What are Rights Issue? And How it affect your investments?

A rights issue is a way for companies to raise additional capital by offering existing shareholders the right to purchase additional shares at a discounted price, typically in proportion to their current holdings. This method allows companies to raise funds without having to go through the process of issuing new shares to the general public.

Today, we try to understand how it works and how it affects your investments, as this will help you make a more accurate decision when a company whose share is in our portfolio offers a rights issue.

What are the rights issue?

A rights issue is a way for a company to raise capital. In a rights issue, the company only offers existing shareholders the opportunity to acquire additional shares in the company.

The price the company offers to existing shareholders is a discount to the market price. This is intended to make the offer attractive to shareholders while compensating for possible capital dilution.

A rights issue also gives shareholders the opportunity to increase their stake in the company.

In the rights issue, shareholders have the right, but not the obligation, to acquire these discounted shares.

Why do companies choose to issue rights?

Companies choose to issue rights for several reasons, primarily regarding their need to raise capital efficiently and cost-effectively. Here are the key reasons why companies opt for a rights issue:

1. Raising Capital

• Expansion and Growth: Companies often need funds to finance new projects, expand operations, or enter new markets. A rights issue provides a way to raise this capital from existing shareholders.
• Debt Reduction: Companies may use the proceeds from a rights issue to pay down debt, thereby improving their balance sheet and reducing interest expenses.
• Working Capital: Additional funds can be used to bolster working capital, ensuring smooth operations and liquidity.

2. Cost-Effective Fundraising

• Lower Costs: Compared to other methods of raising capital, such as issuing new shares to the public or taking on debt, a rights issue is generally less expensive. There are lower underwriting fees and less regulatory scrutiny involved.
• Faster Process: The process of a rights issue can be quicker than other capital-raising methods, allowing companies to access funds more rapidly.

3. Existing Shareholder Base

• Loyalty and Trust: A rights issue rewards existing shareholders by offering them shares at a discount, which can help build loyalty and trust. Shareholders feel valued as they are given the first opportunity to invest more in the company.
• Control: Issuing rights to existing shareholders helps the company avoid diluting control. Since the new shares are offered proportionally, the relative ownership percentages remain unchanged if all shareholders participate.

4. Market Perception and Confidence

• Positive Signal: Successfully completing a rights issue can signal to the market that the company is confident about its future prospects and has the backing of its existing shareholders.
• Avoiding Dilution: By offering new shares to existing shareholders, the company avoids the potential negative market perception associated with diluting the ownership by bringing in new shareholders.

5. Regulatory and Strategic Considerations

• Compliance: In some cases, regulatory frameworks might favor or necessitate raising capital through a rights issue. Companies may find it strategically advantageous to comply with these regulations.
• Strategic Moves: Rights issues can also be part of larger strategic moves, such as funding an acquisition or a significant merger.

Example: Reliance Industries Limited (RIL) – 2020 Rights Issue

• Reason: Reliance Industries launched a ₹53,125 crore rights issue to reduce its debt and strengthen its balance sheet.
• Outcome: The rights issue was highly successful, with strong participation from existing shareholders, demonstrating confidence in the company’s strategic direction.

Example: Bharti Airtel Limited – 2019 Rights Issue

• Reason: Bharti Airtel aimed to raise ₹25,000 crore to fund network expansion and spectrum purchase, critical for its competitive positioning in the telecom market.
• Outcome: The rights issue was fully subscribed, highlighting shareholder support for the company’s growth plans.

Is the right problem a red flag for the company?

A rights issue is not inherently a red flag for a company, but it can raise concerns depending on the context and circumstances surrounding it.

Here’s a balanced view of why a rights issue might be perceived positively or negatively:

When a Rights Issue is Not a Red Flag

1. Strategic Growth: If a company is raising funds to finance expansion, enter new markets, or invest in innovative projects, a rights issue can be seen as a positive move that reflects growth ambitions and future potential.
2. Debt Reduction: When a company uses a rights issue to reduce debt, it demonstrates a commitment to improving its financial health and reducing interest expenses, which can be seen positively by investors.
3. Strong Market Confidence: A rights issue that is well-received and oversubscribed indicates strong shareholder confidence in the company’s prospects, reinforcing a positive market perception.

