The issue of a Rights Issue

Ed Note: This week I wanted to focus the site on things Arsenal could do to ‘compete’ off the pitch against the growing behemoths of City, Chelsea and the established giants in  Madrid, Bayern and Barcelona.  I was in the midst of doing research on the whole right’s issue, and had a great conversation with the likes of Tim Payton and Phil Wall of the AST, Swiss Ramble of you guessed it Swiss Ramble and Darren the tweeter behind @DarrenArsenal1 on twitter. I guess the discussion prompted Phil to write a piece and after reading it here – I reached out to Phil to see if he would mind us publishng it here. Thankfully he agreed and here it is in full glory.

You can follow Phil on twitter as @AngryofN5 and his site is angryofislington.com. I hope you enjoy this piece as much as I did.  – DAG

This subject has been discussed before, but may well be raised again at the supporters’ Q&A with Ivan Gazidis, given the refusal of Stan Kroenke to put money into the club’s coffers, and the apparent desire of Alisher Usmanov to do so.

I’m taking some of the general info and definitions from this web page: http://www.investopedia.com/articles/stocks/05/062905.asp#axzz1woxuRhFG
but adapting it to Arsenal’s circumstances. Football clubs in general don’t always follow standard business models, so standard definitions don’t always work. Plus this is an Arsenal blog, and Arsenal are in the fairly uncommon position of having two shareholders owning nearly 97% of the shares, with both wanting control. Their motivations, as well as those of the remaining small shareholders who are largely also fans, are very different from most business situations.

What is a rights issue?

A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. More specifically, this type of issue gives existing shareholders securities called “rights”, which give the shareholders the right to purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price.

So in plain language, a company issues more shares to get cash, and the existing shareholders have first call on purchasing them, with the incentive of some discount. In Arsenal’s circumstances, where two shareholders between them own 97% of the company, there is no real need to discount the shares. However, small shareholders may not be keen on stumping up upwards of £14k a share; they may not be keen on stumping up anything.

The key point in the definition is that it’s new shares, so the company gets new money. That’s the purpose. Arsenal could save £20m a year in interest and capital repayments if they got rid of their debt with the help of best debt relief companies, or just have a huge pile of extra cash to spend now.

Until the date at which the new shares can be purchased, shareholders may trade the rights on the market the same way they would trade ordinary shares. The rights issued to a shareholder have a value, thus compensating current shareholders for the future dilution of their existing shares’ value.

Trading the rights would cause complications in the case of Arsenal – see below.

Troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money. But not all companies that pursue rights offerings are shaky. Some with clean balance sheets use them to fund acquisitions and growth strategies.

Arsenal is not ‘troubled’ in a financial sense – well, not unless you’re comparing to Man City, but in the sense of running a sound business, not. So I repeat, the idea of a rights issue would be either to pay off the debt and free up the £20m-odd per annum in interest and repayments, or keep the debt and just go on a player spending spree.

For reassurance that it will raise the finances, a company will usually, but not always, have its rights issue underwritten by an investment bank.

This means that if some, or even all, shareholders don’t want to take up the rights issue, the underwriter guarantees to buy them so the company still gets the money it was expecting. In Arsenal’s case, Usmanov has apparently offered to underwrite, but that wouldn’t suit Stan (read on for explanation).

So, how do rights issues work?

Let’s do this in Arsenal terms, but keep the figures simple for the example. In reality they wouldn’t try to double the value of the company in one go.

Arsenal want to raise cash, so suppose they announce that they’re going to issue one new share for every current share, at a price of £10k per new share. So everyone who owns any share or shares can buy the same number of shares for £10k each.
As a shareholder, you normally have three options when considering what to do in response to a rights issue. You can:

• subscribe to the rights issue in full, and buy all the new shares offered to you
• ignore your rights, or
• sell the rights to someone else.

