Monthly Archives: October 2015

What are pre-emption rights and why do they matter?

Share certificate

The board is contemplating an equity raise. The brokers and CFO talk in respectful terms about preserving pre-emption rights and what this means for how they raise the new capital. Maybe you, as a new non-exec, are sitting there wondering what is this all about and why is it so important?

However all directors should understand these issues, particularly as shareholders take this very seriously, and may well hold the whole board to account on this.

This article focuses on publically listed companies, as most private companies will have tighter rules on bringing in new shareholders anyway.

What are pre-emption rights?

Pre-emption is simply the right for existing shareholders to buy new shares before others can. For a private company, this would ensure that the board couldn’t issue a large tranche of shares to another party and so dilute an existing shareholder’s holding and voting rights without the latter’s approval.

For a liquid publically listed stock, shareholders will expect pre-emption rights for any significant share issue. Usually the focus is on any price discount being offered on the new shares. Take an example: A company with a share price of 400p places a 1 for 2 share issue at 300p (a 25% discount), without first offering it to existing shareholders. On a pro-forma basis, the existing shareholders would lose 8% of the value of the holdings as the price moves to the blended average price of £3.67. Meanwhile the new shareholders get an immediate gain of 22%. So you can see why the existing shareholders would be pretty cross about it.

Pre-emption rights mean that any significant new share issue for cash should be offered first to existing shareholders in proportion to their current holdings. This means that if they take up these rights, they would not be disadvantaged, as they would get their fair share of any discounts offered.

A new share issue might also be launched in order to provide equity (as opposed to cash) for an acquisition, with the new shares being offered to the target company shareholders. In this case pre-emption would be impractical, so the issue is likely to be whether the price effectively being paid is a reasonable one.

Rights Issues, Open Offers and Placings

Rights issue: All shareholders are offered the new shares in proportion to their holdings, usually at a significant discount to the prevailing share price. In the above example, a 1 for 2 rights issue would simply mean that all shareholders are offered 1 share for every 2 shares they currently hold. This delivers perfect pre-emption, and so is the more popular mechanism for shareholders. A shareholder who doesn’t take up their rights can receive some of the discount value without investing more cash, as their allocated shares are then sold on the market and the price difference remitted back to them. For these reasons, the rights issue is generally the default mechanism for boards when they consider raising equity.

Open Offer: This is similar to a Rights Issue, but any shareholders who do not participate won’t receive any value for any allocated shares that they do not take up. It therefore adds more incentive to existing shareholders to participate whilst retaining full pre-emption.

Firm placing: This offers no pre-emption. The company will have presold the shares to one or more new investors, likely at a discount. This means that other shareholders will not be able to access any of the discount and may feel aggrieved. However, it enables a company to bring in new investors to the equity issue, which is important if it believes that existing shareholders would not be prepared to provide all the extra capital requested.

Placing and Open Offer: This retains partial pre-emption but also enables a company to bring in new investors as well. Existing shareholders are offered a proportion of the new shares in the open offer (pro rata to their holdings), but can also apply for more shares. If demand from existing shareholders exceeds the total allocated in the open offer, then the company may claw back some of the shares allocated to the placing. This therefore gives full pre-emption in the open offer, and partial pre-emption in the placing.

There are other mechanisms and this can become much more complex than this, but these are the essentials.

How does a board decide which mechanism to use?

The key issue is generally whether the board is sure that existing shareholders will buy all, or nearly all, of the new shares. A board needs to take account of pre-emption, but is even more focussed on making the share issue a success. It is not generally in shareholders’ interests for an equity issue to fail, with all the question marks that this would raise about the company.

You might say that companies usually get an equity issue underwritten, so they are sure of receiving the cash. However, by definition, underwriters will only support an issue if they think it will be almost fully subscribed. It is an insurance policy not a subsidy! The underwriters may also force an even bigger discount in the offer/rights share price in order to reduce their risk.

So if a company feels that it needs to bring new shareholders in to make the issue a success, then it is likely to move towards some variant of a placing, possibly combined with an open offer to provide some pre-emption. The board has to reconcile the desires of some shareholders, who insist on preserving pre-emption, with its need for certainty that the shares will be pretty much fully subscribed.

What do shareholders want?

In the UK, the Pre-Emption Group (representing listed companies, investors and intermediaries) clarified its principles in March 2015;

General authority: General meeting resolutions to give the board a general authority to disapply pre-emption are looked upon favourably only for share issues;

  • For up to 5% of the total share capital; and
  • For up to 10% of the total share capital, provided that anything over 5% is for a specific acquisition or capital investment (fully disclosed at the time).

