Economics: A capital way for the City to calm its critics
Innovations in underwriting fees could cut costs for business and pacify the OFT, argues Peter Rodgers
Sunday 03 November 1996
A pounds 222m rights issue for the Glasgow hotels group Stakis included an auction of part of the underwriting, which resulted in a saving of pounds 400,000 for the grateful company, more than 8 per cent of the total costs of the issue.
A small amount perhaps, but the Schroders innovation has wide political and economic ramifications, accounting for the excitement it generated in the City when it was announced on Thursday morning.
The reason is that the initiative was a direct response to a fierce dispute over the cost of raising capital for British industry. This controversy has aroused the interest of the Treasury, the Office of Fair Trading and the Labour Party, and has split the City down the middle.
For those who have not been following what began as an arcane debate among financial economists, the row was sparked off by the fact that, for decades, merchant banks, brokers and investing institutions have charged a fixed commission for raising money for companies in rights issues of new shares.
The bank that arranges the deal receives 0.5 per cent of the value and the broker 0.25 per cent. The pension funds, insurance companies and other institutions that sub-underwrite - promising to buy the issue if it is not bought by the company's shareholders - receive 1.25 per cent, with a top-up if the underwriting period is extended.
The rates have always been the same, regardless of the size or reputation of the company. It is this aspect that raised the hackles of the OFT and led to two inquiries, the second of which is nearing completion.
By showing that there is potential for competition, Schroders and its City allies hope to persuade the OFT not to recommend an MMC investigation. They may well win more time to demonstrate that the new and more flexible methods are working.
There are some obvious advantages to the fixed commission system. It is quick and simple, and small or risky companies probably pay less than they would with variable commissions. But the economic evidence is that big, safe companies are heavily overcharged.
The fixed fee is intimately bound up with the system of pre-emption rights, in which existing shareholders have a legal right to first call on all new issues of shares by a company.
That in turn has prompted questions about whether the present system keeps the cost of capital high, damaging industrial investment - a conclusion drawn by Labour Party advisers and some Treasury officials.
Closely related to this is the allegation, made by a number of US investment bankers in London, as well as Labour advisers, that the City system promotes a culture of high and rising dividends, further damaging British industry.
Schroders, other traditional London merchant banks and almost all the investing institutions are strong defenders of pre-emption rights. In contrast, integrated investment banks with their own dealing operations such as Morgan Stanley and SBC Warburg would like to see these rights substantially eased to allow companies to sell 15 or 25 per cent of their equity as new shares to fresh investors, without first offering them to existing shareholders. The present limit is 5 per cent.
The not-so-hidden agenda is that this would allow them to promote wider use of US-style bought deals, where a rich bank with lots of capital buys the whole of an issue and sells it for a fee - often several times higher than the fixed commission rate charged in London.
Each side claims the other's methods are more expensive for companies. Advocates of bought deals say this system allows them to find new international markets for stock, getting a higher price that more than offsets the stiff fees.
But this is hotly disputed by defenders of rights issues, who argue that the price advantage is an illusion because stock sold abroad nearly always drifts back to London and depresses the market.
The fact is that new shares issued under the City's present system of pre-emption rights could remain a cost-competitive way of raising capital, compared with US-style bought deals - if there are two basic reforms.
One is the introduction of a more flexible commission system, taking Schroders' innovation as the starting point. The Stakis issue proved that there is money to be saved.
The drawback is that a small, obscure company might find its commissions higher in a genuinely competitive market. On the other hand, with an ICI or Zeneca rights issue and a more extensive auction, there might have been a more dramatic reduction than Stakis' 8 per cent.
For such companies, a deep discounted rights issue, where the discount is set so high that no sub-underwriting is required, ought to become the norm - getting rid of sub-underwriting commissions.
The other essential change to make the present system more competitive relates to dividends.
When a company sells equity through a rights issue to its existing shareholders, the new shares are invariably offered at a discount to the market price. In theory, this discount ought to cost the company and its shareholders nothing, because the benefit goes to the existing owners. In practice, though, there is a hidden cost that makes the new capital more expensive than it should be.
This arises because selling new shares at a discount is arithmetically equivalent to making a free - or scrip - issue. To allow for this, companies ought to adjust their future dividends per share downwards. If they do not, the total cash cost to the firm of the dividend will rise, making the capital-raising exercise more expensive than it should be.
The reality is that companies fear a bad reaction from shareholders unless they announce a maintained or increased dividend per share when they raise capital. This undermines the City's defence of the pre-emption rights system as a cheap method, compared with bought deals. The inflexibility of dividends provides powerful ammunition for critics.
Technical stuff, maybe, but much is at stake. Both the National Association of Pension Funds and the Association of British Insurers have advised their members to be receptive to more flexible dividends after rights issues.
Ideas such as Schroders' auction are a clever way of defending the status quo against the OFT. The second obvious defence is to persuade the City that dividend restraint at the time of a rights issue is in the interest of companies, because it makes their new capital cheaper and more competitive.
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