When a Rights Issue Could be a Red Flag

1. Financial Distress: If a company frequently resorts to rights issues to raise funds, it might indicate underlying financial problems, such as poor cash flow, high debt levels, or operational inefficiencies. This can signal to investors that the company is struggling.
2. Poor Market Conditions: If the broader market conditions are unfavorable and the company issues rights to raise capital, it might be perceived as a desperate move, suggesting the company could not secure funding through other means.
3. Dilution Concerns: Shareholders who do not participate in the rights issue will see their ownership diluted. Frequent rights issues can lead to significant dilution, which might deter investors.

Evaluating the Context

To determine whether a rights issue is a red flag, consider the following factors:

1. Purpose of the Fundraising: Analyze why the company is raising funds. If it’s for growth initiatives or strategic investments, it’s generally a positive sign. If it’s to cover ongoing losses or repay short-term liabilities, it may indicate financial trouble.
2. Frequency of Rights Issues: A company that repeatedly issues rights might be struggling to manage its finances effectively, which could be a red flag.
3. Market Reception: How the market and shareholders react to the rights issue can provide insights. A well-received rights issue often suggests confidence in the company’s future.
4. Company’s Financial Health: Review the company’s balance sheet, income statement, and cash flow. Strong fundamentals coupled with a rights issue for strategic purposes is generally positive, whereas weak fundamentals may signal a problem.

Examples from the Indian Stock Market

• Positive Example: Reliance Industries Limited (RIL) – 2020
  • Purpose: To reduce debt and strengthen the balance sheet.
  • Market Reception: Highly successful, with strong shareholder participation.
  • Outcome: It was not seen as a red flag but as a strategic move to improve financial health.
• Potential Red Flag: Tata Steel Limited – 2018
  • Purpose: To reduce debt and manage high operational costs.
  • Market Concerns: Frequent fundraising activities and high debt levels.
  • Outcome: While it helped reduce debt, it also raised concerns about the company’s ongoing financial challenges.

Can an unlimited number of shares be repurchased in a rights issue?

No, an unlimited number of shares cannot be repurchased in a rights issue. Here are the key points to understand the limitations and regulations surrounding share repurchase during a rights issue:

Rights Issue Mechanism

1. Pre-determined Allocation: In a rights issue, the company announces the number of additional shares that will be available for purchase, along with the terms and ratio of the rights issue. Shareholders are entitled to buy a specific number of new shares based on their existing holdings.
2. Proportional Offering: The rights are typically offered proportionally to the shareholders’ existing ownership. For example, if the company announces a rights issue in the ratio of 1:5, each shareholder can buy one new share for every five shares they currently own.

Regulations and Limitations

1. Maximum Issuance Limit: The total number of new shares to be issued is fixed and specified in the rights issue announcement. Shareholders can only buy up to the number of shares they are entitled to based on their current holdings.
2. Non-transferability: While shareholders can choose not to exercise their rights or sell them to other investors (if the rights are renounceable), they cannot exceed their allotted rights. The rights are non-transferable in non-renounceable rights issues, meaning shareholders must either exercise the rights or let them lapse.
3. Oversubscription Option: Some rights issues might allow for oversubscription, where shareholders can apply for additional shares beyond their entitlement. However, even in such cases, there is usually a cap on the number of additional shares that can be acquired, and it depends on the availability of unsubscribed shares.

Example Scenarios

1. Renounceable Rights Issue: In this scenario, shareholders can trade their rights on the stock market. If a shareholder does not wish to buy more shares, they can sell their rights to other investors. However, the total number of new shares issued remains fixed.
2. Non-renounceable Rights Issue: Here, shareholders cannot transfer their rights. They must either exercise the right to buy the additional shares or forfeit the right. Again, the total number of new shares is predetermined and cannot exceed the announced amount.