This is what happens in each case:

Option 1 – Take up the rights to purchase in full
To take advantage of the rights issue in full, you would need to spend £10k for every Arsenal share that you are entitled to under the issue. If you hold one share you can buy one new one at £10k, and if you’re Usmanov and hold (approx.) 18,500 shares then you have to spend £185 million. If you’re Kroenke and hold about 42,000 shares, then you have to pay £420 million. As I say, Arsenal (or indeed pretty much any business) aren’t going to try and double the size of the company in a single rights issue, and the amounts involved are one reason why.

There’s no legal reason why they couldn’t issue as many new shares as they wanted at any price, if both billionaires were equally desperate to pump money in, but in practice in Arsenal’s case it would be more sensible to issue, say, one new share for every five currently held, with a price of £10k. That would mean about 12,000 new shares times £10k, raising £120 million. The particular difficulty here is the number of small shareholders with only one, two or even four shares – they would be issued no new shares. They might not want them anyway, but the point is that the percentages held by the two big players would change unless every single shareholder bought shares in exactly the percentages they already held. Alternatively, if shareholders with one share each were allowed to purchase another share while the big shareholders could only purchase one for every five, the percentages held by the bigger shareholders would be diluted (admittedly only very slightly, given how few shares remain outside the hands of the big two). Either way the answer to the problem is a share split before the rights issue – see below.

So if everyone takes up their allocation in full, then the percentage holding for each shareholder obviously doesn’t change. In the one-for-one example, everyone has twice as many shares as before, but Usmanov still has just under 30% (his position at time of writing), Kroenke has just under 67%, and the rest have their miniscule proportion. There is no power shift; no one gains an advantage or is disadvantaged. The company has more money, and is worth more, that’s all.

If there are 62,219 shares (the number currently in issue for Arsenal) valued at £14k each and another 62,219 that will be bought at £10k each, then the average value is obviously £12k, so once the rights issue is over, that will be the approximate price, all other things being equal.

However, in football all other things aren’t equal (for one thing, football clubs aren’t generally run with the main purpose of making money for shareholders), and the Arsenal share price is currently affected as much or more by the fight for control as by the actual and potential earnings of the company. So in practice it wouldn’t be easy to predict the ‘new’ price that would be applicable once the dust had settled.

The key point here is that in a standard rights issue the new shares are discounted so the average price is lower than the ‘old’ price, and thus the ‘new’ price, being at or around the average, also ends up lower. For Arsenal there may not be a discount and the price of a share, ‘new’ or ‘old’, has other forces acting on it.

Option 2 – Ignore the rights issue 
If you don’t have the cash to buy the shares offered to you as an existing shareholder, you can just let your rights expire. Normally this is not recommended, because your shareholding becomes diluted thanks to the extra shares issued, and the ‘new’ price is almost always lower than the ‘old’ price. So in our example, you had a share worth £14k at the start of the process, and now you have one worth £12k. That doesn’t look wise.

However, in Arsenal’s case this is less relevant, unless you have been very recently buying Arsenal shares as an investment. Small shareholders aren’t usually bothered about how much of Arsenal they own, they just want to keep a little bit of the club because they’re fans. Obviously it’s nice for them if their asset goes up in value, but only relevant if they’re going to sell, and there aren’t many of those people left.

For Usmanov and Kroenke things are different, and they have different motivations. Kroenke doesn’t want to spend more money, but if he didn’t take up a rights issue then he’d end up with a smaller percentage of shares than before. Maybe he wouldn’t be bothered as long as he still had more than 50%, but presumably he doesn’t want to make it too easy for Usmanov to get over 30% and start causing trouble.

Usmanov, of course, does want to increase his percentage shareholding, and seems prepared to pay any reasonable price to achieve that. So a rights issue suits him, because if anyone else doesn’t take up their full allocation of new shares and he takes all his, then his percentage of Arsenal increases. Realistically Kroenke is never going to let him get to a majority shareholding this way, though it is of course mathematically possible. Usmanov could even offer to underwrite the issue, meaning he would get all the shares that weren’t taken up by any shareholder, thus increasing his percentage still further. So ‘generous’ offers from Usmanov to do this kind of thing should be taken with a large pinch of salt.

