Areas of Opportunity for Value Investors: Investing in Rights Offerings

Rights offerings are more esoteric than many other investments and for this reason may occasionally be of interest to value investors.

Some rights offerings present attractive bargains, but many are fully priced or even overpriced. 

Investors may find this an interesting area to examine but as usual must do their homework.

Unlike a typical underwritten share offering, where buying by new investors dilutes the percentage interest of current shareholders, in a rights offering shareholders are given the opportunity to preserve their proportional interest in the issuer by subscribing for additional shares. Those who subscribe retain the same percentage interest in the business but have more of their money at stake. Investors who fail to exercise their rights often leave money on the table, creating an opportunity for alert value investors.

• Rights offerings can effectively compel current shareholders to put up more money in order to avoid considerable dilution of their investments. By way of example, assume XYZ is a closed end mutual fund with one million shares outstanding, which trade at a price equal to the fund's net asset value of $25. Further assume that XYZ, seeking to raise an additional $15 million to take advantage of market opportunities, issues every holder a nontransferable right to buy another XYZ share for $15. If all holders subscribe, then immediately after the rights offering XYZ will have two million shares outstanding and $40 million of total assets, or $20 per share. If holders of 50,000 shares do not exercise their rights, while holders of 950,000 shares do, the 1,950,000 shares outstanding after the rights offering will have a net asset value of $20.13. The investors who subscribed will have an average cost of $20 per share, while those who did not will have an average cost of $25. Since nonsubscribers will suffer an immediate loss of almost 20 percent of their underlying value, all holders have a powerful incentive to subscribe. Some rights offerings give holders the opportunity to oversubscribe beyond their own proportional interest for shares that others do not buy. In the case of XYZ, investors who chose to oversubscribe for the 50,000 shares left unsold at the original offering could have made a quick $250,000 buying those shares at $15 and promptly selling them at the pro forma net asset value of $20. 
• Companies occasionally employ a rights offering to effectuate the initial public offering of shares in a subsidiary.  In 1984, for example, Consolidated Oil and Gas, Inc., utilized a rights offering to bring its Princeville Development Corporation subsidiary public. Consolidated was an overleveraged energy company that owned some attractive Hawaiian real estate properties, which were held by its Princeville subsidiary. To separate the Hawaiian properties from the rest of the business while preserving the value of those properties in shareholders' hands, Consolidated conducted a rights offering. Under its terms shareholders of Consolidated were offered the right to purchase one share of Princeville for each share of Consolidated they owned. The initial offering price, $3.25 per share, was arbitrary, according to the prospectus, and considerably below Consolidated's cost basis in Princeville. When the rights started to trade, little information had been released by Consolidated Oil and Gas concerning Princeville. The prospectus was apparently not yet publicly available. In the absence of publicly available information, some rights traded for as little as 1/32 and 1/64 of a dollar per right. Alert investors willing to make an educated guess were able to earn an enormous profit on this obscure rights offering; upon completion of the offering, the market price of Princeville quickly rose above $5 per share. Rights that traded as low as 11/2 cents rose in price to nearly $2 only a few weeks later