Practical Example

Let’s consider a company, ABC Ltd., announcing a rights issue with the following terms:

• Number of new shares: 10 million
• Ratio: 1:4 (one new share for every four shares held)
• Share price: ₹100 per share

If a shareholder owns 1,000 shares, they are entitled to buy 250 new shares (1,000 ÷ 4). They cannot purchase more than these 250 shares through the rights issue. If they wish to buy more, they would need to acquire additional rights from other shareholders (if renounceable) or wait for any oversubscription options, which would still be limited.

Regulatory Compliance

Companies must comply with the regulatory framework set by the securities market regulator, such as the Securities and Exchange Board of India (SEBI) in India. SEBI has specific guidelines governing rights issues, including the maximum permissible discount, the process of issuance, and disclosure requirements.

What happens if a shareholder simply waives his right?

If a shareholder chooses to waive or not exercise their right in a rights issue, the following outcomes can occur:

1. Dilution of Ownership

When a shareholder does not exercise their rights to buy additional shares, their proportional ownership in the company will decrease. This is because new shares are issued to those who do exercise their rights, increasing the total number of shares outstanding.

Example:

• Before Rights Issue: Shareholder A owns 1,000 shares in a company with 100,000 total shares, giving them 1% ownership.
• After Rights Issue (assuming all other shareholders exercise their rights): If the company issues 20,000 new shares, the total number of shares becomes 120,000. If Shareholder A does not buy any new shares, their ownership drops to 0.83% (1,000 / 120,000).

2. Rights Expire Worthless (Non-renounceable Rights)

In a non-renounceable rights issue, shareholders cannot transfer or sell their rights to others. If a shareholder chooses to waive their rights, those rights simply expire at the end of the subscription period, and the shareholder gains nothing from them.

3. Selling Rights (Renounceable Rights)

In a renounceable rights issue, shareholders have the option to sell their rights on the stock market to other investors. If a shareholder decides not to exercise their rights, they can sell them to others who wish to purchase the additional shares. This way, the shareholder can still gain some value from the rights even if they do not buy the new shares themselves.

Example:

• Rights Issue Terms: 1 new share for every 5 shares held at ₹100 per share.
• Market Value of Rights: If the rights trade at ₹10 each, Shareholder A with rights to buy 200 new shares can sell their rights for ₹2,000 (200 rights x ₹10 each).

4. Unsubscribed Shares Allocation

If a shareholder waives their rights, the unsubscribed shares might be offered to other shareholders who have expressed interest in buying additional shares (oversubscription). Alternatively, the company might sell these shares in the open market or through another mechanism outlined in the rights issue terms.

Example of Shareholder Action

1. Waiving Rights in a Non-renounceable Issue
   • Outcome: Shareholder A does nothing, the rights expire, and they experience ownership dilution.
2. Selling Rights in a Renounceable Issue
   • Outcome: Shareholder A sells their rights, receiving some monetary value while avoiding dilution to the extent of their rights sale proceeds.
3. Unsubscribed Shares Allocation
   • Outcome: If Shareholder A waives their rights and the issue is undersubscribed, other shareholders or new investors may be given the opportunity to purchase the remaining shares.

Conclusion

When a shareholder waives their right in a rights issue, their proportional ownership in the company will dilute unless they sell their rights (in a renounceable rights issue). Non-renounceable rights will simply expire worthless if not exercised. Companies may have mechanisms to handle unsubscribed shares, potentially offering them to other investors. Understanding the specific terms of the rights issue is crucial for shareholders to make informed decisions.

Final thoughts

A rights issue should be evaluated in context. It can be a strategic and positive move if it aligns with growth and financial health improvement. However, if it indicates financial distress or is a recurring method to raise funds, it might be a red flag.

Careful analysis of the company’s financial situation, purpose of the rights issue, and market reaction is essential to determine its implications.

Frequently Asked Questions