If I were Kroenke and I wanted a rights issue but didn’t want the risk of Usmanov’s percentage increasing, then the only way I could guarantee that would be an agreement up front with Usmanov that both would take up all their rights (they could both agree to take less than their full allocation, but that would be pointless in practice) and that if others didn’t take up their rights, then all shares not taken by others would be split so as to maintain the current percentages between Kroenke and Usmanov. It would be no good agreeing not to take up anyone else’s rights, because then although the percentages held by Kroenke and Usmanov wouldn’t change in relation to each other, they would both have a slightly larger percentage of the whole – and I’m assuming Kroenke doesn’t want Usmanov to have any larger percentage.

Option 3 – Selling your rights to other investors
In some cases, rights are not transferable (non-renounceable rights). But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors or to the underwriter.

Again, in Arsenal’s case, with Kroenke and Usmanov in the positions they are, it’s unlikely there’d be the chance to sell rights: if either of them were going to sell rights, there wouldn’t be much point in having the rights issue, and if small shareholders were allowed to sell then Kroenke wouldn’t want Usmanov to get someone else’s rights and change their relative percentages that way.

In summary:

• a rights issue would be a good way of raising cash for Arsenal to invest in players or pay off debt
• it’s largely a one-off exercise, not something that can be repeated year on year
• there would be complications for small shareholders, but these could be got around with a share split
• in practice it’s not going to happen because Kroenke doesn’t want to spend any more than he already has; that’s the number one thing preventing it. Thus if Ivan Gazidis is questioned about it, his response as Stan’s employee is that it’s unnecessary. I doubt he believes this, but we’ll have to wait for his memoirs to get a different story.

It should be noted that FFP sets limits on what clubs can raise this way, so £120m may fall foul of that.

When I was three quarters of the way through writing this, I remembered that the AST had done a paper about three years ago (to which I contributed) outlining their position on a rights issue. This goes into how it could work for Arsenal, including the share split mentioned above. Some things have changed since it was written: we now have a single majority owner, the share price has doubled in the last three years and the property development eventually broke even. So some of the references have dated, but the principles still largely stand. As this was written three years ago, please do not take this word for word as official current AST policy!

Arsenal Supporters’ Trust: Rights Issue information, 2009

The possibility of a rights issue for Arsenal has been in the news this year (2009), as a formal proposal was put forward by Red & White Holdings as a way to raise capital for the club in the light of a shortfall in expected revenue from Highbury Square. The club rejected the idea on the grounds that a rights issue does not fit with the sustainable model that Arsenal hold dear.

A rights issue is a very common way for companies to raise money and does not mean relying on gifts or a “sugar daddy”. We believe that seeking investment from willing shareholders does not go against the self-sustaining model, especially when using one of the best online trading platforms UK has today. The value of the company is increased by a rights issue, which is a proper investment decision and not an Abramovich-style ‘loan’ or gift. Listed companies frequently issue shares to fund growth and to make acquisitions, and this activity is regarded as self-sustaining.

A one-off rights issue could be used to retire expensive debt, for example that at Highbury Square, and could also be used to invest in the playing squad and the club’s facilities generally. Reduced debt cost means more money available to spend from future turnover. Proceeds could even be used to buy Arsenal Bonds in the open market. These are currently available at heavily discounted prices (circa 60% of par).

The AST has raised the subject of a rights issue with the club in past years, but we were advised by the club that they saw no need for one and no need for the capital it would raise. We could understand this sentiment two years ago when property development was proceeding well and the property market was buoyant. Current conditions in the economy and at Highbury Square have changed the situation. A one-off rights issue now could put Arsenal back on the business plan envisaged when the new stadium was constructed.

The AST would only support a rights issue that was built on the principle that its outcome was ‘ownership neutral’, and that the involvement of small shareholders would not decrease. This would mean that small shareholders must have the right to purchase shares equally with the major shareholders. We are firmly against the idea of one shareholder becoming too powerful.

