14 underwriting of rights issues

Underwriting of Rights Issues

A comparison of underwriting cost versus value in S&P/ASX300 company r ights issues, 2010 - 2012

Jun e 2014

Underwriting of rights issues, cost versus value: June 2014

Author and Acknowledgements

2

Author

This research was prepared by Mike Harut, Governance and Engagement Analyst at the Australian Council

of Superannuation Investors ("ACSI").

Acknowledgments

ACSI gratefully acknowledges the assistance of Dr John Handley, Associate Professor of Finance at the

University of Melbourne. The framework on which this research is based was originally developed in the

Australian context by Dr Handley almost twenty years ago. Dr Handley was also generous in providing

assistance through informal discussions with ACSI on the current research. The final research was not

formally reviewed or verified by Dr Handley.

ACSI also acknowledges the assistance of Ownership Matters which generously provided their proprietary

data on capital raisings that formed the basis of this research. Thanks in particular to Simon Connal and

Dean Paatsch who provided feedback and assistance.

Mike acknowledges the valuable input of fellow ACSI staff.

Australian Council of Superannuation Investors

The Australian Council of Superannuation Investors (“ACSI”) was established in 2001 to represent the

collective interests of profit-to-member superannuation funds regarding the management of

environmental, social and corporate governance (ESG) investment risk.

ACSI has 33 Australian superannuation fund members, who collectively manage over AUD$400 billion in

assets on behalf of over eight million Australian superannuation fund members and retirees, along with

five international members.

Australian Council of Superannuation Investors

Ground Floor

215 Spring Street

Melbourne VIC 3000

Australia

Tel: (03) 8677 3890

Fax: (03) 8677 3889

Email: [email protected]

Website: www.acsi.org.au

mailto:[email protected]

http://www.acsi.org.au/


Table of Contents

3

1. Executive Summary 4

Key Points 4

Background 4

Comparing actual cost with the value of the shortfall risk 5

Study outcomes 6

Recommendations 6

2. Introduction 8

ACSI’s motivation for undertaking this research 8

Background to underwriting of rights issues in Australia 8

Past research 9

3. Methodology and Data 10

Underwriting is a financial option 10

Factors that determine the value of underwriting 11

Adaptions to the framework 13

Data 13

4. Results 14

Aggregate result 14

Consistency of individual outcomes 14

Comparison with 20 years ago 16

Potential drivers of underwriting premiums: size, liquidity, market conditions, reputation and purpose

17

Other potential drivers of underwriting premiums that were not examined 20

5. Recommendations 24

The role of company directors 24

The role of investors 24

The role of regulators and rule makers 25

Appendices 27

Appendix A: Adaptions to the framework 27

Appendix B: Variations to factor inputs 33

Appendix C: Bibliography 34


1. Executive Summary

4

Key Points

This study analyses 63 underwritten rights issues conducted by S&P/ASX300 member companies

between 2010 and 2012 and compares the amount they paid for underwriting against a benchmark

value.

In aggregate, companies appear to be paying more than twice as much in rights issue underwriting

fees than the benchmark value of those underwriting services. On a simple average, companies

appear to be paying a premium of almost 50% over the value of the underwriting service.

This suggests that companies have paid underwriters (typically investment banks and stockbroking

groups) a premium of more than $170 million, or an average of around $2.7 million per raising,

above the benchmark value.

Average underwriting fees are more than 60% higher than they were 20 years ago. This is despite

innovations that, in particular, have dramatically reduced the time required to complete a rights

issue thereby decreasing underwriting risk.

Background

One of the prime reasons that companies list on a stock exchange is for access to equity capital for

purposes such as pursuing an acquisition, commencing a new project, expanding an existing business or

repaying debt. In Australia, a key mechanism for raising that capital is the rights issue1 - where existing

shareholders are offered new shares on a pro-rata basis (e.g. a company may offer one new share for every

10 existing shares held – known as a “1-for-10” offer).

Shareholders are not, though, obligated to purchase these new shares and can elect to forfeit their rights

by not participating (in some cases, investors are compensated for giving up those rights, usually through a

renounceable issue where the rights to the offering can be traded on a market or cleared through a

bookbuild).

This means that in any raising there is an inherent risk that the amount of capital sought will not be

achieved: the shortfall risk. Such a shortfall may leave the company in a precarious position if, say, the

additional capital is urgently required to repay debt and remain solvent.

Companies commonly mitigate that risk by underwriting the rights issue – having a third party, the

underwriter, guarantee that the full amount will be raised by agreeing to purchase, or arranging the

purchase, of any unallocated shares. In exchange for this guarantee, companies pay an underwriting fee,

typically around 2 per cent of the amount being raised to the underwriter. In effect, this agreement

transfers the shortfall risk from the company to the underwriter (who may then pass on that risk to a sub-

underwriter).

1 Sometimes rights issues are called entitlement offers. There are different sub-categories of rights issue which can be either renounceable or non-renounceable. Practitioners also

use terms like AREOs, NREOs, REOs etc. This research considers all sub-categories of underwritten rights issues.


5

Underwriting fees are a direct cost to investors, including ACSI member funds, as the ultimate owners of

the entities raising capital. For example, if the company pays 2 per cent of the amount raised in

underwriting fees then, at best, only 98 cents in each dollar raised from the share sale actually reaches the

company.

ACSI’s view, reflected in its Governance Guidelines2, is that boards should seek to minimise the costs of

raising new equity, and to ensure that the fees paid to advisors, including underwriters, reflect the actual

value delivered and the risks incurred.

Comparing actual cost with the value of the shortfall risk

This study values (or prices) that shortfall risk using a benchmark model, first developed and applied in the

UK by Paul Marsh and, later, in Australia by John Handley3, and then compare it with actual prices paid to

underwriters. The benchmark model is based on the premise that, since underwriting agreements give the

company the right to sell its shares to the underwriter at a predetermined price, they are akin to a put

option bought by a company.

As such, an option pricing model (specifically, the Black Scholes Merton model4) can be used to price the

shortfall risk.5 The four key drivers of the benchmark model value are the discount between the share

price and issue price, volatility of returns, the length of the offer and dilution.6

The value from the benchmark model is then compared to the actual underwriting fees paid by companies

to determine if there is a premium relative to the benchmark model value. If this is the case, it suggests

that on average companies are paying too much relative to the actual risk inherent in the underwriting.

Only rights issues are considered because, under the ASX Listing Rules, underwriting fee disclosure is not

required to be disclosed for other types of underwritten equity raisings like placements.

Care is taken in selecting the inputs into this model, with several modifications being applied in an effort to

make the most accurate (and conservative) assumptions. The robustness of the results is also checked

using different inputs.

The study covers 63 rights issues conducted by S&P/ASX300 member companies between 2010 and 2012,

split into three components:

understanding the average underwriting premium being paid (if any)

analysing whether there is a relationship between amounts paid and risks incurred; and

incorporating some other possible risks that may be being considered, but which the benchmark

model does not capture.

2 The ACSI Governance Guidelines are available here. 3 Marsh (1980) (Marsh is currently at Emeritus Professor of Finance at London Business School) Handley (1995) (Handley is currently Associate Professor of Finance at the University of Melbourne) 4 More commonly called the Black-Scholes model. Robert C. Merton was also instrumental in developing the model, so modern academic texts typically include his name as well. 5 As explained in the body of the research, there are modifications applied to the standard option pricing model in particular to take into account the fact that the underlying shares are newly issued. Dilution is an additional factor that is not relevant for standard options traded on the secondary market (i.e. when the company itself is not a party to the contract). 6 As explained in the body of the research, the other (less material) drivers are the risk free interest rate and the actual cost paid.

http://acsi.org.au/acsi-guidelines23/acsi-governance-guidelines.html


6

Study outcomes

On average there is a statistically significant underwriting premium of 46% relative to the benchmark model value. Equivalently, in dollar terms there is an aggregate premium of around $172m over the three years, or an average $2.7m per capital raising. In aggregate, the total fees across the market are more than

double the benchmark model value. This premium is not generally observed in options traded on the ASX.

The current cost of underwriting a rights issue is around 60% more than it was 20 years ago when the Handley study was done. This is despite innovations that, in particular, have dramatically reduced the time

required to complete a rights issue (and therefore the risk borne by the underwriter).

