As investors around the world are beginning to find out, there is no worse catch-22 than a rights issue. With credit almost non-existent, companies are turning to their shareholders for cash at a time when most people have very little of it to spare.
In London last week, Xstrata, one of the world's largest mining groups, asked for £4 billion (Dh21bn), Cookson, an engineering firm, asked for £240 million and there are rumours that Rio Tinto, another miner, may also seek an additional £4bn in shareholder funds.
In the Middle East, Kuwait's Gulf Bank raised $1.3bn (Dh4.7bn) through a rights issue that was heavily backed by the Kuwaiti Investment Authority and it seems likely that other firms in the region will also have to turn to their shareholders in the coming months.
For investors, these rights issues present a terrible dilemma. Companies usually only tap their shareholders for more funds when things are going badly, which also usually means that the share price has tanked. Investors already sitting on big losses are, therefore, asked to pump more money into the company. The old saying "don't throw good money after bad" suddenly becomes highly pertinent and investors have to weigh the risk of giving a struggling company more of their cash.
Alternatively, if an investor rejects the rights issue they will see their holding in that company diluted as other investors pump in funds. This catch-22 is daunting: put more money into a business that is failing or avoid it and see your holding reduced in value even further.
Investors are going to have to get used to this catch-22 dilemma because it seems likely that they will be asked for additional funds numerous times in the coming year. Goldman Sachs has estimated that up to $500bn may be sought by companies through rights issues in 2009. Clearly, some of these businesses are going to fail to convince investors to pump in more cash.
This has already happened in the banking sector where the first wave of recapitalisation was done last year but was insufficient to stop the rot. Banks are still coming back to investors for more but the well is now so dry that most are having to ask for government backing – or, in the case of Gulf Bank, for assistance from a state-owned investment vehicle.
The miners will be next in the rush for additional funds as they have seen a collapse in commodity prices over recent months that makes the housing downturn look like a blip. In addition, their operations are so vast and expensive that overheads cannot easily or quickly be reduced.
For miners such as Xstrata and Rio Tinto the big concern is being able to meet their debt obligations. The drop in commodity prices means that projected income for this year will be much lower than expected so Xstrata has launched a rights issue to ensure that it does not breach its bank covenants. Rio is in a slightly different position in that it is unlikely to breach covenants but it does have to find $8.9bn by October to repay part of its $39bn debt mountain.
Rio had hoped to reach this target by selling assets and cutting capital expenditure but admitted last week that it was also considering a rights issue. The worry for investors is that even if Rio does come to the market for an additional £4bn, it might not be enough. The Anglo-Australian miner has to come up with a further $10bn debt repayment in 2010 and unless there is a dramatic recovery in commodity prices or the credit markets (to allow rivals to buy its assets) there could be a second call on shareholders – and that really will test investor patience.
The next sector that can expect to see a flood of rights issues is property and this is clearly something that should concern investors in the Gulf. Like the miners, property developers borrow heavily to start projects and are then lumbered with huge ongoing costs that cannot quickly be cut. So, when sales start to fall they are disproportionately affected and must seek cash injections or risk defaulting on loans.
So, which side of the catch-22 dilemma should investors fall? Accept the rights issues, invest more and hope for the best or cut their losses and see a big dilution in their holdings? The answer depends on where a company falls in the recovery cycle.
If, like the banks last year, a company seeks extra funds without knowing the full extent of the damage still to come then investors should cut their losses and run like mad. But if there are signs of recovery and the company has management that can be trusted then jump in because sometimes doubling up on a bet can pay off big.
- The writer is a business correspondent with The Times of London