will have got the point, even if most commentators are baffled.  The danger now is indeed that we go from one extreme to another.  I think Minsky is probably right about that, and – though other aspects of the bailout are demented – the government is right to be doing everything it can to prevent the economy going into a tailspin.  Might have been a good idea to have stopped it flying too close to the Sun in the first place.  I guess there’re a lot of votes in rising house prices.

I do have some qualms about the countercyclical prescription, though.  I dislike the way it relies on the omniscience of policy-makers and regulators.  Make no mistake, this crisis was first and foremost a regulatory policy failure.  We need to understand why they’ve failed before we take the medicine of more regulation prescribed by empire-building bureaucrats.  I suspect what we really need is for the FSA to work smarter, not harder.

More specifically my worry is that you never know exactly where you are in the business cycle.  You may start ordering banks to raise their capital ratios, but asset prices continue to rise so you’re compelled to continue raising ratios.  And on the downside you may allow banks to lower their ratios, but they have no way of knowing the extent of the bad debts on their books, so may still not start lending.

I prefer an agenda of:

1. Trying to damp down price fluctuations in those assets that have most effect on the real economy, i.e. we should be more concerned about residential property bubbles than ones in the stockmarket.

2. Assisting banks and other companies in raising private, not public, capital to cover losses.  Essentially I’m saying that (in the case of the present crisis) the banks paid out too much in dividends in the good years.  There was no way to predict it reliably, but now they need that capital on their books.  Fine, the shareholders may have been able to put it to good use in the meantime.  But now they should pay it back.  Hence my interest in getting rights issues to work properly.

Banking on Darling’s Plan

This piece was prepared for the Guardian’s excellent Comment is Free (CiF) site, and appears there under the title “Risky business”.

The phrase “Swedish model” must have a special resonance in the Treasury. The former Swedish finance minister has made a whistle-stop tour urging other countries to adopt a plan similar to the one credited with saving the Swedish financial system after their banking crisis in the early 1990s. Never mind that, soon after they had been rescued, the Swedish banks invested heavily in the Baltic countries, where they are now running into new difficulties. The UK is now to adopt a similar plan to inject taxpayers’ funds into several of its banks, in return for preference shares, seemingly because it’s the only idea we can come up with for recapitalising the banks. But several commentators have suggested an alternative scheme that would put far less taxpayers’ money at risk and treat bank shareholders more fairly.

Compared to ordinary shares, preference shares are trumps. They are first in line for dividends. Depending on the precise terms, preference shareholders receive proceeds from the sale of a business, or from the liquidation of the assets of a failed company, before ordinary shareholders. But they are still just shares.

The plan to issue preference shares does nothing to reduce taxpayers’ exposure to losses on banks’ assets, because it doesn’t bring a penny of additional private capital into the banks. In fact, the taxpayer’s explicit risk will increase, because the preference share issues are equivalent to guarantees (up to the amount paid for the preference shares) not just to retail savers but to all the banks’ creditors. The point is that, in the event of liquidation, ordinary shareholders are wiped out first, then preference shareholders and only then bond-holders, depositors and so on. Why would we want to put the taxpayer in the firing line like this?

The problem for shareholders is that the government is likely to demand very favourable terms for its investment, in the hope of making a handsome profit for the taxpayer (at the expense of private pension holders and other investors) or in its anxiety to avoid a loss. But the more the government takes, the more difficult it will be for the banks to raise private capital should conditions deteriorate further. The result could be that even more taxpayers’ money ends up being poured into the banks.

Of course, it’s unlikely that any of the banks receiving taxpayer funds will have to be liquidated or even sold at a loss for the taxpayer, but an alternative scheme could put much less taxpayer money at risk.

Darling has said that the banks have agreed to increase their capital, but rather than take up the government’s offer to take preference shares, they could raise new funds themselves. In present market conditions this would be very difficult. However, the government could help simply by offering to underwrite deeply discounted rights issues by the banks. If this is what is meant by the clause in the Treasury’s announcement that the government “is also willing to assist in the raising of ordinary equity if requested to do so”, then Darling may have covered all the bases.

In a rights issue, each existing shareholder receives rights to put more money into a company by buying new shares at a price less than the prevailing share price. Such rights can be sold, but to allow them to lapse is to leave money on the table, since shares could be bought at a discount by exercising the rights and then immediately sold at a profit.

Recent rights issues by banks such as HBoS and Bradford & Bingley failed, because the share price fell below the rights issue price, taking away the incentive for holders to exercise their rights. There are various reasons why share prices tend to decline during the rights issue process. The ability to short-sell shares can amplify the price decline; in fact it is asking for trouble to permit short-selling during rights issues. The ban on short-selling financial stocks which is currently in force would give rights issues at a large discount to the current share price a good chance of succeeding.

Because recent rights issues have failed, the belief has developed that there are no holders of private capital willing to invest in UK banks. This is nonsense. It is true that large investors prepared to inject billions are yet to come forward. But the shares are being traded in the market every day; there are buyers as well as sellers. The problem is simply one of organising a successful fund-raising exercise and discovering a price at which investors will buy into the banks. Rights issues are a possible solution.

At present, underwriters for rights issues by banks are very thin on the ground. Normally, underwriting would be done by other financial institutions, but in the current conditions such organisations are likely to be wary and charge a great deal for their services. Especially as the Bradford & Bingley underwriters may have taken large losses. The government, though, could take on the underwriting role. To avoid later accusations of having provided state aid, the government could charge a reasonable (but not fire-sale) fee (e.g. 1%, raising a figure in the £100s of millions) for its underwriting service. Perhaps the fees, after costs, could be given to the Financial Services Compensation Scheme (FSCS) fund, which is currently short of £14 billion after the B&B nationalisation and will require further funds to compensate Icesave account holders. Only shares not taken up by existing shareholders (or those to whom they sold the rights) would end up owned by the taxpayer and these would be very cheap. It might even be possible to stipulate that any shares left with the underwriter (the government) would have preference status.