Comparisons were also made between rights issues where all of the four key drivers (discount, volatility,

time and dilution) of one issue suggested that it was more risky than the other. Clearly, when each key risk

driver suggests greater shortfall risk, that company should pay more. Among the sample, however, there were 37 cases where companies paid the same - or less - than their apparently less risky comparators. This suggests that some companies are not adequately informed about some key aspects of the shortfall risk

that they are transferring, or about how much other companies have recently paid and, therefore, how much they should pay. In other words, there appears to be inconsistency in amounts paid compared to risks incurred. Companies

appear to be relying on a roughly 2 per cent fee heuristic, rather than a theoretical understanding of the risk they are seeking to mitigate. The result is companies paying similar fees even though the underlying

risks vary markedly between rights issues.

Obviously, the benchmark model may not capture all the risks that underwriters could potentially face during a particular rights issue. As such, further analysis is done on other potential explanations for the

underwriting premium, relative to the benchmark model value. Specifically, analysis evaluates the dollar size of the raising, liquidity, market conditions, underwriter reputation and the purpose of the raising. The

results suggest that none of these factors sufficiently explain the premium. Instead, the additional analysis suggests that two of the four key risk factors already part of the benchmark

model may be mispriced. Specifically, the underwriting premium is largest for companies that undertake

deeply-discounted rights issues over a relatively shorter period.

Recommendations

A 2011 review by the Office of Fair Trading in the UK, on excess in underwriting fees, found that it “can be

tackled most effectively by companies and shareholders doing more to achieve more cost-effective outcomes”. In a similar vein, this study makes recommendations for three groups of market participants who can help companies achieve more cost-effective outcomes in this area.

1. Company directors should appropriately oversee the capital raising process. They should understand the model used by the underwriter to determine its fee, the assumptions that go into this model and whether the premium (if any) is appropriate. Directors should also be aware that

previous research has suggested that past relationships with underwriters are associated with higher premiums and, so, should consider offering others the opportunity to tender for underwriting.


7

2. Investors should first understand the potential loss of value from poorly negotiated underwriting

agreements. They should develop a policy on capital raisings and query the board oversight of the

capital raising process, as well as underwriter selection and fee negotiation. Where relevant, they

should also consider underwriting fees when deciding on proxy voting resolutions regarding capital

raisings. Some may also consider opposing director elections if they believe overall board oversight

of capital raisings to be poor.

3. Rule makers can have a role to play in both enhancing disclosure and continuing to improve the

efficiency of the rights issue process. First, the ASX Listing Rules should be modified to require

disclosure of underwriting fees for share placements in the same way as currently applies to rights

issues. This improved transparency will allow analysis (such as this study) to be applied to

placements, not just rights issues. Second, ASX should continue in its efforts of shortening the

rights issue timetable, since shorter timetables should mean less costly underwriting.


2. Introduction

8

ACSI’s motivation for undertaking this research

The project has its genesis in the 2013 ACSI Governance Guidelines, which state:

“Boards should seek to minimise the costs of raising new equity and to ensure the fees paid to

advisors, including investment banks and underwriters, reflect the actual value delivered and

the risks incurred.”

The project’s primary aim is to see whether this occurs in practice.

Background to underwriting of rights issues in Australia

As noted in the executive summary, when conducting rights issue companies commonly mitigate shortfall

risk by underwriting the issue. In exchange for the underwriter guaranteeing to buy any unallocated

shares, the company pays an underwriting fee of typically around 2 per cent of the amount being raised. In

effect, this agreement transfers the shortfall risk from the company to the underwriter.

Management fees are also paid to external advisors (typically the same party as the underwriter) for

services including determining the appropriate pricing, timing and administration of the rights issue and

finding investors willing to participate in the case of placements and rights that have been forfeited. This

research focuses on underwriting, and so only the underwriting fees are considered henceforth.

Underwriting fees are expressed as a percentage of the funds to be raised. For example, a 2% underwriting

fee for a $100m rights issue means the dollar cost of underwriting is $2m.

The following graph shows the underwriting fees paid among the sample of 63 ASX300 rights issues

between 2010 and 2012, split into buckets (with a ±0.2% catchment for each bucket).

The aggregate cost of underwriting the 63 rights issues was just over $300m.

0

5

10

15

20

1.2% 1.6% 2.0% 2.4% 2.8% 3.2% 3.6% 4.0% 4.4% 4.8% 5.2%

Nu

mb

er

of

rais

ings

Underwriting costs (±0.2%)


9

Past research

As explained below, past research in Australia, New Zealand and the UK suggests that companies are paying underwriting fees significantly in excess of the value of the risk borne by the underwriters. A recent investigation in the UK, discussed below, suggests better company and investor oversight as the most effective tools to achieve a fairer, more cost-effective outcome. ”The Pricing of Underwriting Risk in Australian Rights Issues”

The foundation of this research is from a 1995 Australian study by John Handley.7 Handley’s research was based on a 1980 study in the UK context by Paul Marsh.8 Handley used a benchmark model to estimate the value of underwriting agreements and compared this to what companies actually paid. Handley found there was a premium on average of around 49% above the model value. Marsh’s UK study found a 100% premium on average. A similar study found that in New Zealand the premium was 900% on average.9 In the Australian study, the rights issues with higher underwriting premiums include those:

using leading10 underwriting firms that had prior relationships with the company lower volatility companies; and those that undertook raisings at deeper discounts to the prevailing share price.11

“Equity capital raisings in Australia during 2008 and 2009” and “Equity Capital Raising by the ASX300 post-GFC”

Research conducted by Martin Lawrence and Simon Connal12 (who are currently Ownership Matters principals) in 2010 found that through the global financial crisis equity capital raisings cost companies around 2% of the amount of equity capital raised in underwriting and advice fees. While these results may appear intuitively high, this study did not explicitly value the underwriting agreement to make a comparison. In 2013, Ownership Matters released a follow up study13 which found that although more companies are choosing rights issues they are paying even more in fees than during the uncertain conditions of the GFC.

Investigation by UK competition regulator

In 2011, the UK’s Office of Fair Trading (the country’s competition authority/regulator) investigated underwriting fees in the UK.14 It found there was little effective competition on fees, but that this did not result from poor competition or a lack of providers. Rather, the OFT suggested that buyers of underwriting services (i.e. companies) were allowing themselves to be overcharged. Its suggestion was that shareholders could help in providing the solution:

“[the issue] can be tackled most effectively by companies and shareholders doing more to achieve more cost-effective outcomes.”

7 John C. Handley (1995) “The Pricing of Underwriting Risk in Relation to Australian Rights Issues”, Australian Journal of Management, 20, 1, 1995, June.

8 Paul Marsh (1980) “Valuation of underwriting agreements for UK rights issues”, Journal of Finance, 35, 3, June, 693-716. 9 RJ MacCulloch and DM Emanuel (1994) “The valuation of New Zealand Underwriting Agreements”, Accounting and Finance, 34, 2, November 21-34.

10 In terms of market share.

11 Subsequent critiques have questioned the validity of these results because of the model inputs used. The present research takes all known critiques into account. 12 Martin Lawrence and Simon Connal (2010) “Equity capital raising in Australia during 2008 and 2009”, ISS 13 Simon Connal (2013) “Equity Capital Raising by the ASX300 post-GFC: Too much is never enough”, Ownership Matters 14 Office of Fair Trading (UK) (2011) “Equity underwriting and associated services: an OFT market study”


3. Methodology and Data

10

Underwriting is a financial option

The theoretical foundation of this research is from a 1995 Australian study by John Handley, who estimated

a value of the underwriting agreement using a model based on option pricing theory.15

The academic literature discussed above recognises that an underwriting agreement is like a put option

bought by the company from the underwriter. If there is a shortfall, the company has the option to

exercise the put and sell the shares (i.e. any shortfall) to the underwriter at the issue price (in options

language: the exercise price).16

The Black Scholes Merton option pricing model, adjusted for the fact that the underlying asset is a newly-

issued share, can be used to determine the benchmark model value. This can then be compared to the

actual price to determine if there is a premium.

