OPINION: Rights Issue; Boon or Misuse?

By Deepak Luitel

The rights offering is one of the popular financial instruments in that publicly listed companies can capitalize on the opportunity to raise additional funds quickly & efficiently without having to depend on external investors or issue debt or a bank loan. In another way, we can define this as a financial instrument being used to raise additional funds for the public company that allows existing shareholders to buy new shares in proportion to their holding at a discounted price (i.e., NPR 100). Despite this, executing the right offering is not easy or risk-free. Therefore, the right offering is not only the option, but there are sources that the company can use to raise additional funds.

The country underwent significant change in its economic frontiers after 1992, to be market-oriented and consumption-driven. Thus, the capital market is one of the sectors that came into existence to mobilize savings, allocate capital, determine prices, and foster economic growth & development.  Despite the three decades of capital market history, it is still in the developmental stages. However, many things need to be implemented to make an efficient & strong market. Usually, very young or growing companies go public to issue shares as an initial public offering (IPO) to raise to expand business or pay off debt. Likewise, rights share is another strategy that a company taps into existing shareholders for additional capital in case of tight cash flow or plans to grow & expand its horizon. Similarly, the right offering is a good option for companies that have weak a balance sheet or high leveraged interference to secure additional debt and can turn to the rights issue to meet their short-term obligation. Even though the dilution of outstanding shares is because of the right offering, it will be beneficial to shareholders in the long term to increase the value of the investment. Thus, dilution of outstanding shares spread a company’s net profit over a wider number of shares. Further, it decreases the company’s earnings per share (EPS) and is a major consequence of the right offering.

Likewise, shareholders have a choice about whether to buy rights or not. In the case of full or partial, a subscription of rights can be transferable to others through auction. Therefore, the execution of rights is the key challenge for issuing a company. However, subscription of rights depends on capital market conditions, the right timing, and earnings prospect. On top of that, before issuing a right issue to the shareholders, a company ought to evaluate various factors, such as shareholder demand for new shares, market sentiment, and how it is going to improve the company’s earnings potential in the future. In addition, the theory of finance states that companies seek the right offer due to either financial distress or a high debt ratio, which bars them from injecting further leverage. Notably, rights offering is also known as a defense mechanism that helps to prevent hostile takeovers and strengthen the shareholder base. There are also strategies and tactics, “Poison Pill.” is a defense tool used by the director of a public company to prevent investors or competitors from taking control of the company by buying large amounts of its stock. Thus, in this regard, the right offering is a viable option to raise additional capital.

Nepal capital market and right share approach.

The capital market in Nepal is currently expanding slowly. The NEPSE, the only stock exchange in the nation, started trading in 1994. Currently, more than 250 listed firm stocks are traded each day. Similarly, there has been a noticeable increase in the contribution of market capitalization, which made up 55.5% of its nominal GDP in FY 2023. Moreover, the preference of investors is equity share dominant trading, followed by the corporate debenture or bond market. The securities worth NPR 299.01 billion were listed on the NEPSE during the first eleven months of the current fiscal year. These securities included common shares worth NPR 176.10 billion, government development bonds worth NPR 45 billion, bonus shares worth NPR 39.09 billion, debentures worth 29.19 billion, mutual funds worth 5.49 billion, and right shares worth NPR 4.13 billion. Likewise, FY 2021/22 NPR 10.08 billion worth of right shares listed, compared with a percentage of 62.04% lower than the previous year. Subsequently, out of 250 listed firms, BFI’s stock dominates the capital market, accompanied by equity from the insurance & hydropower industries. Although the liquidity of equity shares is an important consideration of investors who prefer them to bond and debenture instruments, equity liquidity is substantially more dominant in nature, but, prone to higher risk. As a result, rights share is a popular option among listed firms to raise additional funds for capital-intensive projects or to meet regulatory capital requirements.

In addition, the securities exchange board of Nepal (SEBON), which regulates securities, shares issues either in a par or premium value, which is stated in the laws of Sebon. Although the issue price of rights may not be NPR 100, issuing company may value the price of rights are dependent on several factors, such as past & future growth prospects, current equity valuation, quality board & management team, market condition, and demand for shares may communicate & engaged with existing shareholders or potential investors. Obviously, investors would not like to buy rights to lose their investment value without the proper rationale analysis and benefits of exercise. Thus, executing the right issue is another challenge for the company. Because of the positive aspect of rights issues, will appreciate the value of investment in the long-term. Besides, rights issues are often referred to as “sweetener” investments because of their certain benefits to shareholders. Hence, due to this trait, the right issue has been a popular choice for listed companies to raise additional funds.

In the past, as well as in the present time, so many listed companies in NEPSE have issued the right shares to their shareholders, such as, commercial bank’s paid-up capital hike from NPR 2 Arab to NPR 8 Arab approval given by the Central Bank (i.e., NRB). Likewise, the life and non-life insurance industries have given approval to raise their paid-up capital either through en route rights issues or merger & acquisition. On the other hand, microfinance institutions (MFIs) will not be allowed to issue the right share to raise further capital. Such a provision prohibited them in the monetary policy of FY 20/21, but they can strengthen their capital base through either merger or acquisition. However, in other industries, there is no such provision to issue rights. This is a major irony in the Nepal capital market regarding the right issue. How many times does a company issue the right share to its shareholders? Is there any law or specific policy required to issue as many rights as possible? Similarly, sectors such as hydropower are long-term capital-intensive financing projects governed by high debt over equity and have no restriction on issuing the right shares. The monetary policy, explicitly states that hydropower projects can issue rights to pay off their outstanding long-term loans.

Let’s assume, that the company is allowed to issue rights irrespective of whether the company’s shares are traded at the market price of NPR 250 or NPR 35,000. In this scenario, no shareholders will be interested in buying the rights, and the offer will not be fully subscribed to. Or let’s put in other perspectives, for example, companies such as HDL, BNT, and Unilever Nepal are the listed companies in NEPSE as offering the rights at a face value of NPR 100. Then, there would be the full subscription of rights because it assured a huge profit. Regardless, as an issue comes to an end, a discount offered to existing shareholders will not show interest if the price of the issue is higher than NPR 100. This is the biggest paradox of the policy, which needs to be fixed in a logical way.

Currently, over 50 hydropower companies’ shares are listed in NEPSE, and their shares trade regardless of performance or an investor’s perception. The construction of the project is challenging in Nepal due to the complex geographical terrain, which requires a higher per megawatt cost (MW) and a longer horizon to get the benefit of an investment return. In general, hydropower or renewable energy projects’ capital financing is outweighed by debt, so equity can have trouble securing additional loans because highly sensitive interest rates are a major headwind for the sector when choosing rights offerings. Regardless of that, how many times can a project issue rights shares to its existing shareholders? The fundamental quality of some of the projects that have been issued more than three times after an initial public offering (IPO) is not impressive in terms of return on equity (ROE) or free cash flow to equity. In addition, there are projects whose book value is less than NPR 30, which clearly shows the quality of the project that has the potential to perform better. There is still suspicion that it can perform well after raising additional capital. Thus, the regulatory body has a lot of challenges to assess project financial quality, board & management experience, and knowledge of the sector prior to the approval of the rights share.

In the future, I believe the market will slowly start to realize the negative aspects of rights shares without a clear purpose. Thus, the right share is not only an option to raise additional capital, instead, the company may explore other alternative sources, such as private equity (PE) firms, hybrid instruments, preferred stocks, and options on stocks.

(Disclaimer: The aforementioned information in this article is the writer’s own opinion. All the readers are advised to make investment decisions based on their study and analysis.)