Seasoned Equity Offering - Essay Example

Key words: Equity offering, Capital.

Introduction

Seasoned equity offering (SEO) is the transaction of equity shares after the initial public offering and is a process to raise capital through selling stock rather than providing additional debt. Lemmon and Roberts (2010) argue on its preference by suggesting that there is a high probability that internal funds of most companies may be inadequate to attain long-term requirements. These activities include research and development investment, expansion of facilities, and new product development, all of which need a substantial amount of finance, leaves raising capital from external sources as the only viable option.

A public equity offering is a sale of stock or other financial instruments by a company to the public with a purpose of raising capital for business investment and expansion. In the study by Chen, Dai, and Schatzberg (2010), they indicate that it is mostly the primary procedure utilized to get funds for keeping the company operational. In the US, corporate securities viable for public offerings must be listed with and approved by SEC and are often handled by an investment underwriter. A public offering is attained if the sale of securities is to more than 35 individuals.

The chief advantage of public equity offering is that since the deal is available to the public, the company is capable of raising large amounts of capital that can be utilized to fund capital expenditure, cater for research and development expenses, or even settle existing debt. Furthermore, it decreases the overall cost of capital and provides the firm with more power when negotiating for favorable interest rates with banks. Another benefit is an increased exposure and public awareness of the business because public offerings mostly generate a lot of publicity. Research conducted by Gregoriou (2006) indicates that past successful public equity offerings make the company and their products known to a new segment of potential clients, ultimately leading to growth in market share for the enterprise.

Although it has many benefits, public equity offerings provide challenges to companies mostly due to the added disclosure to investors. The regulatory requirements are difficult for newly public companies, and the costs of compliance can be very for small enterprises. In addition, due to the enactment of the Sarbanes-Oxley Act, expenses increased such as accounting oversight committees, financial reporting documents, investor relation departments, and audit fees. The companies also encounter pressure of the market to perform thus causing management to concentrate more on short-term outcomes rather than plan for long-term growth. The increasing scrutiny of business activities and the constant search for profit by investors may cause management to get involved in questionable procedures to increase earnings as evidence in the study of institutional investors by Agnes and Reitenga (2009).

Before implementing a public offering, companies must analyze with the support of an investment bank, the potential benefits, and disadvantages that will emerge. This process occurs during the underwriting procedure, contrasts the cons and pros of the public equity offering, and establishes if it aligns with the firm’s objectives.

The second category of seasoned equity offering is the rights offering. The rights offering is an equity issue method that entitles the company’s existing shareholders, to purchase directly from the enterprise, additional shares in proportion to their existing investment, within a specified time. The new shares are first offered to the existing shareholders before availing to the public, which is referred as the preemptive rights. Mostly in a rights offering, a discount to the market price is offered on the subscription cost at which the shares may be bought to provide shareholders with an opportunity to grow their exposure to the stock.

However, rights are mostly transferable, and until the date of purchasing new shares, shareholders can freely trade the rights on the open market. The rights have value; hence, offset the future dilution of current stock’s value for existing shareholders. Troubled firms often utilize rights offering to pay off debt, especially if they have no capacity to borrow more funds. A perfect example is Royal Bank of Scotland and Lloyds Banking Group that have coerced their shareholders to take rights issue but due to poor business decisions, have resulted in writing off bad acquisitions and loans worth billions of dollars. On the other hand, other financial stable enterprises use them to fund acquisitions and expansion strategies. In 2008, Standard Chartered raised $1.8 billion in a rights offering priced at 390p, a year later the value had increased more than four times (Chowdhury and Chowdhury 2010). For companies to reassure of their capacity in raising the finances, they have their rights offering underwritten by an investment bank.

The main benefit of rights offering is that the control of the company is retained among the existing shareholders, and the share of earnings and voting power is preserved as before. It enables potential fair distribution of shares without disrupting the accepted equality of shareholdings since rights are provided to the individual shareholders in proportion to their equity shares held in the company on that date. Another advantage is that the existing shareholders do not encounter dilution in the value of their shares, which is mostly faced with offering a new issue of shares to the public. The decline in the value of the shares in the rights offering is counteracted by receiving a discount on the market price.