The following gives a brief overview of the six parameters (alternatively called “risk factors” and “inputs” in

this paper) that should drive the model value of the option. While the language used is specific to

underwriting, the principles are those of standard Black Scholes Merton option pricing model.

The methodology is explained below using a fictitious, simplified example. Suppose ABC Co’s shares were

trading at $11 and they decide to undertake a 1-for-2 renounceable rights issue for $10 per share. The

announcement is made on 1 January and the offer closes on 31 January. The stock returns 12% per annum

(1% per month) and the volatility of returns on the company’s shares is 26%, which means that there is a

95% chance that on 31 January the share price will be between $9.46 and $12.76.17 There are one million

shares on issue. The underwriter will receive 1% of the offer proceeds as a fee for underwriting the issue.

A visual representation of this example is:

15

Note some research in this area uses “fair value”. To avoid any connotations associated with the word “fair”, the more neutral terms “value” and “benchmark model value” are

used throughout. 16

In contrast to options between two investors, the underwriting agreement involves newly issued shares and the company itself as one of the counterparties. This type of option is typically called a “warrant”. This research uses the more generic and familiar term “option”. 17 Assuming a Normal distribution, there is roughly a 95% chance of the return falling between two standard deviations of the mean. In this example, the volatility (aka standard

deviation) of returns is 26% (or 7.5% per month) and the mean is 1%. Therefore, the so-called 95% confidence interval is between -6.5% and 8.5%.

$9

$10

$11

$12

$13

Start (1 Jan) End (31 Jan)

Pri

ce

Time

Issue price

Current share price Expected share price at offer close

There is a 95% chance that the share price will be in this range.

Shortfall area

Discount


11

The risk from the underwriter’s perspective is that the share price at the end of the period is in the

‘shortfall area’, where the current share price is less than the issue price. In this circumstance, it would be

cheaper to simply buy more shares in the secondary market from other sellers than to buy them from the

company by participating in the rights issue. Investors will not subscribe to the issue and the underwriter

will have to buy the shares at the issue (and then try to sell them at the lower market price). In short, the

larger the shortfall area the more valuable the underwriting to the company (and the more they should

be willing to pay).

Factors that determine the value of underwriting

As stated above, there are four general risk factors that determine the risk of a shortfall (two of which

apply specifically when the new shares are being issued from the company). The following tables state

these and outlines situations where underwriting should be more valuable to companies.

All else equal, underwriting is more valuable to the company when the…

Explanation

…discount is smaller.

Using the graph on the previous page, the discount is the size of the blue bracket. It is a function of the current share price and the issue price.

Companies can decrease the discount by offering shares at a higher issue price, which is the equivalent to the red square moving up on the graph. Clearly this would increase the shortfall area.

…volatility is higher.

Volatility is a measure of how much the share prices and returns change. A high volatility share has a high probability of large swings in returns over a given period.

In the previous graph, increasing volatility is the equivalent of the orange bracket becoming larger, which also causes the shortfall area to become larger.

…length of the offer is longer.

The longer the rights issue is on offer, the more uncertainty there is about the future share prices. In other words, the range of possible share prices is bigger, and so too is the possibility of a shortfall.

In the previous graph, this would again be equivalent to the orange bracket becoming larger but it is caused by the end date moving from 31 January to a later date.

…(risk free) interest rate is lower.

The potential payment of the issue price by the underwriter is a payment in the future. If the risk free (or government backed) interest rate is high, the underwriter would have to set less money aside at the Start to make the payment of the issue price at the End. If this is the case, companies should pay less.

This is a relatively unimportant parameter generally because the offer period is typically relatively short.


12

Handley shows that in underwriting two further parameters determine the value of the model. They are important because unlike typical options trading, the company itself is a party to an options transaction on its own shares and the shares are newly issued.

All else equal, underwriting is more valuable when the…

Explanation

…dilution is low.

Dilution is the proportion of shares issued to the proportion of shares currently outstanding. In the example above, dilution is 50% (1 new share for every 2 shares held).

Recall that the underwriter will potentially receive new shares in the company. The more new shares the company issues, the more dilution and hence less that each share represents in terms of proportionate ownership of the company’s equity. The lower the proportionate ownership that the underwriter may ultimately receive per share (i.e. the more dilution), the less the underwriter values each underlying share that they may get. If the company is aware of this, they should pay less for the option.

…total transaction costs are higher.

If the underwriter takes up any shortfall, the newly issued shares that they receive will reflect ownership in a company that has just had a cash outflow, namely of the transaction costs. This includes the actual underwriting cost itself.

Typical options trading (i.e. between parties that are not the underlying company itself) do not have this issue because trading options does not affect the company’s own cash flows.

This is a relatively unimportant parameter generally because the cost is typically small relative to the company’s overall size.

The preceding section has only presented the directional (up or down) changes in the underwriting cost given a change in one of the six parameters. More precisely, the formula used by Handley to calculate the value is:18

( ( ) )

( )

(1)

where:

is the value suggested by the benchmark model ( ) is a put option calculated using the Black Scholes Merton model is share price is issue price is the actual underwriting cost paid by the company is dilution (the new shares issued divided by the number of current outstanding shares) is volatility is the length of the offer period19 is the risk free interest rate.

18

For further technical insights on how to calculate the benchmark model value or further theoretical background, assumptions and proofs should consult the primary sources. 19

Note that there are two versions of time used in the formula (taking into account the trading days and calendar days). This is done in the same was as in Handley. See that paper

for further details. Also, when the rights issue was “accelerated” – where it had a separate institutional and retail component – the dollar value of underwriting for each component

was calculated separately then added. See Appendix A for further details.


13

Adaptations to the framework

Subsequent academic papers have generally accepted the overall validity of the framework, instead

focussing critiques on the key risk factor measures used. Based on these critiques, three adaptations were

made to the risk factors before running the benchmark model. The detail of these adaptations is in

Appendix A. Based on the discussion in Appendix A, the following parameters were used as inputs into

formula (1) above:

is the actual share price on the first trading day after the announcement, adjusted for dividends

(see Appendix A)

is the issue price

is the actual underwriting cost paid by the company

is dilution (the new shares issued divided by the number of current outstanding shares)

is 180 day historical return volatility, increased/adjusted for “volatility skew” (see Appendix A)

is the time between the announcement of the offer and offer close (see Appendix A)

is the 30 day20 bank accepted bill rate.

At the outset it should be noted that the methodology was run on a variety of parameter inputs and the

results from using different inputs are presented in Appendix B.

Data

Ownership Matters generously provided data on rights issues among the ASX300; including underwriting

cost (using ASX Appendix 3B announcements), announcement dates, close dates, dilution, issue price,

purpose and underwriter. This was supplemented with additional data collection directly from ASX

announcements.

Share price and dividend data was obtained through Yahoo! Finance, uses Capital IQ and Commodity

Systems Inc. (CSI). Underwriter market share data was obtained from the Bloomberg 2012 Global Equity,

Equity Linked & Rights League Tables survey. Implied volatility and exchange traded option data was

obtained from the share tables at afr.com. Bank accepted bills data were obtained from the Reserve Bank

of Australia website.

20 Handley uses a 90 day rate, noting that this is most aligned with the typical rights issue. Given contemporary rights issues are done over a shorter time horizon (as discussed), the

30 day rate was favoured.


4. Results

14

Aggregate result

There were 63 underwritten rights issues in total, each involving rights issues by ASX300 companies between 2010 and 2012. The results are as follows:

Actual cost (α) Value (αFV) Difference (%) Premium (%)

Simple average 2.4% 1.7% 0.8% A 46%

Weighted average percentage * 2.1% 0.9% 1.2% A 127%

Aggregate dollar amounts $308m $136m $172m A 127%

* weighted by the total amount raised A

Statistically significant at the 1% confidence level.

These results show that on average there is a significant difference between the actual cost paid and the value derived from the model. From the table above, between 2010 and 2012 ASX300 companies paid around $172m more in underwriting fees than the model value, or around $2.7m per raising on average. Results with alternative model parameters are presented in the appendices. While obviously the size of the premium changes, each of these results are still statistically significant and positive. Note that the premium in the simple average is 46%, which is lower than the 49% premium found by Handley (1995). This may reflect the more conservative assumptions on the appropriate discount and volatility.

