Wednesday, 19 September 2012

Rights issues: Reading the fine print can make you thousands

Regular readers would have noticed in my August 2012 expenditure tracker post that I was transferring a significant amount of money out of my home loan offset account into my share investment account.  I didn't give many details at the time but said that it was an investment which I hoped would result in quite a substantial short term gain.

This post will outline that investment and how you can make significant amounts of money out of equity raising's through over-subscriptions.  Often the ability to do this is only written in the fine print so you need to make sure you read over all of the fine print carefully whenever these opportunities arise.

Note that like all investments and opportunities that this carries potential risks.  I have outlined the major risks to this strategy below.

Oversubscriptions in equity raisings: the potential is there for large gains

When a company undertakes a significant equity raising they occasionally offers investors the opportunity to oversubscribe beyond their pro rata share for any untaken equity in the company.  I have posted about oversubscription facilities before on my post on how to make money out of share purchase plans.

However the reason that you can make much money out of a equity raising compared to a share purchase plan is because of the amount of oversubscription you can typically apply for.  In share purchase plans the oversubscription is normally limited to $15,000 while equity raisings are typically up to $100,000 oversubscription.

However the right to oversubscribe is often not very clear and only in the fine print.  The investment that I had which was doing an equity raising was the FKP Property Group's 6 for 7 non renounceable rights issue. The right to apply for an over subscription was pretty hard to find (and you would probably miss it if you were not specifically looking for it).

How do you make money through oversubscriptions?

Like in the case of share purchase plans you make money because the shares are being issued at a discount to the Theoretical Ex Rights Price (TERP).  This is the price that the shares should trade at post the equity raising.  The bigger the discount the more money you make from subscribing to the oversubscription shares.

In the case of the FKP raising above the TERP was approximately $0.29 (which is around what the shares were trading at post the announcement of the equity raising) and the equity raising price was $0.20.  If you subscribed for the full $100,000 over subscription and the price stayed constant you would make the following profit
  • Number of oversubscribed shares = $100,000 / $0.20 = 500,000 shares
  • Profit per share = $0.29 (current price) - $0.20 (price paid per share) = $0.09
  • Immediate profit = $45,000 (45% in just under a month)
As you can see from the above example the potential profits from oversubscription facilities are HUGE however there are several potential risks which you need to consider

What are the risks in participating in the oversubscription?

There are several major risks that you need to consider when participating in the oversubscription.  These include:
  • Being scaled back significantly on your oversubscription or not getting any oversubscription shares at all
    • This is exactly what happened to me the last time I applied for an oversubscription- I posted about it here
    • In this case you effectively lose money because your $100,000 has been tied up for a month and you are losing the interest you can potentially be earning on it.  If you have borrowed to undertake this strategy your potential loss is even worse (I would never borrow for this strategy)
  • The share price trades below the price you paid for the rights
    • This happens quite commonly as well
    • There is a lag between when you apply for the shares and when they are allocated to you and you can sell them.  During this time the share price can fall below what you paid for the rights
    • In the above example you lose $5,000 for every cent the share price is below the issue price
  • The profit you make may not be as high as you expect
    • The TERP is a theoretical price only.  The share price can fall to a level where you are not making as much as you would expect to make
    • The close date for the FKP shares was last Friday and the share price has come off several cents so my potential profits are already lower than I was expecting
The above risks are risks that are inherent in all equity raisings.   They are also the risks you face if you decide to sell your shares as soon as they are allocated to you. If you decide to hold them for longer you also face risks that the company goes bankrupt or that the market tanks or a range of other factors.  This is not a risk free strategy so make sure you understand the risks before you get into it.

What are other things you should consider with rights issues?

There are several things you should consider when you are participating in the rights issue including
  • What is the close date?
    • Often the close date is much closer than you expect.  In the case of the FKP rights issue - the retail rights were only open for 2 weeks instead of the usual month.  Anyone who did not realise this would have missed on their basic allocation as well as the potential for oversubscription
  • How do I participate?
    • Different brokers work differently - if you hold the shares in your own name the chances are that you have to transfer funds to the company or the registry yourself
    • Interactive Brokers has a corporate actions function which you need to navigate - I have posted on this before.  Also note that the Interactive Brokers deadline was before the actual deadline
  • How much should I put into this?
    • I put most of my free cash into the FKP offer.  This was significantly less than the $100,000 I could have put in but given the risks I did not want to borrow to invest in this opportunity
  • Is my bank account able to transfer the required level of funds?
    • My bank would only allow me to transfer $10,000 a day to my Interactive Brokers account.  If I wanted to participate up to the full $100,000 this would have taken a significant amount of time
Rights issues give you the opportunity to make thousands of dollars from oversubscriptions but they come with risks and you need to weigh up your own situation and risk profile before investing.  If you have any questions about them I am happy to answer them below so post a comment and I will reply as soon as possible.

You may also be interested in:
Making money from share purchase plans
Share purchase plans - when things don't go to plan
Corporate actions on Interactive Brokers

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