The announcement of a scheme for the banks to raise funds by rights issues could immediately improve confidence in the banking system, especially if rapidly followed by (pre-arranged) statements of support by major shareholders. The market would know the banks would definitely receive the funds, because the government would be underwriting the share issues.

The worst case for the public finances is that one or more of the rights issues fails and shares end up with the government, as underwriter for the issue, but nothing would be lost compared to the other option on the table, partial nationalisation by issue of preference shares, as long as the rights issue price is less than the government would have paid for a stake anyway.

Going down the preference share route could seriously backfire for the taxpayer. If the economy deteriorates further (e.g. credit conditions are slow to improve, interest rates remain high, house-prices fall by 50% and unemployment rises dramatically), the market may eventually judge one or more of the “rescued” banks to be worth no more than the preference shares (especially if the government is greedy), and the ordinary shares could be effectively worthless. Raising private capital by rights issues or otherwise would then become next to impossible, and the taxpayer would be left holding the baby, i.e. effectively guaranteeing the bank’s creditors up to the value of the preference shares. The government could be forced to put even more than the initial £50bn at risk, by buying more preference shares.

In contrast, if capital is initially raised through rights issues, it would be possible to repeat the exercise should the economy deteriorate badly. One presumes Alistair Darling wants to avoid being recalled in the same breath as Denis Healey as a Chancellor who had to go cap in hand to the IMF for a loan to bail out the UK’s public finances. Perhaps before committing taxpayers’ billions for preference shares he should satisfy himself that all possible alternatives have been exhausted. An informed parliamentary debate on the issue might reassure the rest of us.

Honey, I’ve Shrunk the Banks!

Darling, what have you done?

I’m beginning to think you’re not really trying.  Still, if I were you, I’d probably be making the most of my one brief moment of power as well.  You must be getting a real kick out of waving your hand and transferring vast sums of money from one group of people to another.

Perhaps I could remind you what you should be trying to do.  You should be trying to get more capital into the banks, preferably private capital, since we’re all tax-payers.  It’s not rocket-science.  I’ve spelt this point out a few times – here, for example.  But don’t take my word for it, read John Hussman’s explanation in the comments on this FT piece.  Hmm, maybe it is rocket-science if it has to be spelt out to readers of an FT forum.

Now, has the “nationalisation” of B&B increased or decreased the risk capital available to support the £1.3tr British credit binge?  Let’s see:

• an appendage of this increasingly Triffid-like government – sorry, that’s a bit cryptic: I mean to say one or more of the Tripartite Authorities – recently persuaded the banks (and some funds) to underwrite a £400m B&B rights issue.  They were left holding many of the new B&B shares.  Perhaps they covered the risk by short-selling, but if not, they’re marking down their value probably to zero, that is by some £100mills right now.  More of a write-off than a rights issue, it seems.  Jeremy Warner in the Indy has a quote:

‘As one banker put it last night: “Don’t expect us to put up anything for other banks after this. It’s all very well to make shareholders take the punishment for bad lending, while depositors are protected, but we were trying to help.”‘

• the deal involved Abbey/Santander paying £400m for B&B’s liabilities, i.e the savings accounts. That’s another £400m of risk capital unavailable to the banking system as a whole.

• then we come to the coup de grace.  The Triffid has had the chutzpah, the cancerous gall, the… words fail me, to charge the Financial Services Compensation Scheme (FSCS) for the whole of the £14bn of the B&B deposits that are guaranteed.  Worse, the FSCS doesn’t even have £14bill.  It will have to pay interest to the government (unless LIBOR plummets, more in one year than the £400m the savings business was sold to Santander for, which somehow bothers me a tad – wouldn’t the FSCS’ interest have been better served by managing the savings accounts?).  Now, I’m not an accountant, but if I was, I’d be expecting to see an entry relating to the £14bn + accrued interest on the balance sheet of every bank (and building society) that is a member of the FSCS.  Of course, this amount will be offset by the value of the B&B book, which will hopefully pay off most or all of the FSCS loan.  That is, our little Darling has decided to transfer the black-hole in B&B’s capital onto the banks as a whole.  And there’s a bit of an agency problem in that the surviving banking community will ultimately have to pay for whatever politically expedient decisions the Government takes as it runs down B&B’s mortgage book.

Not only does the nationalisation of B&B weaken the surviving banks, it will also be next to impossible to repeat it.  The FSCS can’t keep borrowing billions, surely.  Or more to the point, banks can’t keep taking other banks’ liabilities onto their books.  I would have thought repeatability was a good test of the effectiveness of a form of intervention.

And don’t think the taxpayer has escaped scot-free.  For political reasons the Government has decided to put the rights of holders of £4bn in deposits above the FSCS £35K limit ahead of the rights of shareholders.  That’s right.  The taxpayer will lose out before those who had more than £35K in a B&B account.  With a wave of his hand Darling has committed the taxpayer to protect £4bn more B&B savings than necessary.  I’d really like to know whether the taxpayers’ £4bn is to be paid back before the banks’ £14bn…

The Government has no coherent plan for restoring the operation of the banking system.  They’re making things worse, not better, they’re draining capital when they should be helping banks raise it.