Consistency of individual outcomes

When each individual rights issue is considered, there are a wide variety of outcomes. The following graph plots each rights issue as a dot, with the underwriting fee paid as the horizontal x axis and the model value as the vertical y axis. The dots above the red line represent good value for money underwriting and the dots below represent poor value for money underwriting, according to the model.

This graph shows that while there is a clustering of actual underwriting fees (around 2%) there is a lot of divergence from value. In fact, value exhibited three times the variability of the actual costs paid. The most extreme cases involved companies that paid the same amount or less in underwriting but one company was more risky for the underwriter based on each key risk factor: specifically a smaller discount21, higher volatility, longer maturity and smaller dilution. In fact, in the data there were 37 such instances where one raising was more risky in each of the four key ways but they either paid the same amount or the less risky company paid more.

21 To the TERP and announcement factor adjusted share price.

0%

2%

4%

6%

8%

10%

0% 2% 4% 6% 8% 10%

Val

ue

of

be

nch

mar

k m

od

el

Actual underwriting fee paid

poor value for money

good value for money


15

To illustrate, consider the following two companies in the ASX200 which both paid 2% in underwriting. Recall

the discussion above regarding the effect of changes in the risk factors.

Parameter/risk factor

Raising A

Raising Z

All else equal, underwriting should cost more for…

Which should cost

more?

Discount (adjusted as above) 15% 7% smaller discount Raising Z

Volatility (adjusted as above) 47% 49% larger volatility Raising Z

Time to maturity (weighted

average between institutional

and retail)

6 days 21 days longer time Raising Z

Dilution 1 for 12 1 for 16 lower dilution Raising Z

Risk free interest rate 5% 4% lower interest rate Raising Z

In each of these ways, Raising A should be cheaper than the Raising Z but in fact both companies paid the same

amount. Both raisings provided poor value for money according to the model.22

As an even stronger example, consider the following two companies. The company undertaking Raising B paid

more, but had an underwriting agreement that was lower risk in every way.

Parameter/risk factor

Raising B

Raising Z


Which should cost

more?

Actual cost 2.5% 2%

Discount (adjusted as above) 9% 7% smaller discount Raising Z

Volatility (adjusted as above) 35% 49% larger volatility Raising Z



and retail)

7 days 21 days longer time Raising Z

Dilution 1 for 7.2 1 for 16 lower dilution Raising Z

Risk free interest rate 5% 4% lower interest rate Raising Z

22

Interestingly, the underwriter of the relatively less risky rights issue was also a substantial shareholder. See “Information asymmetry between company and underwriter and prior relationships” below for further analysis.


16

Comparison with 20 years ago

As a check of this result, the following compares the prevailing circumstances in relevant to the current

research (“Now”) versus when the original research was done (“Then”). The following table shows that the

time frames, number of rights issues considered and the amount raised are broadly similar and that the

amount paid is around 60% more now compared to twenty years ago.

Parameter Then Now

Time frame 3 years ending June 1993 3 years ending December 2012

Number of rights issues 60 63

Amount raised (inflation adjusted to 2012)23 $12.2bn $14.9bn

Average actual underwriting fee paid 1.56% 2.50%

The table below shows the average of each of the key parameters during the two time periods.

Parameter/risk factor Then Now


Which should cost more?

Average discount (pre-

announcement)24

20.6% 17% smaller discount Now

Volatility (adjusted as above) N/A 63% larger volatility ?



and retail)

60 days

15 days

longer time

Then

Dilution N/A 29% lower dilution ?

Average risk free interest rate25 8.9% 4.4% lower interest rate Then

Premium to value26 49% 203% lower interest rate Then

The table shows that while the average discount is slightly lower now, the typical offer is now four times

shorter than 20 years ago. In other words, the “at risk” period has reduced by a factor of four. Interest

rates also suggest underwriting should be cheaper now. Unfortunately, however, given a lack of data on

volatility and dilution it is difficult to draw conclusive results from this analysis.

However, using the same risk factor inputs as in the Handley research yields a premium of just over 200%

as compared to 49% in 1993 (see Appendix B for further details). This suggests that underwriting is even

more expensive relative to the risks transferred as compared to the 20 years ago.

23 Using inflation data from the Australian Tax Office and comparing June 1993 with December 2012. The data is available here. 24 To ensure consistency with Handley, the discount off the dividend adjusted pre-announcement price is taken rather than the approach which takes into account the

announcement factor and TERP. 25 Risk free is not as important as the others when the option expiry is so short. 26 This uses identical inputs to the original Handley research; see Appendix B for further details.

https://www.ato.gov.au/Rates/Consumer-price-index/


17

Potential drivers of underwriting premiums: size, liquidity, market conditions, reputation and purpose

Obviously, a relatively simple theoretical model may not capture all the particular circumstances facing

companies and factors other than discount, volatility, time and dilution may be important. As such, this

research considers the following additional factors:

Size of raising

Liquidity of underlying stock

Market conditions

Underwriter reputation

Purpose of raising

The discussion also considers whether these are legitimate costs to be included as part of the underwriting

component of the fee, remembering that companies also pay a management fee.

Size of raising

According to Handley, underwriters find it more difficult to underwrite a larger capital raising because it

becomes more difficult to reduce the risk through sub-underwriting. As such there may be an entirely

legitimate “size of raising” factor whereby larger raisings cost more on a proportional basis. This suggests a

positive relationship with the level of excess.

On the other hand, larger companies have a higher profile among investors and if they are included in

indices they may be within the investable universe of more fund managers.

Of course, rights issues by definition offer shares first to existing shareholders, who should know the

company. However, the bookbuild process for forfeited rights would involve new shareholders and it may

well be more difficult to find other investors at smaller companies.

Additionally, since larger raisings are typically done by larger, better resourced companies potentially they

may be better able to negotiate a lower fee.

In summary, the size of the raising may be important but it is difficult to say in which direction.

Liquidity of underlying stock

If the rights issue fails, the underwriter has to take up a large proportion of the company’s shares which,

presumably, it does not want. The ability and speed with which the underwriter can then sell shares in this

situation depends on the liquidity of the underlying stock.

In the analysis, the 30 day liquidity prior to the raising is used. It is calculated as the turnover of the

company’s stock (total dollar volume of shares traded divided by the average market capitalisation during

that time).27 The expectation is that underwriters of lower liquidity companies would recognise the

additional difficulty of selling shares in an illiquid stock and would price that in. This suggests a negative

relationship between liquidity and excess returns.

27 This assumes that liquidity does not change, or a uniform change occurs along all companies, after the raising.


18

Market conditions

Handley suggests that market conditions (whether bullish or bearish) may have an effect. Specifically, in bearish

markets where investors are more cautious about committing additional funds there is a greater risk for the

underwriter for which they should be compensated.

However, recall that the model (as previously specified) potentially already captures this risk because of the

impact of volatility. In bearish markets, volatility would be higher and so too would the benchmark model value.

In this analysis, the recent (30 day) historical returns and the volatility of the ASX200 are included. If these are

important, excess returns would be greater during low recent returns and high recent volatility.

Purpose of raising

Each of the rights issues considered can be roughly split into two underlying purposes , namely to fund a new

project or acquisition or to pay down debt or fund working capital. If, for example, the company is seeking to

undertake a large equity raising to pay down debt, particularly where there is a covenant breach, this is likely to

be less favoured by the market. As such the underwriting risk may be greater when the rights issue is to pay

down debt. With the variable specified with 1 being assigned to new projects/acquisitions and 0 otherwise, this

would suggest a negative relationship.

However, again it is worth noting that the model previously specified took the share price after the

announcement and so should already incorporate any market reaction to the news.

Underwriter reputation

Handley also considered whether the underwriter’s reputation determines the premium that they can extract

from companies. Attaching the offer to a more reputable underwriter may well enable the company to achieve

greater demand for its shares and may have benefits in terms of the quality of their share register and the ease

of underwriting. Companies know this and they are willing to pay more.

This aspect is an entirely legitimate additional cost for companies to consider paying, but it clearly falls within

the management aspect of the underwriter’s role, not the underwriting itself. In fact, if the underwriter’s

reputation makes the raising less risky as described above, it would be expected that more reputable

underwriters should charge less for underwriting (but more for management).

