The past 12 months have seen three major rights issues by Swedish corporates, each raising approximately SEK 10 billion in new equity.1 White & Case advised on all of them. In recent talks with other corporates considering the rights issue route, we have had reason to outline not only the process as such, but also the various risks and ways of mitigating these risks. We noted that there are least one important risk mitigant that has attracted less interest in the market during recent years. So we had a closer look at that.
When we start talks with a company about the rights issue rout we typically kick-off by explaining that when you look at what others have done in the market in the past you need to understand something about the pre-text. For example:
- Was the rights issue a means to fund an investment need or an acquisition, or was it a defensive move to handle an envisaged covenant breach, an expired covenant holiday or perhaps an even more critical situation of financial distress?
- When was the transaction executed and what did the market look like at the time? Were there alternative sources of funding available at a reasonable cost? Was the market shaky with potentially disruptive events around the corner, such as a bank runs, significantly increased interest rates and acts of war or terrorism?
- How large a percentage of the rights issue was taken up by existing shareholders?
With this as a starter, we normally proceed to explaining some of the basics about the different approaches to the sequence of events under Swedish company law and what it means in terms of timeline flexibility and risk management. The more sensitive the investment case, and the greater the perceived market risk, the less attractive a lengthy "time in the market" is from a risk management perspective.
At this point, we often take a step back and provide an outline of the risk mitigants.
Pricing with a deep discount to TERP
In the Swedish market, pricing of the rights issue with a deep discount to TERP of 30-35% is common.
TERP stands for "Theoretical Ex Rights Price", that is the market price that the stock will theoretically have after the successful completion of the rights issue. The deeper the discount to TERP, the greater the loss for a shareholder that does not exercise (or sell) its subscription rights. In other words, pricing with a deep discount to TERP does not cause any financial loss to the shareholders assuming that they either exercise their subscription rights and pay for the their respective pro-rata share of the rights issue amount or sell their rights (typically in on the stock market) to someone who then exercises the rights so purchased. Pricing at a healthy discount to TERP creates strong invectives for shareholders to partake in the rights issue and, thus, works as an efficient risk mitigant for the transaction. It is worth underscoring that pricing with a deep discount to TERP is not a sign of weakness, which it is sometimes mistaken for.
Pro-rata subscription undertakings by major shareholders
In the Swedish market, so called pro-rata subscription undertakings is as a common a risk mitigant as the deep discount to TERP pricing model. In essence, it means that major shareholders representing around 30-50% of the total number of shares in the company legally undertake (i) not to sell any of their shares before the rights issue (to ensure that their pro rata participation in the rights issue do not decrease) ) and (ii) to exercise all of their rights and pay for their respective pro-rata share of the rights issue amount. In addition to securing a large portion of the rights issue amount, the pro-rata undertakings by major shareholders also serves as bell-cows, leading the way for the other shareholders.
Underwriting arrangements
As opposed to pro-rata subscription undertakings, underwriting arrangements are not based on current shareholdings. An underwriting commitment means an undertaking to subscribe for a specified maximum numbers of shares in case, at the end of the subscription period, the rights issue is not fully paid for by existing shareholders and other investors.. Underwriting commitments by banks are always subject to certain conditions, and banks are by far the most common provider of underwriting commitments. Their fees are substantial. But their risk may also be substantial. Below we will only discuss underwriting by banks.
Retaining banks for underwriting will entail increased focus on the prospectus disclosure(for which the company's board of directors is responsible), and the due diligence review to be performed by bankers, lawyers and auditors aimed at securing that the prospectus disclosure is correct in all material respects. It is worth emphasizing that if the banks consider the underwriting risk too high, the company will have to make do without underwriting by banks. This may be the case if the discount to TERP is not considered sufficiently deep given the circumstances, or if the company is not able to arrange for pro-rata subscription undertakings in a sufficient amount. Or if there is another issue that makes the banks consider the underwriting risk too high.
Whether bank underwriting will also entail increased focus on shrinking the time line will most likely depend on whether the right issue is defensive or not, and how the market risk is perceived at the time.
What is the time line for a defensive rights issue by a Swedish company?
As noted above, the more sensitive the investment case, and the greater the perceived market risk, the less attractive a lengthy "time in the market" is from a risk management perspective. Time in the market starts when the company announces its intention to carry out a rights issue. We will refer to this as the "Intention Announcement" below. It ends when the company announces the final outcome of the rights issue. This is referred to as the "Outcome Announcement". If some material negative event occurs, or becomes known, during the period between the Intention Announcement and the Outcome Announcement, the result may be that the rights issue is not fully subscribed, or potentially aborted in its entirety.
If banks have been retained to underwrite the rights issue, the banks and the company will enter into a so-called stand-by letter shortly before the Intention Announcement. This is an agreement setting out the conditions under which the banks subsequently would enter into a hard underwriting agreement. If a material negative event occurs after the execution of the standby letter, the banks may not enter into the hard underwriting agreement. If there is a material adverse change after the execution of the hard underwriting agreement but before the Outcome Announcement, the banks may be entitled to terminate the underwriting agreement (which they, however, would refrain from doing to the furthest extent possible, for commercial reasons).The hard underwriting agreement is executed in connection with pricing of rights issue, that is when the board of the company determines the subscription price and other final terms for the rights issue – this is referred to as "Pricing" below.
From the perspective of the underwriting banks, the truly critical period is between Pricing and the Outcome Announcement. During this period the banks are "on the hook" for hard underwriting. The company, on the other hand, is exposed already from the Intention Announcement.
Based on the seven major rights issues that were carried out by Swedish companies during 2008 and 2009 (i.e. in the wake of Lehman Brother's down-fall) we have a very good understanding of the (at the time) fastest possible time line with the most flexibility for underwritten rights issues by Swedish issuers: It took approximately four weeks between the Intention Announcement and Pricing and approximately four weeks between Pricing and the Outcome Announcement. Thus, all in all approximately eight weeks. By some – for good reason – considered a too long time in the market.
Is it possible to mitigate the market risk by condensing the time line?
We are confident that the time from the Intention Announcement to Outcome Announcement can be contracted from approximately eight weeks to a little more than five weeks, a decrease with approximately 30 per cent. With a new approach to the sequence of events as we know them today, we front loaded the time line and put the record date about 2.5 weeks earlier, thus before the general meeting approving the rights issue. This, combined with trading in subscription rights on an "if and when issued" basis, makes it possible.
Will this condensed time line be pursued by Swedish companies taking the rights issue route? Well, we believe that the first case out will be a company with a sensitive investment case where the market risk is perceive as substantial. "Under those circumstances, you do not need to sell this idea to me", as the head of Nordic ECM at one international investment bank commented.
1 Securitas (SEK 9.6 billion), Beijer Ref (SEK 13.9 billion) and Castellum (SEK 10.2 billion).
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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.
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