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Secondary offerings are back in vogue, with a few twists.
Vincent Ryan, CFO Magazine
September 1, 2009
CFOs at publicly traded companies typically have good reasons to avoid raising equity capital if they can help it. Investors tend to interpret seasoned equity sales as a sign of poor financial health or that a stock is overpriced. That translates into an almost automatic 3% drop in share price when the offering is announced. For most CFOs, that's a big pill to swallow.
But equity is making a comeback. Secondary offerings hit $60 billion last May, up from $19 billion in April and just $10 billion in the entire first quarter, according to the Securities Industry and Financial Markets Association.
Why the resurgence? One reason is that companies need to reduce leverage to a manageable level. Paying down debt with equity can take "the going-concern risk associated with high leverage out of play," says William Welnhofer, a managing director at Robert W. Baird & Co. Thus, investors are more tolerant these days of issuers raising equity to pay down debt, notes David Gruber, head of equity at KeyBanc Capital Markets.
Raising capital is also becoming less expensive, on a relative basis. "The cost of debt has risen and equity has come down slightly, so the gap between the aftertax effective cost of debt and the cost to issue equity has closed," says Joe Gentile, chief administrative officer at health-care investment bank Leerink Swann.
Finally, issuers are finding eager buyers for their shares. "Assets are flowing into mutual funds, so portfolio managers have the dry powder to buy shares," says Gruber. In the second quarter, net inflows into equity mutual funds totaled $39 billion, compared with a net outflow in the first quarter, according to AMG Data Services.
But that doesn't mean raising equity capital is a cakewalk. CFOs have to plan ahead to avoid the effects of dilution and squelch concerns that the stock is trading too high. "Investors have to be able to tell themselves another story about what the company is doing," notes Charles Cuny, a finance professor at Washington University in St. Louis. "When a company is very clearly taking on new investment and equity is tied to real expansion, the negative impact on the stock price is smaller."
Short marketing and transaction times, which enable issuers to minimize the effect of market volatility on the share price, are essential. "The longer you are out in the market — with the way the market is moving around — the greater chance you'll be caught with your pants down," says Christopher Malik, a senior associate at KeyBanc Capital Markets. In a so-called accelerated book build, a company can sell equity at a discount in one day, filing a press release after the market closes and pricing the transaction the next morning before the market reopens.
A PIPE with a Twist
Many companies are eschewing marketed secondary offerings and turning to private investment in public equity (PIPE). One variety, known as a registered direct deal, is gaining popularity. Of 391 PIPE deals in the first half of 2009, 19% were registered direct, up from 8% last year, according to Sagient Research. In a registered direct deal, the shares are registered with the Securities and Exchange Commission, then marketed to a small group of handpicked investors, who must sign confidentiality agreements and temporarily refrain from trading in the stock.
Regal Beloit, a $2.2 billion manufacturer of electric motors and generators, netted $150 million last May by selling the equivalent of about 13.7% of its outstanding shares through such a transaction. The shares priced at an 8% discount. Regal raised the money to preload for a possible acquisition, says CFO David Barta. "We didn't want to find the right acquisition opportunity down the road but [then find that] the terms weren't right," he says.
Barta says the firm chose the registered direct route because it's a "quiet approach" that limits the effects of market volatility. If necessary, the company could have stopped the process and pulled out. On the other hand, the transaction still put Barta and other executives in front of investors before the deal priced. "We were out on the road for three days," Barta says. In contrast, "when you do a deal overnight, the best you're going to do is conference calls."
Appealing to the Base
The Regal Beloit offering also provided a twist: in a move called a wall cross, it changed to a public offering on the final day, allowing other investors to get in on the deal at the same discount. "You don't get as wide an audience under a registered direct deal, because some firms have an absolute policy against registered direct," Barta explains. "They don't want to be locked up in the stock." In addition, he adds, "we felt that all of our shareholders deserved some advanced knowledge of the offering."
Indeed, companies are finding their current shareowners to be one of their best capital sources. When National Penn Bancshares needed to raise its equity levels late last year, it decided to go directly to its existing investor base. The bank holding company did so through its dividend reinvestment plan (DRIP), increasing the maximum optional cash contribution for purchasing stock to $50,000 and offering the stock at a 10% discount. It raised $75 million in eight months, or about 6.4% of its market cap, bringing its tangible common equity closer to the amount that analysts like to see on a banking company's balance sheet.
"We thought there would be demand from our existing shareholder base, and if you're going to do a fully marketed deal, the discount to your stock price is going to be 10% to 15% anyway," says National Penn CFO Michael Reinhard. The DRIP offering also incurred no investment banking fees, another plus.
The biggest drawback to raising equity through a DRIP is the time required. "A fully marketed capital raise can be done in a few days, whereas it took us eight months to hit our goal," Reinhard says. "Institutional investors can be interested in the DRIP, but the monthly maximum cash contribution must be sufficiently large to attract their attention."
One other catch: only about 1,500 public companies in the United States have DRIPs or direct stock purchase plans. The annual cost of administering such plans varies based on the number of participants; for National Penn it comes to about $25,000.
In general, the reluctance of management teams to issue equity — whether in highly public offerings or through more-targeted, less-public means — is fading, observes Cuny of Washington University. He says many companies will need to raise equity just to restore the natural balance between equity and debt. "A whole lot of debt distorts decisions," Cuny says. If a company has an extremely high debt-to-equity ratio, management has incentive to ratchet up the level of risk, because it's playing with the debtholders' money. But equity financing suits a time when companies are not making large strategic gambles. Equity holders feel the upside and the downside, so management has to act accordingly.
"There's an enormous backlog" of secondary offerings, says Gruber of KeyBanc Capital Markets. "The hope is that the economic data holds and fund flows continue to be positive. That sets us up for a market to do equity issuance."
Vincent Ryan is a senior editor at CFO.
All Quiet on the IPO Front
Judging by recent numbers, initial public offerings seem to be going the way of the Irish elk. In the first half of the year only 14 IPOs made it to market, raising $2.4 billion, according to Renaissance Capital, an IPO research firm. That's down from 35 offerings and $26.8 billion raised in the first half of 2008. Meanwhile, the number of IPOs withdrawn in the first half was more than double those that priced.
IPOs aren't really bound for extinction, of course; they are highly cyclical and come in waves. But the market needs a push from regulators, asserts Renaissance Capital. In particular, the firm is calling for greater transparency from underwriters and issuers, and tax breaks for investors. For example, Renaissance says issuers should have to immediately publish transcripts of road shows and conference calls, highlight all changes from the red herring to the final prospectus in black line, and disclose insider sales even faster than they do already.
But it's not the regulatory framework that is preventing access to markets, it's the performance of the markets themselves, says David Stone, chair of the corporate securities practice at Neal Gerber Eisenberg LLP. Many companies are just waiting out the economic uncertainty and volatility.
That's not to say the IPO market will rebound to past levels. Companies that want to do an offering in the next couple of years will have to provide realistic valuations as opposed to frothy ones. "The key is not whether the issuer is selling 25% or 50% of its equity, but more that the stake is reasonably valued," Stone says. Companies that did so this year, like Nasdaq's OpenTable, have produced strong returns for investors — in OpenTable's case, 52% in its first two months as a public company. — V.R.