Letter number 72 of February 2013


News : The ABC of preferential subscription rights

On March 6, 2012, when the share price had closed the day before at €14.28, Peugeot announced the characteristics of its capital increase of around €1bn, through the issue of 16 new shares for 31 shares held, at an issue price of €8.27.  This was one of the provisions of the alliance plan with General Motors, announced shortly before.

Some commentators wrote or said that Peugeot was cutting the price, not of its vehicles but of its shares.  Others said that without a discount they wouldn’t have been able to collect €1bn.  And others said that you catch more bees with honey than with vinegar or that the price for friends was obviously a good thing for General Motors which following this capital increase became a Peugeot shareholder with a 7% stake. 

It’s disappointing to hear or to read such comments, given that the mechanism of the preferential subscription right has existed for decades and is very well explained in a number of text books, and not only in the Vernimmen!

No, a capital increase with a preferential subscription right is not a gift to investors who become shareholders of the company at this time! No, a company which carries out a capital increase with a preferential subscription right is not selling off its shares at a rock-bottom price! No, the discount isn’t given to attract customers! It has a single, technical but important aim – to reduce the risk of failure of the capital increase (see chapter 39 of the Vernimmen).

Contrary to appearances, it has no impact on the amount that the investor who becomes a shareholder at the time of the capital increase, has to pay.  In fact, regardless of appearances and regardless of the amount of the discount, the investor buys the share issued at its market value, whether this is the stock market price if the company is listed or its value if it is not.

To illustrate this, let’s take a simple example, that of a company made up of four million shares, each worth €100, and which carries out a capital increase of €75m by issuing a million new shares at €75.  A preferential subscription right is granted to each shareholder who is then able to subscribe a new share for each lot of 4 existing shares in his/her possession.

Since not all of the shareholders will want to or will be able to subscribe to the capital increase in exact proportion to their stake in the company’s capital, some will seek to sell and others to buy the preferential subscription rights.  The preferential subscription rights will have a market value since they enable the holder to acquire for €75 in our example, a share that is worth more.  We can show (1) that on the day that it is detached, the right is worth: (value of the share – issue price)/(1+proportion of subscription).  In our example, the preferential subscription right is worth €5. 


This assumes that the arbitrage of this price is perfect and that it is possible to short-sell the share and accordingly, that there is a market for lending/borrowing securities which is adequately liquid. This is generally the case for listed companies with a share capital of over €500m. Failing this, the preferential subscription right would be undervalued compared with its theoretical value.

*  *  *

Let’s look at the situation of four investors faced with a capital increase:

• the first investor, a shareholder in the company, does not take part in the capital increase at all;

• the second, a shareholder in the company, takes part in the capital increase in exact proportion to his rights, so that his percentage of control over the company remains the same after the capital increase; 

• the third investor does not, at this time, want to invest new funds nor to withdraw from this investment, so he or she only participates partially in the capital increase;

• the fourth investor is not a shareholder of this company and wants to become one on the occasion of this capital increase. 

Each investor has assets of €4,750,000. The first three have €750,000 in cash and 40,000 in shares in the company, i.e., 1% of its share capital, and the fourth investor has €4,750,000 in cash.

On the day of the detachment of the preferential subscription right, the price or the value of the share falls automatically from €100 to 100 – 5 = €95.  As the reader knows, this is not a question of the shareholder getting poorer, but simply a modification of the composition of the shareholder’s asset, which is transformed from a share worth €100 to a share worth €95 and a preferential subscription right worth €5, which is still at total of €100.

Our first investor, who doesn’t want to take part in the capital increase, will thus sell his 40,000 preferential subscription rights for 40,000 x €5 = €200,000.  His assets will then be made up of 40,000 shares worth €95 each, i.e., €3,800,000, plus €750,000 initially in cash plus the €200,000 from the sale of the preferential subscription rights, which works out at the initial amount of €4,750,000.  He has neither been made poorer nor richer on this occasion.  In fact, even if he fails to seize this opportunity to buy for €75 a share that is worth €95, missing out on a gain of €20 for each lot of 4 shares held, he has received compensation though the sale of his preferential  subscription rights, since for each lot of 4 shares, he received 4 preferential subscription rights which he was able for sell for €20.

Let’s take a look now at the situation of our second investor, who, with 1% of the company’s share capital, wishes to subscribe, as she is entitled to do thanks to the preferential subscription rights, 1% of the capital increase, so that her degree of control over the company remains the same. With 40,000 preferential subscription rights on these 40,000 shares, she can thus subscribe 10,000 new shares at €75 each, using her €750,000 in cash to pay for them.  She now holds 50,000 shares out of a total of 4 + 1 = 5 million shares outstanding, which is the percentage she wished to hold onto.  Her 50,000 shares are worth €4,750,000, which means that her total assets remain unchanged.

