Seasoned Equity Offering (SEO) is embedded in the field of Corporate Financing studies. Agca, Senay and Mozumdar (2005) concluded from their study that the main sources of corporate finance are Retained Earnings (1st), Debt (2nd) and Equity (3rd). During the last financial crisis starting in 2007, a lot of SEOs took place due to credit shortage and poor financial performance. The goal of this literature review is to study the different characteristics of issuing additional equity. In a first part, the rationale, costs and benefits of different issuing methods in the UK will be examined. The second part will be focused on academic research papers studying US SEOs. Due to various similarities found by scholars (capital markets structure and SEO observations), the US will be a proxy for Japan and the UK a proxy for EU countries as well as for Canada.
The three main issuance methods in the UK are Rights Issue, Open Offer and Placing.
When performing a Rights Offering, every current shareholder at the time of the announcement will be given the right to subscribe to newly issued equity at a pro-rata basis (UK Listing Authorities, 2000). This means that for every X shares owned by a shareholder, the latter has the right to buy a new one. If shareholders don't want to exercise their rights, they can sell it on the secondary market. The compensation they get from this selling is usually equivalent to the loss resulting from the dilution of ownership. Shareholders will sell their unexercised rights to the underwriter. The latter will find other investors willing to take up these rights, usually current institutional shareholders of the company. Rights Issues are usually underwritten by a financial intermediary (typically investment banks or syndicates of shareholders) unless special circumstances such as financial distress. One of the main benefit that can be extrapolated from Armitage's study (2000) is the fact that Rights Issues, whether they are insured or not, have a lower cost compared to Open Offers and Placings. Costs associated with each issuing method will be discussed in more detail later on. However, two disadvantages linked to Rights Offering can be observed. First, the market reaction to the announcement will lead to a negative abnormal return of 2%. Second, the price at which the new shares are issued display a discount of 15.75% from the current market price (Korteweg and Renneboog, 2003).
Firms wanting to issue new equity by Placings will hire an underwriter, also called issue manager. This underwriter will purchase new issue shares and resell them to institutional investors. As the underwriter bears risk of issue failure, in this case under-subscription risk, he will be compensated by a placing fee. The fixed price at which the new shares will be offered is subject to pitching to be sure every single of them is taken-up. The maximum amount of new issue shares is limited to 5% of the current outstanding amount of shares. This limitation can be overcome at an EGM with 75% approval from the shareholders. Furthermore, the discount at which the new shares will be issued is restricted at 10% of the current stock price (Listing Rules, London Stock Exchange, 1998). Benefits from choosing a Placing are the opposite of Rights Issues' disadvantaged. Placings display a lower discount to current market price (4%) and abnormal returns linked to the SEO announcement are positive (1%). However, costs are higher than for Rights Offering.
Finally, the Open Offer method is very similar to a Rights Issue but differ in the respect that shareholders receive an entitlement rather than a right to purchase newly issued shares. Therefore, this entitlement cannot be sold on the market and just lapses when the issuing deadline is reached. According to the findings of Armitage (2000), Merrett, Howe and Newbould (1967) and Slovin et al., (2000), a large majority of Open Offers are insured. Moreover, firms deciding to perform an uninsured SEO are usually firms in financial distress. As for Placings, Open Offers exhibit positive abnormal returns as high as 3% (Korteweg and Renneboog, 2003) with a moderate discount to current market price of 3.3%. Nevetheless, Open Offers' costs are, as well as for Placings, higher than costs relative to Rights Issues.
Barnes and Walker (2006) stipulate that is it common for UK firms opting for an Open Offer to combine with a conditional Placing. As a result of this observation, the two researchers have decided to focus their work on SEO choice between Rights Offering and Placings. Barnes and Walker (2006) came up with a binary response model to figure out what is the rationale behind choosing Rights Offering or Placing. The variables used in the model were all linked to four main drivers identified by the scholars: institutional characteristics of the market, characteristics of issuer and issue, ownership and control issues, and problems related to proprietary information. Descriptive statistics resulting from the model tell us that on average, firms choosing rights offers are older and had poorer financial performance than firms opting for Placings. The size of the company doesn't appear to have any influence on the selection process. High levels of asymmetry or proprietary information tend to favor the use of Placings. Having a high level of institutional shareholders in the capital structure decreases the probability of picking Placings. Furthermore, rights issuers are looking to raise a significantly higher amount of capital, and the discount to pre-issue stock market price is higher than for issues made via Placings. However, Barnes and Walker (2006) didn't find market liquidity and price elasticity as significant variables explaining the choice of a method over another as previous theoretical works from Kothare (1997) and Hodrick (1999) suggested. Finally, corporations issuing by Rights Offering have a considerably lower market to book ratio than companies using Placings, which confirms a previous academic paper from Slovin, Sushka and Lai (2000).