Omigod, they’ve just rejected the bail-out.  My violin’s just been drowned out…

Righting Rights Issues: Further Reflections

It’s incredibly annoying when media organisations give the appearance of encouraging debate, but in fact simply don’t. The BBC’s “Have Your Say” is truly appalling: there is often a backlog of hundreds of comments over hours or days which have not been “approved”. Why pre-approval of comments is deemed necessary is beyond me (even the most innocuous subjects are “Fully Moderated”) – surely just permitting complaints (and if substantiated removing offending posts) is sufficient. After all, people can post what they like elsewhere on the internet. If the BBC can’t resource “Have Your Say” perhaps they shouldn’t bother – they’re drawing traffic away from other discussion forums and blogs. I recently complained to “Have Your Say” along these lines, but I’ve had no response. I guess they haven’t the resources to respond to complaints. Doh! I’ll be happy to respond to any sensible complaints here!

Anyway, this morning I spied a piece by Jeremy Warner at the Independent. I noticed that the Indy offers the opportunity to post a comment. Maybe this facility is new, as I don’t remember seeing it before. Anyway, at the end of my post I wanted to say “I told you so”, by linking to this blog. Specifically, my parting shot was going to be:

“The current problems were fairly predictable, e.g. see: http://unchartedterritory.wordpress.com/2008/03/19/how-to-play-dominoes/ “

Guess what? Of course, I couldn’t get the Indy’s robots to accept this. Presumably they want to control rather than encourage debate. I notice “JF” endorsed my comment. Perhaps (s)he would have liked to read my blog post too. This attitude is self-defeating. People prepared to increase the value of online articles and comment pieces will gravitate to less restrictive outlets, like the Guardian’s “Comment is Free” forum.

Anyway, I wanted to provide an update to my previous post, as I have become aware of a couple of nuances and thought some more about the rights issue process.

First, I mentioned underwriting costs, saying “I’ve read of 2-3% of the rights issue fee”. This looks like a cut and paste error, what I meant (obviously) was that the underwriting fee is typically 2-3% of the amount to be raised in the rights issue. But in distressed rights issues, which are the ones we’re concerned about here, it can be more. According to the Times, the B&B rights issue will cost £55m to raise £400m! We’re in rip-off City. There must be a better way.

Second, it’s been pointed out to me that there is yet another error in the Motley Fool article I quoted which purported to advise readers about the HBoS rights issue. They said:

“4. You do nothing and, at the end of the rights issue process, your rights are sold and you receive the proceeds.”

In fact, what HBoS would actually do according to their “Rights Issue Guide” is “arrange for the shares that your Rights entitled you to buy… to be offered for sale in the market” and buy more shares with the “premium obtained above the Rights Issue price”. So unless they can dump shares for all the lapsed rights at more than 275p (unlikely, now) you get nothing. When I looked earlier today, you could sell your rights for over 4p each, even though the share price is (just) under 275p. They were worth more last week, even when the HBoS share price was lower. The Rights are behaving like an option. In fact, they are an option. As we get nearer the rights issue date (July 18th) the less chance there is that the HBoS share price will shoot up to a level where it’s worth exercising the rights. So the Fool’s advice relating to points 2, 3 AND 4 is flawed (and in no circumstances would you get the “free money” the Guardian mentions – the best HBoS will offer if you let the rights lapse is HBoS shares to the value of the rights).

It seems more and more to me that the rights issue process as presently conducted is itself likely to drive a company’s share price towards the rights issue price. It’s very interesting to watch the HBoS share price. Today, for example, the stock markets snapped back. Lloyds TSB shares were up more than 6%, Barclays more than 5%, for example. But HBoS gained only just over 1% and closed under the rights issue price at 273.5p. The problems now, of course, are that:

- the market is swamped with options to buy at 275p. No-one holding these need pay more than a little over 275p for HBoS stock (they could try to do a little better by selling the right and simultaneously buying the share at less than 275p + the value of the right, but if enough people do this the rights price falls and the opportunity disappears).

- everyone knows that a huge number of shares are going to be dumped on the market in a couple of weeks and that the sellers (the banks underwriting the issue) will settle for anything over 275p. The Rights Issue Guide says so!

- people have been able to buy HBoS stock at less than 275p for some days (and may well be able to do so again before the rights issue date), which has satisfied many potential buyers of HBoS stock, including holders of the rights who are therefore able to sell them, depressing demand for HBoS stock further.

It seems to me for the third of these reasons in particular, that, once a share falls below the rights issue price for any length of time, it’s rather difficult for it to struggle much above it.

Now, how did we get into this mess?

When a company, such as HBoS, implements a rights issue, its shares are likely to drop in value somewhat, for two distinct reasons. The profits of the company’s business are simply going to be distributed among more shares (“dilution”). What’s more, some of the value of the shares is transferred to the rights, because the rights allow new shares to be purchased at a discount (in the HBoS case I calculate that the shares should have dropped around 10% in value when they went ex-rights on 27th June, so the discount was only “really” around 1/3, not 40% – the only problem is they’d already fallen close to the rights issue price!). Of course, if the market believes the money will be used to grow profits, e.g. develop a new aero-engine or acquire a rival software company, to allude to two issues I remember, there will be more profit to go round. This is not the case for distressed rights issues. The prime purpose is not to improve profits, but to bolster the balance sheet and address cashflow risks (so the 10% drop is a conservative estimate – I’d expect it to be more, though this would occur when the rights were announced or even rumoured, not on the ex-rights day).

The initial price drop will not help market sentiment. But it is the compounding of market sentiment with the mechanics of the rights issue that really causes a problem.

