Active Intermediation of Non-Underwritten Rights Offerings by Mark Peterson

Rights Issues are a way of issuing new equity. They involve the firm giving rights to existing shareholders. These rights entitle the holder to purchase new shares at the subscription price (which is lower than the current market price).

Much research has look at rights issues. This has largely looked at who uses them, how they work, and why we don't see more of them (this latter point is often called the rights offering paradox of Smith 1977).

Mark Peterson offers new insights into this by examining shareholder behavior around rights issues by closed end funds.

SSRN-Active Intermediation of Non-Underwritten Rights Offerings by Mark Peterson:

His findings? That shareholders behave much like the the financial intermediaries (i.e. underwrites) studied by Singh (1997). That is, the shareholders appear to subscribe to more shares when there is an overallotment option (which is rational since the over allotment option allows those who fully subscribe to buy more shares), and actively hedge their positions by shorting shares.

In his words:

"The evidence presented is consistent with shareholders and brokers actively intermediating these offerings in a way similar to that of underwriters in underwritten rights offerings (Singh 1997). That is, intermediaries hedge the shares they purchase in the offering by simultaneously short selling the underlying stock."

Moreover, Peterson suggests that the costs associated with these strategies may explain the rights paradox. Notably:

"Large negative returns during the offering period, evidence of wealth transfers from non-participating shareholders to intermediaries, and difficulties associated with shareholder intermediation make the non-underwritten rights method highly impractical for widely held firms and may partially explain the rights offering paradox."

The paper also has some other "cool things about rights offers" that you may not have known. For instance,

* "Herzfeld (1996), in a survey of closed-end funds that issued rights, reports primary subscription rates of 50-60% for non-transferable offerings and 70-95% for transferable
offerings."

*"The offering of additional shares at a discount through the oversubscription privilege and over-allotment option provides incentives for current shareholders to attempt to purchase more than their pro rata allotment of shares and, therefore, receive a wealth transfer from non-participating shareholders."

*"54% of the non-transferable offerings and 69% of the transferable offerings include fees paid to brokers to aid in the solicitation of rights. In these offerings, the fee, typically 2.5% of the subscription price, is paid to brokers when they or their clients subscribe to the offering."

* and from footnote #7: "Subject to narrow exceptions, closed-end funds are prohibited...from issuing stock to the public at a price that is less than the net asset value. Because closed-end funds typically trade at a discount, a rights offering is frequently the only viable offering method. The SEC (1977)
discouraged the use of an underwriter in rights offerings, suggesting that such offerings were effectively offerings directed to the public."

I^3! (Interesting, Informative, and Important!) It will definitely force me to change my class notes!

Cite:
Peterson, Mark A., "Active Intermediation of Non-Underwritten Rights Offerings" (March 15, 2006). Available at SSRN: http://ssrn.com/abstract=891189