In another study, Korteweg and Renneboog (2003) have opposed Rights Issues to Open Offers and studied the rationale behind the choice between the two methods. They came to the conclusion that the fundamentals behind that choice were the liquidity of the rights market, future growth opportunities for the firm, interests of directors and the stock market uncertainty. Issuers will prefer Rights Issues when the firm has low growth perspectives and directors or institutional investors hold a large share stake (avoid dilution). When there is high market volatility, an illiquid market for rights and when the equity issue is large, issuers will tend to favor Open Offers.
In the UK, a study from Armitage (2000) permitted to calculate the costs associated with SEOs. Over a sample of more than a thousand issuing firms, total cost in percentage of gross proceeds amounts for 8.3% for Uninsured Rights, 6.61% for Underwritten Rights and 11.43% for Open Offers and Placings. The fact that Armitage regroups Open Offers with Placings confirmed Barnes and Walker's (2006) work specifying that Open Offers are often combined with Placings. Investigating this more closely, Armitage separated underwriting cost from non-underwriting cost. The latter incorporates costs such as advisers, legal, consultant or auditing fees as well as the cost paid to the exchange on which the issue takes place. It has been found that underwriting costs for Uninsured Rights represent 0.86% when non-underwriting costs amount for 7.44% of the gross proceeds. The fact that underwriting costs for Uninsured Rights are not equal to zero lies in the fact that, even if the firm doesn't hire an underwriter, it still needs to pay brokerage fees that are considered as an underwriting cost. For Standby Rights, the underwriting cost is of 1.88% and non-underwriting cost sum up to 4.73%. Finally, for Placings and Open Offers, the underwriting cost equals to 1.66% whereas the non-underwriting cost equals to 9.76%.
The fact that the large majority of UK issuing firms choose to insured their offering is explained by a negative perception from the market of companies choosing not to take underwriters (Korteweg and Renneboog, 2003). Indeed, the market often thinks that the company isn't good enough for financial intermediaries to take the underwriting risk. This situation is very different from what happens in the US where the rationale behind the choice of underwriting the issue is the low expected take-up from existing shareholders.
Main issue methods used in the US to raise additional equity are firm commitment offers, best effort offers, rights offers, rights offers with standby underwriting and private placements.
Rights Offerings give to present shareholders the right, materialized by a warrant, to buy additional equity at a pro-rata basis. This right can be considered as an option to either purchase the newly issued securities or sell the warrants to other investors. These warrants usually last for 20 days on average. Every share that hasn't be sold (unsubscribed share) will be proposed to other current shareholders. Firms offer a typical 15 to 20% discount over market price to existing shareholders for the newly issued stocks. Rights Offerings can be underwritten by a financial intermediary (typically investment banks, brokers, any major shareholder of the firm or external investors such as funds) so that the issuing company has the insurance not to have any unsubscribed share at the end of the process. This insurance comes with a cost as the underwriter bears risk through a contractual obligation to buy any leftover stocks.
According to Eckbo and Masulis (1995), the cost of raising capital in the US through uninsured rights amounts to 1.8% of the total proceeds obtained by industrial firms and 0.5% for utilities. These costs are essentially composed of legal fees, listing fees, SEC registration fees and state taxes. While performing uninsured rights in the US, 60% of the proceeds about to be raised are pre-allocated to large shareholders thanks to subscription pre-commitments and the entire amount of the additional equity is fully distributed before the end of the subscription period.
For a US standby offer, firms have to pay an underwriting fee to the financial intermediary consisting in a take-up and fixed commitment fee. Costs for US industrial and utility firms are higher than for uninsured rights offers and amount for 4% and 2.4% of the gross proceeds, respectively. Standby rights allow the company to obtain more than 70% in subscription rate. This fairly good result also reduces the risk taken by underwriters. The typical underwriter take-up in standbys is 15% of the issue (Singh, 1992).