Subsequent share issues:

  • These should be for no more than 7.5% of total share capital over a rolling 3 year period; but
  • If more than 7.5% then only if either shareholders have been consulted, or the reason for the raise was stated with the last general meeting resolution.
  • The 7.5% restricts only the non-pre-emptive element of any share issue. If there is a mix of pre-emptive and non-pre-emptive elements, it applies only to the latter.
  • Any discount offered to shares issued non-pre-emptively is a matter of concern and, except in exceptional circumstances, should be limited to 5%.
  • The 5% discount may be larger for underwriting provided that it is believed to be a backstop, which will not be drawn upon.

Requesting a specific disapplication:

Companies are expected, if possible, to inform shareholders and to discuss with them, any intention to initiate a cash raise, particularly if it is to be non-pre-emptive. Shareholders will expect a strong business case for the raise, covering alternative sources of finance, consideration of the cash raising mechanism, requirement for avoiding pre-emption, and demonstration of good corporate governance and value enhancement.

Consulting shareholders:

Clearly not all shareholders can be consulted, so there is recognition that this is really aimed at large, usually institutional, shareholders. Care needs to be taken as to when any consultation effectively gives the shareholders inside information.

Shareholder voting:

Some shareholders adopt a very purist line on pre-emption. Their corporate governance team may vote their shares against any capital raise which is not almost completely pre-emptive. This can be despite the fund manager being supportive of the board, having understood the need to get new shareholders and to ensure the issue is a success. They may well still buy the shares, even in a non-pre-emptive element. A vote against therefore may be largely symbolic, but given that this is a special resolution, requiring 75% majority, it wouldn’t take many symbolic votes to threaten the issue.

Conclusion

Pre-emption is all about making sure that existing shareholders are not disadvantaged by equity being issued cheaply only to certain shareholders or new investors. This is a highly complex area, and this article summarises only the key points. In a real situation, lawyers and bankers will be on hand to advise in detail. The key point is for boards to be aware that shareholders take a very close interest in pre-emption and directors should understand how the different equity raising mechanisms affect this.

Summary

  1. Pre-emption is about protecting existing shareholders from issuing new shares to others without themselves being offered those shares, particularly when the offer is at a discount.
  2. Rights issues are the most perfect form to offer pre-emption, but are less appropriate if the company believes that it needs new investors.
  3. Placings can enable companies to bring in new investors, and can be combined with, at least partial, pre-emption.
  4. There are quite specific rules on how a company can disapply pre-emption, both as a general authority and for a specific fund raise.
  5. Large shareholders like to be treated properly and consulted as far as is practical, preferably in advance of any final decisions on a capital raise.
  6. Although these rules are mostly applied to share issues for cash, increasingly shareholders are concerned about acquisitions for shares being value-generative. Boards should ensure that these are well justified and backed by good governance.
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What’s all the fuss about cash?

Purse

Companies differ very much in their attitude to the importance of cash. If a business is private equity owned, highly geared (ie has a lot of debt) or has not a lot of headroom against its overdraft or debt covenants, it is likely to be very focussed on cash. Others, especially subsidiary boards, may look almost exclusively at profit.

All boards should take cash very seriously. This is because profit is a theoretical concept, whereas you can only pay employees, suppliers and shareholders in cash. You should take particular notice when a profitable business is using cash. If this is because it is in an investment phase, and it in spending capital to expand, then this may be absolutely fine. However, be very aware of negative movements in working capital. This is often a tell-tale sign of bigger problems.

Net debt

This is exactly what it says. It is the net of all bank borrowing less any cash deposits. If cash held exceeds debt, then the company has net cash, rather than net debt. It is a vital indicator of how the business is faring. Its absolute level tells you how much of the business is being funded by borrowing, and movements in net debt tell you whether the business is generating or using cash.

Ensure that net debt and its movement are reported in board packs. The Cash Flow Statement required by accounting standards is pretty useless to management (and if truth be told, to everyone else too). This is because it adds down to movements in ‘cash and cash equivalents’ (which are generally irrelevant as they exclude debt), and mixes up lots of different activities. Ask instead for an explanation of movements in net debt; staring with EBIT, adding back depreciation (which gives you Ebitda), less working capital movements, less capital expenditure, plus disposals, less interest, less dividends.