How would it work?

To make a rights issue easier to manage we would advocate a share split being undertaken at the same time. This would also make our sharesave scheme easier to operate. This affects only the mechanics of the scheme rather than the principle, but we are keen on a share split as a lower share price allows all smaller shareholders to buy more shares.

Our rough calculations show that a 1-for-5 rights issue at £6,000 per share (more than a 25% discount on the recent mid-price) would raise £75m. However, without a share split the scheme would have to be skewed so that shareholders holding fewer than 5 shares (around 2% of current shares in issue and 1,300 shareholders) would be entitled to take up 1 share; shareholders holding between 5 and 10 would be entitled to take up 2, and so on. In other words the general principle of 1-for-5 applies, but larger shareholders may need to take a pro rata reduction in their allocation to ensure small shareholders are fairly treated.

As an alternative, a 1-for-3 rights issue at £7,000 per share would raise £147m. Again, without a share split the scheme would have to be skewed so that shareholders holding fewer than 3 shares would be entitled to take up 1 share; shareholders holding between 3 and 6 would be entitled to take up 2, and so on. So the general principle of 1-for-3 applies, but again larger shareholders may need to take a slight pro rata reduction in their allocation to ensure small shareholders are fairly treated.

It’s unlikely that all shareholders would take up their full allocation under the rights issue, so the underwriting of such a scheme needs to be carefully considered. To maintain plurality, no single shareholder (or group of shareholders acting in concert) must reach a holding of 30% of issued shares, as stock market rules would force a mandatory bid for all shares at this point. Thus any shares not taken up by current shareholders should not be available to major shareholders – ‘major’ in this case being, say, any individual or company with more than 5% before the rights issue. But there would be a need for the rights issue to be fully subscribed, to prevent changes in percentages held by major shareholders. This raises the possibility of underwriting by an outside party, for example a financial institution (or even an individual) who was prepared to purchase shares and perhaps hold them to be available for buyers in the sharesave scheme or make them available to any other non-shareholder.

The underwriter would buy shares at the rights issue discount price, but be able to sell them at market price. A profit is appropriate in such circumstances to compensate for the risk involved in such a deal. It’s important to note that sharesave purchasers would not lose out: they would be buying shares at market value, exactly as though they were buying from any other shareholder. The difference with this scheme is that money has already gone directly to the club at the time of the rights issue.

Clearly there are many factors to consider to ensure that all shareholders are treated fairly and plurality is maintained. Terms of the rights issue (ratio and price) can be set in numerous ways and the above examples are purely indicative.

Further, the self-sustaining argument could be reinforced by issue of redeemable preference shares under the rights issue; that is shares the club can buy back in the future as funds allow and once other debts are repaid. Such preference shares could even attract a modest coupon of perhaps 1%, albeit rolled up and paid at redemption, but still demonstrating self-sustainability. Having said that, the AST is not generally in favour of dividends being paid. We believe all monies earned by the club should be reinvested in the club.

Summary

Depending on the price and terms, a rights issue could easily raise £100m. This could provide a significant boost to funds for squad strengthening, or an equally significant reduction in debt.

We would like to state clearly that there is a need to make sure small shareholders are not disenfranchised by this. All shareholders must have the right to subscribe to a rights issue. Of course they could also sell any rights in the market if they are unwilling or unable to take them up.

If a rights issue was promoted alongside a sharesave scheme then a very powerful PR message of custodianship is given, whilst not significantly denting the big shareholding blocks. If the value of the club increased in line with expectations as a result of a rights issue, then all those taking up rights with a discounted rights price would be getting clear benefit for their investment.

The AST stands for custodianship and plurality of ownership, including small shareholders having a significant (ie greater than 10%) shareholding in Arsenal. We will urge all major shareholders to commit to preserving this position through the sharesave. As detailed here, we believe a rights issue can greatly assist in this aim.