With a Private placement, the company does not rely on a financial intermediary to help raise additional equity but on private groups of investors. Another method available to US companies is the Best Effort Offer. In this case, the issuing company bears the risk of offer failure as the financial intermediary, in this case an investment bank, simply plays the role of a marketing agent. Private placements represented only a small fraction of seasoned equity offerings until the mid 80s in the US. During the 1990s, the use of private placements has significantly increased (Eckbo and Masulis, 1995).
In a Firm Commitment contract, the investment bank acts as a marketing agent and enters in an underwriting agreement with the issuer, guaranteeing the firm to place every equity stock issued at an agreed-upon price. The underwriting fee paid by the issuing company to the underwriter is a result of a bilateral negotiation between the firm and the bank or by a competitive bid involving several investment banks put into competition. In contrast with Rights Issues, shareholders are not given an option to purchase the newly issued equity. Firm commitment offers' costs are typically 6.1% for industrial US corporations and 4.2% for public utilities. Bhagat and Frost (1986) found that underwriting compensation for negotiated contracts is much higher than for competitive bidding contracts. As for every method involving an underwriting contract, Firm Commitments allow the company wanting to complete a SEO to have the insurance that all the new equity stocks are going to be subscribed.
Shelf Issues, also called Shelf-Registered Corporate Equity Offering, allow the company to prepare up to two years in advance its SEO. Therefore, if the firm fulfilled SEC requirements ($700m of market capitalization or $1bn of debt issued over the past three years), it can raise additional capital as soon as the time is right, wasting no time in the process. Bhagat, Marr and Thompson (1985) concluded that costs linked to shelf offerings are decreasing. However, Denis (1993) has found contradictory results due to "selection biases and the inclusion of zero underwriting fee bought deals in the shelf sample". Shelf Issues' main benefit lies on the fact that they allow the issuer to prepare up to two years in advance its equity offering. Therefore the corporation is able to be agile when the time is right and perform a successful offer.
Until the 1950s, SEOs in the US were mainly done through uninsured rights and standby flotation methods. This pattern changed in favor of firm commitments as principal approach to raise additional equity. Rights Offerings are mainly used in countries with modest capital markets and therefore small equity capitalization. This is the case for Canada and European countries whereas roughly 80% of Japanese and US' SEOs are done through firm commitments (Eckbo, Masulis, 1992). However, according to a recent publication from Autore, Kumar and Shome (2008), there was a remarkable shift from traditional issuing methods that were largely used in the 1980s to shelf issues that now represent the favored option to raise additional equity. In the US, shelf-registered equity offerings outperform historical methods (e.g. firm commitment or rights offers) both in terms of total capital raised and frequency.
The US "Rights Offer Paradox", as documented by Eckbo and Masulis (1992) and Smith (1986), stipulates that even if Public Issues such as Firm Commitments are more costly than Rights Offering, indirect costs linked to the latter push the majority of US firms towards Public Issues. In addition, Bhide (1993), among others, documented that US capital markets encourage dispersed ownership and are very concerned about market liquidity. Public Issues allow for both dispersion of ownership and minimization of trading spreads, which can explain the rationale of selecting Public Issues.
Several conclusions can be drawn from this literature review. First, there are three main equity-issuing methods in the UK: Rights Issue, Open Offer and Placing. For each of these methods, the company has the choice to insure or not the SEO. Most firms choose to underwrite the issue because of the market reaction. Rights Issues are less costly but display a negative abnormal return and have a bigger discount than for other methods. Open Offers and Placings are more expensive for corporations but have a positive abnormal return and a smaller discount. In the US, the main issuing methods are Firm Commitment Offers, Best Effort Offers, Rights Offerings, Private Placements and Shelf-Issues. A Rights Offer is very similar to its UK counterpart. It is also cheaper than Firm Commitments and allows the firm to have a very good subscription rate. Firm Commitments are more expensive than RO, but their cost can be reduced while executing a competitive bid between investment banks. Firm Commitments have become the most popular method but have now to compete with Shelf-Issues as the latter possesses a clear benefit in their ability to be triggered quickly.
