Over the last couple of months, you have probably seen or heard this term on multiple occasions, Auckland Airport, Z Energy, Sky TV, Cochlear and Ramsay Healthcare are all examples of companies who have recently announced capital raises – but what exactly does it mean?
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A capital raise is where a company issues new shares in exchange for additional funds (or “capital”). The specifics of each raise will vary, but new shares will usually be offered at a discount to current price, the size of which will depend on how confident the company is of full subscription, i.e. if a company is very confident demand for new shares will be high, it only needs to offer a small discount compared to a company that doesn’t believe demand will be as high and thinks the market will need more encouragement. There can often be two or three weeks between the offer price being announced and the closing date, meaning the offer price can become far more or less attractive than was initially intended. Sometimes the number of new shares available to an investor will be dependent on their current holding (i.e. pro rata), other times will be capped at a certain amount (i.e. up to $X each) or have no restrictions at all.
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Why would a company decide to raise capital?
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The benefit to a company raising capital is a quick injection of cash into the business, without needing to raise debt levels (and therefore interest costs). The reasons a company would require a quick cash injection usually falls into one of two main categories; the business is experiencing a cash flow problem and needs to strengthen the balance sheet, or the company has found a growth opportunity and needs cash to fund it (e.g. build a new factory, acquire a company etc.). Examples of each would be Auckland Airport (massive reduction in cash flow due to Covid-19) and Ramsay Healthcare (increasing it’s cash reserves, ready for opportunities in a global recession).
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What are the negatives?
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If discounted shares for you and more cash for the business sounds like a win-win, it’s unfortunately not that simple. Once a capital raised is announced, we will usually see the current share price be pulled down closer to the offer price. This is due to a couple of factors; 1) A change in the supply and demand dynamic. Investors are wary that people who receive new shares at a discount would be inclined to sell them and bank a quick profit, so therefore sell themselves and increase the supply. Investors who were thinking of buying more shares on market may decide to instead participate in the capital raise (if they’re eligible), reducing market demand for a while and 2) the issue of new shares has a dilutionary effect. The dilutionary effect is best explained with a simple example; Imagine a company with 1,000,000 shares valued at $1, giving that company a market valuation of $1m. Now imagine this company decided to raise capital by issuing another 1,000,000 shares, but at a discounted price of $0.80 (therefore raising $800,000). Assuming all else remained equal, we would now expect this company to be worth $1.8m (the original $1m plus the additional $800,000 raised) but as there are now 2,000,000 shares on issue, they would only be worth $0.90 each. This is a great result for investors who were lucky enough to receive the discounted new shares, but a bad result for the people who didn’t.
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Should I take part in capital raises?
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Unfortunately, there’s no blanket rule – each capital raise should be viewed on its merits these will vary greatly on your individual portfolio and situation at the time. Recessions and economic uncertainty will often lead to a spike in capital raises, so we’d expect a few more yet. Please don’t hesitate to contact your adviser if you’d like to discuss any.