She hasn’t got richer or poorer as a result of this operation either.  She did buy, using her 40,000 preferential subscription rights, 10,000 shares at €75 which were worth €95, making a gain of €200,000.  But her 40,000 initial shares were devalued by €5 each, which cancels out to the euro, her gain.  The financial cost price of these new shares is indeed €95 per share, which is the market price, since for 4 shares she could buy one at €20 below its value, the 4 other shares have each lost €5, i.e., a total of €20.

As for the third investor, who does not wish at the time of the capital increase, either to invest new funds nor to obtain any, he will have to sell 31,580 preferential subscription rights for a unit price of €5, i.e., a total of €157,900.  With the balance of his preferential subscription rights, i.e., 8,420, he can subscribe 8,420/4 = 2,105 new shares for a cost of 2,105 x €75 = €157,875 and he’s left with €25.   His assets will be made up of 42,104 shares each worth €95 and €750,025, which is an unchanged total of €4,750,000.

Before the capital increase he had 40,000 shares each worth €100, and now, without having spent or gained anything, 42,105 shares each worth €95, which is the same total.

Accordingly, there is in any capital increase with a preferential subscription right, a dimension of free share allocation, which means that the share price after the capital increase cannot be compared with the share price before the capital increase, without it being adjusted (2), here by a factor of 0.95.  In fact, each preferential subscription right represents a fraction of the share that it allows the shareholder to buy, either through selling or exercising the right.

Finally, the fourth investor who wants to become a shareholder of the company at the time of its capital increase, must spend €1,000,000 on acquiring 200,000 preferential subscription rights at €5.  Thanks to these 200,000 preferential subscription rights, he can subscribe 50,000 new shares at €75 each, for €3,740,000.  All in all, his 50,000 shares would have cost him €4,750,000, or €95 per share.  He will have acquired them at the market price, no higher, no lower.  He received no gift.

If now, instead of being 25% like in our example, the discount had been 50% the company would have had to issue 1.5 million new shares to raise €75m.  The total number of preferential subscription rights would be the same but shareholders would have to have 8 shares to subscribe 3 new shares.  The preferential subscription right would be worth €13.64 and the share after detachment would be worth €86.36.

The first investor would get more cash from the sale of his preferential subscription rights, but since the value of his shares would have dropped by more, his assets would remain the same, simply the relative share of cash would be larger.

The second investor would subscribe more shares since more would have been issued, but at a lower unit price.  But overall, her percentage of control would remain 1%, she would have more shares but they’d be worth less because of the detachment of the preferential subscription rights which would be worth more, but all in all, her assets would have remained unchanged.

The third investor who doesn’t want to invest new funds nor obtain new funds following the capital increase, would have to sell fewer preferential subscription rights and subscribe more shares.  All in all, he would also have more shares which would have a lower unit value, so that his assets would remain unchanged. 

Let’s finish off with the fourth investor who wants to become a shareholder at the time of the capital increase.  He would spend €2m buying preferential subscription rights and €2,750m subscribing 55,000 new shares at a unit price of €86.36.  He would then, like previously, have 1% of the company’s share capital (post capital increase) which he would have acquired at the market price, not more not less, i.e., €4,750,000, or €86.36 per share.  The fact that he’d have more shares that were each worth less would change nothing, as long as the product of one multiplied by the other is constant, which is indeed the case.

*  *  *

So that’s how preferential subscription rights work, making it possible to place the shares and to allow existing shareholders the time to make up their minds. But they don’t make it possible to favour financially any individual investor or to give gifts, as long as the arbitrageurs are able to do their work properly, which shows, we’ll just say in passing, that traders are of some use.

And to end where we began, the investor who subscribed Peugeot shares at €8.27 when they were trading the day before the operation at €14.28 – in other words who paid €12.23 for them since the theoretical value of the preferential subscription right was €2.05 (3) – knowing that today they’re worth around half of that, will certainly not think that he got a price for friends! But that’s another story, and it should always be remembered that shares are not a short-term investment!

(1) See chapter 26 of the Vernimmen.

(2) See chapter 23 of the Vernimmen.

(3) €14.28  - €2.05  = €12.23

Statistics : P/E ratios in Europe

Research : Value Creation and Drivers of Secondary Buyouts in France

This paper by François Evers (HEC Paris) studies the value creation and drivers of secondary buyouts (SBO) in France in the aftermath of the financial crisis. He has used two data sets: a unique, self-constructed sample of 438 French private equity (PE) sponsored buyouts between 2007 and 2011, and a sample of 139 French PE exits for the same period. 52% of PE investments were exited via SBO in 2011, making it the preferred exit strategy for PE firms.

The SBO trend started in the 2000s and has attracted more and more the attention of researchers. Conventional wisdom generally accepts three levers of value creation in leveraged buyouts (LBO): pricing, operational performance and leverage. However, it doubts the value creation potential in SBOs. SBOs are more expensive because of the skilled seller hypothesis and most of the operational performance improvement has already been realized in previous LBOs. Hence, it is often argued that the only true value creation lever in SBOs is the increased used of leverage.