Market share of ECM (equity capital markets) business, as collated by Bloomberg, is used to proxy for the

underwriter’s reputation. A dummy variable was created where a “top underwriter” status is assigned for the

top 3 ECM firms by market share in any year. This provided a reasonable mix among the sample. (Unfortunately,

this data was only available for 2011 and 2012 so it is assumed that these top underwriters were the same in

2010.)

Original benchmark model variables

As in the Handley research, to check whether there is proper pricing of the core factors in the model (being the

discount, time, risk free rate and volatility), they are all included again in this analysis. If the market is properly

pricing each of these factors, they will not be statistically significant. (Note that dilution is not separately

included because, holding market capitalisation constant, the size of raising is a linear function of dilution.)


19

A regression was set up with the following specification:

In other words, this analysis tests whether the excess fee, or premium, can be explained by:

Parameter/risk factor Measurement

Purpose Dummy variable; 1 if purpose is to undertake a new project or acquisition, 0 otherwise

Underwriter reputation Dummy variable; 1 if underwriter was in the top 3 underwriters by market share during 2011 or 2012, 0 otherwise28

Size Dollar amount raised (transformed into a natural log)

Liquidity Dollar turnover of the company’s stock as a proportion of its market cap

Mkt Conditions Return Continuously compounded return on the ASX200 in the 30 trading days preceding the announcement

Mkt Conditions Risk Volatility (standard deviation of returns) of the ASX200 in the 30 trading days preceding the announcement

and/or the following factors, that have already been incorporated into the benchmark model:

Discount Percentage discount between issue price and share price immediately after

announcement (adjusting for dividends and TERP, as necessary)

Values are presented as negatives

Vol 180 day historical volatility of returns on the underlying stock

Time Days between announcement and offer close, weighted by the proportion

Risk free 30 day bank accepted bill rate at the time of announcement

A linear regression of these variables yields the following results:

Prediction Coefficient t-Stat29 p-value

Intercept None 0.025788 0.70 0.685

Purpose Negative 0.004001 1.03 0.308

Underwriter reputation Negative -0.002 -0.51 0.613

Size Positive -0.00028 -0.08 0.934

Liquidity Negative -0.0006 -0.81 0.420

Mkt Conditions Return Negative 0.058555 1.39 0.171

Mkt Conditions Risk Positive -0.02096 -0.51 0.609

Discount No relationship -0.12262 -3.35 0.002

Vol No relationship -0.0286 -1.75 0.087

Time No relationship -0.25759 -2.10 0.040

Risk free No relationship 0.167695 0.42 0.677

28 An interaction term between the purpose and underwriter’s reputation was also added and tested. This did not alter the outcomes. 29 These are calculated using robust standard errors to correct for heteroskedasticity in the data.


20

Note that there was little explanatory power any of the new factors proposed (i.e. each of purpose,

reputation, market capitalisation, liquidity and market conditions were statistically insignificant). The

statistically significant factors were the discount and time.

The additional insight from this analysis is that it can shed light on the specific characteristics of a rights

issue that are most prone to a large underwriting premium. Specifically, the characteristics are deep

discounts and rights issues with shorter timetables or (because time is weighted by the institutional and

retail components) larger institutional shareholdings.

The fact that discount and time to offer close are explaining the level of excess suggests first that they are

indeed the most important determinants of what companies actually pay. However, to repeat, these

factors have already been incorporated into the benchmark model.

It is worth noting that this result is similar to the Handley research, which found that “excess returns are

associated with lower volatility and deeper discount issues”. While volatility now appears to be properly

priced, the length of the offer is now not.

Other potential drivers of underwriting premiums that were not examined

Management costs

There are obviously many other important functions performed by underwriters. These include preparing

all the associated documentation, determining pricing, gauging market appetite and timing, finding new

investors, ensuring the stock trades well in the secondary market after the issue and many others.

However, the total fees paid are split between management and underwriting and all of the items

described above clearly fall into the management component of their service. As such, these are not

relevant considerations for the underwriting component of their service.

Disclosed versus actual costs

When the announcement of a rights issue is made, the underwriting fee is disclosed to the ASX according

to the ASX Listing Rules in a form called Appendix 3B. The final audited fee can then be determined from

the company’s annual report.

Comparing Ownership Matters’ data on the audited fees versus the fees disclosed at the time in Appendix

3B yields the following:

Average total fees as disclosed in Appendix 3B: 3.12%

Audited total fees as disclosed in annual report: 3.47%

Difference: 0.35% (this is significant at the 1% level)30

30 This analysis includes 53 raisings where data was available. Raisings where fees are not applied in a uniform way are excluded.


21

This suggests that underwriting and management together ends up costing around 11% more than what is

disclosed up front. If this is the case for the underwriting component then the results above are

understating the true premium to the benchmark model value.

However, it’s unclear which of those two components actually end up costing more than disclosed. Also,

the audited fees are aggregated in annual reports and do not provide the split between underwriting and

management required to perform analysis of just underwriting fees. They may also include other fees (such

as legal fees) but these are typically immaterial.

Termination clauses

Underwriting agreements typically include clauses that enable the underwriter to terminate the agreement

if certain adverse events occur throughout the underwriting period. The option to terminate clearly

reduces the risk for the underwriter.

As one example, the June 2012 capital raising by Ten Network Holdings included (among others) the

following termination triggers for its underwriter:

material disruptions in the financial, political or economic conditions in key markets

delays in the timetable without the underwriter’s consent

an adverse change to the business, operations, prospects, management, financial position,

earnings position or shareholder’s equity relative to the position as at announcement

a drop in the ASX200 by 10%.

This effectively shields the underwriter from having to take up a shortfall if there is a materially adverse

market or company specific event. It appears therefore that this would shield them from the most adverse

outcomes and as such, companies should pay less.

Although these termination triggers are noted as “customary” in the Ten Network Holdings disclosure and

others, the uniqueness or otherwise of the particulars of such arrangements was not studied further.

Information asymmetry between company and underwriter and prior relationships

Handley also suggests that the existence of a prior relationship with the underwriter may reduce

information asymmetry between the relatively uninformed underwriter and the company, which has

superior knowledge of its operations. As such, the prediction is that the existence of a past relationship

between the underwriter and the company reduces the premium or excess. However, Handley found the

opposite effect – specifically that excess fees were generated precisely when there were prior relationships

(although only in the case by ‘top underwriters’).

Given data collection and time constraints, this argument was not explored in detail.

However, the following case study provides evidence consistent with Handley’s results.


22

Recall the table at the top of page 15 where two companies paid the same for underwriting yet one was

less risky in four key ways. In the less risky raising, the underwriter was also a substantial shareholder and

had board representation. Clearly, information asymmetry would not be relevant in this case. However, as

the analysis above showed, this company paid in excess of benchmark model value. This case suggests that

when the underwriter is close to the company, it may be a situation of the underwriting premium being

even bigger than otherwise. The underwriter in this case was one of the ‘top underwriters’, which is

consistent with past results. Obviously, no firm generalisations can be made given this is one case study.

Expected take up and soft soundings

Adverse selection is a phenomenon where there is information asymmetry between (well informed)

companies and (poorly informed) potential new investors. If potential new investors subscribe to a “bad”

offer they may be disheartened by the experience and withdraw from the market altogether. Companies

know this and in order to induce new investors to subscribe may seek to use underwriting to certify the

offer/lease its brand name.

Given rights issues are only offered to new investors if existing investors decline to participate, this effect is

larger (and the cost to underwrite should be greater) if current shareholders do not participate. Therefore,

underwriting should cost more for companies where there is lower expected current shareholder

participation.

Additionally, it is likely in modern capital raisings that the largest shareholders and potential new

shareholders were already contacted confidentially prior to the raising (so called ‘soft soundings’).

According to a recent investigation by the Australian Securities and Investments Commission (ASIC), this is

the usual practice and “involves a lower level of risk for the underwriter. In practice, this means that

investment banks and brokers will not usually sign an underwriting agreement unless they have sufficiently

sounded the market to their satisfaction.”31 As such, the underwriter may potentially have informal

agreements from the market for the full raising before they sign the underwriting agreement. In these

circumstances, their risk is negligible.

