Cash-strapped banks - and other companies - are striking deals that favor new investors over existing shareholders
Since the credit crisis began gripping the world’s financial markets, a succession of marquee-name banks including Royal Bank of Scotland (RBS), Wachovia and Washington Mutual (WaMu) has been striking a flood of deals to raise new capital.
It’s not chump change, either. Financial institutions have raised more than $100 bn so far this year, exceeding last year’s pace and reflecting Europe’s largest funding transaction ever, at $24 bn.
It seems each day brings another story about a financial institution, weakened by subprime lending exposure and massive write-downs, seeking to shore up reserves. The financial sector may have been the most active in raising new capital, but it’s not alone. Energy firms had infusions of $5.5 bn and healthcare firms $2 bn through April, according to the equity research team at Keefe Bruyette & Woods (KBW).
It’s a lot for IROs to handle. ‘We are seeing more and more companies coming to market almost every day,’ says KBW banking analyst Frederick Cannon. ‘The shorthand from regulators to banks is that you can’t have enough reserves, you can’t have enough liquidity and you can’t have enough capital.’
To raise cash, banks are selling common stock, interest-paying ‘preferred’ stock and rights issues to myriad private equity firms and investor groups. The deals are attractive, often at a big discount to market prices. But these extra shares are a thorn in the side of current shareholders: more shares mean a larger base over which to spread corporate earnings, so earnings per share fall and the stock price usually follows.
The pain has been widespread. Shareholders of Cleveland, Ohio-based National City saw an offer dilute their holdings by 70 percent. Owners of Société Générale, the French bank stung by a rogue trader’s losses, saw theirs shrink 30 percent due to dilution from a special rights offering. RBS shareholders lost 46 percent.
‘There was a dilution in our shares, too,’ says Scott Adams, a pension fund adviser for the American Federation of State County and Municipal Employees (AFSCME). AFSCME is a 1.4 mn-member organization with investment positions in many US banks, including WaMu, which recently raised $7 bn.
These common shareholders can also take a potential hit from an institution issuing preferred stock to raise cash. Preferred stock pays a debt-like guaranteed interest payment. That’s attractive to buyers, but it reduces free cash flow. Also, preferred shares can generally be converted into common shares in the future, creating additional dilution.
Many buyers thought preferred stock was a ‘great deal’ because equity prices had fallen so far and it appeared they could convert in the future at attractive prices, says Nouriel Roubini, a business professor at New York University and founder of economic research firm RGE Monitor. But equity prices for many institutions and US banks ‘fell sharply after these deals were done,’ he adds.
Kal Goldberg, managing director of Financial Dynamics’ special situations team, has a different take. ‘When you look at the stock charts on the transactions that have been done, it’s not as precipitous a reaction as you might think,’ he says.
Necessary step
While dilution may be tough for shareholders in the short term, the situation would likely be worse with no recapitalization. Raising capital reduces uncertainty and default risk, and benefits the stock price outlook even though the extra shares also dilute current shares. ‘Basically, you need to strike a balance between the two,’ says Cannon.
Goldberg, a former investment banker, says it is important to be able to communicate the transaction’s details and fund-raising constraints as broadly as possible to shareholders and the market. The deals must usually be completed in a compressed time frame, and must comply with the demands of regulators, ratings agencies and other important constituents. ‘The fact that you have to raise the capital in a tight window of time means it is very difficult to structure these transactions where you involve existing shareholders,’ Goldberg explains.
An effort to raise capital does send a signal of confidence from professionals who have studied the business and are risking their own cash. ‘The point is to communicate that there are smart people who believe the assets are still good,’ Goldberg says.
Kerry Killinger, CEO and chairman of WaMu, got this message. He sold his deal, which had private equity firm TPG as an ‘anchor’ investor, as ‘a vote of confidence from some of the smartest, most sophisticated investors around’ at the AGM.
Other concerns
Shareholder pocketbook issues are important, but they aren’t the only issues at stake. For example, some are taking the opportunity to raise related governance concerns. ‘There does seem to be some shareholder outrage, and a lot of this is coming from union funds that have a particular ax to grind on executive pay,’ explains Drew Hambly, an assistant vice president in the corporate governance group at Moody’s Investors Service.
Hambly is aware of investor anger over executives at troubled institutions ‘who made a lot of money on the run up’ either not being punished or being awarded hefty severance packages on the way out. ‘That has particularly irked a lot of the pension funds, and you see a lot of shareholder proposals and anger directed at that,’ he adds.
AFSCME has problems with WaMu protecting its incumbent management after performance suffered so badly. WaMu ‘shielded these executives from exposure to the subprime and credit fall-out’ when calculating their bonuses this year, Adams asserts.
WaMu also cut a deal with TPG that ‘rewarded bad behavior at the expense of shareholders,’ Adams says. WaMu kept current management in place in favor of competing deals that might have put those jobs at risk. ‘That’s not how a cash infusion should happen,’ Adams adds.
There are also some issues with the composition of the new investor groups. Selling stakes to sovereign wealth funds, which have been stepping forward as white knights for banks, brings the potential for political backlash, for example.
‘People are worried about the Chinese or the Gulf states taking control of financial institutions,’ Roubini says. If those concerns are real issues, companies can offer preferred shares – which generally have no voting rights – to shore up capital levels while maintaining existing channels of control, he adds.
When will this be over?
With rising delinquencies in areas like mortgages, car loans, credit cards and commercial loans, the end of this cycle is not yet imminent. Goldberg says the rescues and infusions at high-profile banks have been well publicized, but smaller banks are in distress too.
‘The challenge is that we don’t think every company that needs capital is necessarily going to be able to raise it,’ Cannon explains. ‘There may not be any value left in some organizations.
‘Obviously, postmortem, there was a true lack of understanding of all the risks involved, and boards and management teams will have to do a better job in future so the need for emergency capital infusions doesn’t arise.’
Hambly agrees. ‘In the future, there will be more pressure for banks to be a little more risk-averse than they’ve been for the last two or three years, until this sorts itself out,’ he says. And Roubini adds: ‘Most people believe the worst is behind us, but I am a pessimist. I think the worst of the financial losses are ahead of us.’
