Equity underwriting and associated services

An OFT market study

January 2011

OFT1303

© Crown copyright 2011

This publication (excluding the OFT logo) may be reproduced free of charge in any format or medium provided that it is reproduced accurately and not used in a misleading context. The material must be acknowledged as crown copyright and the title of the publication specified.

CONTENTS

Chapter/Annexe Page

1  Executive summary 4 

2  Introduction 14 

3  Overview of equity capital raising 21 

4  The process of equity raising 29 

5  Market developments 41 

6  How equity underwriting services are purchased 63 

7  Conflicting interests 86 

8  Conclusion and next steps 97 

Annexe A Glossary 108 Annexe B Respondents: parties consulted 117 Annexe C Company survey responses 123 Annexe D Legal and regulatory background 141 Annexe E Data sources and econometric analysis 148

1 EXECUTIVE SUMMARY

1.1 The equity capital market is an important source of funds for both new and established companies in the UK. The long-term growth of the UK economy depends partly on the ability of companies to raise equity capital efficiently.

1.2 When they raise equity capital, companies usually engage one or more underwriters. Underwriters agree to purchase shares to be issued at a specified price, if the shares are not subscribed to by anyone else by a certain date, thus guaranteeing that the company will receive the proceeds of the issue. Underwriters also advise companies on how and when to raise equity capital and perform the administrative and distributional work associated with the share issue. It is usually investment banks that provide these services.

1.3 In 2009, 59 different companies within the FTSE 350 undertook 68 equity issues. FTSE 350 companies raised an estimated £50 billion of equity capital in the UK, paying an estimated £1.4 billion in fees for equity underwriting services. This scale of equity-raising was significantly higher than previously seen during the period between 2000 and 2007, when in each year there were fewer than 10 issues together raising less than £5 billion. The increase in the scale of equity raising in 2009 was largely due to the financial crisis which led a large number of companies to seek additional funding to strengthen their balance sheets.1

1.4 In early 2010, we became aware of company and institutional shareholder dissatisfaction with equity underwriting services. Prior to launching the market study, we held informal discussions with some corporate users of equity underwriting and associated services, and there was some public debate about the functioning of this market. Dissatisfaction focused primarily on increases in underwriting fees and discounts on rights issues. Discounts are designed to incentivise

1 Most of this additional funding was sought via right issues, the form of equity raising typically used where a company needs to raise a significant amount of equity capital).

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shareholders to take up the share offer, but they also reduce the risk that the underwriter will have to purchase unsold issued shares and therefore the value of the underwriting service provided.

1.5 This market study has examined equity underwriting services for the different types of follow-on share issues used by FTSE 350 listed companies to raise capital in the UK. We have looked at how equity underwriting services are purchased, how they are provided, and how the regulatory environment affects their provision, with the aim of understanding how the market works and identifying any concerns.

Key findings

1.6 There has been a significant increase in fees since the onset of the financial crisis. Average fees rose to more than 3 per cent in 2009 from around 2 to 2.5 per cent in the period from 2003 to 2007. In the same period, average discounts on rights issues rose to nearly 40 per cent from around 30 per cent. While such increases can be explained, at least in part, by the increase in volatility and risk in this period, our analysis suggests that fees and discounts have been slow to fall in line with subsequent reductions in risk, in particular from lower stock market volatility. In addition, while there was significant variation in fees and discounts for most of the last 10 years (which is likely to reflect variations in the risk of individual transactions), in 2009 there was significant clustering of fees and discounts. There are some indications from the limited number of issues in 2010 of a reduction in underwriting fees, although it is difficult to determine at this time the extent to which these share issues are representative of a decreasing trend.

1.7 In terms of structural features, we do not have significant concerns over the number of available providers of equity underwriting services. Concentration2 amongst investment banks, both for equity underwriting

2 A concentrated market is one where a large proportion of the market is accounted for by a small number of suppliers.

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and for corporate broking services3 does not appear to be unduly high (for example, it is significantly lower than in the UK retail banking sector).

1.8 Instead our analysis suggests that the trends towards higher fees and discounts, and greater clustering of fees and discounts, may be the result of companies not negotiating cost effective outcomes with investment banks and shareholders not putting sufficient pressure on companies raising equity capital to reduce costs. We have found that companies, albeit sophisticated purchasers of services generally, typically lack regular, repeated experience of equity-raising and are not focused principally on the price they are paying for equity underwriting services when they issue shares. Furthermore, the way in which underwriters are appointed also appears to reduce competitive tension.

1.9 We have also considered whether there is potential for the interests of both institutional shareholders and investment banks to conflict with those of companies raising equity capital. We have concluded that the potential conflicts that we identified initially generally seem to be managed appropriately, or do not raise significant concerns.

1.10 On the basis of this analysis, we have set out in this report a number of options that may be available to companies and institutional shareholders to achieve more cost effective outcomes in this market. These include a number of broad proposals to increase the knowledge, and improve the bargaining position, of companies raising equity capital, and some more specific proposals (in particular relating to the scope for institutional

3 Corporate brokers act as a communication channel between a company and its shareholders. Services provided by corporate brokers may include: market making, providing a sales function, research and corporate advice. We have found that brokers generally become underwriters of share issues.

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shareholders to commit to sub-underwriting4 prior to the announcement of an issue) that may also be appropriate in certain cases.

Buyer experience and incentives

1.11 We have found that it is difficult for companies raising equity capital to assess fully whether they are receiving a cost effective outcome when they buy equity underwriting services. There are two key reasons for this:

• most companies are not involved in raising equity capital very often, which prevents them from building up sufficient experience of, and expertise in, the market to hold their underwriters to account on fee and discount levels effectively, and

• the complexity of the transaction, and a lack of transparency as to how the fee is determined, makes it difficult for buyers to assess the value of the services being received.

1.12 Moreover, when companies issue shares, their priorities are generally speed, confidentiality and a successful 'take-up'. They rate the price of the equity underwriting service as less important. While institutional shareholders place greater importance on the cost of raising equity capital, and have expressed concerns about the fees that companies are paying for equity underwriting, there appears to be more that those institutional shareholders could do to persuade companies raising equity capital to achieve better outcomes.

4 Sub-underwriters agree (in exchange for a fee) to meet part or all of the underwriters’ obligation to buy shares that are not taken up during the period of the share issue. This allows underwriters to limit the amount of risk they run during the equity raising. Sub-underwriting is usually performed by existing institutional shareholders of the issuing company, other institutional shareholders, other investment banks, lending banks or hedge funds.

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How equity underwriting services are purchased

1.13 On the vast majority of occasions, companies select their corporate brokers as underwriters. Corporate brokers were involved in transactions as underwriters in 82 of 85 rights issues between 2000 and 2009 that we looked at. A corporate broker has a strong understanding of a client company and its position which is difficult for other prospective underwriters to match. Holding a competitive tender for equity underwriting services is also perceived to increase the risk of a market sensitive leak of information occurring given that it increases the number of parties who know in advance about the issue. As a result, there appears to be relatively limited competition for equity underwriting appointments, and competition between investment banks instead appears to be focused on securing roles as corporate brokers which enhance their ability to secure equity underwriting and other transactional work (such as mergers and acquisitions) in the future.

1.14 Once underwriters are selected, companies are typically in a weak negotiating position when they come to agree fees and discounts. This is because it would be time consuming and potentially expensive for a company to remove an underwriter once work on the issue had begun. Furthermore, a company’s decision to switch underwriters may be interpreted by the stock market as a signal that the share issue was unlikely to be successful. We have found that only a small number of companies have introduced additional underwriters while the issue is being prepared in order to create greater competitive tension over fees.

Conflicting interests

1.15 We have considered whether the equity underwriting process raises potential for the interests of institutional shareholders and investment banks to conflict with the interests of companies raising capital.

1.16 Conflicting interests could arise for institutional shareholders as a result of their twin roles as both investors in the company raising equity capital (where they would like capital to be raised as cheaply as possible) and as potential sub-underwriters (where they may have an incentive to push

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for higher sub-underwriting fees). However, we have found that while individual institutional shareholders may in some circumstances benefit from increasing sub-underwriting fees on a particular deal, institutional shareholders as a group, do not have a strong incentive to press for higher sub-underwriting fees and in general there is limited evidence of sub-underwriters pressing for higher sub-underwriting fees.

1.17 We identified a number of areas where investment banks’ interests might not always fully align with those of their clients. These include:

• investment banks advising companies on whether or not to perform equity raising activity that the bank will be remunerated for underwriting only if the transaction goes ahead

• investment banks advising on how far to discount a share issue, when the decision will impact upon the bank’s own risk as underwriter, and

• investment banks' incentives to hedge their exposure to underwriting risk which if acted on in certain ways could potentially have an adverse impact on its clients' share price.

1.18 We have seen little evidence that these potential conflicting interests are having a significant impact. Underwriters are under a general legal obligation to manage conflicts of interest fairly, and the underwriter who acts as the nominated Sponsor5 on a transaction has a specific duty to identify and manage existing conflicts. Importantly, many companies raising equity seem to be aware of these potential conflicts and have taken steps to address them. For example, it is now common practice for companies raising equity capital to restrict the hedging activity of their underwriters within underwriting agreements, and a number of companies engage independent advisors to provide guidance on both when to raise equity and the appropriate fees and discounts.

5 Broadly, the role of Sponsor is to ensure that a company complies with all its obligations under the Listing Rules (found in the FSA Handbook at http://fsahandbook.info/FSA/html/handbook/).

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Options for achieving more cost effective outcomes

1.19 There is more that companies and institutional shareholders can do to achieve more cost effective outcomes in the equity underwriting market. Companies could do more to create competitive tension between underwriters and apply greater downward pressure on fees and (where appropriate) discounts. Institutional shareholders need to be willing to hold directors to account where appropriate to achieve this, and there are actions that institutional shareholders could consider taking, that may contribute to a reduction to fees. We have set out in this report a number of options that may be available to companies and institutional shareholders to achieve more cost effective outcomes. The extent to which these options are suitable may depend on the particular circumstances of the company raising equity - for example, some of these options may only be appropriate for equity raising aimed at funding growth rather than balance sheet repair.

1.20 For companies raising equity capital, the options that we set out in the report include:

• reducing the knowledge and experience gap by seeking more advice from those with more experience of the process, such as their institutional shareholders, legal advisers and (in many cases) from board members that have had previous experience of equity raising, or by taking independent advice

• improving competitive tension between providers pitching for equity underwriting appointments, for example by inviting the banks that they have existing relationships with, including corporate brokers and lenders, to compete with each other for certain elements of the equity underwriting work, and/or increasing the number of investment banks that they have relationships with to expand the pool of potential providers when they award equity underwriting or other transactional work, and

• putting greater pressure on fees, for example by requesting that underwriters provide a breakdown of their proposed fees into

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separate charges for the different elements of the work, allowing companies greater scope for challenging individual elements of the fee.