Working Capital

The three main constituents of working capital are stocks, creditors and debtors;

Stocks: A significant increase in stocks, in the absence of a similar increase in sales, should be something to look at carefully. It may indicate that the business has problems in its supply chain and demand forecasting, or worse perhaps is producing stock just to enhance profit (because some overheads may be capitalised in the stock valuation and thus costs are apparently reduced). It’s worth asking whether this is happening and also how large any provisions are against the stock valuation. Both the size and movement may be significant.

Creditors: Trade creditors are what the company owes its suppliers. An unexplained increase in such creditors may show that management is conserving cash by lengthening payment terms or just not paying its suppliers to terms. Other creditors can include taxation, social security, and accruals/provisions. An unusual movement in deferred income and provisions is definitely worth querying. If a company wishes to hide profit for a while, increased provisions would be one place where that would show. Similarly a rapidly reducing provisions line might show that the company is drawing on previous reserves.

Debtors: Trade debtors are amounts owed by customers to the company. Again, watch for any movement in this line that seems out of step with sales. A step up may mean that management has lost focus on debt collecting or even that, in its desire to maintain sales, it is offering customers longer payment terms. It is worth asking if payment terms are changing and, if so, why.

Borrowings/cash: These may be appear to be working capital as they are put in current assets and liabilities in a statutory balance sheet, but it is important to exclude them.

Ratios to help watch movements in working capital are;

Stock: Days stock held (stock divided by daily throughput) or stock turnover (annual throughput divided by stock).

Debtors: Debtor days (debtors divided by daily throughput) or debtor turnover (annual through divided by debtors).

Creditors: Creditor days (creditors divided by daily throughput) or creditor turnover (annual through divided by creditors).

Derivatives: This is an area that causes even qualified accountants to break out into sweat. However, do not just assume that financial people have got it right. Twice in my career, I have come across derivatives that the CFOs thought were fine, and explained them to me in highly complex, bankers’ language. However both of them were in fact toxic and nearly brought both companies down.

Leaving aside financial services companies that may create and trade in derivatives, for most companies they have a sole purpose: to reduce risk. If the business is exposed to varying interest or foreign exchange rates, it may choose to hedge against them. Note that this is a choice, not a necessity (although a lender may insist on it as part of its funding arrangements). There are two basic questions to ask management here;

  1. If we don’t purchase the derivative what’s the worst that can happen? You may want to tolerate some risk, for example, if the worst case still wouldn’t have a serious impact on overall profit or cash. Companies may choose to hedge only a proportion of their exposure.
  2. If we do purchase the derivative, what’s the worst that can happen? If the worst case with a derivative is not very different to that without, then maybe the instrument is not actually reducing risk.
  3. Is the derivative actually reducing our risk? A hedge is designed to provide a cap or offset to a financial risk on another asset or liability. Where companies typically have got into trouble is when they have taken out a hedge that is not a mirror image of the target risk. Mitchells & Butlers took out an enormous interest rate swap to ‘fix’ the rate on a number of debt instruments (ie loans). However it did this before the loans were signed off and they were never actually taken out. It therefore had a massive swap exposure to interest rate movements on debt it didn’t have. This ultimately cost the business over £400m.

The basic check is that any hedge is carefully (in amount, terms and length) matched to the exposure that it is trying to hedge. If this is not the case, the hedge may well increase risk, not reduce it. Also be very careful that termination conditions are similar for both the original instrument and its hedge. A number of banks made good profits from selling long-term interest rate swaps to very small businesses that found subsequently that, although they were able to pay off the associated loans early, the swaps had a fixed life. With falling interest rates, those swaps became massive liabilities for those businesses.

Do not assume that the banks, or whoever else is offering the security, are working in your best interests. In general, they will sell off the derivative straight away and book their profit. You meanwhile have the financial cost of the derivative for its entire life.

Theoretically a hedge will be accounted for as a hedge ie all gains/losses are set off against the underlying gain/loss to give a neutral profit effect. If this happens, it is a good indicator that the hedge is fine. However the accounting rules are so stupidly tight, that many perfectly good hedges are not treated as such. So even if the accountants don’t treat them as a hedge, this doesn’t of itself mean that the derivative is not a good one.

Swaps or caps? A common issue for boards is whether to hedge an exposure by either a swap or a cap. In simple terms, a swap attempts to provide a mirror image of the original exposure. For example, if a variable-rate loan increases its interest rate, the hedge pays out a similar amount to offset this extra cost, and vice versa. A cap however will only pay out if the interest rate goes above a certain threshold set at the beginning. It therefore caps exposure, acting rather like an insurance policy with a big excess.