Let’s imagine that rights have been awarded to shareholders and shares in the company in question have dropped appreciably for the reasons just discussed. Now:

(1) Some shareholders will simply not be able to take up their rights. They might simply not have the cash (fairly predictable that much of the retail base of HBoS shareholders won’t right now, I’d have thought). Or, perhaps important in the case of HBoS, the shares could be in an ISA wrapper (HBoS provide one) to which cash cannot be added without incurring a penalty, i.e. the loss of the year’s entitlement to set up another ISA (including a cash ISA). Whatever the reason, shareholders unwilling to exercise their rights will either have to sell them or carry out a “tail swallow” (which involves a net sale of rights). This will depress the value of the right. E.g. in the case of HBoS the share price might be 300p, but the rights price 20p. [Actually, even at 25p the rights would be a bargain because of the value of the option to buy at 275p. This is worth something more than zero to represent the possibility that the share will fall below 275p before the rights issue date. This option value is ignored until point 3.].

(2) Now the “tail swallow” is not the whole story. It may be the only practical option for retail investors and is the only option provided on the HBoS form. But it would be daft for a fund manager who doesn’t want to exercise the rights to sell them at 20p and buy shares at 275p (by using the proceeds to take up the rights issue) if the shares were at 300p. They’d be much better off selling shares (and rights) at 300p to take up rights at 275p.

Consider: 100 rights at market value of 20p, 100 shares at market value of 300p.

a) Tail swallow: have to sell 13.75 rights to take up a share. Therefore can sell 94 rights raising 1880p. Exercise rights for 6 shares. Result 106 shares + £2.30 (+ use of £18.80 for some weeks).

b) Sell shares to exercise rights: sell 92 shares raising £276. Exercise rights for 100 shares for £275. Result 108 shares + £1 (+ use of £276 for some weeks).

Magic! Of course stamp duty (0.5%) and dealing costs need to be taken into account, but for a fund with, not 100 HBoS shares and rights, but 1,000,000, these would be negligible. So if the rights fall even 1% below “fair value” it would be better to carry out option b) rather than option a).

So if the value of the rights drops – because of supply and demand – it also drags the value of the shares down towards the rights issue price.

(3) Now we need to take the value of the right as an option into consideration. If the value of the share is above the rights issue price, it may still be worth buying the rights above fair value price, or holding them (in point 2(b)) for the option to buy HBoS at 275p (and to reflect the fact that they don’t have to put the money up for a while), hoping to in fact buy HBoS for less than 275p. The more likely the share price is to remain above 275p the less the rights are worth purely as an option, and the closer they should be to fair value. So our fund manager in 2b may prefer to sell the shares at 300p as described even if the rights price is (say) 26p, if the possibility of buying below 275p (see also point 4(c), below) is worth more than 1p, i.e. if the right simply represents a mispriced option.

Once the right has a high option value – say the shares are at 280p and the right is worth 10p in the market – then the incentive to “tail swallow” is greater. Selling the right yields 10p, exercising it a profit of only 5p.

This dumps still more rights on the market, depressing the value below what the option to buy at 275p should be worth.

(4) We also have to add into the equation the ability to sell short. If the right is worth less than fair value, i.e. share price (e.g. 300p) – rights price (275p) + rights value as an option to buy at 275p, then it is worth selling the share short and buying the right.

Say the right at this point costs 28p. I sell the share at 300p and buy the right. Net cash 272p. Now:

a) If the share stays above 275p I can exercise the right. I lose 3p (but see also point (c)).

b) But if the share falls below 275p I can close my position by buying the share. At 270p I make a 2p profit plus what I can sell the right for.

c) But it’s better than this. As long as the share price falls below 300p I can buy the share and sell the right. E.g. at 280p, the right may have relatively more value than when the shares were at 300p. Maybe it’s worth 10p. [Because of demand: instead of buying the share at 280p, some people will buy the right (or mispriced option) to lock in the price (effectively 285p) in the hope the share will rise before the issue date (in which case they can sell the share short and close the position by exercising the right).] If I’ve sold short, I might buy the share at 280p and sell the right for 10p. My closed position is worth 272p – 280p + 10p – a 2p profit again. [Or maybe I just change strategy, in which case I don't sell the right but just close the short share position. I've now gained 20p (less taxes etc) on the share deals and have a right (that cost 28p) for a net 8p, which the market values at 10p, but which I might value at 12p, because its price is reduced by the excess of sellers of the rights over buyers].

So the conclusion so far must be that if there is any possibility whatsoever of a rights issue failing, the rights represent cheap options from which traders can profit.

(5) The more volatile the market, the more expensive options should be. I wrote earlier that LloydsTSB shares rose over 6% today and RBS over 5%. That’s a large movement. No-one has a clue whether the UK housing market will drop 10% or 40%. HBoS stock is likely to be volatile. Indeed it dropped dramatically in March after some rumours and bounced back the same day. Therefore options should be more expensive than usual. But a rights issue gives a cheap supply of options to buy (calls).

(6) Once the share price drops below the rights price, then, as we have seen, it’s unlikely to rise above it, because when its below the offer price people can simply buy shares in the market and sell the rights – increasing the supply of rights. The cheap option allows people to sell short even below the rights price, because their risk is limited by the ability to close the position by exercising the right.

(7) Then to complete the picture, we have short-sellers who anticipate all this happening (maybe not consciously, but based on experience). They can sell the shares short ahead of and at the start of the rights issue to get the price to the range where the share is vulnerable, possibly hedging their position with regular options.

Now, maybe all this is not conscious. The “evil hedgies” doing all this will, I presume, have software giving them a minute by minute update of their exposure, flagging opportunities and even trading automatically. In any case, they are worried only about their own position and not the market as a whole.

