The good, the bad, and the ugly of secondary public equity offerings
The good, the bad, and the ugly of secondary public equity offerings
Rolls Royce has recently raised around £2 billion in equity from investors, to repair its balance sheet from the effects of the pandemic. It is in good company.
Existing listed companies raised around £17 billion on the London Stock Exchange in the first six months of 2020, double the average of the previous decade, and a record amount for the first half of the year, outside of the 2008-09 financial crisis.
Stock markets had been losing ground in the popularity stakes to private equity and debt, when it comes to a company’s choice of where to raise money. However, the trials brought on by Covid-19 have boosted their credentials.
This is good news for companies. However, for investors who back them, the results have been less clear cut.
Our research into over 1,600 secondary offerings that have taken place on the London Stock Exchange since 1998 found that a sizable proportion go on to perform very well but a similar proportion lose investors most of their money. If there was ever a time when good active management was needed, this is arguably it.
The ability to raise finance relatively quickly from a large shareholder base has been an invaluable lifeline this year, with wider societal benefits.
It has helped keep companies afloat, people in jobs, and it has mitigated or avoided the need for companies to borrow their way through the pandemic. This provides a more resilient basis on which to deal with the challenges ahead. It can also act as an accelerator to the plans of those companies in growth-mode. The stock market is not ready to be written off just yet.
Nor is this just a flash in the pan. Since 1998, around twice as much has been raised via such secondary offerings – the issuance of new equity by existing public companies, most commonly via rights issues or placings – than initial public offerings/new issues. Since 2015 the equivalent multiple has been around three times.
2020 has seen secondaries power even further ahead. For the companies involved, a stock market listing retains tremendous value.
The good and the bad
The disappointing news is that most companies that raise additional equity go on to underperform their sector (64% over three years and 66% over five years) – according to Schroders’ research into 1,638 secondary equity issues that took place on the UK main market of the London Stock Exchange between January 1998 and March 2020.
Shares bought as part of the capital raise have had better results, thanks to the ability to normally buy in at a discount. However, even allowing for this, most underperformed.
This does not mean that investors should avoid companies that are raising equity. It just means you need to be selective in which ones to back. Returns of these companies follow a bi-modal distribution: a relatively large proportion fall close to zero but an almost identical proportion deliver substantial returns.
In 18% of cases, a company’s share price fell by more than 90% in the five years after raising money, effectively wiping shareholders out. However, in 19% of cases, returns exceeded 90%. For shares bought as part of the equity issue, the proportion that delivered gains of more than 90% over the subsequent five years increases to 23%.
Performance is less favourable when assessed relative to a company’s sector. However, the same bi-modal distribution exists, with a high percentage delivering very good returns and a similar percentage delivering very bad returns.
While clearly being relevant at the individual company level, many factors that you might expect to influence the likelihood of success or failure in general, turn out not to. Our analysis found no notable relationship with leverage or return on equity, nor whether either was rising or falling. Nor profit growth. Nor the size of a fundraising, or whether it takes place at a discount or premium to the share price, or the size of that discount or premium.
However, one factor that investors would be wise to pay attention to is refreshingly simple – whether a company is profitable or not. The distribution of outcomes has been more favourable (but still very wide) for profitable companies than loss-makers.
Loss makers have gone on to deliver lower medium-term upside, lower median/average performance, and worse downside risks than profitable companies. The difference is statistically significant.
For example, on a five year horizon, the average loss-making company that raised additional equity went on to underperform its sector by 38%.
In contrast, the average profitable fundraiser outperformed its by 4%. While top quartile profitable companies (the best performing 25%) outperformed their sector by an impressive 40%, their loss-making equivalents fell slightly short of theirs. Bottom quartile loss-makers (the worst performing 25%) also had poorer outcomes.
Loss-makers need not - nor should not - be avoided entirely, as some go on to deliver very good returns. The top 10% outperformed their sector by an impressive 81% over the five years post-raise. However, investors do need to be especially selective in which ones they back.
The need to be active
Existing public companies clearly value their ability to raise additional money on the stock market. Investors can also do well from backing these companies, but only if they take a very active approach in deciding which to support. Even within profitable companies, the range of outcomes is wide, with large proportions thriving but large also proportions struggling.
There is no substitute for rolling up your sleeves and carrying out proper fundamental analysis of the company in question, and its management. Not all fundraisings deserve to be backed. Creative destruction is healthy for economic growth. Due diligence and high levels of discrimination are essential. Passive investors do not have that luxury. They are forced to buy additional shares in response to every new equity issue, if they are to maintain an appropriate allocation to each stock.
The need to be active does not stop there. Once money has been raised, it is the responsibility of a company’s shareholders to hold management to account on how they execute on their strategy, how they spend that money, and, ultimately, on the sustainability of their business model. Not to do so would be complacent at best, negligent at worst.
Even passive investors cannot afford to be passive shareholders.
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