1.21 For institutional shareholders, the options that we set out in the report include:

• applying greater pressure on the companies they own shares in to reduce fees and discounts, for example by having regular discussions with company executives about the principles that they would like to see adhered to on future equity raising, and

• taking steps during the equity raising process itself that could contribute to a reduction in fees such as:

- committing where possible to sub-underwriting issues before they are announced to reduce the risk that the underwriter bears and potentially the underwriting fee, and

- indicating that they are willing to accept lower sub-underwriting fees and applying pressure for underwriters in turn to bring down their fees to reflect the reduced cost of bearing the risk.

Conclusion and next steps

1.22 Our findings indicate that there is little competitive tension between investment banks during the equity raising process and that companies raising equity capital are not focused principally on reducing underwriting fees. Our report has set out several options that companies and institutional shareholders could consider for applying greater pressure on underwriting fees and discounts.

1.23 These findings are broadly consistent with those of the Rights Issue Fees Inquiry (RIFI) conducted by the Institutional Investor Council (IIC) which was published on 14 December 2010.6 Both this market study and the

6 The RIFI Report can be downloaded at www.iicouncil.org.uk/docs/rifireport.pdf.

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IIC’s inquiry highlight the fact that fees and discounts have been slow to fall in line with the reduction in risk since mid-2009, and both conclude generally that there is more that companies can do to negotiate better outcomes, and more that institutional shareholders can do to ensure this happens.

1.24 The detailed analysis of fees and discounts and other trends in the market presented in this report highlights the costs to companies, and the institutional shareholders that own shares in them, of not negotiating cost effective outcomes. Our market study provides a detailed explanation of the equity raising process, and of how companies raising equity capital typically engage with investment banks and other advisers during the process. We expect that this will be of value to companies whose management has little or no previous experience of raising equity capital in helping to bridge the ‘experience gap’ that they may face. Our detailed analysis of the incentives and diverse priorities of market participants should also be of assistance when considering the options available to companies raising equity capital to achieve more cost effective outcomes.

1.25 In the light of our findings, we have concluded that a Market Investigation Reference (MIR) would not be appropriate in this instance. The equity underwriting market has been through an exceptional period, and it is difficult to assess at this time how the market is adjusting as it returns to more typical conditions. To the extent that the concerns we identified persist, we consider that they can be tackled most effectively and efficiently by companies and institutional shareholders doing more pro-actively to achieve better more cost effective outcomes, principally by applying greater pressure on underwriting fees and discounts. The regulatory remedies that we have considered appear to be either too rigid or to pose a risk to the competitive process. In these circumstances, and taking account of the public resources required, and the cost to business, we do not consider that an MIR is justified at this time. Our reasons for this provisional decision are set out in this report. We are consulting on this provisional decision and responses should be emailed to: equityunderwriting@oft.gsi.gov.uk by Friday 11 March 2011. Alternatively, they can be sent to:

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Equity underwriting market study Office of Fair Trading Fleetbank House 2-6 Salisbury Square London EC4Y 8JX

1.26 We are sending a copy of our report to the Independent Commission on Banking (ICB). The ICB will be making recommendations, due by the end of September 2011, on possible structural and related non-structural reforms to the UK banking sector to promote financial stability and competition.

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2 INTRODUCTION

2.1 Equity capital is an important source of funding for companies, and the ability of companies to raise equity capital efficiently and cost effectively is important for the growth prospects of the UK. In early 2010, there was public debate about the functioning of the UK equity underwriting market, with concerns expressed by companies that had raised equity capital and institutional shareholders about the level of fees being charged by investment banks acting as underwriters. These concerns, when also considered in the context of previous studies undertaken by the UK competition authorities throughout the 1990s, prompted us to undertake this market study.

2.2 This chapter sets out the background to this market study, including the OFT’s mission and powers, and describes the scope and approach of the market study.

OFT’s mission and powers

2.3 The OFT’s mission is to make markets work well for consumers. The OFT has a broad interpretation of consumers, including both businesses and final consumers.

2.4 Market studies7 involve an analysis of a particular market, or practices across a variety of goods and services, with the aim of identifying and addressing significant aspects of market failure, ranging from competition issues to consumer detriment and the effect of government regulations.

2.5 Possible results of market studies include:

7 Market studies are conducted under the OFT’s general function in section 5 of the Enterprise Act 2002 (EA02), which includes the functions of obtaining information and conducting research. For more information on market studies, see: www.oft.gov.uk/OFTwork/markets-work/market-studies-further-info.

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• future enforcement action by the OFT

• a reference of the market to the Competition Commission

• recommendations to government or regulators for changes in laws, regulations or policy

• voluntary action by industry players to address any problems found

• campaigns to promote consumer awareness, and

• a clean bill of health.

Background

2.6 We announced plans to undertake a market study into the provision of equity underwriting and associated services in the UK by way of an initial consultation on 10 June 2010.8 We set out the final scope of the market study on 6 August 2010.9

2.7 Prior to launching our market study, informal discussions with companies that had recently raised equity capital revealed concerns about increased underwriting fees and discounts for rights issues. The responses of market participants to our initial consultation also indicated similar concerns existed.

2.8 The UK equity underwriting market has been subject to detailed consideration by the OFT and the Monopolies and Mergers Commission (MMC) previously. Three reports on equity underwriting in the UK were published by the Director General of Fair Trading (DGFT) between 1994

8 See: www.oft.gov.uk/news-and-updates/press/2010/61-10.

9 See: www.oft.gov.uk/news-and-updates/press/2010/87-10.

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and 1997, and in 1999 the MMC published a report on underwriting services for share issues.10

2.9 Two more recent studies focused on this market have been conducted by other bodies. In 2008, the Rights Issue Review Group (RIRG) published a report examining how the capital raising process in the UK could be made more effective.11 In December 2010, the Institutional Investor Council (IIC) published the report of its Rights Issue Fees Inquiry (RIFI).12 Among the issues identified by the IIC inquiry were:

• a potential shortfall in sub-underwriting capacity over the past decade

• non-financial companies negotiating fees from a less well-informed position than their bank advisers

• opacity around the disclosure of underwriting fees, the impact that the regulatory environment has on the ability of investors to talk to companies at critical times during the share issue process

• investor concern about the role played by the lending banks acting as underwriters, and

• the potential for alternative structures to be used as a way of introducing competition into the market.

10 Details of these previous investigations can be found at pages 11 to 13 of the OFTs statement of scope of 6 August 2010. See: www.oft.gov.uk/shared_oft/market-studies/statement-of-scope.pdf.

11 Further details of this investigation can be found at page 14 of the OFTs statement of scope of 6 August 2010. See: www.oft.gov.uk/shared_oft/market-studies/statement-of-scope.pdf.

12 The RIFI Report can be downloaded at www.iicouncil.org.uk/docs/rifireport.pdf.

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Scope of the market study

2.10 This market study examines the provision of equity underwriting services for the different types of share issue used by listed companies to raise equity capital in the UK. These include rights issues, placings and other types of follow-on offer. The study does not examine Initial Public Offerings (IPOs) and is limited to equity issues carried out by FTSE 350 listed firms. IPOs were not included in the study because they are a significantly different type of transaction, involving a greater amount and different type of work, over a longer time frame, and raise different levels of underwriting risk compared to other equity issues. Focusing on equity issues by the FTSE 350 gave us coverage of the vast majority of equity capital raised on the Main Market,13 and smaller FTSE listed companies tend to use different advisers and underwriters. AIM14 listed companies frequently have different ownership structures and issue shares under a different regulatory regime.15

2.11 The objective of the market study was to understand the way in which the equity underwriting market works and to assess whether there is potential for improving the way that it functions. We have considered how underwriting services are purchased, how they are provided, and how the regulatory environment affects the provision of these services. In doing so we have taken a holistic approach, examining the incentives of the various participants in the market, their levels of knowledge and experience and their conduct, and we have considered how all of these affect the outcomes observed in relation to equity capital raising.

2.12 We have also considered both corporate broking services and corporate lending to the extent that this is necessary to inform our understanding

13 'The Main Market is the London Stock Exchange’s principal market for companies from the UK and overseas.

14 AIM is the London Stock Exchange’s market for smaller, growing companies.

15 See paragraphs 50 to 57 of our Statement of Scope for a more detailed explanation.

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of equity underwriting. Corporate broking is relevant as corporate brokers appear generally to become underwriters of share issues. The position of lending banks as major company creditors has also recently appeared to lead to them gaining underwriting work.

2.13 The study focuses on equity underwriting for issues which have been carried out over the previous 10 years. Prior to launching this market study, we recognised that the equity underwriting market had been subject to significant challenges from 2008 onwards. Given the financial crisis and recession, this was a period of intense equity raising. Although it is important to consider how and why the equity underwriting market has changed since the beginning of 2008, we consider that it is inappropriate to focus solely on this period due to the unusual economic circumstances. We have therefore taken a longer term perspective on these markets, considering the last 10 years, which is the period since the previous MMC investigation.

Research and analysis conducted

2.14 Over the course of the study we have collected information from a variety of sources, and conducted a variety of types of analysis, to give us a broad perspective on this market. We have:

• sent information requests to:

- FTSE 350 companies that have issued new shares since the beginning of January 2006

- investment banks involved in underwriting share issues

- institutional investors, and

- independent advisers that have provided advice to companies on equity raising

• spoken to a number of companies about their experiences of equity raising in greater depth

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• analysed equity issues since 2000, focusing on rights issues, including an econometric analysis of underwriting fees, and

• conducted a review of relevant publically available market reports, government reports, company law, regulations and guidance, and academic literature.

2.15 We have looked at high level issues across a wide range of share issues (for example, in an analysis of rights issue fees and discounts and in a survey of companies that have recently raised equity capital) and at more specific points in relation to a narrower set of share issues (for example, through more detailed discussions with a smaller number of companies regarding individual experiences of raising equity capital).

2.16 We are grateful for the assistance provided to us throughout our study by investment banks and other advisers, institutional shareholders and their representative bodies, companies who have raised equity capital, and regulatory bodies. In particular we would like to thank the IIC for the constructive dialogue maintained throughout the course of the RIFI.

2.17 The information used to compile this report was requested under section 5 of the Enterprise Act 2002 (which sets out the OFT’s general function of obtaining, compiling and keeping under review information). Material may appear in an anonymous, aggregated or otherwise redacted form in this report for reasons of commercial confidentiality.