How could this happen? Perhaps rights issues are being carried out as they’ve always been, but insufficient modelling has been done to reflect the changed landscape. Maybe the game theorists need to be brought in. But of course the people who should do this – the investment banks – have a vested interest in the current method of carrying out rights issues: those massive underwriting fees. Even so, whoever decided that the HBoS rights issue should be at 275p has made a serious mistake (since even the underwriters don’t want the issue to fail), since the current problems were easily avoidable simply by choosing a lower price at which to offer the shares. £4bn worth of shares at 275p aren’t selling, but £4bn at (say) £1 each might have done. And if you’re going to put 1.5 billion options in circulation it might be best to be absolutely sure they’re worthless as hedges against short-selling!

Who’s lost and who’s gained? Well, the canny traders have gained – all those little gains per share we identified earlier. The main losers are HBoS shareholders who haven’t bought shares in the market at less than 275p. They’ve been diluted by 2 shares for every 5 for very little compensation. Of course, having said all this, HBoS shares may really be worth less than 275p! The market could be pricing them perfectly!!

I suggested back in March that the BoE/FSA should basically order banks to raise capital through rights issues (or otherwise), which is what seems to be happening. This presupposed a way of conducting orderly rights issues. I suggest now the authorities look at how rights issues are conducted and perhaps adopt my new method of discounting against the price on the day of the rights issue, not as at present against an arbitrary price some weeks before.

Righting Rights Issues: Issues

I spluttered on my morning coffee on Saturday when I read the advice to HBoS rights holders in the Guardian “Money” section (which I always enjoy reading for its coverage of telecomms and other rip-offs if there’s time left after the Killer puzzle in the main section!). What the Guardian writers neglect to tell their readers is that even though the HBoS share price is below the rights issue price (275p), and has been consistently for some days now, the rights still have value. This is because they are now in effect an option to buy the stock at 275p. This option is of value to people who, for example, may have sold HBoS shares short (no-one’s going to buy them simply to participate in the issue when they can buy the shares more cheaply in the open market). The short sellers will have to buy HBoS stock back at some point to close their position, and having an option to do so at 275p would protect them against some sudden good news on the UK housing market, say (I know, I know, we can but live in hope) or some sudden heavy buying of HBoS (perhaps more probable) causing the shares to rise suddenly. With many short-sellers trying to buy to close their positions at the same time it’s possible for the share price to rise rapidly – an extreme case of the phenomenon is termed a “bear squeeze”. An option to buy at 275p would limit any losses short-sellers could incur, or lock-in profits, depending on the price at which the shares were sold short. Investors may also want to buy the rights just in case HBoS shares do rise above 275p by the issue date (18th July), in which case they would be able to participate in the issue.

Right now the HBoS share (bid) price is showing 273.25p, and the rights are worth 6.25p (at HBoS). None of the following constitutes financial advice, but a “best guess” must be that the shares will not change very much at all before the rights issue date of July 18th – otherwise there would be an excess of buyers or sellers and the price would have already moved… Now, HBoS are offering to deal in the rights for nothing, so if you’re definitely not going to participate in the rights issue, it’s likely to be best to sell the rights straightaway. I say straightaway since the value of the option will decline (unless the share price increases) as we approach July 18th (because it expires on that date and the less time there is, the less chance HBoS shares will increase in value).

On the other hand, if, all along you’ve remained happy to “take a long-term view” and invest at 275p you could simply buy the shares in the market this afternoon for less than 275p and sell the rights for 6.25p each.

But if you simply let the rights lapse and the unsold shares are sold in the market it is very unlikely you will get anything back, let alone the “free money” the Guardian mentions. If no-one wants HBoS shares today at 273.25p it’s not likely they’ll be queueing up to buy them at 275p on July 18th, is it? Unless something changes, of course.

At first I assumed it was just the Guardian that was omitting the crucial bit of information that the rights have value even if the share price is below the issue price. But the Guardian was not alone. They report themselves that: “One newspaper this week bluntly advised shareholders to ‘dump this document in the recycling’ as the issue was dead in the water.”

Sunday morning, and once again I found myself spluttering on my coffee. An email from Motley Fool linked to an article “HBoS Rights Issue: Yay or Nay?”. Now, this is a freebie from an organisation that, if I understand their business model correctly, would like me to subscribe to premium content investment advice. Well, it hardly encourages me to sign on the dotted line when they identify the various options:

“1. You take up your rights, sending off a cheque for the full amount

2. You partially take up your rights. In practice, you sell most of your rights and use the proceeds to buy some shares. This process is sometimes called tail swallowing.

3. You sell all your rights and receive the proceeds which will depend on the market price at that time.

4. You do nothing and, at the end of the rights issue process, your rights are sold and you receive the proceeds.”

and go on to say:

“However, when the share price falls between the announcement and completion of the rights issue there is an additional complication. If the share price falls below the rights issue price there is no point taking up your rights as you can buy the shares more cheaply on the open market. This is why it often pays to wait and see what happens with a rights issue rather than making a decision straight away. A share price fall of this magnitude also means there will be no money available to fund option 2 and no sale proceeds from options 3 and 4.”

As I’ve already demonstrated, it is simply not true that there will be “no sale proceeds” from option 3. By the same token, if you chose option 2, HBoS would (presumably) sell the rights for you now at around 6.25p each, so, since you’re likely to have at least 100 rights, you would end up with a few shares come July 18th.