If interest rates fall, a cap simply costs what you originally paid for it. However, a swap becomes an open-ended liability, and you have to make payments to the provider. This is why it was swaps that brought companies into such difficulties, when global interest rates fell following the financial crisis.

Ask management for the financial impact (P&L and cash) of both under different scenarios to help show which looks more attractive at the time. But always be careful about any risk around differing maturity and early termination conditions.

Conclusion

Boards generally pass over the Balance Sheet quickly, partly because non-financial people, and quite a few financial ones too, are afraid of its complexity. However this is a mistake, as most skeletons, if they exist, will be sitting in that balance sheet. Additionally, there are many indicators of possible issues with the business that stand out in a balance sheet, if you go looking for them, just as clearly as other issues show in the P&L. The Balance Sheet can be your friend.

Summary

  1. Don’t be afraid of the balance sheet and ask questions about significant movements on it.
  2. Take cash very seriously. Ensure that reports explain movements in net debt.
  3. Do look particularly at working capital movements both year-on-year and against budget.
  4. Take an interest in any new derivatives that are taken out. Ask whether they really reduce risk in all circumstances.
  5. Be particularly vigilant on swaps and ask to see clearly the instrument that they are hedging against. Check they are similar amounts and maturities, watching our for early termination issues.
  6. Don’t assume that a derivative must be the right thing just because the CFO proposes it.
  7. Remember that the skeletons are usually hiding in the balance sheet.

What if you join a board, but have no financial experience?

Bank of EnglandOne mistake that non-financial people often make is to assume that financial people both know what they are talking about and understand all the financial issues. Once you realise that neither of these may be true, you will feel less cowed by financial jargon and able to participate more freely.

I have twice in my career come across toxic derivatives held by companies that the financial team believed to be sensible and prudent. The other board members took their lead from them. However, this nearly brought both companies down. Asking apparently silly, basic questions could have unearthed the issues. Non-execs should sometimes challenge whether the Emperor is actually wearing any clothes.

It can be daunting joining a board for the first time, and possibly being asked to join the audit committee too, when you have no financial background. There are some courses around to give an introduction to finance, which would be very worthwhile if you feel that your understanding of basic finance is poor. This article cannot provide such a foundation course in finance, but it can provide some pointers to things to watch out for.

The Budget

Every business is likely to have a budget or plan, probably an annual one. This is likely to be set at the beginning of the financial year and to be the benchmark for financial bonuses. The executives may well propose reforecasts during the year, but these are very unlikely to be used to reset bonus levels. Shareholders tend to be very sniffy about any attempts to do this.

It is difficult for an NED to really evaluate whether a budget is set at the right level: Too low and it makes it too easy for the executives to be seen as heroes, too high and it will be unachievable and demotivating. One benchmark will be ‘City expectations’ or ‘consensus forecasts’. You should expect the budget to be set, at least in profit terms, a little ahead of the City benchmark. This gives room for life being a little tougher than expected and still meet expectations. How much of a ‘cushion’ is needed will vary from business to business. Ask for a schedule of full year profit variances against each year’s budget for the last few years. This will give you an idea of the accuracy of budget forecasts.

The budget may also have a ‘discount’ or ‘cushion’ already built in. This is sensible, as most budgets are set initially with a ‘can do’ mentality that ends up with an ambitious number. Discounting this back gives a more balanced target. You might compare the discount to the historic budget variances to get an idea as to how adequate it is.

Profit

Most board attention is focussed on profit, usually profit before tax (PBT), which is before tax but after interest. If attention is focussed on operating profit (also called Ebit: Earnings before interest and tax), then it may be that the executives are not focussing on the importance of cash.

Ebitda is simply Ebit before subtracting depreciation and amortisation. It shows you, broadly, ‘cash earnings’. This is the basic cash flow from which everything else, such as capital expenditure for example, gets paid. It is always worth thinking hard about the level of such investment if capital spend is very different to the booked depreciation.

There may be a number of complicating factors;

Profit from associates and joint ventures: These are just another source of profit from part-owned bits of the business.

Amortisation: This is the writing off over a period of a cash spend in the past. Some companies may exclude it from their PBT shown in management accounts, as they see it as an accounting entry, which has no relevance to today’s profit.