Structure of this report

2.18 This report is structured as follows:

• Chapter 3 provides an overview of equity capital raising and the roles of various players

• Chapter 4 describes the equity capital raising process, including the key stages in the process

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• Chapter 5 sets out an analysis of market developments and trends, in particular changes in the level of fees and discounts, from 2000 to 2010

• Chapter 6 discusses how equity underwriting services are purchased, taking account of the incentives of the various market participants and how these (and their knowledge and experience) affect the outcomes at different stages in the process

• Chapter 7 analyses the potential for the interests of both institutional shareholders and investment banks to conflict with those of companies raising capital, and

• Chapter 8 sets out the conclusions of this market study and proposed next steps.

2.19 This report also contains the following Annexes:

• Annexe A provides a glossary of the technical terms used in the report

• Annexe B lists the respondents to our market study

• Annexe C presents the responses that we received to our information request to FTSE 350 companies

• Annexe D sets out the relevant legal and regulatory background on equity capital raising in the UK, and

• Annexe E presents details of the data sources we have used and our econometric analysis of fees over the period 2000 to 2010.

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3 OVERVIEW OF EQUITY CAPITAL RAISING

3.1 When seeking to raise capital, companies are likely to consider a range of possible options. There are several different sources of capital, and a number of different ways in which equity capital can be raised in the UK, to consider. Despite a wide range of potential options, in most cases a company’s capital raising choices will be dictated by the reasons for needing capital, the amount that needs to be raised and the particular circumstances of the company and the prevailing market conditions.

3.2 This chapter provides a brief overview of the different ways companies can raise capital, as well as providing further details on the different types of equity capital and the roles of advisers and other organisations involved in the process. The process of equity capital raising in the UK is set out in more detail in Chapter 4.

Options for raising capital

3.3 There are a number of different reasons why companies may wish to raise capital, including funding an acquisition16 or expansion, or strengthening their balance sheets (for example, to prevent the company being unable to repay a loan, to re-structure existing debts or to reduce leverage or gearing ratios).

3.4 There are three broad sources of capital available to companies:

• Internal finance: options include increasing retained earnings, selling unnecessary or under-utilised assets and divesting part of the business

16 Companies acquiring assets or businesses may be able to finance all or part of those acquisitions by issuing equity directly to the seller(s) of the assets or businesses. These ‘vendor consideration’ issues do not involve market-based issuance, though they may be used in conjunction with market-based issues as described in this Chapter.

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• Debt finance: options include bank loans and issuing bonds (including convertible bonds17), and

• Equity capital: options include initial public offerings (IPOs, where shares are sold to the public for the first time), and various forms of follow-on issues (where a company with shares already held publicly, sells additional shares) including rights issues, open offers and placings (described in more detail below).

3.5 Which of these options are available to a company is likely to depend on the reason for raising capital, the amount to be raised and the company’s financial position. For example, where capital needs to be raised to repay debt and reduce leverage or gearing, this will need to be done by either raising equity capital or (if a suitable means exists) through internal finance. Similarly, the scope for funding growth or acquisition through debt will depend on the current and desired level of leverage or gearing. It may be difficult to find options for raising significant amounts through internal finance and this option may therefore be more suitable for small investments. Equity capital and internal funding may be more suitable for more risky investments, or where the returns are not anticipated for a considerable period of time, in order to avoid the commitment to interest payments and repayment of capital that arise from debt finance.

3.6 In principle, companies can choose from the different methods of raising capital, taking account of the relative costs of each method. In practice, however, it appears that the constraints discussed in paragraph 3.10 mean that companies often have little or no choice but to raise equity capital. Of the 48 companies which responded to our survey, 32 indicated they could not have met their needs through another form of capital raising. This means that other forms of capital raising, such as internal or debt finance, will provide little or no competitive constraint on the equity underwriting market.

17 Convertible bonds are debt finance that is sold with a conditional option which allows it to be converted into equity at a particular time and price at a future date.

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Options for raising equity capital

3.7 There are two broad types of follow-on equity issue:18 pre-emptive and non-pre-emptive. Pre-emptive issues require companies to offer shares to their existing shareholders in proportion to their current shareholdings - where these rights are not taken up, they can be offered more widely. Pre-emption is important because it allows shareholders to either maintain their level of control in a company or be compensated for their shareholding being diluted.19

3.8 There are two main forms of pre-emptive issues - rights issues and open offers. In a rights issue, the rights to buy new shares can be traded, and shareholders that do not take up their rights are compensated for the dilution to their holding. In an open offer, the rights to buy new shares cannot be traded, and there is typically no compensation for existing shareholders that do not purchase their allocation.20

3.9 A placing is a non-pre-emptive issue of new shares to a limited number of investors. Placings can be carried out very quickly, but are normally restricted to raising smaller amounts of equity.21

3.10 In principle companies may be able to choose between types of equity capital raising. In practice, however, the option used is likely to be dictated by the circumstances of the company, in particular the amount

18 The focus of this market study is follow-on issues rather than IPOs and the latter are not considered further in this chapter.

19 The issue of pre-emption rights and their effect on equity capital raising is discussed in detail in Paul Myners, Pre-emption rights: Final Report, February 2005 (URN 05/679), www.berr.gov.uk/files/file28436.pdf.

20 The open offer process can, however, be varied to provide for compensation (see paragraph 4.12).

21 The ABI’s Guidance Directors’ Powers to Allot Share Capital and Disapply Shareholders’ Pre-emption Rights (31 December 2008) (‘ABI Guidelines’) recommends that companies do not raise more than five per cent of their issued share capital via placings for cash in one year.

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of capital required relative to the existing equity capital. Rights issues are typically used where significant amounts of equity capital need to be raised, and placings are typically used for smaller amounts of capital, with open offers used less frequently. In some cases, companies undertake a placing and an open offer (or a placing and a rights issue) at the same time, where a significant amount of capital needs to be raised and it is anticipated that not all of this can be placed with existing shareholders. These points are discussed in further detail in Chapter 4.

Underwriting equity capital raising

3.11 Companies typically choose to have their share issues underwritten to guarantee that a specific level of funds will be raised - in essence, equity underwriting is a form of insurance for companies. The role of the underwriter is to guarantee that the amount required from the share issue will be raised, if necessary by purchasing newly issued shares if existing, or potentially new, shareholders are unwilling or unable to take up shares.

3.12 One alternative to an underwritten equity issue is a non-underwritten ‘deeply discounted’ share issue22 where the issue price is set at a significant discount to the theoretical ex-rights price (TERP).23 A deep discount should encourage the take-up of the shares among investors, and thus give the company a reasonable chance of raising the equity it needs while avoiding the need for, and costs involved in, underwriting the issue.

22 Deeply discounted equity issues are almost always done by way of a rights issue, as there are restrictions on the level of discount in open offers and placings (see Chapter 4).

23 The theoretical ex-rights price (TERP) refers to the market capitalisation of the firm before a rights issue takes place plus the amount to be raised in the share issue, divided by the number of shares, both the existing ones and those added by the share issue. This is calculated using the price just before the share issue is announced. TERP takes account of the dilution affect that the new shares have on the share price.

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3.13 The MMC observed that deep discounting may be one way for companies to encourage underwriters to reduce their fees.24 However, since 1999, this option has been little used. Deep discounting does not offer a company the same absolute certainty of proceeds that underwriting does, and in many cases this will mean a non-underwritten deeply discounted issue is not viable (for example, in equity issues associated with acquisitions, companies are likely to have a specific amount they need to raise in order to purchase a target company). Company executives are also keen to avoid the perception by the stock market of financial weakness and a lack of shareholder support that non-underwritten deeply discounted issues are sometimes associated with.

3.14 Underwriting services include three main elements, which are:

• Advice: This includes advice on how and when to raise capital and is typically provided by the company’s corporate broker or other appointed advisers, and usually starts before a firm decision to raise equity has been taken.25

• Administration, compliance and distribution: This includes preparing necessary disclosure, compliance and other documents (such as the prospectus), promoting the share issue among the company’s shareholders and looking after the administration of the issue itself. Much of this work is legal in nature.

• Guaranteeing the proceeds of the share issue: The underwriter agrees to purchase shares that remain unsold at the end of the issue at an agreed price. Underwriters can manage their risk by appointing sub-underwriters that take on part of the underwriting risk.

24 Monopolies and Mergers Commission, ‘Underwriting Services for Share Issues’, 24 February 1999, paragraph 2.29.

25 The advice can be on a range of matters, including mergers and acquisitions or restructuring, and it may not always be clear where to draw the line between advice on a specific equity capital raising transaction and other advice.

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3.15 The key players in preparing equity raisings are:

• Underwriters/bookrunners: It is usually investment banks that underwrite and distribute the issue. One or more of these underwriters, normally the issuer’s corporate brokers, will take a lead role in managing the process, including setting the timetable for the process itself, coordinating the preparation of the issue documents and coordinating the input of lawyers and other advisors. Increasingly lending banks are participating in the guaranteeing of the proceeds of share issues. Companies generally have an established relationship with one or more banks that provide lending facilities, and these banks will have a significant knowledge of the internal finances of a company which can give them an advantage in seeking to participate in the underwriting of an equity issue.

• Sponsors: Sponsors are responsible for giving assurances to the FSA that the issuer has met all of its relevant regulatory and other obligations and understands its responsibilities. Often the Sponsor is one of the company’s corporate brokers and a senior member of the underwriting syndicate, because the kinds of declarations needed require detailed knowledge of the company. Independent advisers also perform this role, however, and it is not uncommon for joint Sponsors to be appointed in connection with an equity issue.

• Lawyers: Corporate lawyers assist in document preparation and help ensure compliance with the various applicable rules and laws.

3.16 The size and number of investment banks involved in an equity issue may vary depending on the size and complexity of the transaction, as well as the size of the balance sheet of the investment bank(s) involved and their willingness to bear the risk involved. The proportion of the transaction which is allocated to each underwriter in the syndicate can be set by the company involved or by the underwriters themselves with the approval of the company. In addition, the regulatory and other process tasks may be divided between the underwriters in line with their knowledge and particular skills.

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3.17 Companies have a number of sources of advice available to them, both generally and specifically on equity issues. These include:

• Corporate brokers: The role of a corporate broker is to act as an agent and adviser to a client company. In essence, the corporate broker acts as a communication channel between a company and its shareholders. During an equity issue, the corporate broker will attempt to convince shareholders of a proposal’s merits and relay investor sentiment back to the company. Corporate brokers have detailed knowledge of both the financial position of the company (and therefore the capital requirements of the company and the most suitable method of raising capital) and the company’s shareholders (and their anticipated appetites for taking up new shares). This places corporate brokers in a strong position to win equity underwriting mandates.

• Independent advisers: Companies sometimes engage an independent advisor to assist them during the preparation stage. Independent advisors can assist in advising on structure, timing, the appropriate level of fees and discounts, and which investment bank(s) would be best suited to underwriting an issue.

