By Andrew He, Jimmy Xu, Gary Palar
The issue of ownership dilution, when companies raise new capital, has always had routine attention. But it has not been as prevalent as in recent times, as companies face the brunt of global lockdowns in response to COVID-19. Here, we explain the changes to the wealth of retail shareholders in light of a temporary measure by the ASX to increase the cap relating to issuance of new equity in a 12 month period, implemented in March until July of this year.
Preview to Lockdown
The pandemic outbreak of COVID-19 has put the ASX share market in a fragile place. There were unprecedented drops in the ASX200 early this year. The growth that has occurred during the past four years in the coveted “highest average return per year” domestic share market was wiped in less than a month. The worst-hit industries include transportation, travel and retail, all of which have taken blows since late February when governments began implementing social distancing and travel restrictions.
In response to deteriorating cash flow in these industries, and those that depend on these, many ASX listed companies have attempted to prolong their business by reducing costs and shoring up their balance sheets. It is no question this is in effort to handle decreased demand, but to also look to the future and be well-positioned to come out on top after the virus passes.
Raising equity through institutions (typically investment banks) has been the means to get quick capital, and this is unlikely to change. But the ease of getting capital comes with tradeoffs. The most obvious: the huge discounts of raising new equity. Clearly, this has been to the detriment of the shareholders who don’t get a slice of the newly issued pie. In many cases, these are retail shareholders.
On March 31st, the ASX announced a temporary measure to Listing Rule 7.1. This rule, 7.1, describes how companies are limited to issuing new equity of 15% of their issued capital without shareholder approval, within 12 months. The ASX Compliance Update was of a “temporary uplift in the 15% placement capacity in (Listing Rule) 7.1, to 25%” from the March announcement until July 31st. However, this was on the condition firms make follow-on offers to retail investors. ASIC also temporarily allowed certain ‘low documentation’ trading including share placements or share and rights offerings.
This had an immediate effect on the decisions of some companies in the market. Travel agency Webjet (ASX:WEB) was disrupted severely by COVID-19 and launched a raising of at least $275 million at $1.70 per share the day after announcement on April 1st, presenting a nearly 40% discount from its last share price, and 90% off from its highest point in the past year. The impact of COVID-19 is not limited only to travel.
Medical device company Cochlear Ltd. (ASX:COH), which supplies Nucleus cochlear implants, has been affected by the forced cancellation of implantation surgeries due to the outbreak. They had recently subsequently announced a raising of $800 million at a fixed price of $140 per share, or a 25 percent off from its share price on the trading day.
Institutional and retail shareholders
For institutional shareholders and strategic shareholders, this can be beneficial as they have the opportunity to buy into a firm they’ve been eying but didn’t yet have exposure to. Or, they may want to increase their holdings in one that is already promising, and at a substantial discount to market value. For retail shareholders, large capital raisings typically dilute their ownership in the company. In this case, this is dependent on how many retail shareholders take up new equity offerings after the initial placements to institutions.
Nevertheless, this usually results in a hefty wealth transfer from retail to institutional shareholders as it is almost certain not all retail investors take up this offer. The model below shows a comparison of the loss of control and wealth transfer from original shareholders, through an example of capital raises between issuing 15% of new capital, before March 31st and 25% new capital as in the temporary rule.
Modelling for New Capital
For our model, we assumed Company X Ltd has 100 million shares on issue with a current share price of $10 each, hence the market cap is $1 billion. Due to the COVID-19 crisis, assume Company X Ltd wishes to raise some capital. Hence, it raised the allowed maximum of 15% of currently issued equity, so it raises 15M shares. Recently, we have seen huge discounts so we’ve modelled using a 40% discount rate. In this case, the issued share price is $6.
Modelling for Wealth Loss when Max 15% Capital Raise Rule is Increased to 25%
Initially, to find the change in ownership we need to calculate the total new shares. We calculate this by adding 100M (original number of shares) plus the 15M (number of issued shares), which is 115M. Hence, if the company raises 15% of their equity, it causes original shareholders to lose 13.04% of ownership. Once we increase the allowed maximum limit from 15% to 25%, around 20% of the company is now controlled by the new shareholders which is a substantial amount. More generally, holding such a large stake in the company gives the shareholder power to sway votes in favour of them.
The Wealth Transfer
As for the wealth transfer, we need to calculate the post-deal share price.
The formula is:
This led to $9.48 at the 15% model. This estimated post-deal share price may not be a true reflection of what actually happens in practice. It is hard to predict what the post-deal share price is, however we present this as one of the most common ways to estimate it. In reality, if the issue share is $6, the stock price could fall close to $6 which causes an even greater wealth drop for original shareholders.
To determine the wealth loss, we need to find the difference between the equity value of the original shareholders before and after the capital raising. To find the equity value we need to multiply the post-deal share price with the number of shares. Finally, the wealth loss for original shareholders was subtracting the new equity value minus the original equity value which represented a decrease of 52M, which is 5.22% decrease of the original shareholder’s wealth.
This value is greater if we increase the maximum amount of capital raised to 25%, in this case we see a decrease of 80M of wealth loss, which is 8% of original shareholder’s wealth. This is a huge loss and is detrimental for the original shareholders, and especially so for retail shareholders.
On the other hand, the investors who participated in the capital raising would make 52.2M, as a whole. This represents a potential gain of 58% if they sold at $9.48, at a “free-profit”. We can see the stark contrast between the wealth gain and loss for the new shareholders compared to the original shareholders. Hence we can see that increasing the placement capacity to 25% can significantly impact the original shareholders. However, this was a model based on our above assumptions, and it may not reflect truly how the market reacts. In reality, there will be some discrepancy.
In addition, we haven’t modelled how non-renounceable rights issues taken up by retail investors, after private placements, would affect the wealth balance.
After the placement
Besides raising capital, many companies are cutting capital expenditure and other non-fixed costs by taking measures such as dismissing employees, pay cuts for senior managers, reducing employee benefits, deferring dividends or seemingly any combination of these to decrease perceived unnecessary expenses. Despite the criticisms about companies that are abusing the new measure, which, as previously mentioned harms the control of current shareholders, COVID-19 leaves some companies with little choice.
If these companies did not secure enough funding, they might be bankrupt in a couple months time. Although shareholders, as modelled, have been impacted negatively and their holdings were diluted, it may have been necessary to raise the capital to weather them through this storm.
We’ve attached the excel file down below, if you want to test it.
If you’re interested, you can try to model Webjet’s capital raising and see the wealth loss for the original shareholders.
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Thanks for reading!
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Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.