Equity Issues and the Disappearing Rights Offer Phenomenon

Abstract

The rights offer method - in which current shareholders receive short-term warrants to purchase a new share issue on a pro rata basis - were once the dominant method for U.S. public companies to raise equity. However, despite the low direct issue costs of rights, since 1980 a mere 2.5% of U.S. public industrial issuers have used rights. Rights offerings have continued to be the dominant issue method in Europe as well as much of Asia during this period. But even in Europe, there has been a clear trend toward various forms of underwriting, especially as listed European companies have grown in asset size and ownership has become more dispersed. I explain why the cost of rights is likely to be prohibitively high in larger companies with a fragmented shareownership structure. The discussion centers on the adverse selection argument originally developed in Eckbo and Masulis (1992) and which implies that a rights offer is the lowest-cost flotation method provided current shareholders are expected to buy and hold the new shares. When shareholders sell their rights to outside investors, the rights method becomes expensive because it fails to address investor concern that the issue (and therefore the rights) are overpriced. For sufficiently low expected shareholder takeup, issuers should consider hiring a reputable investment bank to certify the quality of the offering, and abandoning the rights become optimal. I also discuss empirical evidence which lends support to this argument.

Keywords: Seasoned equity issue, rights offer, underwritten offer, shareholder takeup, adverse selection, issue costs

JEL Classification: G24, G32