• Legal advisers: Corporate lawyers can assist companies in a number of ways, such as advising on compliance with the relevant legislation and regulations and on the structuring of an equity issue. Their regular involvement in advising companies on accessing equity markets gives corporate lawyers a depth of understanding that executives of issuing companies may lack.

3.18 Underwriters of equity issues (in particular large issues) usually seek to limit their risk by entering into sub-underwriting agreements. The decision for an underwriter on how much equity to have sub-underwritten will depend on the riskiness of the transaction for the underwriter and the size of the underwriter’s balance sheet. If the transaction represents a low risk, an underwriter may be more content to hold a larger proportion of the ‘naked’ underwriting risk, whereas for a more risky transaction, the underwriter may wish to arrange for a larger

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proportion of the issue to be sub-underwritten. The underwriter’s appetite for having the transaction sub-underwritten may also be affected by sub-underwriting fees.

3.19 Sub-underwriting is often carried out by institutional investors, generally those that are existing owners of shares in the issuing company, although some institutional shareholders are prepared to sub-underwrite issues in companies that they do not hold shares in. Institutional investors that are existing shareholders have an incentive to ensure successful share issues and therefore frequently provide sub-underwriting of their proportion of the total shares being issued. In some cases, they may either be prepared to sub-underwrite a greater proportion than this, or may only be willing to sub-underwrite a smaller proportion. Some institutional shareholders (often overseas investors) are not willing (or able for legal or compliance reasons) to sub-underwrite at all. Other organisations involved in sub-underwriting include hedge funds and other banks, which have the large balance sheets which are required when acting as a sub-underwriter.

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4 THE PROCESS OF EQUITY RAISING

4.1 There are three options open to companies that are already listed and wish to raise equity capital: rights issues, open offers and placings. The option that a company selects will be dictated largely by the amount of capital that a company needs to raise. The method used has significant implications for the level of resources and the length of time required to prepare the issue and the length of the issue period.

4.2 This chapter describes the various methods of raising equity capital, the key stages of each and the roles performed by the various players.26 For comparative purposes, it includes a simplified timeline diagram. Annexe E sets out further details on the relevant legal and regulatory background to equity capital raising in the UK.

The process of equity raising

4.3 The three ways in which equity is raised by FTSE 350 companies are through rights issues, open offers and placings.

Rights issues

4.4 In a rights issue, new shares are offered, on a pro-rata basis, to existing shareholders, typically at a discount in order to encourage shareholders to take up their rights.

26 On 8 December, the European Commission announced that it is undertaking a public consultation as part of a review of the Markets in Financial Instruments Directive (MiFID). The Commission is considering whether, ‘given the specificities surrounding [underwriting and placing] services, more detailed and tailored requirements in the implementing directive might be appropriate.' Possible options include requiring firms providing these services to establish ‘specific organisational arrangements and procedures’, and ‘addressing relevant practices through specific conflicts of interest requirements’. Given that the Commission's review is on-going at the time of writing, and the early stage of these proposals, we have not commented on these possible changes.

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4.5 Shareholders have at least 10 business days27 to make a decision about whether to purchase new shares, sell their rights to purchase new shares (known as ‘nil-paid’ rights) or do nothing. Shareholders that do not subscribe for new shares can be compensated by selling their nil-paid rights or by receiving a share of proceeds obtained from the sale of unsubscribed shares (namely, a pro rata share of the difference between the issue price and the price obtained from the sale), known as the ‘rump’ shares.28

4.6 Rights issues require a substantial amount of preparation prior to launch. Investment banks’ responses to our information requests indicated that this can take between one and two months. A prospectus needs to be prepared and sent out to shareholders.29 Other work includes compiling the necessary information and documentation (such a Circular,30 if required, and due diligence on the issuer), liaison with the UK Listing Authority (UKLA), the development of a compelling explanation for the

27 UK Listing Rule 9.5.6 specifies a rights issue must remain open for at least 10 business days. However, where a company has not disapplied the shareholder pre-emption rights in section 561 of the Companies Act 2006, a rights issue must remain open for at least 14 calendar days: section 562(5) Companies Act 2006.

28 UK Listing Rule 9.5.4.

29 Sections 85(1) and (2) of the Financial Services and Markets Act (2000) and Prospectus Rule 1.2.1 (which forms part of the FSA Handbook) require that companies wishing to have new securities admitted to trading on a regulated market must publish a prospectus in a form approved by the FSA. There are exceptions, however. For example, Prospectus Rule 1.2.3(1) provides that a company does not have to issue a prospectus where the issue of new shares in a 12-month period – including those proposed to be issued – amounts to less than 10 per cent of the total number of issued shares (which is commonly the case for placings).

30 A Circular is defined in the UK Listing Rules as ‘any notice to shareholders, excluding any document issued to holders of listed securities including notices of meetings but excluding prospectuses, listing particulars, annual reports circulars and accounts, interim reports, proxy cards and dividend or interest vouchers.' A FTSE 350 company will be required to issue a Circular to its shareholders where, for example, it requires a general meeting to obtain shareholder approval for an equity-raising.

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issue to encourage shareholders to take up issued shares and communicating this explanation to institutional investors.

4.7 A general meeting will be required to authorise a rights issue where company directors do not have pre-existing authority to raise the amount of capital the company is seeking. Listed issuers routinely seek authority to complete pre-emptive issues at Annual General Meetings.31 Company directors normally do not have authority to raise an amount which extends beyond two thirds of the company’s issued share capital.32 Where a general meeting is required, a special resolution of shareholders (that is over 75 per cent) is required to approve the rights issue before it goes ahead.33 A general meeting extends the process by at least two weeks.34 Other than as explained above, there is no technical upper or lower limit to the amount of money that a company can raise via a rights issue, although investment banks will generally advise companies to use rights issues where they need to raise over 10 per cent of their issued share capital. For smaller equity raisings, other options are available.

31 It is common, at AGMs, for shareholders to authorise directors to issue new shares up to a maximum of one third (although two thirds is possible) of the company’s existing issued share capital for a rights issue (or open offer), and disapply the statutory pre-emption rights to permit placings of five per cent of the issued share capital.

32 The ABI Guidelines provide for a total headroom including rights issues of this amount, though subject to certain safeguards and we understand that the majority of companies adhere to this guidance.

33 Companies Act 2006, section 571(1).

34 Section 307(2)(b) of the Companies Act 2006 requires at least 14 days’ notice to be given to shareholders ahead of a general meeting. For a detailed discussion on the obstacles associated with the general meeting notice period and rights issue subscription period running concurrently, see Chapter 7 of the 2008 RIRG Report, available on-line at: www.afme.eu/assets/0/386/524/7cbcd2ec-0a18-4aa1-bf2d-72196958c1f2.pdf.

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Open offers

4.8 An open offer is similar to a rights issue, with all existing shareholders being offered a chance to subscribe to new shares on a pro-rata basis at a discount. Unlike rights issues shareholders are not usually compensated if they chose not to apply for their entitlement of new shares. New shares issued in open offers cannot be discounted more than 10 per cent to the current share price35 without shareholders’ approval.36

4.9 An open offer normally requires the publication of a prospectus,37 and a general meeting will be required where the company making the open offer does not have pre-existing shareholder consent for directors to issue the new shares.38 Unlike a rights issue, however, the process will not be elongated by the need for shareholder approval since the issue period and the shareholder notice period can run concurrently.

Shareholders must be given at least 10 business days to subscribe to new shares.39

4.10 We were told by market participants that open offers are used only in relatively specific sets of circumstances. Open offers tend to be used to take advantage of a timetable that is shorter than for rights issues where a general meeting is required or, by being coupled with a placing (the so-

35 UK Listing Rule 9.5.10. ABI guidelines recommend a discount of no more than 7.5%.

36 UK Listing Rule 9.5.10(3).

37 See footnote 29.

38 Companies Act 2006, section 551(1)

39 Where a company has not disapplied the shareholder pre-emption rights (in accordance with section 561 of the Companies Act 2006), an open offer must remain open for at least 14 calendar days (Companies Act 2006, section 562(5)). Where a company has disapplied shareholder pre-emption rights, paragraph 3.9 of the London Stock Exchange Admission and Disclosure Standards (April 2010) states that an open offer must remain open for subscription for at least 10 business days.

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called ‘placing with clawback’) to bring new shareholders onto the register – useful where the anticipated level of shareholder support for the issue is uncertain.

4.11 Companies usually, but not always, use underwriters to guarantee the proceeds of an open offer. Underwriting may not be required where, for example, a company does not need to ensure that the share issue raises a specific amount of capital.

4.12 Although the traditional open offer model does not compensate shareholders that do not take up the offer to purchase new shares, companies can introduce a compensatory element. For example, in March 2009, Lloyds Banking Group undertook an open offer in which non-subscribing shareholders were paid a pro-rata share of the proceeds from the sale of the rump shares.40 This is known as a ‘compensatory open offer’.

Placings

4.13 A placing is an issue of new shares, usually to institutional investors selected by a company (often current shareholders), normally at a small discount to the prevailing market price (normally not more than five per cent41). Given that not all existing shareholders are given the opportunity to subscribe for new shares, placings require the company to have disapplied the pre-emption rights afforded to shareholders under section

40 See www.lloydsbankinggroup.com/media/pdfs/investors/2009/2009May20_LBG_Circular_and_NOM.pdf

41 UK Listing Rule 9.5.10 mandates a discount of not more than 10 per cent to the middle market price, however the ABI Guidelines recommend five per cent as a maximum. Rule 9.5.10(2) sets out that the middle market price ‘means the middle market quotation for those equity shares as derived from the daily official list of the London Stock Exchange or any publication of a [Recognised Investment Exchange] showing quotations for listed securities for the relevant date.'

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561(1) of the Companies Act 2006. A placing does not normally require the publication of a prospectus.42

4.14 Because placings have the effect of diluting non-participating shareholders’ ownership without compensating them, they are generally used where a relatively small amount of equity is to be raised, typically less than five per cent of the company’s issued share capital,43 though sometimes more for an issue of shares that is paid up in exchange for assets in an acquisition and where the issue is outside the scope of pre-emption rights.

4.15 A company may seek to place shares either at a pre-determined price, or take orders to build a book of demand once the issue is launched (known as a ‘bookbuilt placing’). Shares are then offered to selected institutional investors. A placing will often remain open for as little as a few hours.

