Raising Equity in the Capital Markets

Hey all,

Just a quick question to clear up a concept that I'm a little foggy on.

There's a lot of capital raising going on at the mo, and a whole heap more expected (apparently). Now, I can't imagine that the big swathe of issues are because companies are looking for cash to invest somewhere or to expand the business - I'd presume it's got more to do with cleaning up balance sheets and altering debt to equity ratios / leveraging levels.

My questions are:
1. Am I right in the above - is all of the raising due to reinforcing the business's finances given the erratic and unsure future? If not, why so much capital raising and why now?

2. When fresh capital is raised, does this dilute the shareholders equity already on issue? There will be far more shares for the same level of profit earned by the company next time a dividend is declared (I understand that the newly issued capital should be made to earn some form of return, but if it's been raised primarily to reduce leverage then this return would be negligible, no?).

If the above is generally the case, how do share prices behave following a capital raising? Presumably they're going to take a dip?

Also, how exactly do companies go about a capital raising? Is it a tender process or what? Surely there must be a lot of arbitraging going on around a capital raising as the company tries to match what the current market value is?

Thanks in advance,

Cheers,

AMSH

1/ Yes - its about reducing leverage, protecting capital ratios (remember losses erode capital via the retained earnings line - important for debt covenants, credit ratings and compliance with regulators requirements), restructuring balance sheets and providing the ready funds to keep surviving.

As for why so much and why now, that's easy. Companies need the money more than ever. Their balance sheets have been under strain for some time and the little bump in share prices we've seen lately gives them the opportunity to raise at a slightly better price.

2/ Yes it will dilute the existing equity. Whether or not it dilutes an individual's share of the company will depend on whether they participate pro rata. New equity will normally rank parri passu with the existing.

If the above is generally the case, how do share prices behave following a capital raising? Presumably they're going to take a dip?

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Up, down, steady, who knows. In the sense that each share in the company is now equal to a smaller percentage of the company, perhaps it will fall. But then, sometimes the capitalisation of the company is a massive concern and its depressing the share price so it actually goes up. Then there's the issue of how the raising is structured - sometimes you'll see them go up into a rights issue...

Also, how exactly do companies go about a capital raising?

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Depends if they're public or private, how desperate they are and how much they need. Often they call their bankers and see what they can do or what they recommend.

A few more to note in addition to the great answer from DrJ

AMSH said:

1. Am I right in the above - is all of the raising due to reinforcing the business's finances given the erratic and unsure future? If not, why so much capital raising and why now?

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Most are for strengthening balance sheet, with the only recent exception being Santos which raised to pay for their LNG ambition. CBA also raised last year to acquire BankWest, then they did it again shortly after for balance sheet purpose (the one they stuff up).

For many smaller companies, refinancing debt is the key concern, not just falling revenue. So they use equity to replace debt, as equity can never be called back and dividends are discretionary.

AMSH said:

2. When fresh capital is raised, does this dilute the shareholders equity already on issue? There will be far more shares for the same level of profit earned by the company next time a dividend is declared (I understand that the newly issued capital should be made to earn some form of return, but if it's been raised primarily to reduce leverage then this return would be negligible, no?)./QUOTE]

As equity replaces debt there is always a bit of saving in interest payment.

I once heard that companies sell shares (i.e. raise capital) when they believe their share price is high, and buy shares (i.e. buy back) when they believe their share price is too low. Although I suspect this doesn't apply in today's environment many are forced to raise capital at a low price.

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It wont dilute the share price too much

lets say a company has 10 shares issued and share capital is $10 ie: $1 per share

They issue 10 new shares. Most people would think that now there is 2 times more shares so the share price should halve

This is not true as now there is 20 shares and share capital is $20 ie: Still $1 per share

Obviously this can change the price slightly but the effect is usually quite small

However, as the equity raised is “not” being used for expansion, the companies income “in normal circumstances” potentially stays the same with the addition of the saved interest payments. Divide the income by the total shares now on issue and it makes the P/E blow out a bit.

To make things worse, profits are under pressure now as well. The reason why these companies were leveraged in the first place was for greater returns on a P/E ratio no doubt. The problem is the new equity “new cash” has already been spent to make the existing profits. IMO It can only put downward pressure on the share price unless the share price is perceived as being oversold at the time.

On a side note : The reason why these companies are raising equity is because they have little choice in many cases. Company bonds have not been selling. There are now higher risks with investing into these companies and to make things worse the government is guaranteeing bank deposits. So where do depositors stick their money? Banks....... There is a fload of equity raising now because confidence has increased and the markets have recovered a little.

MR. said:

However, as the equity raised is “not” being used for expansion, the companies income “in normal circumstances” potentially stays the same with the addition of the saved interest payments. Divide the income by the total shares now on issue and it makes the P/E blow out a bit.

.. There is a fload of equity raising now because confidence has increased and the markets have recovered a little.

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BINGO! . also blows the market cap out of the water and going on beamstas example it means the OVERALL value of the company has just doubled for what ? dilution ?

and yeah they makin hay while the sun shines m8 .....

When new shares are issued to retire debt, the company saves on interest expense, so after-tax profit goes up (assuming economic conditions and operating profits stay the same). But this increase in profit is usually not enough to offset the increase in number of shares, so EPS gets diluted. And dividends are paid out of EPS, so they drop too.

However, the risk of the new lower EPS should also drop (less debt, less risk). Lower risk deserves higher P/E. How much higher? In practice it's not predictable, just like the share price.

alphaman said:

However, the risk of the new lower EPS should also drop (less debt, less risk). Lower risk deserves higher P/E. How much higher? In practice it's not predictable, just like the share price.

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You're right, but sadly, people's risk profiles are changing, meaning the multiples they're willing to pay are falling at the same time. It's quite difficult, but it's a golden opportunity to find the companies that are survivors.

Look for companies that are well capitalised, well managed and 3-10 in their market in terms of market share. These are the ones that stand to benefit most over the long term...

AMSH said:

There's a lot of capital raising going on at the mo, and a whole heap more expected (apparently).

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quote
$20 billion in capital raised on the market by Australian companies since the beginning of the year.

http://business.smh.com.au/business...ion-as-macmahon-joins-rush-20090514-b3y9.html

alphaman said:

When new shares are issued to retire debt, the company saves on interest expense, so after-tax profit goes up (assuming economic conditions and operating profits stay the same). But this increase in profit is usually not enough to offset the increase in number of shares, so EPS gets diluted. And dividends are paid out of EPS, so they drop too.

However, the risk of the new lower EPS should also drop (less debt, less risk). Lower risk deserves higher P/E. How much higher? In practice it's not predictable, just like the share price.

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Actually lower risk sometimes = lower PE. Look at the PE of Woolworth vs PE of CSL. Remember the PEs of tech shares in 2000. Because lower risk typically = lower growth prospects.

skc said:

Actually lower risk sometimes = lower PE. Look at the PE of Woolworth vs PE of CSL. Remember the PEs of tech shares in 2000. Because lower risk typically = lower growth prospects.

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True. As you said, the higher P/E is driven by higher growth expectations, not by higher risk. To simply say "lower risk = lower PE" could lead one to load up as much debt as possible and expect a very high share price. That doesn't make sense does it.

By the way we are talking about financial risk here.

The typical "lower risk low growth" is about the risk of unleveraged earnings, which is an entirely different risk.

Thanks for the input gents. Very informative.