Desirable Features of Rights Offerings
You may ask, If the stockholder is no better off in terms of total valuation, why undertake a rights offering? There are a number of possible advantages.
As previously indicated, by giving current stockholders a first option to purchase new shares, the firm protects the stockholders’ current position in regard to voting rights and claims to earnings. Of equal importance, the use of a rights offering gives the firm a built-in market for new security issues. Because of this built-in base, distribution costs are likely to be lower than under a straight public issue in which investment bankers must underwrite the full risk of distribution.4
Also, a rights offering may generate more interest in the market than would a straight public issue. There is a market not only for the stock but also for the rights. Because the subscription price is normally set 15 to 25 percent below current value, there is the “nonreal” appearance of a bargain, creating further interest in the offering.
A last advantage of a rights offering over a straight stock issue is that stock purchased through a rights offering carries lower margin requirements. The margin requirement specifies the amount of cash or equity that must be deposited with a brokerage house or a bank, with the balance of funds eligible for borrowing. Though not all investors wish to purchase on margin, those who do so prefer to put down a minimum amount. While normal stock purchases may require a 50 percent margin (half cash, half borrowed), stock purchased under a rights offering may be bought with as little as 25 percent down, depending on the current requirements of the Federal Reserve Board.
HSBC Holdings Plc. Rights Offering Finance in ACTION Global
HSBC Holdings Plc. is Europe’s biggest bank with a worldwide presence. It is also known as Hong Kong Shanghai Banking Corporation, and while it was originally focused in Asia, now Europe accounts for over 50 percent of its assets, Hong Kong and Asia Pacific about 25 percent, and North America 20 percent, with Latin America about 5 percent. The credit crisis of 2007–2009 put tremendous pressure on HSBC’s capital ratios. HSBC had set aside loan loss reserves of $53 billion during 2007–2009 to cover investments in U.S. subprime debt and direct exposure to loans packaged into securitized financings, but it needed more equity capital. European banks like the U.S. banks found it difficult to sell their high-risk assets, and many like HSBC, Royal Bank of Scotland, UBS of Switzerland, Bank America, Citibank, and others were forced to either write down their assets or sell them at fire-sale prices. This caused their capital ratios to shrink below the required limit of 6 percent.
The solution was to find equity capital in the form of common stock and preferred stock. Common stock was high-risk equity without a guaranteed dividend and was considered tier 1 capital, while preferred stock was considered tier 2 capital. Total capital had to equal a minimum of 6 percent with tier 1 capital (common stock and common shareholder equity) equaling a minimum of 4 percent. Most banks and investors wanted ratios well above 6 percent in the uncertain economy with more potential losses from bank loans and investments looming on the horizon. In the United States, the U.S. government bought several hundred billion dollars of preferred stock in many banks to bolster their capital, and banks like Bank of America, Citigroup, and others also sold common stock through secondary offerings. As Table 17-2 shows, in Europe, banks used rights offerings to raise capital.
HSBC did not want to borrow from the British Government, so on March 2, 2009, it announced a rights offering intended to raise approximately $17.7 billion dollars through the sale of 5.06 billion shares of common stock. The rights offering was successful, and 97 percent of the shares were sold to existing stockholders with the investment bankers exercising the 3 percent that was left over. Before the rights offering, HSBC’s tier 1 capital ratio was 8.3 percent; after the rights offering, the ratio jumped to 9.8 percent, which was at the upper end of the 7.5 to 10.0 percent target HSBC liked to maintain. The big question after the offering was “Did they raise enough capital?” With continued losses expected over the next several years, was this new infusion of equity enough to cover future loan losses, or would earnings from operations be enough to cover any future losses? What did the market think about this?
HSBS trades in the United States as an ADR (American Depository Receipt). When the bank announced the offering on March 2, 2009, the price of its ADR in the United States was $28.25, and by November 2009 the stock had more than doubled to $64.42. This would indicate that the market thought their rights offering and very high capital ratio had minimized the risk from future losses. The stock price drifted down to $35.75 in 2011 and recovered to $54 per share by June of 2013. You might want to check on the stock price to see how HSBC is doing. The ticker symbol is HBC.