4.16 Placings are sometimes used in combination with rights issues or an open offer. For example, it might be judged that an insufficient number of existing shareholders will subscribe to new shares and new shareholders need to be brought in to fill this gap in demand. Alternatively, a non-shareholder may express an interest in acquiring a stake in a company, and a placing offers the company the ability to accommodate this investor at the same time as offering shares to existing investors via a rights issue or open offer. Such placings can be either ‘firm’ (which means that the placee is guaranteed to receive the shares it subscribes for) or, as is sometimes the case when used in conjunction with an open offer, subject to a ‘clawback’ (where the placee’s allocation is subject to the level of existing shareholder demand).

42 See footnote 29.

43 The Pre-emption Group’s July 2008 Statement of Principles on disapplying pre-emption rights recommends that a company does not issue for cash consideration more than five per cent of its issued share capital via a placing. We understand that the scope of most companies’ authorisations to disapply pre-emption rights fall within the Pre-emption Group’s recommended boundaries.

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4.17 Placings can be underwritten or, where certainty of funds is not essential, issued subject to an investment bank using its ‘best endeavours’ to place shares.

The stages of an equity-raising

4.18 This section describes the key stages of the equity raising process. For some methods, some stages will not occur, or will take place in a modified form. To assist the reader, Figure 4.1, below, sets out the indicative timelines for the key stages for placings, open offers and rights issues from the preparation stage through to the company receiving the proceeds.44

44 The rights issue example is for where a general meeting is not required. Where a general meeting is required, the period will be extended by approximately two weeks: see paragraph 4.7, above.

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Figure 4.1: Typical equity-raising timetables

Decision to raise equity

4.19 In the period leading up to an equity issue, a company and its advisors will be communicating closely. In particular, two key issues need to be resolved, namely how much capital to raise and how best to raise it.

4.20 The method of equity raising used will, to a significant extent, be determined by how much equity a company needs to raise as a percentage of its issued share capital. Where less than five per cent is to be raised, a placing will usually be the most appropriate mechanism given its relative speed and simplicity. Conversely, where a much larger proportion of its issued share capital (over 10 per cent) is to be raised, then a rights issue is more likely to be used as, given the significant dilution to the value of existing shares, a pre-emptive issue that provides for compensation to shareholders that do not take up their rights will generally be considered appropriate.

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Preparation

4.21 Preparation for an equity issue can take from just a few weeks for a placing, up to two months for a rights issue.

4.22 At the start of the process, a team of advisors, investment banks and lawyers is assembled by the issuer. The investment banks which the issuer wants to take a leading role in coordinating the issue are appointed first (normally these are the investment banks with which the company has the closest existing relationships45). Additional underwriters can be added later in the process and will typically play a more junior role (sometimes taking on the risk of guaranteeing the proceeds of the issue, which allows each member of the underwriting syndicate to limit its underwriting risk, but not undertaking any of the advisory and distribution work). Although there may be one or more banks acting as ‘lead’ underwriters managing the process, it is not uncommon for some or all of the banks in the underwriting syndicate to have played some role in the advisory and/or distributional aspects of the share issue.

4.23 At an early stage in the process, underwriting fees will often be discussed and a range within which the shares will be discounted is usually agreed. Further discussion of underwriting fees and discounts may occur throughout the preparation period, but underwriting fees and discounts are not typically agreed at this point. The likely success of the transaction will often be understood better by both companies and their underwriters as the issue date draws closer and more of the work preparing for the issue has been carried out.

4.24 Independent advisers may be involved early in the process to advise on timing, structure, fees, etc although they will not themselves be involved

45 In 85 rights issues between 2000 and 2009, we found only three examples of an issuing company not appointing its corporate broker as an underwriter (see paragraph 6.21). A detailed description of the considerations taken into account by companies when appointing an underwriter is set out at paragraphs 6.17 to 6.26.

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in underwriting or distributing the equity issue. They may also be engaged later in the process to review the proposed levels of underwriting and sub-underwriting fees.

Pre-marketing

4.25 Selected investors are often contacted and briefed on a confidential basis about the issue. This normally occurs a few days (occasionally up to a week) before the launch of an issue. Typically the investors contacted are institutional shareholders that already own shares in the company, although non-shareholders are occasionally pre-briefed at the same time. Investors who agree to take part in the pre-marketing stage are said to be ‘wall-crossed’ or ‘off-side’ and cannot trade on, or disclose, information they receive until it is made public.46

4.26 Discussions with these investors are often used to inform the final decision on the issue price of new shares.47 Where the issue is to be underwritten, these discussions provide useful information on the levels of risk involved.48 They also serve another important purpose: gauging the willingness of investors to sub-underwrite the issue. This is particularly important in the case of rights issues, where underwriters frequently sub-underwrite over half the value of the issue.

Announcement

4.27 Underwriting agreements are normally signed just before the announcement (sometimes on the morning of the announcement). Sub-

46 Trading on such information would amount to ‘market abuse’ under section 118 of the Financial Services and Markets Act (2000) (‘FSMA’).

47 We understand that the visibility that issuing companies have of these pre-marketing discussions varies. In some cases, the issuing company is very involved in the process whereas in other cases, relatively little information is passed on by investment banks.

48 For this reason involvement in the pre-marketing phase can be helpful for issuing companies in understanding the level of underwriting fees that may be appropriate for their share issue.

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underwriting contracts are not ordinarily signed before the announcement of the issue but shortly thereafter. A verbal understanding regarding sub-underwriting will, however, often be in place prior to launch.

4.28 For a rights issue, the announcement date will usually correspond with the start of the issue period, except where a general meeting is required. In this case, two weeks’ notice must be given of the meeting, and the issue period can commence only after shareholders have approved the transaction.49

4.29 For an open offer, the announcement date normally corresponds with the commencement of the issue period, whether or not a general meeting is required.50 Applications for additional shares are received prior to the general meeting and are conditional upon shareholders voting in favour of the issue. Companies will sometimes choose to issue new shares via an open offer, rather than a rights issue, to take advantage of this shorter timeframe. As set out above, however, open offers are used less frequently as a method of substantial equity capital raising.

4.30 Placings are announced at the beginning of the placing process.

Issue period

4.31 The issue period is the time that shareholders and investors have in which to subscribe for new shares. During the issue period, the company and the equity underwriters promote the issue actively to shareholders and encourage them to take up their allocation, for example via investor roadshows.

49 The announcement date may also not correspond with the start of the issue period where details of an impending announcement are leaked and a company has been forced to bring forward the announcement.

50 Where details of an impending announcement are leaked, however, a company may be forced to bring forward the announcement that it intends to launch an issue.

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4.32 For both a rights issue and an open offer, the issue period must remain open for at least 10 business days.51 It is during this time that, in a rights issue, shareholders who do not wish to subscribe for more shares can sell their nil-paid rights to other investors. For a placing, there is no mandated issue period, and it can last anywhere from one day (as in an accelerated bookbuild) to a week.

Post-issue period

4.33 Once the issue period is closed, the equity underwriters will work out the amount of ‘rump’ shares. Following a rights issue, the equity underwriters will typically have one or two days to allocate the rump shares (under the terms of the underwriting agreement), and will contact institutional shareholders that they think may be interested.52 The rump is usually sold off via an accelerated book-build, although it can be sold into the stock market during the normal course of trading if it is small enough.

4.34 Any shares which the equity underwriters are unable to place in the one to two days following the issue will have to be taken up by the sub-underwriters and underwriters. These unallocated shares are known as the ‘stick’.

4.35 Finally, the company receives its funds and the newly issued shares are admitted to trading alongside the existing shares.

51 See paragraph 4.5 on rights issues and 4.9 on open offers.

52 This is not relevant to a placing, as this is a process underwriters will have already been through to sell the shares. Similarly, there is no provision for non-subscribing shareholders to receive proceeds from the placing of ‘rump’ shares in an open offer, and so underwriters do not have to engage in this process (except in the case of a compensatory open offer: see paragraph 4.12, above).

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5 MARKET DEVELOPMENTS

5.1 One of the factors that prompted this market study was the significant increase in equity underwriting fees and discounts that occurred between 2007 and 2009, and the concern this raised among companies raising equity capital and institutional shareholders. This period was marked by the financial crisis and recession, as a result of which several retail banks and many other companies needed to raise equity capital to repair their balance sheets. The number of rights issues, and the scale of some of these issues, made it a particularly challenging time for raising equity capital.

5.2 This chapter looks at the changes in the equity underwriting market in recent years, including the size, value and type of transactions carried out. It also considers the shares of suppliers for corporate brokers and equity underwriters, and considers trends in the supply of sub-underwriting. In addition it provides an analysis of underwriting fees, discounts and sub-underwriting fees.

Equity capital raising by FTSE 350 companies since 2000

5.3 The level of equity capital raising by FTSE 350 companies varied from year to year between 2000 and 2007, but the amount raised each year was in the range of £10 billion to £20 billion, as shown in Figure 5.1 below. The financial crisis and recession brought about a significant increase - in 2009 a total of around £50 billion was raised. By 2010, the amount of equity capital raised had returned to the previous ranges observed between 2000 and 2007.

5.4 In 2009, both the number of companies raising capital and the size of some of the transactions reached unprecedented levels as many FTSE 350 companies needed to raise equity capital to repair their balance sheets. Our data indicated that in 2009, approximately two-thirds of the equity issues taking place were to raise funds for balance sheet repair and similar needs, while the remaining third was for other purposes,

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including a variety of investment, expansion and acquisition plans.53 Suppliers sought to manage this increase in demand for equity issues by forming larger syndicates of equity underwriters to spread the risk. With such unusual circumstances, the scope for choosing between equity underwriters for individual transactions may have been limited by high utilisation of the available equity underwriting capacity.

Figure 5.1: Number and value of follow-on equity issues by FTSE 350 companies

Source: OFT internal analysis of Dealogic data. Includes all types of follow on offer by FTSE 350 companies (that is, all share issues by companies that are already listed and were part of the FSTE 350 at the time of the issue). The data for 2010 covers the period 1 January to 24 November.

5.5 The majority of this additional equity capital was raised through rights issues. Figure 5.2 shows that following the onset of the financial crisis in 2008, there was a significant increase in both the number and value of rights issues. Whereas, between 2000 and 2007, there were fewer than 10 rights issues per year raising less than £5 billion in each year; in

53 OFT internal analysis of Dealogic data.

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2009, there were more than 30 rights issues which raised almost £40 billion.54

Figure 5.2: Number and value of rights issues by FTSE 350 companies

Source: OFT internal analysis of Dealogic data. The data for 2010 covers the period 1 January to 24 November.

5.6 In contrast, as shown in Figure 5.3, there was a less pronounced increase in both the number and value of placings during the financial crisis and recession. There are typically more placings than rights issues in a year (in the range of 10 to 20 annually between 2000 and 2007), but because the amount of capital that can be raised in a placing is restricted,55 the total raised was smaller (between £1 billion and £7 billion annually).