Frequent provision of rights issue creates a better image and increases the goodwill of the company in the shareholders perception thus increasing assurance of a source of capital rather than issuing fresh shares to the public, whose procedure expenses can be avoided. In addition, it reduces the misuse of issuing new shares by directors who offer relatives and friends at a lower price, since by doing so they will decrease their control in the company.

The significant disadvantage with the rights offering is that it raises limited funds as compared to shares offered to the public because some smaller companies have a low number of shareholders. Stout (2012) based on experience, asserts that a company can only raise up to 25% of the current equity value of the enterprise through a rights issue. It also increases the potential risk of little demand when offering new shares since some negative information among the public may be distributed to discourage them from purchase. Another con is that if the shareholders do not take up their rights within the specified period, their shareholding will be diluted. It is a risky procedure for existing shareholders because the lengthy period results in potential manipulation and high levels of volatility. The costs involved such as underwriting fees are a substantial amount of smaller firms and if available, debt is a cheaper method of finance as the interest is tax deductible thus lower than right offering expenses. Since the shareholders are free to sell the rights on the open market, the company has no control to whom or when they can be sold.

Although the interest rates have fallen, and the investors have increased their risk uptake, past scenarios have made them more discriminating by ignoring rights issues that are meant for rescuing a poor performing company, but have concentrated instead on rights offering by firms that will utilize the funds for growth and expansion.

Private placement of equity is the sale of securities to a few select investors as a method of raising funds. The investors are mostly large insurance companies, mutual funds, pension funds, and banks. Since the offer is to a small number of individuals, the placement is not required to be registered with the SEC. However, individual investors involved in a private placement of equity must be an accredited investor, having attained the requirement of having an annual income over $200,000. The secondary issuance of additional shares dilutes the percentage of equity ownership that are held by existing shareholders, and the magnitude of dilution is correspondent to the size of the private placement of equity. The dilution of shares mostly results in a subsequent decrease in share price in the short-term; however, the long-term effect is uncertain and relies on how efficiently the management utilizes the additional funds raised from the private placement.

Most companies perform private placement if they cannot attract huge numbers of retail or institutional investors because the firm’s market sector is currently deemed unattractive. Also, the management may identify an opportunity for growth that needs additional financing; eventually, the economies realized from expansion may boost the stock price. However, some companies that are on the verge of insolvency due to bad management and poor strategies utilize private placement as a method to avoid bankruptcy. In 1992, the SEC eliminated most of the restrictions it had previously placed on the private placement of equity to enable small companies to raise funds through this process. The rules incorporated under Section 4 (2) of the federal securities law currently permit firms to promote their private placement of equity offerings more widely and to sell the shares to a larger number of investors. Also, it has enabled the easy resale of such securities by the investors (Stowe 2012).

The principal advantage of the private placement of equity is that it is cheaper and less time-consuming since it does not require the assistance of underwriters or brokers. Other equity financing options entail extensive vetting procedures from the SEC and meeting the necessary requirements may involve more than a year, and the associated costs can be a burden to smaller companies. Since no securities registration is required, fewer legal expenses are identified with the private placement process, and the limited number of investors leads to less negotiation thus the company can receive funding within a short period. Due to the exemption under Regulation D, a company can retain privacy while raising capital since they are not required to disclose information to the public in each quarter. It is also not required to surrender a management position or a seat on the board of directors to the group of investors. Rather, control over financial management and business operations remains with the existing shareholders.