Constant Currency: In a multi-currency business, the board will want to know how that business is doing, free from distortions from movements in exchange rates through which foreign units are being reported. Constant currency therefore reports every unit at a set currency rate, probably the budget one. Boards will want to see the actual currency version as well, as this is ultimately what the value is in the home currency.

Non-underlying adjustments

In the good old days, one-off items, usually losses, were treated separately as extraordinary, and then later as exceptional items. Nowadays, the rules are much tighter so CFOs have to be more creative.

Boards understand that there are circumstances in which you have to adjust for one-off items to understand the true underlying profit movement. Regulators however have reacted in a simplistic way to abuse of the exceptional line, by making it more difficult for a company to show investors what it believes underlying performance to be. It’s a bit like the government announcing that it believes sick leave is being abused, so it will in future ban sick pay.

The internal management accounts may well have ‘exceptional items’ beneath PBT, which are usually helpful for a board to understand underlying performance. However the published accounts may put ‘non-underlying items’ in a separate column, so companies can show the P&L with and without them.

Boards do need to be vigilant that adjustments to underlying profit are valid. They will tend of course to be losses rather than profits! It takes no financial knowledge to challenge a cash cost adjustment (ie not amortisation), so all directors should be sceptical of these. This is especially true when management is trying to exclude a cost from the profit used to determine their bonuses.

These are the absolute basics for a financial understanding for non-execs. I haven’t forgotten to discuss cash or derivatives yet, but these deserve an article to themselves.

Summary

  1. If you know really nothing about finance, try to get short course on the basics. The company may well pay for this.
  2. Don’t assume everyone knows more than you or that the finance team have got it right. Ask apparently simple questions, you may be surprised at the answers. If you are worried about looking stupid, ask the questions privately to either the CFO or Chair of Audit.
  3. Try to assess how realistic the budget is by past performance and the size of any discount included.
  4. Even if the CFO talks to Ebit or Ebitda, keep a very careful eye on PBT.
  5. Look hard at exceptional or non-underlying adjustments. At best, they help to understand real underlying performance. At worst, they just give PBN (profit before bad news).
  6. Be very wary of attempts to restate or change the budget during the year.
  7. Always keep an eye on cash.

Dodgy statistics and wild claims just patronise women

Grant Thornton has just published a Report comparing the effect on corporate return on assets (ROA) of having women on an executive board across three countries (UK, US and India). It concludes that such diverse boards cause companies to perform “Materially better”. The report quantifies the economic benefit from having more women executives on boards as “a staggering $655 billion”, boosting GDP by 3%.

Now that’s some benefit just from changing the sex of one board member per company. It sounds too good to be true, doesn’t it? Well, of course, it is. Grant Thornton seems not to have published the full workings behind this claim, but let’s examine what it has disclosed;

  1. The sample size is tiny. It is able to use just 127 of the over 1,000 companies in the top echelons of the three countries to make this dramatic conclusion. The report makes no mention of how the results could be random variation in a small sample size.
  2. It’s a static analysis that compares companies currently with a female executive board director to those without. However, this statistic does not tell you the effect of a company deciding to appoint an extra female (ie a dynamic analysis). The analysis should have tracked the change in performance of companies that did this, in order to conclude that putting more women on boards boosts performance.
  3. The analysis is not comparing all male boards with mixed ones. All but 60 of the over 1,000 boards already have female non-executive directors. There is no gradation reflecting how many females are on each board.
  4. It assumes that correlation equals causation. It may well be that higher performing companies are simply better at attracting high performing female executives. Given the pressure on boards to have more females, and the resulting increased demand for female directors, then it would be logical for women to be able to choose to work for more successful companies.
  5. The report extrapolates the average ROA from just 127 companies to over 1,000. However, if female executives are a source of competitive advantage, then this would of course be nullified if every company had such an advantage.
  6. Somehow, the extrapolated 1,000 companies gain is then turned into 3% GDP growth, worth $655bn. Even if those companies did increase their returns, the report does not explain how they have calculated such a boost to GDP. For example; higher dividends might be remitted abroad; smaller companies would be likely to suffer increased competition from the 1,000; employees might demand a greater share of the profitability; and so on.

So adding 923 female executives would create an extra $655bn in growth. That’s over $700m per female director per year! Maybe they should ask for a pay rise.

More diverse boards may well make more effective teams. We do need more talented women in senior management. But it is very patronising to women to have to argue for this using dodgy statistics and ridiculous economic claims.

Maybe Grant Thornton published this report just as a publicity gimmick. But business is crying out for regulation that is based on real evidence, not political expediency nor ridiculous statistics.