Finally, in many cases the participation of a major shareholder is announced as part of the market

announcement. Below is one such example from Ten Network Holdings’ June 2012 rights issue:

In Handley, the percentage of total shares held by the top 20 shareholders was used to proxy for the

expected take up. Given the increasing use of pooled nominee accounts by custodians which do not

disclose beneficial owners, this proxy was deemed insufficiently accurate and the issue was not explored

further.

31

Australian Securities and Investments Commission, (2014) “Report 393: handling of confidential information: briefings and unannounced corporate transactions” (available here – see paragraph 205)

TEN Managing Director and Chief Executive Officer, James Warburton, added: “[..] In a strong endorsement of our

turnaround strategy, four of our major shareholders accounting for approximately 43% of the shareholder register

have committed to take up their entitlements in the Entitlement Offer. Those shareholders are interests

associated with Bruce Gordon, Lachlan Murdoch, James Packer and Gina Rinehart.” (emphasis added)

http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rep393-published-27-May-2014.pdf/$file/rep393-published-27-May-2014.pdf


23

Sub-underwriting

Sub-underwriting is where the head underwriter agrees with other institutions that they will take a portion

of the shares in case there is a shortfall. The underwriter pays a fee to the sub-underwriter for this service.

The existence of an active sub-underwriting community may affect the cost of underwriting for the

company. A large group of sub-underwriters collectively may be better able to withstand having to buy a

large amount of shares from a failed raising; therefore the cost should be lower if sub-underwriters are

used.

There is no data available to ACSI on sub-underwriting and as such it was not explored further.


5. Recommendations

24

This section highlights the role of three market participants in helping achieve a more cost effective

outcome for companies and their investors.

The role of company directors

Given the above results, the following questions may aid company directors in overseeing capital raisings:

What model does the underwriter use to determine the underwriting fee? What value does it

generate?

What inputs go into this model? Specifically, what assumptions are used regarding discount, time

to maturity and volatility? What other risks are being incorporated?

If there is a premium to what the model suggests as the value of the underwriting and the

proposed fee, is it reasonable?

Handley’s research found that the existence of prior relationships with underwriters on average meant that

premiums were larger.32 This suggests that directors should carefully scrutinise fees when there is a prior

relationship and suggests that, where possible33, affording others the opportunity to tender for

underwriting may lead to more cost effective outcomes because it will build competitive tension between

underwriters.

The role of investors

First, investors should be aware of value loss that can occur as a result of poorly negotiated underwriting

agreements and so should also develop policies outlining their expectations of company executives and

boards in this area.

The ACSI Governance Guidelines34 include a section on its expectations regarding “Capital Raisings and pre-

emptive rights of existing shareholders” (section 7) which may be a starting point for other investors.

There are two main mechanisms through which investors can exercise their ownership rights to ensure

more cost effective outcomes, namely company engagement and voting. These are discussed in turn

below.

Engagement

Directors of most last Australian companies engage meaningfully with investors and investor

representatives like ACSI. Where relevant, that the discussion should also include investors explaining their

policy on capital raisings.

32 As noted above, the current research did not consider this factor given a lack of readily available data. 33

Given the rights issue would be material non-public information, companies would clearly need to consider confidentiality of the information very carefully. In a similar vein, once an underwriter is selected directors should also be aware of ‘soft soundings’ where potential investors of the upcoming issue are contacted to gauge their interest (see ASIC report 393, cited above under the heading “Expected take up and soft soundings”, for further details). Putting the underwriting service to a tender process would also involve a more lengthy process. 34 Available here.

http://acsi.org.au/acsi-guidelines23/acsi-governance-guidelines.html


25

Where the company has recently conducted a capital raising, using the ACSI Governance Guidelines section

7.2 as a basis, potential questions for boards include:

How did the company35 oversee the capital raising process?

How did the company select the underwriter?

How did the company35 negotiate the fees paid to underwriters?

How was the issue price determined?

How was the shortfall allocated?

There are also important broader questions regarding the existing shareholders’ access to the capital

raising that are further explored in the Guidelines.

Timely and informed engagement with the board will demonstrate the importance of the issue from the

investor perspective and hold boards more accountable for their oversight in the area.

Voting

Shareholders do not vote on resolutions involving rights issues. However, under the current ASX Listing

Rules (Chapter 7), where companies undertake placements beyond specific thresholds they are required to

seek shareholder approval or subsequent ratification. Clearly, where the placement is underwritten, one

consideration in deciding whether to support the resolution should be the fees paid to underwriters.

Unfortunately, as discussed below, the current disclosure regime for placements does not sufficiently

enable shareholders to understand fees.

Some investors may also consider opposing director elections based on poor oversight of capital raisings.

The role of regulators and rule makers

ASX Listing Rule Disclosures for placements

This study only considers rights issues despite the fact that many more placements are done – and they can

present greater loss of value to existing shareholders given the discretion to allocate shares to any investor.

However, for underwritten placements there is no requirement to disclose the underwriting cost under the

ASX Listing Rules. For rights issues, the underwriting cost is required to be disclosed to ASX using the

Appendix 3B form. Part 2 of this form, which includes questions 20 and 21 regarding the underwriter and

cost, are only required for pro-rata raisings.

This is an anomalous regime because the capital raising mechanism that has more potential to undermine

existing shareholder rights (through the abandonment of pre-emptive rights) has lower disclosure

requirements. As such, ACSI recommends increasing the disclosure requirements for placements to at least

match those of rights issues. ACSI has advocated this policy position in the past with ASX.36

35 An earlier version of this report erroneously said “board” in these two places, rather than “company”. 36 For example, see point 7 of ACSI’s response to the ASX BookBuild Consultation Paper, available here and page 3 of ACSI’s response to the “Modernising the timetable for rights issues” paper available here.

http://www.asx.com.au/documents/public-consultations/ACSI_BookBuild_Submission.pdf

http://www.asx.com.au/documents/public-consultations/Submission_ACSI.PDF


26

Shortening the standard timetable for rights issues

In June 2012, ASX released a consultation paper entitled “Modernising the timetable for rights issues:

Facilitating efficient and timely rights issues”.37 The proposal to shorten the standard timetable from 26

days to as short as 18 days was generally supported by the market and has now been incorporated into the

ASX Listing Rules. In discussing the feedback received from stakeholders, ASX noted:

These comments sit comfortably within the theoretical framework used for this research, where the longer

the offer period the more expensive underwriting should be (see “Methodology and Data” above).

In its discussion, ASX noted that further shortening of the timetable is possible but there are barriers,

including the ability to make real-time payments and the current requirement of hard copy dissemination

of disclosure documentation. In its original response to the consultation, 38 ACSI was generally supportive

of both these developments as long term goals and continues to support these given they may also lower

underwriting costs.

37

ASX Consultation Paper (2012) “Modernising the timetable for rights issues: Facilitating efficient and timely rights issues” (available here) 38 ACSI’s response is available here.

There was strong in-principle support from almost all stakeholders for the objective of shortening the

standard timetable for rights issues to improve their relative attractiveness as a mechanism for raising

capital. Some saw the potential for market users to benefit from the expected process efficiencies and

for a reduction in the level of risk associated with possible changes in market conditions during the life

of a rights issue. Others also saw the potential for issuers to secure underwriting more easily and cost-

effectively. (emphasis added)

http://www.asx.com.au/documents/public-consultations/consultation_paper_rights_issue_timetable_3Jul12.pdf

http://www.asx.com.au/documents/public-consultations/Submission_ACSI.PDF


Appendices

27

Appendix A: Adaptations to the framework

The following section explains the three adaptations to the benchmark model as compared to Handley.

They are each inputs into the benchmark model formula or, in other words, key risk factors in valuing the

shortfall risk.

Share price

The share price used in the Handley research is the last closing price before the announcement of a rights

issue is made. As noted above, using a lower share price in the model would narrow the premium between

the actual cost and the benchmark model value.

There are at least three reasons why the share price drops on announcement of the offer, namely:

theoretical Ex-Rights Price (TERP) effect

an announcement effect; and

dividends.