54 OFT internal analysis of Dealogic data.

55 Typically the amount raised in placings is less than five per cent of the company’s issued share capital (see paragraph 4.14 and footnote 43).

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Figure 5.3: Number and value of placings by FTSE 350 companies

Source: OFT internal analysis of Dealogic data. The data for 2010 covers the period 1 January to 24 November.

5.7 As discussed in Chapters 3 and 4, open offers are less frequently used. Figure 5.4 shows data on open offers. This data is split into two categories – open offers and open offers that were undertaken alongside placings. For open offers that were undertaken alongside placings, the dataset we used does not distinguish the value raised through the open offer and the value raised through the placings – the figure given is for the total raised in both the open offer and the placing. There have been only 13 open offers from 2000 to 2007 inclusive, with no more than three in any one year. Even at their peak in 2009, there were only nine transactions.

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Figure 5.4: Number and value of open offers by FTSE 350 companies

Source: OFT internal analysis of Dealogic data. The data for 2010 covers the period 1 January to 24 November. This figure shows open offers as well as issues which combined open offers and placings.

The supply of equity underwriting services

5.8 Equity underwriting services are typically provided by investment banks. A key requirement for providing equity underwriting services is a large balance sheet, required to meet the cost of having to purchase shares in the event of a share issue not being fully subscribed. Providers also need knowledge, expertise and experience to handle the advisory, administrative, compliance and distribution aspects of providing equity underwriting and associated services.

5.9 The equity underwriting market is not particularly concentrated. Table 5.1 below shows the shares of supply for equity underwriting services

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on rights issues by FTSE 350 companies from 2000 to 2010.56 In 2010, the top three underwriters (Bank of America/Merrill Lynch, Deutsche Bank, and Morgan Stanley) together accounted for between 35 and 40 per cent of supply, and the top eight underwriters accounted for between 80 and 85 per cent of supply. This represented a significant change from 2007 to 2009, where underwriters outside the top eight accounted for 40 per cent, or more, of supply. This could be due to the small number of transactions in 2010.

56 These shares of supply were calculated using the value of equity issues in which a particular equity underwriter participated. Where more than one underwriter participated, we have made the simplifying assumption that the value of the underwriting was split equally between all underwriters. These shares of supply should not be interpreted as being representative of a defined economic market or markets.

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Table 5.1: Shares of supply of equity underwriting services on all follow on offers by FTSE 350 companies (per cent)

Underwriter 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Merrill Lynch

[0-5] [30-35] [5-10] [10-15] [15-20] [10-15] [10-15] [10-15] [10-15]

Bank of America

[0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5]

[5-10] [15-20]

Deutsche Bank

[0-5] [0-5] [5-10] [5-10] [5-10] [5-10] [0-5] [0-5] [0-5] [0-5]

[10-15]

Morgan Stanley

[10-15] [0-5] [5-10] [15-20] [5-10] [0-5] [10-15] [0-5] [10-15] [0-5]

[10-15]

Barclays Capital

[0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [5-10]

[10-15]

RBC Capital Markets

[0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5]

[10-15]

Cazenove [20-25] [20-25] [10-15] [15-20] [20-25]

JP Morgan [0-5] [0-5] [10-15] [0-5] [0-5]

[15-20] [10-15] [10-15] [5-10] [15-20] [5-10]

Goldman Sachs

[15-20] [10-15] [5-10] [5-10] [15-20] [0-5] [15-20] [0-5] [10-15] [5-10] [5-10]

UBS [5-10] [20-25] [15-20] [0-5] [15-20] [15-20] [10-15] [10-15] [10-15] [5-10] [5-10]

Others [30-35] [5-10] [40-45] [30-35] [10-15] [40-45] [30-35] [45-50] [40-45] [45-50]

[15-20]

Source: OFT internal analysis of Dealogic data. The data for 2010 covers the period 1 January to 24 November. Shares of supply have been provided in ranges to withhold underlying data.

5.10 The shares of supply vary significantly from year to year. We do not consider, however, that this reflects vigorous competition for equity underwriting appointments. As noted in Chapter 3, and discussed in detail in Chapter 6, equity underwriting is typically undertaken by the company’s corporate brokers and other advisers, and equity underwriting mandates are typically awarded with little or no competition taking place at the time of the transaction. An investment bank’s share of supply of equity underwriting services will therefore typically depend on how many of the companies that it provides corporate broking and other services to raised equity capital in that particular year.

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5.11 As a result, it is helpful to analyse data on the shares of corporate broking appointments. Table 5.2 below shows the eight largest providers of corporate broking services and their shares of supply in each year from 2000 to 2010.57 These shares of supply are based on the number of corporate broking clients within the FTSE 350 held by each corporate broker and do not take account of the different sizes of these FTSE 350 companies. While the share of the market leader (JPMorgan/Cazenove) has remained broadly constant, and the top three corporate brokers typically account for over 40 per cent of the supply, there are significant fluctuations in shares and there has been a significant growth in the shares of smaller corporate brokers (shown by the increase in share of ‘others’) from 2004 onwards. The corporate brokers with the largest shares of supply are similar, but not identical, to the equity underwriters with the largest shares of supply for underwriting services on rights issues by FTSE 350 companies in Table 5.1. This is because not all FTSE 350 companies raise equity capital in every year.

57 These shares of supply should not be interpreted as being representative of a defined economic market or markets.

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Table 5.2: Shares of supply of corporate broking services to FTSE 350 companies (per cent)

Corporate Broker 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Cazenove [20-25]

[20-25]

[25-30]

[25-30]

[20-25]

JPMorgan [0-5] [0-5] [0-5] [0-5] [0-5]

[25-30]

[20-25]

[20-25]

[20-25]

[20-25]

[20-25]

UBS [15-20]

[15-20]

[10-15]

[15-20]

[10-15]

[10-15]

[15-20]

[15-20]

[10-15]

[10-15]

[10-15]

Merrill Lynch [5-10]

[5-10]

[5-10]

[5-10]

[10--15]

[5-10]

[10-15]

[5-10]

[5-10]

Bank of America [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5]

[5-10]

[10-15]

Hoare Govett [10-15]

[10-15]

[10-15]

[10-15]

[10-15]

[10-15]

[5-10]

[5-10]

RBS [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5]

ABN AMRO [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5] [0-5]

[5-10]

[5-10]

[5-10]

Deutsche Bank

[5-10]

[5-10]

[5-10]

[5-10] [0-5]

[5-10] [0-5]

[5-10]

[5-10]

[5-10]

[5-10]

SSSB - Citigroup [0-5] [0-5] [0-5] [0-5] [0-5] [0-5]

[5-10]

[5-10]

[5-10]

[5-10]

[5-10]

Credit Suisse [10-15]

[5-10]

[5-10]

[5-10] [5-10]

[5-10]

[5-10] [0-5] [0-5] [0-5] [0-5]

Dresdner/Commerz

[5-10]

[5-10]

[5-10]

[5-10] [5-10]

[5-10]

[5-10]

[5-10]

[5-10] [0-5] [0-5]

Others [15-20]

[15-20]

[15-20]

[15-20]

[10-15]

[15-20]

[15-20]

[20-25]

[20-25]

[25-30]

[25-30]

Source: Data supplied by Hemscott, OFT internal analysis. Shares of supply have been provided in ranges to withhold underlying data.

5.12 There have been a number of changes to the equity underwriting market in the period covered by Tables 5.1 and 5.2 above. There have been some new entrants to the UK market by way of mergers and acquisitions, including the US based JP Morgan Chase acquiring the

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British investment bank, Cazenove.58 Other large mergers and acquisitions include the purchase by a consortium including RBS of ABN AMRO during 2007 and the 2009 merger of Commerzbank with Dresdner Bank. Some mergers arose as a response to the financial crisis - in 2008, Nomura purchased the European business of Lehman Brothers following its bankruptcy, and Bank of America purchased Merrill Lynch.

5.13 Most of the new entrants in the equity underwriting and corporate broking sector have entered by purchasing an existing business, with few examples of banks starting to expand into offering these services. One example of entry to the UK equity underwriting market which was not undertaken through an acquisition of a business operating within the UK market was Barclays Capital which expanded into corporate broking and equity underwriting in Europe following its purchase of Lehman Brother’s investment banking and capital markets business in the USA in 2008. The fact that most entry has occurred through acquisition rather than de novo, suggests that there may be significant barriers to de novo entry in this market, for example from the costs of building a reputation and relationships with potential clients.

5.14 There are two changes which are not reflected in the shares of supply presented in Tables 5.1 and 5.2 above. The first is that the shares of supply of equity underwriting services of lending banks increased during the financial crisis. For example, HSBC had a [five-10] per cent share of supply in equity underwriting services for follow-on equity issues in 2009 and Lloyds Banking Group had a [zero-five] per cent share.59 Market participants (including investment banks and institutional shareholders) indicated in their responses to our information requests that lending banks have sought to use the lending relationship as a basis for obtaining advisory and equity underwriting appointments. These respondents told us that lending banks have generally been successful in

58 JP Morgan Chase acquired 50 per cent of Cazenove in 2004 forming a joint venture and acquired the remainder of the business in 2009.

59 OFT internal analysis of Dealogic data.

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obtaining appointments as junior underwriters, fairly late on in the share issue process.

5.15 The second trend not reflected in Tables 5.1 and 5.2 is that the size of underwriting syndicates increased significantly during the financial crisis and recession. As noted in paragraph 5.4, this may have been due to the historically high levels of equity capital raising, and the scale of the transactions, during the financial crisis and recession, which meant that investment banks sought to share the risk to a greater extent than before. The growth in the size of underwriting syndicates can be seen in Figure 5.5 below.

Figure 5.5: Average number of investment banks underwriting rights issues

Source: OFT internal analysis of Dealogic data. The data for 2010 covers the period 1 January to 24 November.

5.16 This section has shown that the financial crisis and recession have had a significant impact on the equity underwriting market. The unusual circumstances (in particular the very high levels of demand) may have meant that the scope for choosing between equity underwriters for

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individual transactions may have been limited by high utilisation of the available equity underwriting capacity.

Underwriting fees and discounts

5.17 This section examines trends in the levels of equity underwriting fees and discounts over the last 10 years, focusing on rights issues. As the section above has shown, there have been relatively few open offers in recent years. While placings are more common transactions, data on underwriting fees for placings is relatively scarce and unreliable since (unlike for rights issues) fees do not need to be disclosed in prospectuses.60 There is also unlikely to be any significant variation over time in the discounts for both placings and open offers since the level of discount is limited for these types of offer.61

Trends in underwriting fees

5.18 Underwriting fees are the payment made by an issuing company to the underwriter or underwriters on the share issue. The fee is typically paid for the bundled offering of multiple services which equity underwriters provide, including ongoing and transaction-specific advice, the administrative, compliance and distribution work required for an issue and guaranteeing the proceeds of the share issue (as discussed in Chapter 3).

