The UK rights system is inefficient at recapitalisation and short-changes shareholders. Is it time to learn from the US system, asks Leonard Geiger
In a year notable for the near-collapse of the global financial and credit markets, it is a pleasure to be writing about the best way to raise equity. Capital formation is critical to the health of any industry and a necessary antidote to the over-leverage threatening the global banking system and real estate sector.
The recapitalisation process that has swept across the listed real estate industry this year has been a resounding success and an encouraging start. While the first wave of new capital helped repair balance sheets, the second wave will be used to fund acquisitions.
On aggregate, global REIT recapitalisation for the year to date exceeds US$36.5bn (€25.9bn). UK REITs have relied largely on pre-emptive rights offerings for new equity, while US REITs have raised capital via rapidly executed secondary offerings.
As one of the largest investors in global real estate securities, Cohen & Steers believes that the US method is faster, more efficient and better preserves shareholder value. The rights model, by contrast, increases the cost of capital and puts UK-based companies at a competitive disadvantage against global peers, which should be unacceptable for shareholders of UK listed equities and for the UK real estate industry as a whole. Given the substantial capital raised in the UK property industry this year, we believe it is time for the UK government to evaluate the impact of this model on the British real estate sector.
Rights offerings were designed to prevent the transfer of wealth from existing shareholders to new investors, thus protecting shareholders from equity dilution. In the UK it can take up to five weeks from the time of the announcement before there is certainty about the success of the offer (a risk banks seek to underwrite through a commitment to buy unsubscribed rights).
Ordinarily, this includes 14 calendar days to call an extraordinary general meeting, 10 business days of trading in the rights (reduced this year from 15 days) and finally, the placement of any unexercised rights (the ‘rump').
In a primary add-on, or open stock offering, favoured in the US, a company issues new shares for sale to the public, which increases the number of shares outstanding, attracts new investors and may dilute existing shareholders' interests in the company and its earnings if they do not take part in the offering.
Advantages of this model are the speed of execution (‘overnight' placement after the market has closed, or with a one-day marketing period), the certainty of proceeds without the deeper discount an underwriter might require, the typically tighter discount to the market price (which means fewer new shares need be issued) and the offer being open to new shareholders.
The UK government, which is aware of the weaknesses of its system, sought to improve competitiveness by shortening the period in which rights must trade. But the rights model needs more than incremental improvements - it needs to be overhauled.
Regarding the case against rights issues, the UK model has several things working against it. First, the system is cumbersome, and the lengthy timetable exposes shares to substantial market risk. The extended process and 10 business-day rights trading period allow short sellers to manipulate pricing and capitalise on any uncertainty about the execution of the transaction, which, in turn, can create unnecessary volatility and destroy the shareholder value that rights were designed to protect.
The substantial growth in the hedge fund industry has made these time lags untenable. Reported shares on loan for the major property companies that announced rights issues in February and March peaked shortly after announcement, and share prices troughed two to three weeks later. Hedge funds were the big winners during this period.
Of course, if hedge funds manage to drive the rights price below the issue price, and the transaction has not been fully underwritten, they can derail the process. Moreover, weaker companies that may not be first in line for underwriting by investment banks, may see their share prices come under attack and be shut out of the capital markets.
Sponsoring banks unwilling or unable to underwrite these risks may ‘sub-underwrite' rights issues by passing risk to shareholders, for a fee. This is how the large discounts to TERP (theoretical ex-rights price) are justified, as shareholders require meaningful discounts to sub-underwrite the issue. But that shifts the focus away from the real costs: large discounts drive down the share price and drive up the cost of capital. In short, sub-underwriting stands in the way of management's accessing the lowest cost of capital.
The rights for this year's capital raisings were issued at a nearly uniform 40% discount to TERP to ensure success, regardless of whether the issue was perceived to be for offensive (acquisitions) or defensive (balance-sheet repair) purposes. While this benefited the underwriting banks and fund management groups who sub-underwrote the deals (deep discounts are more likely to ensure subscription), it arguably came at the expense of shareholders who did not subscribe, and who therefore suffered the effects of substantial dilution in ownership.
From a systemic point of view, a rights offering does not govern who has access to capital; virtually any company can persuade shareholders to subscribe and underwrite if the discount is good enough. This lack of discrimination entrenches weak companies with poor business models, while failing to reward strong managers with a superior cost of capital.
Despite the argument that rights issues do not dilute equity ownership, highly discounted offerings are dilutive to earnings and to net asset value (NAV) if new shares are priced below this level. We calculate that this year's UK REIT rights were issued, on average, at 60% below our theoretical ex-rights NAV estimates - an extremely high cost of equity. By contrast, as of 27 July, we calculate that the capital raised in US secondary offerings this year carried a 1.9% premium to our estimated trough NAVs. Clearly, the US secondary issues enjoyed superior execution and a much lower cost of capital.
Rights issues do not allow companies to take advantage of high stock prices and attract new shareholders willing to pay above NAV for going-concern value. The US model allocates capital more efficiently by subjecting companies to the forces of market competition. Secondary offerings in the US succeed only if the company is strong enough and well-managed enough to attract investment, which is as it should be - the reward is a lower cost of capital.
Capital formation has taken on new urgency in this year's economic climate. Many parts of the global economy are over-leveraged, the banking system remains under strain and real estate valuations have dropped further and faster than ever before. REITs are ideal vehicles to help recapitalise the industry.
But at this time of great need, the UK rights system is preventing REITs from accessing capital at the lowest cost to shareholders. More than this, the rules have cut off sources of less expensive capital in order to get the deal done with little or no risk.
REITs, properly capitalised, have the opportunity to provide liquidity to UK real estate markets, and the follow-on benefits would pervade the economy. A more responsive, accommodative system will accrue to everyone's benefit.
Leonard Geiger is senior vice president in the investment team at Cohen & Steers Capital Management