Theoretical Ex-Rights Price effect

First, there is the simple mathematical dilutive effect that occurs whenever new shares are issued at a

discount and each has the same proportional ownership of the equity. This new price is called the

Theoretical Ex-Rights Price (TERP) and is commonly quoted in announcements. For the fictitious example in

the section entitled “Underwriting is a financial option”, the TERP is $10.66 (a 3% drop).39

By way of a real example, in the announcement of its 2012 rights issue AGL Limited used the TERP when

discussing its issue price:

However, the model as specified already incorporates this effect through the denominator (1 + q) in the

formula (1). Nevertheless, given that accelerated rights issues do not have a cum-rights trading period (see

below), isolating this effect is now more difficult in practice. As such, the share price is decreased for the

TERP factor even though it is already factored into the model. Since decreasing the share price means

decreasing the discount, this approach yields more conservative results (i.e. increases the benchmark

model value).

39 Before, there were 1 million shares at $11 each (total equity value of $11m). The rights issue will add a further 0.5m shares at $10 each (total value of $5m) and will result in a total

of 1.5m shares. The total value of the company should be $11m plus $5m, so $16m. This equates to $10.67 per share ($16m divided by 1.5m).

The offer price of $11.60 per new share represents:

A 22.3% discount to last close; and A 19.7% discount to the theoretical ex-rights price (TERP).

1

1 The theoretical ex-rights price is the theoretical price at which AGL shares should trade immediately after the ex-

date for the Entitlement Officer. The theoretical ex-rights price is a theoretical calculation only and the actual price at which AGL shares trade immediately after the ex-date for the Entitlement Officer will depend on many factors and may not be equal to the theoretical ex-rights price.


28

Announcement effect

The second reason why the share price on average drops during a rights issue is because it is often a

negative signal. Investors may perceive a rights issue as symptomatic of an inability to generate cash

through operations or other sources such as debt according to the “pecking order theory”.

However, Hansen40 documents a share price drop on the announcement of a rights issue and further drop

in share price until the offer close. In the Australian context, Grundy41 suggests that firms and underwriters

generally know that the price will drop because of the announcement and therefore use a lower share

price to determine the appropriate underwriting fee.

Of course, the underlying purpose of the raising would also influence the magnitude of a share price drop

and operational announcements are often made at the same time as rights issue announcements. For

example, if the purpose of the raising is to pay down debt (especially if debt covenants may be breached

otherwise), the market impact would probably be more than if the purpose was to fund a new project that

investors agree is value adding.

These effects are known to the company and its underwriters and they will price the underwriting

agreement to take them into account.

To incorporate this into the model the closing share price on the first trading day after the announcement

is made is used rather than using the pre-announcement price. This is essentially assuming that the

company and underwriter can, on average, make an unbiased prediction/estimate of where the share price

will be after the offer and any associated news is announced.

An alternative would be to discount each price by the average price drop across all raisings, but it is not

preferred given the different discounts and purpose of each specific raising would be ignored.

For rights issues that are “accelerated”, there is typically no “cum-rights” market, which means that anyone

buying the shares after the announcement is not entitled to participate in the offer. For example, below is

a typical announcement made by ASX whenever a company announces a rights issue:

This means that the closing price on the next trading day after announcement incorporates both the price

drop from the dilution/TERP adjustment and the market’s assessment of the other news associated with

the raising. For traditional rights issues, the effects of the announcement and the TERP are added.

40 R Hansen (1988) “The demise of the rights issue”, The Review of Financial Studies, 1, 289-309. 41 B Grundy (2009) “A Note on the Costs of Equity Financing”, response to the Australian Energy Regulator’s draft decision for TransGrid. (available here)

Trading issues

ASX will not price a “cum” market with respect to trading in the Company’s securities. Persons who acquire the Company’s securities after the commencement of the trading halt on Thursday, 21 June 2012 are not entitled to participate in the Entitlement Offer. (emphasis added)

http://www.aer.gov.au/sites/default/files/Appendix%20Q%20-%20Grundy%20Report.pdf


29

As one final point, Hansen’s research suggests a further drop in share price of around 4% between the

announcement and offer close. The actual price drop between these two dates in the current sample was

not significantly different from zero; nor was there any significant abnormal return after applying a simple

Market Model.42 As such, this effect was ignored.

Dividends

Finally, as is common in option pricing (and incorporated in Handley), the stock price was adjusted down if

dividends were payable throughout the offer period. The adjustment is necessary because, should a

shortfall occur, the underwriter would not receive the dividend.

Volatility

A second critique of the model proposed by Handley was around the volatility parameter. Volatility

assumptions are regarded as the most crucial to accurately pricing options because of its effect on option

values and that, of all the parameters, it is the only one that is not directly observable. The following

section outlines two adjustments that were considered.

Volatility prior to issue versus volatility during the issue

The volatility estimate used in Handley’s research was the volatility of returns in the 180 trading days prior

to the rights issue announcement. A subsequent paper found that the volatility of returns was materially

greater during the offer period rather than before.43 Using the volatility during the period (a higher value)

meant that there was no premium between cost and the benchmark model value. The argument is that

companies and underwriters know that stocks are more volatile during the period than in the more

tranquil period before so they price in this increase.

However, in the current sample this relationship does not hold. In fact, the volatility during the offer period

was slightly lower than in the 180 days before the announcement on average. This would mean that the

premium between cost and benchmark model value would be greater using the volatility during the period.

As such, volatility during the offer period was not used.44

Volatility “skew”

One further issue is the often observed effect of the “volatility smile” or “volatility skew”. Recall that the

underwriting agreement is like an option held by the company to sell shares, otherwise called a put option.

For put options where the issue price is much lower than the share price (i.e. “out of the money”, or in

underwriting language “heavily discounted”), the option price is higher than the Black Scholes Merton

model would predict.

42

In the present sample, there was no difference from zero at the 10% level using either the actual return between the announcement and offer close or the excess returns from the

market model (with parameters estimated using daily data from the sample). 43 Howard W. Chan (1997) “The effect of volatility estimates in the valuation of underwritten rights issues”, Applied Financial Economics, 7, 473-480. 44 Additionally, given many contemporary rights issues have an accelerated institutional component that is often done over one or two trading days or while the shares do not trade,

the volatility during the period is undefined. This means that the sample is heavily biased to only the retail portion of the offer.


30

The volatility input that would make the observed option price equal the Black Scholes Merton option price

at a given issue/exercise price is called implied volatility because it is implied/calculated from observed

prices.

(One explanation is that there is a relatively large demand of options as insurance against large falls in

share price, so these options attract a special premium. It could also be a reflection of returns not being

normally distributed, which is an assumption of the Black Scholes Merton model, and instead having a

greater chance of a more extreme outcome. This phenomenon is sometimes called “fat tails”. Regardless of

the underlying reason, what is clearly important is to take it into account.)

The important thing to note is that this phenomenon is relevant for precisely the type of rights issue that is

typically undertaken – a heavily discounted one. The error that can arise from not adjusting for the

volatility skew is underestimation of the value.

Unfortunately, for all but the largest ASX-listed companies there are no exchange traded options on the

ASX. This means that actual option price data are not available and nor can implied volatilities be

calculated. In the present sample, only seven (of 63) companies that undertook rights issues had exchange

traded options on the market at the time.

Instead, to establish the percentage increase in volatility given different discounts to the current share

price, weekly data for all exchange traded put options was collected. Where the options were actually

traded during the week, the average percentage increase between the volatility at a given discount

compared to equivalent at-the-money options was measured.

Graphically this produces the following:

Note: this graph excludes cases where there are fewer than 75 data points at a given discount and the buckets capture 1% either

side of the point. The x axis has negative numbers because these are all discounts to the share price.

-20%

0%

20%

40%

60%

80%

100%

-35% -30% -25% -20% -15% -10% -5% 0%Vo

lati

lity

pre

miu

m r

ela

tive

to

at-

the

-mo

ne

y o

pti

on

Discount

Volatility premium relative to at themoney option

Line of best fit


31

This confirms that there is indeed a volatility skew over the period. For example, if there was a rights issue

conducted at a 20% discount to the share price using the historical volatility would underestimate the value

of the option as it would be if it was trading in the market. Applying a 54% premium to the volatility input

should correct for this.

