Forget CEO pay, the largest misappropriation from shareholders in recent years has occurred far less obviously — through the unfair and opaque capital raising process and the billions of dollars paid to investment banks. During the global financial crisis, when Australian companies clamored to raise precious capital to shore-up their balance sheets, investment bankers and their favoured institutional clients made out like bandits, according to a detailed report compiled by corporate governance experts ISS Governance Services (formerly RiskMetrics). In fact, the amount paid to investment banks in 2008/09 was three times the total remuneration paid to all the CEOs of the top 200 companies in Australia.
Not only did investment banks earn almost $2 billion in fees, but the placement and non-renounceable rights issue process was weighted very much in favour of particular clients of those banks, largely at the expense of retail clients. The majority (54%) of the funds raised we used to repay debt and strengthen balance sheets. In a touch or irony, those very companies were generally encouraged by their investment banks to increase leverage and rectify “lazy balance sheets” in the recent boom period.
The most popular way of raising capital in 2008/09 was done by way of private placements. This involves companies allocating shares directly to sophisticated investors. The advantage of this method is it avoids the need for a prospectus and can occur quickly. The problem with placements, especially those that provide discounted shares to institutions, is that it leads to a dilution in the value of non-participating shareholders’ stakes in the company. ISS determined that the average discount was 12% — in total, non-participating shareholders suffered a 19% dilution in the value of their holdings.
Unsurprisingly, the returns of the favoured few institutions that were given shares by investment banks were spectacular. ISS determined that an investor who participated in all 140 placements would have received a return of 22% on their investment (before dividends) in around six months.
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A further $31 billion was raised by way of non-renounceable rights offers. Share purchase plans, which are offered to retail shareholders (and give retail shareholders the chance to enjoy the discounted share offers) raised only $8 billion.
But the real winners from the capital-raising gold rush were investment banks. The role of an investment bank in a placement or rights issue is two fold. First, financial advisers such as Macquarie, Goldman Sachs and Deutsch Bank are responsible for arranging the transaction (which can include preparing a prospectus for a rights issue). More importantly though, financial advisers will often also underwrite the deal (most of the fees earned by investment banks are the result of their underwriting role). For companies, the benefit of having the raising underwritten is that the risk that not enough capital is raised is moved from the company itself to a third party (usually, an investment bank). For this privilege, most companies pay about 2% of the capital raised to the underwriter.
The kicker for investment banks is that while they ostensibly assume the risk of not raising the money, in reality, because companies tend to offer the shares at a deep discount to the market price, the risk is largely avoided. Moreover, investment banks are able to contact their favoured clients who will assume a large proportion of a placement very promptly, so the time period of the risk is often little more than a day or two (and in most cases, the shares were placed within a morning).
The perfect example was the Commonwealth Bank’s controversial December 2008 capital raising. CBA had initially appointed Merrill Lynch to manage a $2 billion private placement. Unfortunately Merrill and CBA failed to adequately tell investors about a profit downgrade at the bank and the initial placement had to be cancelled. CBA promptly appointed UBS to conduct the transaction. UBS spent less than four hours working the phones and was able to easily place the shares at $26 each ($1 cheaper than what Merrill had done and well below CBA’s prevailing share price). In return for what would have amounted to four hours and some phone calls, the folk at Swiss-owned UBS were paid about $30 million.
The CBA-fiasco wasn’t the only example of investment banks laughing all the way to the, well, bank.
Singapore-owned power company SP Ausnet paid Macquarie and UBS 75 basis points for their under-writing of entitlement offer. SP Ausnet was especially generous — it paid the investment banks an under-writing fee on the proportion of the funds raised on its own shareholding (which was 52%). Just to clarify, SP Ausnet paid someone to underwrite its own purchase. Perhaps it was worried about getting cold feet.
Similarly, embattled waste-management company Transpacific sought to raise funds by way of an accelerated renounceable entitlement offer in June 2009. Under the deal, Warburg Pincus, a private equity firm, agreed to take a “cornerstone” stake in the company. Warburg also agreed to sub-underwrite the entire retail component of the offer. Despite this, Transpacific agreed to pay Macquarie and Deutsch approximately $19 million in fees to under-write the sub-underwritten transaction.
But the easiest payday belonged again to UBS, the helpful Swiss bankers who were appointed by Asciano to raise capital after the company’s ill-fated attempt to monetise some of its assets in late 2008. Asciano initially sought to raise about $2 billion, of which $1 billion was being raised by way of an institutional placement. Possibly due to the substantial discount offered, UBS encountered extremely strong demand for investors and increased the size of the placement from $1 billion to $1.35 billion. Asciano then agreed to increase the size of the offer and UBS received an additional $7.9 million in fees for doing what appeared to be absolutely no extra work and assuming no further risk.
Admittedly, Asciano may have been grateful to UBS for other reasons. Coincidentally, UBS undertook a book-build on behalf of Asciano CEO (and major shareholder) Mark Rowsthorn, which allowed Rowsthorn to sell 40 million of his Asciano shares for $1.25 each. UBS then granted Rowsthorn a “collar” loan to enable him to acquire his full allotment of 76.2 million securities in the offer at the discounted price. The deal allowed Rowsthorn, who as CEO would have presumably played a large role in appointing and determining UBS’ fee, a “paper profit” of $10.2 million.
ISS makes several recommendations to improve the capital-raising process. First, ISS suggests that the lengthy prospectus process for entitlement offers should abandoned given that companies are required to provide continuous disclosure to the market under ASX rules. ISS also recommended that when allocations made under a non pro-rata basis (for example, where the underwriting bank is able to grant shares to its favoured clients), full disclosure of such distributions should be made to the market. ISS also recommended increased disclosure of fees that are paid to investment banks.