Apr 1, 2011

The good, the bad and the ugly

In a recent paper, signed by Joseph Harvey, President and CIO of Cohen and Steers (disclaimer, Cohen and Steers is as far as I know one of our shareholder), the investment manager argues about the merits of allowing European REIT to execute capital increase excluding subscription rights. (The document can be read at the following address http://bit.ly/flBlrP)

Having executed a recent capital increase for alstria with the exclusion of subscription rights, I wanted to share my thought on the matter, and explain how we have looked at the issue from a company perspective.

Cohen and Steers highlights the rationale behind the subscription right concept which is (1) to prevent shareholders dilution and (2) to prevent management from selling shares to a specific third party at an advantageous price at the expense of existing shareholders.

Considering that the German regulation impose that non preemptive capital increases within a 5% margin from the prevailing market price, the only remaining rational for the subscription rights in Germany is to prevent shareholders dilution. On the face of it, there is nothing wrong with the concept of the right themselves. It is just fair that the company which is looking to do a capital increase (which is assumed to be more often dilutive than relutive) offers its existing shareholders the opportunity to provide the capital first.

From my perspective, the negative about the rights is not in the concept, but in the implementation. In order to be able to offer rights to shareholders, the company needs to give a two weeks preemption period, during which shareholders can decide whether or not to exercise their rights. During this two week offering period, the share price is under the risk of market volatility and short-sellers strategies (http://reut.rs/g5xJjn). In order to protect itself against such risk which could see the share price going below the offer price, companies usually decide to offer the shares at a hefty discount to their trading price. During the highs of the 2008 crisis, the minimum discount recommended by investment banks was 40%. Advocates of right issue argue that the discount per say is not relevant, as the shareholders suffers no dilution thanks to the right concept. This is arguable and I would see a high discount more as a threat to shareholders than a choice offered to them. If a shareholder does not (or cannot) participate, he will have to suffer from a very high dilution. Much higher than in any overnight book building.

We believe that our task as management is, at a time of a capital transaction, to insure that we reasonably minimize the cost of capital of the company. In the case of a capital rising, this translates into maximizing the proceeds, while minimizing the number of shares issued. At the time of electronic trading, flash orders, and other advance trading technics being out in the market for two weeks is just too expensive. Considering market volatility in the last three years, the cost of theses two weeks was just prohibitive.

Exclusion of subscription rights offers the advantage of allowing the transaction to be executed in a much quicker fashion which in turn commands a lower discount, and thus a lower cost of capital. The pricing in any case need to be within a 5% range of the prevailing share price at the time of the transaction. It also allows for new shareholders to enter into the stock, at similar conditions than the existing shareholders, which for a company in growth like alstria is also a key feature. Existing shareholders to a certain extend are protected by the fact that they can adjust their holding for dilution acquiring shares in the market at similar conditions that the offering.

The main difference between the right offering and the non-preemptive offering is mainly linked to the timeframe of execution. One is quick and therefore less sensible to the volatility of the market, but in turn less protective of existing shareholders right, while the other protects (or so it seems) shareholders right, but is much more sensitive to markets. So far, we always took the view that avoiding market risk and reducing the cost of equity should be the decisive factor. Other market circumstance might drive us to a different view in the future.

Unfortunately while we allowed ourselves the option to be free from preemptive right as a private company, it is very unlikely that we will be able to replicate this in the future as a public company. Proxy voting and existing case law make it very difficult (if not impossible) to get a waiver for preemptive rights for more than 10% of the share capital of the company. From that perspective, we welcome and support Cohen and Steer effort to offer European REIT management team the choice between the two options. Alternatively we would welcome any effort to reduce the preemption period to just a few days rather than the two week period.

In a recent FT column (4th march 2011; http://t.co/8xmcngi ) John Authers wrote: “if you want a company to pay out a dividend because you don’t trust management to treat cash responsibly – you should ask why you invested in the first place”. The same probably also apply if you do not trust the management to make the right decision with respect to right offer/non preemptive offer.


1 comment:

  1. I have read most of the blog posts so far and found them usually very interesting and enlightening.

    As an Alstria shareholder since 2008, I cannot agree to this post.

    In the case of the capital increases in order with subscription rights, the discount offered in comparison to the current share price is NOT equal to the cost of capital.

    Rather the discount of the value of the new capital in comparison to the old is: old share price - (offer price + market price of the subscription right). Usually, there turns out to be a negative impact, because the market assumes that the new capital will not be put to the same profitable use than the average of the existing capital.

    But in no way is the discount equal to the cost of capital. This is just wrong. The discount just has to be high enough for the issuance price to remain below the share price for 2 weeks.
    For me, the advantage of the subscription model is that the entire market determines what the new capital is worth. In the case of the capital increase, this is left to the participants of the accelerated bookbuilding.

    In this case, there were no less than 10 million new shares and 18,2 existing shares on offer. If I can calulate this correctly, this represents 16% and 32% in relation to the existing capital (61,5 million shares), so a total of no fewer than 46%!!! I do not understand the comment regarding preemptive rights for 10% of the capital if there were 16% new shares offered this time?

    My point is that if you offer about half of the company in an accelerated bookbuilding - you need the presence of massive demand in that bookbuilding to limit the discount to a reasonable dimension. If you leave that process to the entire market for two weeks, there's more time for all of the market to come to a conclusion on the value of the new capital.
    I would be very interested to know how large the discount was in the end. The share price performance looks like it must have been around 10%. If it was even larger, there was a nice little extra for the signing parties. In the case of subscription rights, this extra "valuation mistake" goes to the current shareholders, not to the new ones.

    I am in no way against capital increases to seize market opportunities. But I do sincerely hope that in the future, Alstria will go back to the usual capital increase with subscription rights and not offer about half of the capital in an accelerated bookbuilding.

    With best regards, Gerrit Roth.