The percentage increases also did not exhibit any strong relationship with time – in other words there were

not, for example, a larger increases in any one period versus another. There were three ‘spikes’ in the data

although none of the rights issues to be tested fell on these times. Again, to be conservative, all the data

was retained (alternatively - if you removed the ‘spikes’, the volatility increase is smaller). Also, the data did

not exhibit any short term patterns (or, technically speaking, ‘serial autocorrelation’).45

Given these results, and to retain a simpler model, the same increases in volatility were applied regardless

of when the rights issue occurred. Finally, as stated above, to be conservative no reductions in volatility

were applied even when the results suggested doing so and the ‘spikes’ were not removed.

For the current data set, the formula that was applied was:

(2) 46

Note: ATM is “at the money”. Discount is always a negative number, so this formula yields positive numbers.

The discount between issue price and share price adjusted for the announcement factor, TERP and

dividends was used for these adjustments.

Time to maturity

The current research also raised questions on one other parameter – time to maturity.

Accelerated rights issues

Perhaps the most dramatic change in how rights issues are conducted is the so-called “accelerated” (or

“dual track”) rights issue where the institutional shareholders have a very short window in which to take up

the offer and the retail shareholders have a longer period. Until recently, accelerated rights issues have

been allowed through ASX granting waivers of the ASX Listing Rules although recently ASX has moved to

formalise an accelerated rights issue timetable alongside the “traditional” approach.47

Despite them not being formally within the ASX Listing Rules, accelerated rights issues are unequivocally

the norm in large Australian companies. Among the current sample of ASX300 companies between 2010

and 2012, only 16% were traditional rights issues.

As noted above, accelerated rights issues reduce the time to maturity dramatically – in the current sample,

the institutional component was completed three times faster (from announcement to settlement) than

the retail component on average.

45 A correlation of virtually zero between errors from one period to the next and p-value of 0.88. 46 This parameter (-2.4) was highly statistically significant (p-values were virtually zero). Where there was a premium to the price, volatility was left unchanged. 47 ASX Consultation Paper (2012) “Modernising the timetable for rights issues: Facilitating efficient and timely rights issues” (available here)

http://www.asx.com.au/documents/public-consultations/consultation_paper_rights_issue_timetable_3Jul12.pdf


32

This development should not come as a surprise given the pricing framework introduced earlier because a

shorter time to maturity means less risk for the underwriter and (hopefully) lower direct underwriting

costs. Given the different settlement periods it can also have beneficial cash flow implications for the

company because they will receive the institutional component (on average) around 22 days before the

retail component. A successfully completed institutional component can also be a signal to retail

shareholders that the offer is attractive. This appears to be the at least part of the intent behind

documents sent to retail shareholders, which occurs after the institutional component is completed (see

above under “Expected take up and soft soundings”).

This research takes accelerated rights issues into account by splitting it into its two components, calculating

the model value of each component then taking the weighted average of the two. The weights are simply

the number of shares issued under the component divided by the total number of shares issued.

Offer close date versus settlement date

Handley used the offer close date as equivalent to the maturity date for the underwriting option. This

would be appropriate for exchange traded shares (or options), where the clearing and settlement system

effectively eliminates counterparty risk.

However, in primary market transactions like capital raisings the clearing and settlement risk is borne by

the company and its underwriter. In other words, if a party subscribes to a capital raising but does not have

sufficient funds, then the company simply does not get funds and the settlement fails. The ASX itself does

not bear any counterparty risk in primary market transactions.48

Nevertheless, it is assumed that the actual risk of failed settlement through uncleared funds is low because

it results from cheques failing to clear. First, it is assumed that only electronic payments were used among

institutional shareholders. Second, cheque use is also assumed to be low among retail shareholders.

According to the APCA (Australian Payments Clearing Association) cheques are widely used by around 5%

of the Australian population, with this demographic representing “the elderly, rurally isolated and the

unwaged”. 49 Outside of outright fraud (which occurs in less than 0.02% of transactions and 0.001% of

cheques according to the APCA website) cheques can be dishonoured.

Additionally, if a retail shareholder subscribes to a rights issue but the cheque is dishonoured this may

present a benefit to the underwriter because presumably by this point the rights issue would have clearly

succeeded, with the issue price remaining below the share price. The underwriter can take this (probably

small) parcel of shares at the issue price and sell in the market at a profit without affecting the price.

As such, it is assumed that this risk is negligible and, like Handley, the present research uses the offer close

date in determining the benchmark model value.

Residual issues

Some rights issues are only partly underwritten. In these cases, the non-underwritten component was

stripped out prior to completing the analysis. Also, where the full rights issue was not completed in the

time period, the whole issue was ignored. This occurred typically where the announcement was made in

late 2012 and the retail component was not finalised until 2013.

48 This point was confirmed with discussions between ACSI and ASX. 49 Australian Payments Clearing Association (2011) “The Role of Cheques in an Evolving Payments System” (available here)

http://www.apca.com.au/docs/role-of-cheques---consultations/future-of-cheques.pdf


33

Appendix B: Variations to factor inputs

To test the robustness of results, the methodology was run using different assumptions. These showed that

the headline result as presented were robust to sensible changes in methodology. Below is the outcome

using identical inputs to the original research conducted by Handley.

The following parameters were used as inputs into formula (1) in the original research:

is the actual share price on the last trading day before announcement, adjusted for dividends

is the issue price

is the actual underwriting cost paid by the company

is dilution (the new shares issued divided by the number of current outstanding shares)

is 180 day historical return volatility

is the time between the announcement of the offer and offer close

is the 30 day bank accepted bill rate.

As was discussed in Appendix A, the differences are an adjustment of the share price to factor in an

announcement effect and increasing volatility.50

Actual cost (α) Value (αFV) Difference (%) Premium (%)

Simple average 2.5% 0.80% 1.61% 203%

Weighted average percentage * 2.1% 0.29% 1.77% 608%

Aggregate amounts $308m $43m $264m 608%

The difference and premium are statistically significant.

50 The necessary changes were splitting the rights issue into the institutional and retail components for accelerated rights issues and using a 30 day, rather than a 60 day risk free rate.


34

Appendix C - Bibliography

ASX Consultation Paper (2012) “Modernising the timetable for rights issues: Facilitating efficient and timely

rights issues”

Australian Payments Clearing Association (2011) “The Role of Cheques in an Evolving Payments System”

(available here)

Australian Securities and Investments Commission, (2014) “Report 393: handling of confidential

information: briefings and unannounced corporate transactions” (available here)

Howard W. Chan (1997) “The effect of volatility estimates in the valuation of underwritten rights issues”,

Applied Financial Economics, 7, 473-480.

Simon Connal (2013) “Equity Capital Raising by the ASX300 post-GFC: Too much is never enough”, Ownership

Matters

Bruce Grundy (2009) “A Note on the Costs of Equity Financing”, response to the Australian Energy Regulator’s

draft decision for TransGrid (available here)

John C. Handley (1995) “The Pricing of Underwriting Risk in Relation to Australian Rights Issues”, Australian

Journal of Management, 20, 1, 1995, June.

Robert Hansen (1988) “The demise of the rights issue”, The Review of Financial Studies, 1, 289-309.

Martin Lawrence and Simon Connal (2010) “Equity capital raising in Australia during 2008 and 2009”, ISS

Robert MacCulloch and David Emanuel (1994) “The valuation of New Zealand Underwriting Agreements”,

Accounting and Finance, 34, 2, November 21-34.

Paul Marsh (1980) “Valuation of underwriting agreements for UK rights issues”, Journal of Finance, 35, 3, June,

693-716.

Office of Fair Trading (UK) (2011) “Equity underwriting and associated services: an OFT market study”

http://www.apca.com.au/docs/role-of-cheques---consultations/future-of-cheques.pdf

http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rep393-published-27-May-2014.pdf/$file/rep393-published-27-May-2014.pdf

http://www.aer.gov.au/sites/default/files/Appendix%20Q%20-%20Grundy%20Report.pdf

Cost of Capital Raisings: the costs of underwriting ASX300 rights issues 36

Ground Floor, 215 Spring Street, Melbourne VIC 3000 Australia I T: +61 (0)3 8677 3890 I F: +61 (0)3 8677 3889 I E: [email protected] I W: www.acsi.org.au

14 underwriting of rights issues

Documents

underwriting of rights

value of underwriting

underwritten rights

spasx300 company rights

role of investors

australian context

acknowledgments acsi

dr handley