Re‐equitizing Corporate Balance Sheets: Choosing Among the Alternatives

Abstract

Companies are generally reluctant to issue new equity because it can be expensive capital. Among the largest costs of an equity offering are so‐called “market‐impact” costs. To the extent the typically negative market reaction to a stock offering causes an issue to be underpriced, such underpricing dilutes the value of current shareholders.Despite such costs, many companies—particularly financial institutions—are raising equity capital to “delever” balance sheets that have been squeezed by the credit crunch and economic slowdown. And far from transferring value from existing shareholders, these offerings can preserve and even increase the value of highly leveraged companies by shoring up their capital bases and providing the flexibility to get through a difficult period. According to recent studies, announcements of equity offerings by distressed companies have been accompanied by positive stock returns in excess of 5 %.The challenge for CFOs is to determine why and when issuing equity is the value‐maximizing strategy. The kinds of companies that are most likely to benefit from equity offerings are those that score low on credit metrics, have experienced cyclical declines in operating performance, and have growth opportunities as part of their recovery.There are a number of options for raising equity capital, but no set rules for identifying the optimal one. Nevertheless, the author offers a number of suggestions designed to help CFOs make smarter decisions:Communicate clearly to investors the intended uses of the proceeds from the equity offering and how they are expected to create value;Consider judicious cuts to the dividend to preserve capital;Involve current shareholders to minimize dilution, perhaps by considering a rights offering, and strengthen their commitment;Seek out “smart money” such as private equity or SWFs as long‐term investors;Get the offer size right the first time so a second offering can be avoided; andMonetize volatility in uncertain markets by issuing convertible securities.