Featured Articles: About Share Placements

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Share Placements - Good or Bad?

Roger Tan & Don See, 21 Oct 2003

The number of share placements made by listed companies has grown in recent days. Yes, we are in a bull market and perhaps in the midst of a global economic recovery. With a recovery, there are more opportunities for businesses, deals and contracts. It makes a lot of sense for these companies to tap the equity markets to raise proceeds for further investment at this early stage. However, we believe not all that glitters are gold. We question the intention of some.

We are not planning to give names as we have no facts but a mere conjecture on our part. One of our investee company announced that it would be placing a huge amount of shares through a financial institution to raise funds. This placement will allow them to raise a few million Singapore dollars to expand their operations overseas.

This is bad news to us as it seems the management is hinting to us that their shares are overvalued. However, instead of a drop, the share price rose after the news! Ordinarily, we must be pleased but we do not accept facts as they are. We begin to hypothesis the possibilities. We swam through both conspiracy and financial theories and came to a single deduction.

We threw out conspiracy theory and instead focused on a signaling theory. For the rest of the article, we will explain why the hype over the recent issues can be attributed to signaling theory and the issues are nothing more than an "overvaluation" signal through the "Pecking Order" argument.

Revisiting Capital Structure Irrelevance

Proponents of placement share issues argue that shareholders should be happy that the management has raised new funds to expand and grow businesses. Whether these funds are raised through debts or equity is not the most important concern - the potential returns on these new investments are what matter most.

Miller and Modigliani's Proposition I (MM I) propose that the capital structure of the firm is irrelevant to the value of the firm under the perfect capital market assumptions. Financing methods will not influence firm value. It is the incremental value that these funds can achieve that is critical to the valuation issue. Investors who are buying up shares in these companies attest to this belief.

Altering the Perfect Capital Market Assumption - Information Asymmetry

Roger mentioned in his previous article "Explaining Perfect Capital Market - The Final Frontier" that the perfect capital market assumptions forms a starting point of an analysis. What happens when we change the perfect capital market assumption to that of information symmetry?

It is a reasonable assumption and expectation to say that insiders and managers hold a greater deal of information than non-insiders. They are in the best position to hold proprietary information knows exactly the number of contracts they are chasing or the amount of utility bills they have been paying. If they have such an immense amount of information on hand, we can safely assume that they know if the company shares are overvalued or undervalued. If the managers are rational, their next course of action would be to place out new shares.

What can the shareholders do then? Observe! Though shareholders do not have superior information like managers, shareholders can observe and track the actions of the managers. In the event of a share placement, it would be reasonable to infer that if managers start selling shares (new or old), that the firm must be overvalued.

What about the other side of the coin then? Say the managers do predict a significant upturn in the economy and that today is the most appropriate time to begin investing in new facilities, equipment and machineries, then raising equity is very justified indeed.

Managers do raise funds for good projects but to raise equity would be sending signals that shares are overvalued. To avoid that, managers therefore would try to fund projects with funds that attract the least "attention" - retained earnings. When such funds are insufficient they would then use debts and then finally equity. This order of source of funds is known as the "Pecking Order". Pecking order also explains why companies try to keep high level of "Financial slack".

At this point, we will like to highlight our assumption that the managers are investing in new projects and capital goods that will produce an incremental value. This is basic managerial finance. They will be committing a cardinal sin if they raise equity to invest in projects that are not incremental in value. We certainly hope they are not raising cash for the sake of investment or following the crowd like what many did during the technological hey days.

Coming back, if we base our assumption on information asymmetry and the pecking order theory, placement share issue, as a result, is nothing more than a signal from management that shares are overvalued.

Implications of Discount on Placement Share Issues

What about the discount on the placements shares? We observe that many placements are made at prices lower than the current market price. Herein, we believe management and the placement agent will argue that in order to place out a huge placement successfully, a discount to buyers is required to attract them. However, in our opinion we think shareholders could be short-changed in this instance. The discount is a cost to the company and the shareholders. The discount will effect a wealth transfer from current shareholders to new shareholders and the financial intermediaries .

Indirect wealth transfer happens when new shares are sold at a lower price than its fair value. If prices are a discount of future cash flows, this discount means that the new placement shareholders are receiving higher returns than the current shareholders. When no new investments are made, this higher return of the placement shareholders comes from the current shareholders. When new investments are made, placement shareholders enjoy higher risk premiums then the current shareholders even though both undertake the same risk.

Right Issues For Corporate Governance

Proponents argue that rights issue is less favorable then placement issue because of at least 3 reasons:

1. rights are issued at a higher discount
2. rights may not be fully subscribed
3. rights issue entails higher float cost

These are all true but rights issue will demand stricter monitoring and governing on the corporate managers. How so?

