Will capital be the next battleground

Increased accountability in equity raising means many boards may need to review their balance of skill sets to better evaluate key capital decisions, says John Hobson.

In June this year, in an opening salvo flagging that capital raising is set to be the next shareholder battleground, the Australian Council of Superannuation Investors (ACSI) released a report asserting that between 2010 and 2012, Australian companies paid investment banks $170 million above the fair value for the risk incurred for underwriting equity issues – overpaying on average, $2.7 million per transaction. Concurrently, the Australian Shareholders’ Association (ASA) amended its policy platform mandating that companies employ a single bookbuild for rights issues.

ACSI’s 36-page report Underwriting of Rights Issues stated: “some investors may also consider opposing director elections based on poor oversight of capital raisings.”

With industry superannuation funds now controlling more than $400 billion, and growing at over 10 per cent each year, it is clear that directors will quickly feel the wrath of shareholders if they have indeed been profligate.

While ACSI’s report encouraging directors not to waste shareholders’ funds by paying excessive underwriting fees is well-intentioned, it is based on flawed analysis.

At first glance ACSI’s report appears to be robust as it uses a model based on financial theory. However for the reasons outlined below, the study’s results are materially overstated.

Underwriting fees
The report states that “the amount paid [for the underwriting fee] is around 60 per cent more now compared to twenty years ago.” The clear inference is that the increase is a combination of greed on the part of investment banks and management ineptitude for allowing such practices. However ACSI did not disclose whether the total fees paid had risen over this period or whether there was primarily a re-allocation between management and underwriting fees.

An analysis of equity raising fees highlights modest fluctuations between 1997 and 2005. Contrary to expectations, underwriting fees declined after the introduction of the Goods and Services Tax (GST) on 1 July 2000. Other factors appear to be involved as well.

The dot.com bubble (1997-2000) ended abruptly in March 2000 with the ensuing value destruction largely confined to the US technology sector. Although stock markets gyrated wildly after the 11 September tragedy, there was an abundance of available capital which contributed to the Dow Jones Industrial Average Index rising 40 per cent between March 2003 and December 2005.

By contrast the global financial crisis (GFC) had a devastating effect on investment banks – their profitability, their balance sheets and their appetite and capacity to underwrite risk. The fallout included the collapse of Lehman Brothers, Bank of America stepping in to acquire Merrill Lynch & Co and Bank of Tokyo-Mitsubishi buying a 22 per cent stake in Morgan Stanley.

Australian companies, many of which were highly motivated to repair their balance sheets, were confronted by fewer investment banks willing to underwrite risk. In the face of such supply/demand dynamics, underwriting fees were destined to rise. The ACSI report, which is based upon finance theory, fails to consider the market environment in the aftermath of the GFC as a factor contributing to the underwriting fees paid by companies during the period under review. This is a glaring shortcoming.

A priority for all companies should be to minimise the total equity raising costs, including GST. Importantly, GST applies to the management fee component of equity raisings but not generally to the underwriting fee. The generally accepted industry practice sees total equity raising fees now being split 80:20 between underwriting and management fees, irrespective of the company’s size or share price volatility.

Over-simplification
One key determinant in the price of underwriting fees is the length of the risk exposure. However ACSI’s model defined the risk exposure as the time between the announcement of the offer and the offer close. This simplification can substantially underestimate the underwriters’ risk because in many transactions the underwriters’ risk exposure commences prior to the launch date of the offer.

In the case of AGL Energy’s acquisition of Macquarie Generation in 2014, the duration of the underwriters’ $1.2 billion risk was approximately seven months, rather than the 22-day offer period, as the company battled regulatory hurdles. To deliver a more accurate result, ACSI’s model needed to reflect the duration of the risk rather than the offer period. This important distinction may not be readily observable, as the information is generally not publicly disclosed.

The application of a 180-day share volatility as another key input also significantly underestimates the underwriters’ risk as it ignores the potential risk associated with exogenous events, as well as the binary nature of equity raisings. 

The shortfall in the recent Arrium Mining capital raising highlights the limitation of applying a 180-day share volatility for assessing the underwriting risk. Arrium’s share price plummeted 48 per cent in October 2014 resulting in a shortfall on the retail component of 97.9 per cent ($283.6 million). At the recent share price of $0.34, the underwriter/sub-underwriters were staring down the barrel of an $82.7 million loss. This loss is five times greater than the underwriting fee of $16.4 million.

Art not science
The focus of the ACSI report was misguided as it micro-analysed one component of equity raisings i.e. underwriting fees and paid scant regard to execution risk. Raising capital is an art, not just a formulaic process. Poorly communicating the rationale for the equity raising, or mis-pricing the offer metrics, can result in significant destruction of shareholder value. For example, a two per cent reduction in market capitalisation by the 50th largest ASX listed company would result in a $115 million loss in shareholder value dwarfing, by a factor of more than forty times, the stated overpayment in underwriting fees of $2.7 million.

The value that equity capital markets professionals bring to this process – intellectual horsepower and experience as well as additional arms and legs – can be considerable.

While ACSI’s report did recognise that underwriters perform many other important functions including “preparing all the associated documentation, determining pricing, gauging market appetite and timing” it failed to ascribe a value to these functions.

Investment banks also provide non-executive directors with additional assurance levels in an environment where there is an increasing propensity for class actions. In focusing solely on the dollar cost of underwriting, as measured against a simple risk model, ACSI’s report failed to assess whether the total equity raising cost represented shareholder value.

Without any apparent discussion with corporate Australia, the ASA incorporated into its policy platform a requirement that S&P/ASX 200 companies raise capital through a renounceable pro-rata entitlement offer with a single bookbuild. Legal practitioners David Friedlander, Evie Bruce and Nigel Hunt from law firm King & Wood Mallesons responded rapidly, stating: “the criticism is unfortunate, and not necessarily supported by evidence.” Ian Curry, chairman of ASA, defending its entrenched position, and going further, stated that “the ASA believes Origin Energy’s forthcoming $1 billion entitlement offer should have a single bookbuild for all non-participating shareholders.”

The implicit threat is that if companies do not heed the ASA’s recommendations, then their annual general meetings (AGMs) may become increasingly fraught.

The data underpinning the ASA’s position is materially flawed as it excluded the largest equity raising undertaken in 2012, namely AGL Energy’s $904 million equity raising for the acquisition of the Loy Yang A power station and coal mine, which won the Secondary Market Equity Raising of the Year at the 2012 Australian Financial Review Capital CFO awards.

More importantly, this accelerated rights issue saw the retail bookbuild price exceed the price obtained for the institutional bookbuild shortfall. Several of the largest transactions in recent years have delivered outcomes that run counter to the ASA’s position, notably Transurban Group and AGL Energy.

There appears to be little justification for the ASA to mandate a particular offer structure especially if a renounceable offer includes a facility for retail shareholders to trade their rights. That said, the ASA should be mindful that the ultimate responsibility of directors is to deliver the best outcome for the company while acting in the best interest of all shareholders.

The conclusion of ACSI’s report suggesting $170 million over-payment to investment banks is alarming, but for the reasons outlined in this article, these conclusions are not defensible. This recent emphasis on capital suggests that corporate governance bodies are stepping out from their more traditional focus on remuneration and ESG, and in the process are willing to devote substantial resources to espouse their positions.

Holding boards more accountable for their oversight in the area of equity raisings appears to be an emerging trend for which directors must be prepared. To ensure that this issue is neutralised before it escalates into a battle on the AGM floor, boards may need to re-evaluate the balance of their skill sets to reduce their reliance on investment banking advice and to better evaluate key capital decisions.