Since the media are fairly consistently encouraging people to ignore the rights issue altogether I wondered how much this might be costing the poorer-than-last-year HBoS shareholders. The prospectus advises me that the Rights Issue is of 1,499,662,328 shares – call it 1.5 billion (who skimmed the missing 337,672, I wonder?!). HBoS has a lot of direct retail investors – though unfortunately the Rights Issue prospectus doesn’t seem to tell me the number of shares in small holdings – but if it’s even 10% of the stock that’s 150 million rights. If even 10% of these fail to sell their rights because of what they’ve read in the press, then that’s 15 million rights that have lapsed unnecessarily. This is not enough to swamp the market – HBoS are selling far more than that on a daily basis – so they could be sold for (say) the 6.25p on offer today. 15 million x 6.25p is near enough £1m. So on my assumptions (which I consider fairly generous), the press would have cost the suffering shareholders of HBoS amongst their readers a collective £1m windfall. Not to mention their employers the massive fines for giving poor financial advice which are surely heading their way!

Surely avoiding little slips like this in future would justify for a week or two of remedial training for a few financial journos at their friendly local business school.

But I digress.

I wanted to revisit my previous post on this topic, which got a little confused towards the end.

The issue of how banks raise additional capital is kind of important because, if they can’t do this successfully, they have no choice but to continue to ration mortgages (given the lack of any sign of a reopening of the market for mortgage securities – I’d have thought this would be a priority for GB at the G8, but not as important as the BOGOFs in my fridge, it seems, not that I don’t agree that these are a scandal). And the longer and tighter the rationing, the greater the suffering of homeowners, particularly first time buyers – often young families – and the fewer houses will get built, storing up even more problems for the future. Not a trivial problem.

Let’s recap. Rights issues by banks are not proving a rip-roaring success: it looks like the HBoS and B&B issues will mostly be left with the underwriters (perhaps they could have a BOGOF promotion or maybe they could give a “free” B&B with every HBoS…). And funds aren’t too enthusiastic to help (TPG at B&B).

I suggested in my previous post, that a number of problems could be avoided by awarding existing shareholders rights to purchase at a discount to the price on the day of the rights issue rather than at an arbitrary price announced prior to shareholder agreement to proceed with a rights issue, i.e about 6 weeks in advance.

I realise this might be a bit counter-intuitive. How can the new shares be at less than the price of the existing shares when in fact they are exactly the same thing? But we mustn’t confuse the cost of the new shares with their value. Only holders of the rights at the issue date will be able to buy the new shares at the offer price. And the market (arbitrage) will ensure that the new shares are issued at (almost) exactly the market price of the old shares less the (market) value of the rights needed to buy them.

In fact, we found laboriously last time, but could have worked out with 5 minutes reflection, that the value of the rights can be established accurately. In my scheme, remember, each existing shareholder receives a right to invest a certain amount of cash in the company per existing share, at a predetermined discount. The actual number of shares their rights will buy is determined by the price on the day of the rights issue (perhaps averaged over the day to prevent market abuse).

Let’s take HBoS as an example. Their share price was at about 460p when they announced that each existing shareholder could buy 2 shares for every 5 shares they already held, at a price of 275p – about a 40% discount at the time. What a bargain! But calamity struck! HBoS has sunk below 275p and most of these shares will be unsold. “Fortunately”, other banks and investment institutions have agreed to underwrite the issue and will offload the shares on HBoS’ behalf at whatever price they can get.

In my scheme, HBoS could have announced instead that every shareholder could invest 550p in new HBoS shares for every 5 they already hold, at a discount of 40% (this figure is not critical) to the price on the day of the rights issue. A tradeable right could have been created for each HBoS share giving the right to invest 110p on July 18th and obtain shares with a market value of 185p on that date.

Putting it this way it’s fairly obvious that the fair value of a right (granted per share held before the rights issue, remember) is 75p. This value will not be affected by any movements in the share price of HBoS before the rights issue date.

HBoS would have to create extra shares to allow for any fall in the share price between the date of the rights issue announcement and the actual rights issue. But this is not a problem. According to the prospectus they have created (as opposed to issued to shareholders) 2.5 billion shares ahead of the current rights issue, rather than the 1.5 billion they need. There’s nothing stopping them creating 10 or 100 times as many. Surplus shares can always be cancelled, or just retained by the company (all subject to agreement at shareholders’ meetings, of course).

Now, I suggest that this new method would avoid many of the problems we’re seeing:

- most important, it’s much more likely the money would be raised. The rights in the case of HBoS would, for example, be worth 75p a share whatever happened to the HBoS share price by the date of the rights issue. The rights price would fluctuate in the market, but not by much, since any fall would allow investors to make an immediate profit on the date of the rights issue. They could obtain the right to buy shares for 75p less than the market price for less than 75p! The value of the rights would never drop to a few pence, representing an option to buy the shares, since anyone owning them would simply lose 75p per share if they allowed them to lapse. It would be crazy not to either exercise the right or sell it.

- because the rights issue would not rely on the share price remaining above a predetermined level, traders (such as those evil hedgies!) could not profit by creating a short-selling bandwagon (with the ever-present temptation of spreading a few malicious rumours) hoping to make the issue fail, creating an overhang of shares in the market, depressing the share-price further. Short-sellers, of course, are hoping to buy back the shares for less than they paid for them. In the new scheme it becomes more rather than less important to take up your rights as the company’s share-price declines, since you receive more new shares the lower the company’s share price on the day of the rights issue. This acts against the short-sellers.