Better managed companies keep a low financial slack because excess cash is a drag on return on asset. Don also wrote about signaling effect of dividends in his last article. He quoted Easterbook who argued that dividends force firms to maintain a regular cash payout and as a result lead them back into the capital markets to raise new cash when they need it for investment in NPV positive projects. He believed that firms that pay high dividend signals the managersEintent to maximize investorsEwealth and to subject him to capital market monitoring and reduces the potential for managerial self dealing and thus reduces agency costs.

Since good companies maintain a low level of financial slack in the company (through dividend and share buyback), they will often have to raise new funds when good investment arises. The high cost involved in issuing rights issue and the risk that shareholders may not fully subscribe to the rights (due to concerns of the investment) will discourage low quality firms from paying out high dividends or buy back their own company share as they rather invest in their own self.

As right issues are also offered at a substantial discount it will increase the cost of equity and capital. However, unlike a share placement, it does not have a wealth transfer amongst shareholders. The company will be extremely cautious on the use of the raised proceeds. They must scrutinize the projects or investments thoroughly before undertaking them.

Don't Give it if you Don't Want To

In conclusion, this article aims to dispel the myths on share placements. Indirectly, through this article, we would like to remind investors and shareholders that your managers have significant discretion powers simply because you have given them the right to do so.

A resolution to allow managers to place certain amount of shares at their discretion must be agreed by the shareholders in a general meeting before such placement can take place. I noticed that many such resolutions are passed (by the majority) but shareholders are unhappy after the placement. Don't Approve Such Resolutions If You are Not Comfortable.

Just another interesting point to note, if you realize that in the last three weeks alone, there are several companies that have placed out shares. However, not all have seen their share price rise after the placement. Some have and some have not. For reasons that are not difficult to see.

Remember all that glitters are not GOLD.

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Lost the link and date of the article below... :(
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Placements: three things to bear in mind

By R SIVANITHY

THESE days, placements are an increasingly common sight in the local stock market. This is to be expected since companies and vendors quite naturally want to capitalise on buoyant sentiment to raise cash (some observers believe a rising number of placements signals a market top, but we'll leave aside discussion of the market's outlook for now).

But the problem is that placements are often a double-edged sword for shareholders - they can work for you in some instances but against you in others. Worse, as is often the case in the stock market, things may not always be what they seem.

At the simplest level, placements can be viewed as creating an overhang of shares which would impede future progress. Thus, when it was announced last week that investment company Temasek Holdings placed out almost 800 million Singapore Telecom shares at a discount to the prevailing price, the market reacted understandably by selling down SingTel's shares to around the placement price. Several days after the announcement, the counter has still not recovered.

The reaction to the SingTel news was predictable and mirrors how the market generally receives news of more shares entering the market (for example, investors tend to take a dim view of a rights issue for the same overhang reasoning). For now, the basic lesson to be drawn is this: placements move prices.

Not all placements, however, are received negatively. For those who have tracked placements in the second line, it would be clear that sometimes the outcome is a price rise. One example of this is when a small or medium-sized company's main owner privately places out shares to a big-name player that the market perceives to be a sophisticated investor.

If the entrant commands an influential presence in the market, chances are good that the shares would rise after the exercise is completed.

Perhaps more importantly for shareholders, the price paid by the new shareholder forms a base in the market's collective psyche - a floor below which it is unlikely to fall. The reason for this should be obvious: markets always like to know what sophisticated investors have paid for their stakes so that when the price falls close to this level, investors, traders and punters invariably move in to buy, believing that the sophisticated party's entry price approximates true fair value.

Whether or not this is really the case is debatable and we'll discuss this point shortly. For now, we reach a second conclusion about placements: they serve as a signalling mechanism because when a big name moves in, the placement price signals a floor of sorts.

Things get a bit tricky from here on. If placements move prices and if they also serve as a signalling mechanism in certain circumstances, might it not be possible that sometimes, a false signal could be sent?

Put differently, might it not be in the interests of vendors, shareholders and big-name new entrants if the actual price paid for a placement is lower than that which is disclosed? It certainly bears thinking about - telling everyone that a sophisticated player has bought into a company at a higher price than that which was actually paid would clearly be beneficial all round.

Major shareholders or vendors gain because of the subtle signal of where the floor price lies; the new entrant benefits because it enjoys a large price cushion and is therefore in-the-money right from the start; and shareholders benefit because the signal ensures plenty of price support.

The only parties at a disadvantage in such situations would be the investing public at large, which leads us nicely to a third and final conclusion about placements: all of them should be viewed with scepticism.

Whether or not vendors deliberately send a false signal like the one just described is a matter of conjecture but it does bear thinking about - especially the next time a parcel crosses, the price starts to move and you're tempted to jump on board.