5.19 Figure 5.6 shows the level of fees for rights issues and the mean fees for each year from 2000 to 2010. While mean fees were broadly stable

60 Within our sample period (1 January 2000 to 24 November 2010), we have underwriting fee data on 59 out of 87 rights issues, 12 out of 28 open offers, and 28 out of 154 placings. We have discount to TERP data on 79 out of 87 rights issues, and discount data for 27 of the 28 open offers, and 144 of the 154 placings.

61 Shareholder approval is needed to discount open offers by more than 10 per cent (see paragraph 4.8). Placings are not normally discounted by more than five per cent (in line with the ABI guidelines), although discounts of 10 per cent are permitted under the listing rules: Listing Rule 9.5.10(3)(a).

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during the early part of the period, at around two to 2.5 per cent between 2003 and 2007,62 there was a pronounced increase in 2008 and 2009 with mean fees over three per cent in 2009. Figure 5.6 also shows that there was a pronounced clustering of fees at 3.5 per cent in 2009, whereas previously there had been significant variation between transactions in the level of fees. Just three rights issues by FTSE 350 companies were completed by 24 November 2010 (and one further issue was announced in December 2010) and underwriting fees for these three were below three per cent.

Figure 5.6: Underwriting fees for rights issues by FTSE 350 companies, 2000 to 2010

Source: OFT internal analysis of Dealogic data.

Note: The data for 2010 covers the period 1 January to 24 November. There are varying numbers of rights issues for which we have data in each year. In particular, there are relatively few data points before 2003 and therefore the mean value shown starts in 2003.

62 We have not drawn any conclusions about this period from 2000 to 2003 because the Dealogic database contains details on relatively few of the transactions that took place during this period.

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5.20 Figure 5.7 shows the level of underwriting fees relative to the volatility of the FTSE 350 index.63 This shows that market volatility increased significantly in late 2008 and it is not surprising that fees also rose to reflect the increased risk that equity underwriters faced at that time. However, it also shows that fees continued to be high and clustered around 3.5 per cent during 2009 despite a pronounced fall in market volatility during that year. There are some indications from the limited number of issues in 2010 of a reduction in the level of underwriting fees, although it is difficult to determine at this time the extent to which these share issues are representative of a decreasing trend.64

Figure 5.7: Underwriting fees and volatility, 2000 to 2010

Source: OFT internal analysis of Dealogic data. The data for 2010 covers the period 1 January

to 24 November.

63 Volatility of the FTSE 350 index is defined as being the monthly average of the two-month standard deviation of daily returns of the FTSE 350 index. Closing prices are adjusted for dividends and stock splits.

64 The IIC noted in the RIFI Report that '(t)he comparatively limited data for 2010, which saw a reduced number of issues, compared to the previous two years means that the apparent reductions in fee levels and discounts should be seen as essentially provisional in nature. A number of these were intrinsically of lower risk than those undertaken in the previous two years.'

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Detailed analysis of underwriting fees

5.21 We have considered the extent to which changes in the level of underwriting fees can be explained by differences in the risk of transactions. In order to compare fees before and after the financial crisis, it is important to control for other factors that might have changed at the same time and might also have affected underwriting fees.65

5.22 As part of this analysis, we obtained data on underwriting fees for rights issues by FTSE 350 companies occurring between 2000 and 2010, as well as data on other factors that we considered likely to affect underwriting fees, such as size and riskiness of the transaction.66

5.23 We estimated the relationship between underwriting fees and drivers of underwriting risk, including volatility in the issuer’s adjusted share price67 and transaction size,68 and used this estimate to predict underwriting

65 For example, it could be the case that rights issues by companies seeking to repair their balance sheets are more risky than other rights issues (and therefore could expect to attract higher underwriting fees), and that more rights issues were made by companies seeking to repair their balance sheets in the period since the financial crisis began than had been the case in the period before. In this case we would expect to observe a higher level of fees on average in the period since the financial crisis began due to the greater proportion of more risky transactions compared with the period before.

66 The data sought was that indicated by a survey of academic literature and discussions with stakeholders during the study.

67 Volatility in the issuer’s adjusted share price is the standard deviation of the percentage change in the closing share price compared to the previous day over the two months prior to announcement.

68 We also considered the reasons cited by companies for raising capital to see if this was related to equity underwriting fees. We found that approximately two-thirds of companies in 2009 were issuing equity because they were in financial distress, and the remaining third for other reasons such as business growth and acquisition. We compared the average underwriting fees paid by companies in both situations and found there was no statistically significant difference between the two.

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fees throughout the period 2000 to 2010. We found that our estimates systematically under-predicted underwriting fees after the start of the financial crisis - actual underwriting fees were consistently higher than our model would suggest after controlling for the risk of the transactions. In contrast, there was no systematic pattern of under or over prediction of underwriting fees for the period before the financial crisis. The systematic under prediction of underwriting fees in the period after the start of the financial crisis could be due to the omission of relevant variables from our model, but we consider that the variables included (in particular adjusted share price volatility) represent the most important risk factors.

5.24 We concluded that our analysis was consistent with underwriting fees for rights issues having increased after the start of the financial crisis and remained clustered around this new higher level, even when we control for the risk of the share issue. Further details of the methodology, results and limitations of this analysis can be found in Annexe E.

Trends in discounts

5.25 For rights issues, discounts refer to the extent to which the offer price is lower than the TERP. Figure 5.8 below shows the discount to TERP for individual rights issues from 2000 to 2010, and the mean level in each year. For most of the period discounts vary significantly between rights issues (and therefore no meaningful trends can be discerned from the average discount level), but in 2009 discounts became clustered at around 40 per cent, a high level when considered in a historical context.

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Figure 5.8: Discount to TERP for rights issues by FTSE 350 companies, 2000 to 2010

Source: OFT internal analysis of Dealogic data.

Note: The data for 2010 covers the period 1 January to 24 November. There are varying numbers of rights issues for which we have data in each year. In particular, there are relatively few data points from 2001 to 2003, which means caution should be used in interpreting the movements of mean discounts in those years.

5.26 Figure 5.9 shows the level of discounts for rights issues by FTSE 350 companies relative to the volatility of the FTSE 350 index.69 As with underwriting fees, discounts were high and clustered during 2009 despite a pronounced fall in stock market volatility during this period. There are some indications of a reduction in discounts from the limited number of rights issues in 2010, although it is difficult to determine at this time the extent to which these share issues are representative of a decreasing trend.70

69 See footnote 63 above.

70 See footnote 64 above.

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5.27 The clustering of discounts observed in Figure 5.8 is consistent with discounts being set by reference to the level of discounts agreed in other transactions, rather than on the basis of the estimated risk of the individual equity issue.

Figure 5.9: Discount to TERP and volatility

Source: OFT internal analysis of Dealogic data. The data for 2010 covers the period 1 January

to 24 November.

Supply of sub-underwriting

5.28 Sub-underwriting services are often provided by institutional investors that hold shares in the issuing company. Other financial agents, such as hedge funds and lending banks, also supply sub-underwriting services on a commercial basis, without an ownership interest in issuing companies (see Chapter 3).

5.29 The main change we have noted in relation to the provision of sub-underwriting services since the onset of the financial crisis and recession is that a smaller proportion of share issues are sub-underwritten than in the period 2000 to 2007. Some investment banks told us that the

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previous market norm was for 100 per cent sub-underwritten issues, but this is now less common.

5.30 Respondents to our information requests suggested two explanations for this trend to sub-underwrite a lower proportion of issues:

• A decline in sub-underwriting capacity: There are both short term and long term elements to this decline in capacity:

- a long term reduction in capacity due to developments relating to institutional shareholders: Since the mid-1990s, the shareholder base of UK companies has become more diverse with a greater proportion of overseas investors, some of which are either unable71 or unwilling to participate in sub-underwriting of equity issues. Analysis of ONS data by the IIC indicates that, between 1994 and 2000, the proportion of UK equities owned by UK institutional investors declined from 60 per cent to around 45 per cent. This trend has continued, albeit at a slower pace, and by 2008 the proportion was around 40 per cent.72 We are also aware that there has been some consolidation among major investment funds which has reduced their overall capacity to sub-underwrite equity issues. The IIC and several respondents to our information requests consider that hedge funds and lending banks have, at least to some extent, replaced the lost sub-underwriting capacity from institutional investors.

- a short term decline in appetite for undertaking sub-underwriting due to the financial crisis and recession: Some respondents to our information requests noted that sub-underwriting capacity fell during the financial crisis as appetite for risk among

71 A number of stakeholders explained to us that overseas investors do not always have the same flexibility in rules and regulations to allow for sub-underwriting of UK share issues. The IIC’s RIFI Report in December 2010 noted that '[i]nternational investors however are generally unable or unwilling to sub-underwrite in the way that UK investors did in the past’ (page 19).

72 RIFI Report, chart 3, p.18.

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institutional shareholders was subdued due to the turbulent market conditions. Some investment banks indicated that interest in sub-underwriting among institutional shareholders has been returning recently.73

• Underwriters not seeking fully sub-underwritten issues: Some sub-underwriters told us in their responses to our information requests that this is a strategy by underwriters to increase revenues by retaining a higher proportion of the underwriting fee. For example, one sub-underwriter noted that '(t)here has been an increased tendency for the lending banks to act as primary underwriters and then retain that underwriting exposure rather than permit this to be passed onto the sub-underwriters, so as to maximise their fees from the transaction.' One investment bank, in response to our information requests, stated '(i)n recent years, investment banks have started playing a more important role in the rights issue market, providing underwriting services and being willing to retain hard risk on their own balance sheets; therefore, there is no longer a need to sub-underwrite 100 per cent of an equity issuance. Whilst there are no set rules as to the overall split, which is usually done on a transaction by transaction basis, recent averages have been around 50 per cent of the total underwritten amount on certain transactions; longer term average proportions have been lower in most cases.'

Sub-underwriting fees

5.31 The fees paid to sub-underwriters are not publically available, but data on levels of sub-underwriting fees for rights issues by FTSE 350 companies between January 2006 and 31 August 2010 was provided

73 For example, one sub-underwriter in response to our information requests, stated ‘at the beginning of 2009 when the tone of equity markets was cautious, it was difficult for companies to find enough sub-underwriting capacity to cover the whole amount of an issue. By the middle of 2009, the position was reversed and it was common for sub-underwriting to be comfortably over-subscribed.'

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by two institutional shareholders. This data only covers 44 out of the 51 rights issues that were carried out during this period.