Moreover, other drivers than the traditional value creation objective of LBOs are believed to be behind SBOs. Market conditions such as the cheap financing before the outburst of the financial crisis are often named as one of the most important drivers. However, the SBO trend has continued since the outburst of the financial crisis in spite of the rising financing costs. This paper provides one of the first studies of the driving forces behind SBOs in the aftermath of the financial crisis.

In this study, Evers shows that SBOs have no significant impact on the pricing of buyouts. Rather, the facts that SBOs are on average larger and more likely to occur in high-multiple industries seem to positively influence the difference in pricing. Moreover, PE firms are better in boosting sales in LBOs than in SBOs, but their impact on operating margins is higher in SBOs. A possible explanation is the natural selection phenomenon. Companies that are selected for an SBO have already successfully managed at least one LBO before, and management and employees may be better suited to achieve operational efficiency gains.

When combining these findings, Evers concludes that PE firms focus in LBOs on growing the sales of smaller and younger companies and in SBOs on improving operating margins of larger and more mature companies. Thus, PE firms seem to focus on the low hanging fruits in LBOs and on the higher hanging fruits in SBOs. Finally, PE firms do not seem to use significantly more leverage in SBOs. All in all, Evers concludes that there is room for value creation in SBOs and that the value creation objective remains a valid driver behind SBOs in France.

Furthermore, Evers confirms the existence of other drivers behind the recent SBO trend. He finds that the likelihood of an exit by SBO is not only negatively related to hot IPO markets and the cost of debt financing, but also positively related to the amount of undrawn capital commitments in the PE industry and the pressure for the selling PE firm to monetize its investment.

Finally, Evers finds no evidence that the reputation of the selling PE firm or the profitability of the portfolio company have a significant positive impact on the likelihood of an exit by SBO.

Thus, the main contribution of this paper is the finding that SBOs are not only driven by the macroeconomic conditions of the IPO and debt markets but also by the microeconomic profit maximization, i.e. the value creation objective, and structural conditions of the PE industry, i.e. the pressure to monetize investments and to invest undrawn committed funds.

For the interested reader, this research is available on the vernimmen.com website under resources/research thesis. As a matter of fact around 30 such high quality research papers are available on this page written by students in their last year of master.

Q&A : Why is change in finished goods inventories recorded under income on some income statements?

First of all, change in finished goods inventories is only recorded on the by-nature income statement which classifies expenses as personnel expense, depreciation and amortisation, purchase of raw materials, etc.  It is not recorded on the income statement presented by function which records cost of goods sold, marketing costs, administrative costs, R&D costs, etc. (1)

The by-nature income statement records expenses for the financial year, whether or not these are related to income or services sold during the course of this financial year.  We are thus thinking in terms of production and not sales.

But let’s not allow ourselves to be misled, the operating income or the net income recorded on the by-nature format does correspond, as it should, to the difference between sales and the total of the direct and indirect costs incurred in order to achieve these sales.

How then do we reconcile expenses recorded on the income statement when they are contracted, independently of sales, and earnings (losses) that only take into account expenses that can be directly or indirectly attached to sales for the financial year?

By change in raw materials inventories, work in progress and finished products.

In fact, if we record purchases of raw materials on the by-nature format income statement, the presence of change in raw materials inventories which is recorded as a negative amount just below, results in the overall appearance, not of purchases, but of the consumption of raw materials for the financial year.  We’re getting close to consumption of raw materials included in products sold during the course of the financial year, but we're not there yet.  Effectively, if the company has stocked more finished products than it has destocked during the financial year, or if it has stocked fewer finished products than it has destocked, there will be a residual gap which will not be negligible.

The ultimate corrective measure is the change in finished product inventories.  When it appears as a positive amount under income, below sales, this means that the company has produced more than it has sold during the financial year.  Since finished product inventories are valued as the sum of the production costs that resulted in them taking their current form, they included the cost of the raw materials that they required.

In other words, by recording change in finished products inventories as a revenue, it’s as if we were recording them as negative amounts of the consumption of raw materials, in order to obtain, in the end, only the consumption of the raw materials needed to product the products sold during the financial year.   In fact, increasing revenues or reducing expenses by the same amount will have no impact on the result which is the balance.

The same can be said, for example, of personnel expense, which is recorded as an expense for the financial year, even though a part of the work performed contributed to making the products that will be sold the following year.  But this isn’t serious since this part will be found in the finished products inventories at the end of the financial year, and thus in the change in finished products inventories that will reduce the apparent expenses in the determination of the earnings (losses) for the financial year.

From a teaching point of view, it would perhaps be simpler to deduct them from expenses, and not record them under revenues, so that it would be clear that these are not a form of income like sales, but expenses that have been “over-counted”.  But that’s the way it is.

(1) For more on the different formats of the income statement, see chapter 3 of the Vernimmen.