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

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 offersThe 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)

September, 2008

Select book-runner and co-managers

Registration

Marketing, road show, andbook-building

Issue final prospectus, pricing, and allocation

Announcement of the filing

Trade begins

2 – 3 weeks

Prepare preliminary prospectus

The Bought Deal Process (Figure 1)

September, 2008

Investment banks submit bids after the close of trading

Bank that offers the highest net price wins

Re-sell the shares

Announcement of the filing

Trade begins

Usually overnight

Registration

The Accelerated Bookbuilt SEO Process (Figure 1)

September, 2008

Select the book-runner

Accelerated bookbuilding

Pricing and allocation

Announcement of the filing

Trade begins

Usually 1-2 days

Registration

Demand Curve without Marketing

September, 2008

1P

2P

1X 2X

NX p

Supply

Demand

Price

Quantity

Marketing Effects

Marketing flattens the demand curve

Marketing changes current shareholders’ beliefs

Marketing increases the number of investors paying attention to the stock

Demand Curve with Marketing

September, 2008

1P

2P

1X 2X

*P

Price

Supply

Demand

With Marketing

Without Marketing

Quantity

NX p

N M X p

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

September, 2008

1P

2P

1X 2X

Supply

Demand Signal of Overvaluation

Quantity

Price

Announcement Returns

Announcement returns incorporate anticipated price pressure effects

Otherwise an arbitrage opportunity exists

What We Observe on the Announcement Day

1P

2P

1X 2X

P

Supply

Information and Price Pressure

Demand

Quantity

Price

Number of SEOs by Year and Offering Method

  Sample SEOs   Bought Deals  Accelerated Bookbuilt

SEOs  Fully Marketed SEOs

Year Number

Total Proceeds ($

billion)

  Number

Total Proceeds ($

billion)

  Number

Total Proceeds ($

billion)

  Number

Total Proceeds ($

billion)

1996 400 43.38 1 0.06 0 0.00 399 43.32

1997 359 32.30 2 0.45 8 1.40 349 30.45

1998 250 24.52 8 1.40 2 0.03 240 23.05

1999 298 32.03 19 2.51 2 0.32 277 29.20

2000 311 49.16 27 2.94 2 0.07 282 46.15

2001 232 32.18 35 6.34 17 1.47 180 24.38

2002 223 37.86 25 5.48 41 10.36 157 22.02

2003 254 28.25 36 6.09 42 5.15 176 16.88

2004 283 28.06 35 4.51 51 6.58 197 16.90

2005 219 21.95 32 3.91 29 3.17 158 14.87

2006 236 19.37 43 3.73 36 6.58 157 11.88

2007 211 20.91   27 1.99   46 3.17   138 14.52

Offer Characteristics (Means)

  All SEOsBought Deals

Accelerated Bookbuilt SEOs

Fully Marketed SEOs

Normalized Market Capitalization ($M) 1,183 2,795 2,718 855

Normalized Proceeds ($M) 176 220 208 168

Relative Offer Size (%) 22.53 9.26 11.37 25.09

Number of Days from Filing to Offer 26 0 1 31

Average Gross Spreads Conditional on Offer Mechanism

  All SEOs Bought DealsAccelerated

Bookbuilt SEOsFully Marketed

SEOs

Gross Spread (%) 4.82 2.28 4.23 5.10

Average Announcement Effect and Underpricing

  All SEOs Bought DealsAccelerated Bookbuilt

SEOsFully Marketed SEOs

Announcement Effect (%) -1.72 -1.49 -2.55 -1.66

Underpricing (%) 3.11 1.09 2.10 3.43