BUSINESS VIEW : High cost of capital raises spectre of new Big Bang
Friday 21 June 1996
If it does grasp the nettle and set up a full-scale MMC inquiry, perhaps in the autumn, the only predictable thing about the outcome is that it is likely to lead to radical changes in the way the City operates.
Some of the more nervous already see this as the corporate finance equivalent of the OFT inquiry in the early 1980s that sparked the reforms of the Stock Exchange that led to Big Bang.
At present, the main way for companies to raise new equity capital in the UK is the underwritten rights issue, in which existing shareholders have a legal right to first refusal of new shares, and City institutions usually guarantee, for a fee, to buy any shares not taken up. In this way the risks are spread widely round the markets.
If this system of pre-emption rights combined with underwriting were to disappear or be seriously weakened, the big international investment banking and securities houses could sweep the smaller corporate finance and broking players off the field. Only the international houses have sufficiently strong balance sheets to cope with the alternative methods of raising capital, which involve advisers taking large quantities of shares on to their own books and selling them direct to investors rather than spreading the risk around the City.
Not surprisingly, self-interest has deeply divided the City between those who like the present system, those who would prefer to tear it up and start again, and a third group somewhere in the middle that believes pre- emption rights and underwriting should be kept, but in a watered-down form.
The idea that there is a unified City view is a complete illusion, as the vested interests scrap among themselves and accuse each other of multiple conflicts of interest. For example, the fee-earning sub-underwriters are the same institutions that also buy most of the shares, so they hardly have a neutral interest in the price.
But the rights issue argument is only a part of it. What was once an arcane subject confined mainly to the corporate finance textbooks is growing into a much wider debate about the cost of capital. Does the way the City raises capital for companies hold back British industry?
John Mayo, finance director of drugs giant Zeneca and a member of the Confederation of British Industry companies committee, is one of those who believe the City's methods are a hindrance to British competitiveness because they raise the cost of capital. The employers have set up a committee expected to make recommendations to the OFT this summer. The Treasury is also said to be questioning current practice for the same reason.
Several intertwined questions complicate the debate and they will require a great deal of patience from the MMC if it is to disentangle them. The first is whether pre-emption rights should be kept; the second is the high level of fees charged for rights issues by advisers and underwriters; and the third is how the overall cost of raising capital through underwritten rights issues compares with alternative methods, in which share offers are open to all-comers.
The purist case in defence of the existing system, heard from big fund managers such as MAM, as well as from some of the independent merchant banks, emphasises first the supremacy of shareholders, as owners, over managers. They object to managements being allowed more freedom to sell shares to third parties at prices over which existing owners have little control.
This classic case is underpinned by a set of arguments about the discount to market price at which rights issues are made and its impact on the cost of a company's capital. Many companies wrongly believe the discount increases their cost of capital. Essentially, the size of the discount is irrelevant in a rights issue, because those who put up the new money still own the whole of the company. As owners, they are selling the new shares to themselves.
One difficulty is that companies nearly always promise to maintain dividends even on the enlarged equity after a rights issue. So arithmetically, the cost, in effect, of servicing the new capital does rise as the discount increases. Defenders of rights issues have two responses to this. One is that they would not object if companies did start slashing their dividends when they make rights issues, to reduce the cash drain.
This represents a highly significant shift of opinion among pension and insurance funds, away from their previous position of defending dividends at all costs. But their fundamental argument is that to regard dividends as the cost of capital is to measure the wrong thing. The real cost of equity to the shareholders who own the company is not the dividend but the opportunity cost - what they would get if they put their money elsewhere.
The important judgement, according to defenders of the system, is whether the managers of the company will make an adequate return on investing the new money they are handed by shareholders. Only the existing owners are entitled to make that judgement, so therefore the rights issue must stay.
Most defenders of pre-emption rights accept only one serious argument against the present system: that the City's fixed underwriting fees, which have held steady at 2 per cent for the last 40 years, are too high and ought to be brought down, preferably by increased competition.
Studies by Paul Marsh of the London Business School have suggested that the fees amount to profiteering on a grand scale, and while the Bank of England disputes his figures it has accepted that there are excess profits.
The real problem is that all these arguments for the status quo only hang together if the capital markets are seen as a closed world, where British industry is owned and funded by British institutions. The case becomes much weaker, certainly for larger companies, the more they look to international markets for finance.
US companies, which have no preemption rights to worry about, can choose the cheapest market to raise equity capital, on either side of the Atlantic. British companies have no such flexibility: they are bound to go first to their existing shareholders, largely in the UK, and over the years they will be penalised.
At present, they can sell up to 5 per cent of their shares to new investors, without the restraint of preemption rights. They want this limit raised to at least 15 and preferably 25 per cent, so they can sell shares, as the Americans do, direct to new holders.
True, fees to investment bankers are even higher in the US. But the strong US preference for these more liberal methods suggests the overall cost of capital may well be lower.
In fact, by focusing on City underwriting fees John Bridgeman, director- general of the OFT, may be going down a blind alley. The best way to cut the cost of raising capital would be to encourage competition from alternative methods of raising equity, and that does mean easing the rules on pre- emption rights.
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