Perceived under or overcapitalisation can damage a company’s share price and destroy value for investors. A sound strategy for such a situation is paramount, says Jan de Ruiter, joint CEO of ABN AMRO Rothschild.

The absence of a maturity date on a company’s equity capital does not mean that one should fail to have a clear strategy in place on how to manage one’s equity position. Equity investors have become increasingly interested in a company’s balance sheet and credit ratings – and perceived under or over-capitalisation is reflected immediately in a company’s share price. Companies should therefore have an adequate tool set in place to respond to this challenge. An imbalanced debt to equity ratio will result in value destruction for its equity investors.

Under-capitalisation

During the bear market of 2000–2003, the market witnessed many situations where stretched balance sheets resulted in depressed valuations of both a company’s traded debt as well as its equity price. In situations where a company’s debt has been downgraded to levels of BB or lower, its equity will most likely trade with similar distress characteristics (such as high volatility, large turnover, and few long-term holders).

In many of these cases, additional equity has been raised through (deep) discounted rights issues. The result has nearly always been that, due to the improvement of the balance sheet, long-term investors came back to the company’s register as the risk of holding the equity declined significantly. One example is the German bancassurance giant, Allianz.

Allianz, hit by losses in its banking arm and its investment portfolio, undertook a significant capital strengthening in May 2003. During the first few months of 2003 its share price declined from almost E90 to a low of E40 in March, underperforming the German DAX Index by about 30%. On April 9, the company announced a seven for 15 rights issue, an increase in the company’s issued shares by 47%. At the low of the market, in March 2003, the market cap of Allianz had dwindled to approximately E11bn. The rights issue aimed to increase the equity base initially by E3.8bn, but as the deal was welcomed by investors as the right medicine, at the right time, the deal was upsized to E4.4bn while leaving the ratio of seven for 15 unchanged.

Since the successful closing of the rights issue, the DAX increased by 36% while Allianz rose by 53% (having outperformed even more significantly previously, see graph). The company’s market capitalisation is back to E36bn and it is a clear illustration of how effectively an equity injection can unlock a lot of additional value for both its debt and equity holders.

Rescue rights issue

Yet another striking example occurred early in 2004, when Dutch electrical wholesaler, Hagemeyer, embarked on a rescue rights issue of E460m combined with an offering of E150m subordinated convertible bonds.

At the time of the deal announcement in December 2003, the company’s share price traded at E1.66, valuing the equity at E180m. Between the announcement of the financial restructuring and the actual launch of the transaction in early January, the company’s share price drifted further to a low of E1.33. The company’s share deterioration was largely because many observers had expected the company to solve its financial issues by issuing new shares to a venture capital firm. Once it became clear that the company had chosen a standalone approach, some investors doubted the possibility of a successful outcome.

The proposed rights issue was indeed very bulky, asking shareholders to buy seven new shares for every two shares they already owned in the company. On January 15, from a market level of 1.33, the fully underwritten rights issue was launched with a subscription price of 1.20 for the new shares, leaving the underwriters very little margin for error. After a hesitant start, the shares started to appreciate, ending at 1.78 at the close of the subscription period. The key reason that the equity performed so well, was that the company had been able to convince its shareholders with a credible equity story, based on a sound financial platform.

ABN AMRO Rothschild won the mandates for both these transactions and executed them as sole global co-ordinator.

Over-capitalisation

The issue of (perceived) over-capitalisation is more difficult to tackle, but will have a similar impact on a company’s market valuation if not addressed properly.

Over-capitalisation is often seen as a sign that a company is going ex growth, a statement no company likes to make to the markets: slower or no growth will result in contraction and the de-rating of a company’s share price. De-rating may itself further impact on the firm’s ability to grow as the company’s shares – an important capital base for acquisitions, for example – will be valued lower by the market.

The burning question, therefore, is how to avoid this trap? The key is for the company to honestly acknowledge the phase it is going through, and to adapt its equity base to this evaluation. Most investors will come to the ex growth conclusion more easily than an executive board will do. Investors will quite simply re-balance their portfolios, take money out of one stock and re-invest in a company they believe to have a better growth profile. As such, denial of the perceived – and maybe temporary – ex growth characteristics of the company, will not prevent the stock from being de-rated in the first place.

Management tasks

Management will need to look for new growth areas that can be achieved at reasonable cost. At the same time, they may need to re-balance the return on their share capital from capital appreciation to (direct) yield. Recent examples of firms exploring these avenues are telecoms companies Swisscom and KPN of the Netherlands, which have both embarked on share buy-back programs to return excess cash to shareholders.

Unlocking value for your shareholders by means of addressing overcapitalisation can be a tedious and difficult process. However, the issue must be addressed through both increasing direct returns (dividend yield, share buy backs) as well as looking for new growth areas. Both themes need to be communicated in a clear and transparent way to the company’s shareholder base.

Both over and under-capitalised balance sheets result in a sub-optimal valuation of a company’s stock price. As such, it is advisable to have a strategy in place that looks at this issue on a regular basis. Peer group comparison can be a very powerful tool, as this is the way investors will decide when to buy a company’s stock, or that of a competitor.

Jan de Ruiter is joint chief executive of ABN AMRO Rothschild, the equity capital markets joint venture between the ABN AMRO and Rothschild groups

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