The greatest disadvantage associated with private placement of equity is that they are often sold at a high discount below the market value to attract investors and compensate for their longer-term returns and greater risk. Since this method limits the variety and number of investors, the company can reach, selling becomes more challenging whereby in some instances it has caused the issuing company to spend more funds and time identifying and enticing investors than a public equity offering would need. Besides, Ramirez (2011) highlights that little amount of capital is raised using this procedure since the limited number of investors may not have substantial amounts of funds to invest individually. Having a credit rating, though not being a mandatory requirement, has an advantage since investors can determine their risk; however, it will increase the expenses and is time-consuming.

ArcelorMittal is the largest steel manufacturer globally and a significant producer of coal and iron ore. The enterprise has a large employee base of over 209,000 individuals with operations globally. The supplier for steel to London’s Wembley Stadium and New York’s One World Trade Center, it has encountered challenges in a turbulent time in the global steel industry with a slump of 37% in the shares for past year, due to the significant Chinese steel exports that have lowered the prices in the US and Europe.

ArcelorMittal announced a proposed raise of capital through a rights offering whereby its existing shareholders will be offered preferential rights to take the company’s ordinary shares. It expects to raise $3 billion by offering some new common shares in the rights issue. The sale of shares will be on March 14, 2016, at the end of business hours in each applicable market, and each shareholder will be provided one right per existing company share held as at the date. Shareholders will be allocated seven new shares for every ten they hold at a price of $2.44. The shares allocated in the rights offering will have a 35.3% discount established on the closing price of ArcelorMittal shares on March 10, 2016, on Euronext Amsterdam (Cumming & Johan 2013).

Mittal family trust entities have pledged to exercise their rights for new shares to maintain their shareholding of 37.38%. Bank of America, Credit Agricole S.A., and Goldman Sachs Group Inc. is underwriting the rights offering with the funds raised being utilized to decrease the company’s indebtedness that stood at $15.7 billion and to strengthen the balance sheet (Cumming & Johan 2013). As it suspended dividends, closed down plants, and reduced expansion plans last year to assist minimize borrowing, ArcelorMittal management is embarking on a strategy to raise the profits to $3 billion annually by 2020.

Community HealthCare Trust Inc. is an investment firm in the healthcare real estate that obtains and manages properties, which are leased to health systems, doctors, hospitals, and other healthcare service providers, particularly in the non-urban region. The real estate investment trust (REIT) have received significant attention, especially in the health sector due to the good returns on investment. Community Healthcare strategy is based on favorable demographic trends including the rise in health care spending; estimated to grow to $4.3 trillion by 2020, shift to community-based outpatient facilities as a method of providing healthcare services, and the increasing aging population that needs more healthcare attention (Jayaraman, 2012). There is significantly less competition for the non-urban facilities from existing institutional buyers and REITS, and the management’s extensive relation with owners of health care facilities and healthcare providers allocates the company with the opportunity to obtain attractive healthcare amenities.

Community HealthCare Trust Inc. is selling 4.5 million new shares through a public equity offering, each priced at $17.75 (Cumming & Johan 2013). Although secondary offerings are viewed as bad for existing shareholders, they are also an indication of sound financial management. With the federal interest rates increasing Community Healthcare has sought to issue equity as a cheaper method of financing that consist of a lower interest rate. The funds will be utilized to reduce the expensive debt and refinance with a cheaper option, which the savings on the interest payments will assist to improve the health of the balance sheet, consequently boost the share prices (Zhengfei 2011).

Brookfield Asset Management Inc. is an alternative asset administrator consisting of over $225 billion in assets worldwide under management, and has an extensive history of owning and handling assets with a focus on private equity, infrastructure, and renewable energy. The company announced it would issue 17.9 million shares at a price of $56 each that will raise almost $1.1 billion. The syndicate of underwriters includes Citigroup Global Markets Canada, CIBC, Deutsche Bank Securities, and RBC Capital markets. The company’s management has been growing the capital resources through long-term debt placements and asset sales. The private placement of equity will further boost the business’s capacity to exploit the broad range of investment opportunities available (Cumming & Johan 2013). Though the company rarely issue common shares, the private placement will provide partnerships, which together with the capital should allocate considerable flexibility.