Do preferential issues shortchange the small investor?
Preferential allotment over rights issue restricts investor participation
It is observed that in the last few years, companies raised substantially more capital through preferential allotment than through rights issues. Is this corporate choice for preferential allotment resulting in a denial of opportunity to existing shareholders to participate in the corporate growth story?
Rights issue provides a legal assurance to the existing shareholders by providing them with an opportunity to invest in the company and participate in the growth of the company. Section 62 (1) (a) of the Companies Act 2013 provides this assurance.
However, if the management of the company is not sure whether existing shareholders will subscribe or if the money is required urgently then the company is allowed to raise capital from identified subscribers after taking shareholders’ approval through a special resolution. This mechanism of raising money is known as the preferential issue.
In the last decade of the Indian securities market, resource mobilization through preferential issues has exceeded rights issues.
The total amount of resources raised through preferential allotment in the last 12 years has been around ₹8.03 lakh crore, which is four times more than the rights issue ( ₹2.09 lakh crore) and also significantly higher than IPOs ( ₹3.34 lakh crore).
The year 2020-21, however, was an exceptional one where rights issues worth ₹64,059 crore took over preferential allotment ( ₹40,940 crore) in terms of resource mobilization.
This rise is particularly attributable to the rights issue of Reliance Industries Ltd. ( ₹53,124 crore); if this is not considered, the trend of preferential allotment exceeding the rights issue continued.
Over a period of time, Sebi has been undertaking various reforms with respect to the rights issuance process such as shortening the timeline of rights issue, enabling demat and trading of rights entitlement, rationalizing eligibility and disclosure requirements to make this mode of fundraising easier, faster and cost effective. Perhaps, due to these reforms, the mega rights issue of Reliance successfully penetrated its wide investor base of retail investors and institutional investors. This validates that the reachability through rights issue was smooth and is quite achievable. Yet, the rights issue route has failed to catch the imagination of other companies.
A random set of 37 preferential issues in 2021 were examined to gain some insight into the preferential allotment route for resource mobilization.
Most of these issues stated that “financing future growth opportunities and general corporate purpose" was the objective of fundraising.
If future growth was the objective, clearly it indicates that it was not urgent to raise the funds and rights route could have been adopted and if growth is foreseen why not share with existing shareholders?
What deters the companies to tap the existing institutional investors for such requirements is one question that needs to be looked into.
Preferential allotment may be a rational choice when existing shareholders are hesitant in making further investments if the company is not doing well. The pitching-in by promoters to supply the capital to spruce up the financial health of the company is understandable.
In our sample, 24% of allotments were exclusively made to promoters and primarily their objective was to strengthen the capital base, improve balance sheets and repayment of debt, etc.
While this could be one reason for choosing this route, there were also cases where promoters aimed at strengthening their shareholding and minimizing the dilution impact of QIBs.
Another reason for preferential allotment could be that companies are interested in inducting strategic partners who can bring in immediate capital and technology to take off at a higher level (there were 20% such cases in our sample data). The other reason for preferential issue route could be increased working capital requirements.
Were such preferential allotments in the interest of preferential allottees or shareholders?
Analysis of the price performance of the sample companies post preferential issues shows that 96% of them had a distinct upward price movement after the allotment. Had the existing shareholders been offered these shares, they would have also benefitted. This trend suggests that perhaps choice of preferential allotment over rights issue denied opportunity to the existing shareholders to participate in the growth of the company and existing shareholders were shortchanged.
