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Debt Overhang Problem. If a company has risky debt outstanding, the cash infusion associated with an equity offer increases the collateral backing the debt, making it less risky What effect does this have on the existing shareholders?. Example with a $200 million equity issue.
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Debt Overhang Problem • If a company has risky debt outstanding, the cash infusion associated with an equity offer increases the collateral backing the debt, making it less risky • What effect does this have on the existing shareholders?
Example with a $200 million equity issue • Pre-issue enterprise value of $1 billion • Face value of debt of $900 million • Market value of debt of $600 million • 100 million shares outstanding at $4 per share • After equity issue, risky debt increases to market value of $750 million • What is the post-issue enterprise value?
How many shares have to be issued to raise $100 m? • $1,200 m enterprise value - $750 million MV debt = $450 m post-issue equity value • $450 million = price/share×(100 m old shares + new shares) • $200 million = price/share×new shares • Solve for price/share
New shares = $200 m ÷ price/share • $450 MV of equity = (100 + 200/price) × price/share • 450 = 200 + 100 × price/share • Price/share = $2.50 • New shares to be issued to raise $200 million is 80 million
Seasoned Equity Offerings (Follow-on Offerings)
Rights offers • A rights offer involves offering shares to existing shareholders at a fixed exercise price • These are rare in the U.S.
Equity Capital Raised by US and European Financials in 2008 • UBS $15.3 billion rights offer • AIG $13.4 billion SEO • ($7.5 fully marketed common but only 4 days) • ($5.9 billion convertible) • Washington Mutual $7.2 billion private equity by TPG • Societe Generale $8.5 billion rights offer • Citigroup $4.9 billion accelerated bookbuild • Citigroup $12.5 billion convertible sovereign funds • Citigroup $3.2 billion convertible • JP Morgan Chase $11.5 billion accelerated bookbuild
Follow-on Offers • Frequently occur after a large stock-price runup • On average, the stock has gone up 70% in the year prior to the announcement, although there is wide variation around this number
September, 2008 New Development • Accelerated seasoned equity offerings (SEOs), including bought deals and accelerated bookbuilt offers, have become more common throughout the world during the last decade (Bortolotti, Megginson, and Smart, Summer 2008 Journal of Applied Corporate Finance)
September, 2008 Two Types of Accelerated SEOs Bought deals The issuing firm (or the selling shareholder) announces the amount of stock it wishes to sell and invites investment banks to bid. The investment bank that offers the highest net price wins the right to buy the shares. The winning bank then re-sells the shares immediately. Accelerated bookbuilt offers The investment bank that wins the right to underwrite the offer builds an order book and sets the final offer price very rapidly, usually within 48 hours.
September, 2008 What is Special about Accelerated SEOs? • The most important differences between an accelerated SEO and a fully marketed SEO are the amount of marketing and the speed to market • Similar to an IPO, in a fully marketed SEO, the lead underwriter conducts a road show after the registration • There is NO road show conducted for bought deals and accelerated bookbuilt offers, which implies little marketing effort • Shares in accelerated SEOs are generally allocated exclusively to institutional investors
September, 2008 The Fully Marketed SEO Process (Figure 1) Select book-runner and co-managers Prepare preliminary prospectus Registration Announcement of the filing Marketing, road show, and book-building 2 – 3 weeks Issue final prospectus, pricing, and allocation Trade begins
September, 2008 The Bought Deal Process (Figure 1) Investment banks submit bids after the close of trading Bank that offers the highest net price wins Registration Announcement of the filing Usually overnight Re-sell the shares Trade begins
September, 2008 The Accelerated Bookbuilt SEO Process (Figure 1) Select the book-runner Registration Announcement of the filing Accelerated bookbuilding Usually 1-2 days Pricing and allocation Trade begins
September, 2008 Demand Curve without Marketing Price Supply Demand Quantity
Marketing Effects • Marketing flattens the demand curve • Marketing changes current shareholders’ beliefs • Marketing increases the number of investors paying attention to the stock
September, 2008 Demand Curve with Marketing Price Supply Demand With Marketing Without Marketing Quantity
September, 2008 Model Predictions • The fully marketed offer method is preferred to the accelerated offer method if: • The ex ante demand curve of the issuing firm’s stock is relatively inelastic • The offer size is large
September, 2008 Asymmetric Information Theory Price Supply Demand Signal of Overvaluation Quantity
Announcement Returns Announcement returns incorporate anticipated price pressure effects Otherwise an arbitrage opportunity exists
What We Observe on the Announcement Day Price Supply Demand Information and Price Pressure Quantity