- in fact, I can’t think of how a rights issue based on a discount to the market price on the issue date rather than weeks before could come under speculative attack. The only potential problem I can think of is that holders of the rights would have an interest in lowering the share price before the rights issue date – they would gain at the expense of shareholders who had sold their rights – but to try to lower the share price would be market abuse (which could happen with any stock anyway). No bandwagon would develop because as soon as the overall value of the company fell below the market consensus, investors could profit from either buying the shares or the rights. This risk could easily be addressed by averaging the share price on which the rights award is based over a trading day (or longer). There’s also an inbuilt check for market manipulation: any movement of the rights significantly above fair value (75p in the HBoS example) would be a red flag to the regulatory authorities (though significant positions would also have to be disclosed, as at present). [The rights would be expected to trade at a little more fair value, 75p in my example, because they allow the holder to pay for HBoS stock in the future - i.e. the balance (110p per right in my HBoS example) can be invested elsewhere until the issue date.]. [Postscript: The fact that any market-manipulators would also be possibly able to profit by pushing the share price up and shorting the rights, is another factor weighing against a market bandwagon developing in the shares and/or the rights between the rights announcement and issue dates, in my suggested scheme].

- the costs of underwriting are much reduced. In my HBoS example, very few shareholders are likely to leave 75p on the table, so the underwriters would have very few shares to sell. In fact, the underwriters would most likely achieve more than the discounted price for shares to be sold on (but less than the market price), so would command a fee less than the value of the lapsed rights! That is, shareholders taking up the offer (or selling their rights) and the underwriters would make a small profit at the expense of any shareholders who allow their rights to lapse (judging by the post from Computershare which I “return to sender” unopened on a regular basis, some such shareholders may well have died some years ago!). At present the company (i.e. shareholders) have to pay a significant fee (I’ve read of 2-3% of the rights issue fee) to the underwriters whether or not the issue fails, and lapsed rights of a failed rights issue are worthless (i.e. no-one profits directly from the existence of lapsed rights since like a share option they have no intrinsic value).

I suggest that my new scheme is closer to the original intention of rights issues. The basic idea of a rights issue, I suggest, is that shareholders all agree at a meeting to put some more money into a company either to exploit an opportunity (e.g. develop a new product, fund a takeover) or to cover losses or a change in the economic climate threatening the company’s cashflow position or its ability to raise cash any other way (e.g. by issuing debt). The fact that the share price can fall below the rights issue price is merely a result of bureaucratic delays and the need to grant shareholders a period to raise the cash or sell their rights. The scheme I’ve described would sidestep the problems that can result from this delay, particularly in today’s fast-moving markets.

Worth a try?

Rights (said Fred?) may not be dead

The UK’s banking sector is certainly providing the entertainment missing from this year’s Wimbledon women’s singles non-tournament. After the Rock it’s now the turn of the Bradford Bungley bank. The Guardian includes a brief synopsis of events in its report of the latest stage of the fiasco. The basic problem is that rights issues aren’t working for the banks because the share price keeps falling below the issue price. This has happened to HBoS as well as B&B. There may be some technical reasons contributing to these mishaps, but the main reason is that the prices of the rights issues were set before the extent of the car crash that is the UK housing market (and economy in general) became fully apparent. When commenting on a piece by WIll Hutton last week it occurred to me to wonder why such rights issue accidents are allowed to happen.

Cutting to the chase, my suggestion is that instead of setting the price of the shares to be issued 2 months (say) before the issue date, and thereby becoming a hostage to fortune, companies could simply set the percentage discount to the share price at which the new rights issue shares will be issued. That is, if I was HBoS and my shares were around 500p, but I wanted to raise another £4bn to cover the possibilities implied by the possible UK housing meltdown scenario my strategists have identified, instead of announcing:

(1) as now, that shareholders will be able to purchase 1.5bn (approx.) of new shares at 275p in 8 weeks time, at a ratio of 2 new shares for every 5 shares held;

I would say:

(2) that shareholders will be able to subscribe to rights in new shares at a rate of 55p (a guesstimate of what HBoS are raising) for each share held. The new shares would be issued at a price 20% (say) below the closing price on the day of issue. For example, in the HBoS case, the shares could have risen to 550p by the rights issue date. In this case, putting in 55p for each share I already hold, I would receive one share for every 8 pre-rights issue shares I had (i.e. my new shares would be at a cost of 440p each). Alternatively, and closer to reality, the shares might have fallen to 275p. I would still have put in 55p for every share for which I had received the rights. But this time I would receive one new share (at 220p each) for every 4 shares I held before the issue.

I thought I’d work through this proposition a little more. In a rights issue we want to achieve 3 things:

- we want to raise a predetermined amount of money. In both case (1) and (2) we raise (say) 55p per existing share.

- we need to provide an incentive for shareholders to stump up the dosh. This is only true in case (1) if the share price stays above the offer price. Because it might not we shell out a fortune to underwriters. In case (2) shareholders always have an incentive to subscribe to the rights issue, otherwise they face being diluted by shares sold at a discount, equivalent to if a placing had occurred. But placings have the drawback that existing shareholders can lose out, i.e. lose their pre-emption rights. Much of the point of rights issues is to avoid this.

- we can protect shareholders who don’t want to or are unable to subscribe to the issue, allow other investors to buy in and reduce under-writing costs by allowing the rights to be transferable – i.e. bought and sold. The market price of the rights would converge on 20% of the value of a share after the rights are purchased (some recursive arithmetic is needed). [no it isn't - the rights price will not vary simply because the share price changes - see Postscript.]. For example, in my HBoS example, it’s rational to buy the rights for up to about 10p (another guesstimate) if you think the value of HBoS shares after the issue of new shares will be more than £2.50. Obviously there are other factors to consider – e.g. the effect of the additional capital on the credit rating and hence cost of capital for the organisation.

[More accurately, in the example above, 1 share at 220p would be issued for every 4 existing shares if the HBoS share price is 275p on the rights issue date. If HBoS was worth 275p just before the rights issue, it should be worth ((4*275)+220)/5 = 1320/5 = 264p immediately after the rights issue, reflecting the 1 for 4 issue at 220p, so the rights to a share should have been worth (264-220)/4 = 11p.]. *

It would be irrational not to at least sell your rights (as it is now), but some shareholders are bound to let them lapse. The underwriters could be required to purchase the new shares corresponding to these rights, though in theory would make an instant profit (or companies could just ask for a bit more money than they need).

The threat of an overhang of unsold rights issue stock would be much reduced. Since such an overhang is one cause of share price declines ahead of rights issues, the current way of issuing rights at a deeply discounted share price falls into the self-fulfilling prediction category.

Existing practices could still take place. Rights could still be treated as pseudo-options, albeit a little differently than at present. You could still “tail swallow” by selling enough shares to cover your rights, because you are still being asked for a certain amount of money per existing share, though may end up selling a few more shares than necessary (since the price of the new shares is not known beforehand).

The only instance in which there would be no market for a rights issue would, it seems to me, be if a company is worth less than zero, that is, if it is not a going concern (and everyone agrees that this is the case), in which case no amount of rights issues would save it. Otherwise, even if the share price and hence price of the nil-paid rights drop dramatically before the rights issue [see Postscript - actually the value of the nil-paid rights would be unaffected], there will eventually come a point where it makes sense to take up the rights, since, as the share price declines, the rights issue (which, remember, is per existing share) will buy a larger and larger proportion of the company.

There may be legal niceties to overcome. For example, it might be necessary to issue (or get permission to issue) more shares than needed (since e.g. an EGM might be necessary for this), so that the number sold can vary depending on the share price. Shares not sold could be cancelled.

Procedures would be needed to deal with the entitlements to fractions of a share that might arise in method (2), but this is already the case in method (1). It’s slightly worse in method (2), since the fractions are not known in advance. In this age of electronic payments, and online share-trading, giving people a small amount of change (or allowing them to elect for it to go to charity!) should not be an insurmountable problem.

Why wouldn’t such a system be workable? Wouldn’t it reduce the risk of rights issues failing, and hence underwriting costs? Answers, especially attempted debunkings, on a postcard, please.

—————-

*[Postscript 18:00 4/7/08: The example above in square brackets isn't quite right. If I knew the share price was going to drop to 264p I'd sell my shares at 275p and buy them back! We need to add the option price (11p) into the calculation (264 + 11 = 275), i.e. the share price + the value of the rights should be 275p, but this would mean the actual share price is 264p, so we'd issue a few too many shares. Rather, we have to reach the share price at the moment of the rights issue by doing the calculation the other way round. If we think the company plus new capital is worth a certain amount (in £bn) then we can create a formula for the option price (z), share price (x) and number of shares (y) to be issued at the moment of the rights issue.

We estimate V, the value of the company after the rights issue.

We know a, the number of shares before the rights issue, b the discount for the rights issue and C the amount of money to be raised.

We can solve for y, the number of new shares to be issued:

After the rights issue, the share price, x = V/(a+y) [1]

The money raised C = xy [2]

From [1] and [2]:

C/V = y/(a+y) [3]

That is, very simply, the number of new shares to be issued y, as a proportion of the total shares in the company after the rights issue, is given by the money to be raised as a proportion of the value of the company after the rights issue.

Doh! We can do this even more simply, from the known value, V, of the company after the rights issue and the known amount to be raised, C, and assuming the rights issue completes, the value of the existing shares x, after the issue is:

x = (V-C)/a [4]

We can then derive y straight away from [2].

Never mind, let’s do an example!

E.g. company value £100 after we raise £20. 100 shares before issue.

20/100 = y/(100+y) from [3]

100+y = 5y

y = 100/4 = 25 (we issue 25 new shares).

So x, the share price, at the issue is 80p (£20/25 shares).

Check: The 100 existing shares must also be worth 80p, so we now have shares worth 125 * 80p = £100.

—

BUT what is the price worth paying for options (rights) to buy these shares that will be worth 80p?

The value of the rights must be the same if we subscribe ourselves or if we don’t.

If I subscribe to the rights issue I receive new shares so can imagine I am not diluted by 125/100 and still have the same proportion of the company afterwards as I did before. It costs me 20p per pre rights issue share to avoid being diluted by 25%. But this is 20*(100/125) = 16p per diluted post rights issue share (this may seem a strange line of reasoning, but this is what we’re comparing it with). With no dilution, my shares would be worth 100p each. For this option, that is, if I subscribe to the issue, each post rights issue share is therefore worth 100p -16p to me, that is 84p.

If I sell the right I only end up with a share worth 80p + the money I received for the rights issue. I should sell if I can get more than 4p.

You could derive this perhaps more simply, as the total discount for each of original shares. i.e. the total discount in this example was 5 shares (with no discount we’d have issued 20 rather than 25 new shares), which we’ve shown will be worth 400p, spread over 100 original shares, giving tradeable rights of 4p/share.

In general:

Undiluted share value – discount per original share = final share price + option/rights price (z), i.e.:

V/a – C(1-b)/a = (V-C)/a + z [4]

az = V – C(1-b) – V + C

z = Cb/a [5]

In this example,

z = £20 (0.2)/100

z = 20p * 0.2 = 4p. Bingo!

That is, the value of the nil paid rights (before supply/demand fluctuations) is simply the discount per share. We don’t need to know anything else to trade these babies. The amount of dilution, though, follows from the share price at the moment of the rights issue which itself is simply derived – everything depends solely on what you judge the company to be worth after the rights issue (taking into account any risks you identify) compared to the amount being raised in the rights issue.].