5.32 The data shows that there was a significant increase in sub-underwriting fees in 2008 following the onset of the financial crisis and recession. From early 2006 to March 2008, sub-underwriting fees were often around one per cent of the deal value. After the onset of the financial crisis in 2008, however, sub-underwriting fees rose, and between February 2009 and November 2009 sub-underwriting fees were 1.75 per cent for all of the 27 rights issues that we have data on (out of the 30 rights issues that took place in this period). We have very little data for rights issues in 2010, so it is not possible to determine accurately the trend in sub-underwriting fees beyond the end of 2009.

5.33 Some increase in the level of sub-underwriting fees in the financial crisis may be expected given the increased levels of risk due to volatile stock market conditions. In their responses to our information requests, a number of market participants also referred to the reductions in sub-underwriting capacity discussed in paragraph 5.30 as a cause of the increase in sub-underwriting fees.

Conclusion

5.34 There are many suppliers of corporate broking services and equity underwriting services. The equity underwriting market is not highly concentrated, despite several mergers and acquisitions, both before and during the financial crisis and recession.

5.35 There have been significant increases in underwriting fees, discounts and sub-underwriting fees during this period. Some increase in these variables would be expected in the context of the financial crisis, given the increased risk of equity issues in turbulent stock market conditions. Our econometric analysis of underwriting fees for rights issues was consistent with underwriting fees having increased in this period even when taking into account the level of risk associated with these share

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issues.74 In addition, underwriting fees remained clustered at 3.5 per cent throughout 2009, despite a significant reduction in stock market volatility. We also found evidence that the level of discounts had clustered around a historically high level of 40 per cent during late 2008 and throughout 2009, despite the falling stock market volatility seen during 2009. Levels of sub-underwriting fees also appear to have risen in the financial crisis and clustered around 1.75 per cent during 2009, despite the falls in stock market volatility.

5.36 The small number of equity issues in 2010, and the specific characteristics of some of the companies that issued shares and the way in which the specific share issues were conducted,75 makes it difficult to draw clear conclusions about the speed and extent to which underwriting fees, discounts and sub-underwriting fees may be returning to previous ranges.

74 This analysis should be interpreted with caution and results are indicative rather than definitive. Further details of this analysis and its limitations can be found in Annexe D.

75 The IIC noted in its Right’s Issue Fees Inquiry that ‘The comparatively limited data for 2010, which saw a reduced number of issues, compared to the previous two years means that the apparent reductions in fee levels and discounts should be seen as essentially provisional in nature. A number of these issues were intrinsically of lower risk than those undertaken in the previous two years’ (page 16).

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6 HOW EQUITY UNDERWRITING SERVICES ARE PURCHASED

6.1 An optimal, efficient equity underwriting market requires companies, as purchasers, to drive competition. This, in turn, relies on those companies having the right incentives and the capability to enable them to act as effective purchasers. In this context, where relevant, it is important that shareholders (in particular, institutional shareholders) use their leverage to ensure that their interests as shareholders are safeguarded when the company raises equity capital.

6.2 This chapter looks at the incentives of companies and their executives and the way they shape the operation of the equity underwriting market. Different factors come into play at different stages of the equity underwriting process, and the incentives of companies, shareholders and other market participants may differ at the various stages of the process. The second part of this chapter therefore examines the incentives, abilities and negotiating power of the key players involved at different stages of the process, and the impact these factors have on the outcomes we see in the market. It ends by highlighting a number of possible options for addressing the issues identified.

Incentives of companies and their executives

6.3 The priorities of companies as purchasers of equity underwriting services are likely to depend, at least in part, on the reasons for the company wishing to raise capital. Chapter 3 describes some of these reasons and outlines the different options available to companies when raising finance.

6.4 Whilst this study focuses on raising equity capital via follow-on share issues, companies will consider their financing needs holistically. Some companies may look for suppliers who can meet a range of financing needs, and their decision about which equity underwriting supplier to appoint may reflect these wider considerations.

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6.5 Responses to our survey of companies that had recently raised equity capital, indicated that companies considered the following factors to be the most important when raising equity:

• Success with shareholders: a high ‘take-up’ of newly issued shares by existing shareholders delivers a positive message to the stock market about the company's position and is therefore highly valued. Companies are keen to avoid an outcome which leaves investment banks holding a substantial number of shares at the end of the issue period as this is likely to depress the share price76 and may be interpreted as a lack of faith in the company’s future performance and direction.

• Confidentiality: The leak of sensitive information can prevent companies from legitimately delaying disclosure,77 forcing them to make premature announcements about share issues and preventing them from presenting information in a manner of their choosing. A leak about an impending equity issue may also lead to a loss of value for an issuer and companies therefore emphasise the importance of confidentiality during the equity-raising process.

76 Industry commentary suggested that the market will know that the underwriters are left holding shares that they probably do not want and will eventually have to sell (a stock overhang).

77 Under the FSA Disclosure and Transparency Rules (DTR 2.2.1R), an issuer must notify a Regulatory Information Service as soon as possible of any inside information which directly concerns it unless an exception applies. The Disclosure and Transparency Rules (DTR 2.5.1R) allow an issuer to delay disclosure so as not to prejudice its legitimate interests (as defined), provided that: (1) the delay is not likely to mislead the public, (2) any recipient of the information owes a duty of confidentiality to the issuer and (3) the issuer is able to ensure the confidentiality of the information. The December 2009 edition of the UK Listing Authority (UKLA) newsletter, ‘List!', makes it clear that issuers and their advisors should, when delaying disclosure, continue to monitor various media (and when appropriate, market prices) for signs of possible leaks and/or related price movements. Whilst an issuer may not be required to respond to a rumour that is false, when speculation or market rumour is largely accurate, it is likely that an issuer can no longer delay announcement of inside information.

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• Speed of the process: a swiftly executed transaction is likely to reduce the risk of information leaks and thereby avoid the negative outcomes described above. Speed is also likely to be particularly important where, for example, funds may be required in a short period of time, for example to avoid breaching a bank covenant on a loan to the company or to meet a deadline for submitting a bid for an acquisition target.

6.6 At an individual level, a poorly handled issue might have a negative impact on the career prospects of the executives involved. This risk may reduce executives’ willingness to use innovative approaches to equity raising or to depart from the advice they receive, as it is more difficult to criticise them with hindsight if they followed this advice and/or established approaches.

Dynamics at different stages of the equity underwriting process

6.7 The way in which investment banks, as suppliers, respond to the incentives of companies also helps to explain the differing intensity of competition between investment banks for corporate broking compared to equity underwriting appointments and the tendency for suppliers to deliver a range of different services in a bundled manner.

6.8 In effect the first stage of significance for the equity raising process comes before any decision is taken to raise equity capital, when a company appoints its corporate broker or brokers. A company will appoint one or more corporate brokers to act as its agents and advisers on a broad range of topics, and the company-broker relationship may have been in place for many years before a share issue is contemplated. The second stage of the process is the appointment of one or more underwriters to provide advice on how and when to raise capital, carry out the administration, compliance and distribution work associated with the issue and guarantee the proceeds of the share issue. The third stage is the agreement of the underwriter’s fees and the level of discount at which the newly issued shares will be offered to existing shareholders. The final stage is the appointment of sub-underwriters and the agreement of the sub-underwriting fees.

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Appointment of the corporate broker(s)

6.9 For the company, the main priority is to appoint a corporate broker that will provide good quality advice and act as an effective channel of communication with investors. Companies want to find corporate brokers that they can trust and rely on and can work well with. When deciding which organisation to appoint, they tend to focus on the corporate broker’s reputation and the quality of their relationship with the corporate broker, rather than on the fees that they might be charged. Of the 48 companies that responded to our survey, 22 said that the reputation of the corporate broker in their sector was a ‘very important’ factor at the point at which a corporate broker was selected, 19 said that their existing relationship with the corporate broker was ‘very important’, and only two thought that the level of fees charged by the corporate broker for broking services was ‘very important’.

6.10 To assess the importance that companies attach to established relationships we analysed data on the number of FTSE 350 companies that switched some or all of their corporate brokers each year in the period between April 2000 and April 2010, shown in Table 6.1. We found that, on average, 18 per cent of companies changed at least one of their corporate brokers each year, including one per cent that had made a complete switch of their set of brokers, and three per cent that had switched the only broker they employed.

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Table 6.1: Rates at which FTSE 350 companies switched corporate brokers 2000-2010

Period (September to September)

Companies changing at least

one of their corporate brokers

(%)

Companies with two or more brokers making a

complete switch of corporate brokers (%)

Companies using a single broker

switching to another broker (%)

2000-01 16.3% 0.4% 4.8% 2001-02 14.3% 0.3% 4.0% 2002-03 19.7% 1.0% 5.9% 2003-04 12.5% 0.0% 1.7% 2004-05 22.5% 2.0% 4.0% 2005-06 17.8% 0.3% 3.0% 2006-07 20.8% 1.3% 4.0% 2007-08 16.2% 0.0% 2.5% 2008-09 22.3% 3.8% 2.7% 2009-10 16.0% 0.3% 0.3%

Average switch rate 17.8% 1.0% 3.3%

Source: Hemscott, OFT analysis.

6.11 To provide context, in April 2006, economic consultancy Oxera found that switching rates in the UK audit market were four per cent or less, which it described as ‘low’.78 In the UK commercial insurance sector, a June 2010 report by Datamonitor found that 19 per cent of small and medium enterprises (SMEs) changed their insurance provider at their last renewal.79

78 Oxera, Competition and choice in the UK audit market, April 2006, www.oxera.com/cmsDocuments/Reports/DTI%20Auditors%20executive%20summary.pdf. These findings were confirmed by the OFT in evidence to the Lords Select Committee on Economic Affairs in November 2010: House of Lords, Unrevised Transcript of Evidence to Lords Select Committee on Economic Affairs: Inquiry on Auditors – Market Concentration and their Role, www.parliament.uk/documents/lords-committees/economic-affairs/auditors/ucEAC091110ev5.pdf.

79 Datamonitor, ‘UK Commercial Insurance Distribution 2010’, June 2010, p.54.

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6.12 We also used Hemscott’s data on corporate brokers for the FTSE 350 to assess the length of time that companies typically retain appointed corporate brokers. A total of 89 companies had remained in the index for the 11-year period 2000-2010 and were thus suitable candidates for further analysis. Companies often have more than one corporate broker at any one time and we counted 263 ‘broker relationships’ during this period. As Table 6.2 below shows, over 55 per cent of relationships between a corporate broker and client lasted longer than five years, and over 25 per cent lasted longer than 10 years. By contrast, only 9.5 per cent of relationships lasted exactly five years or less. 80

Table 6.2: Duration of corporate broker relationships for the 89 companies remaining in the FTSE 350 from 2000-2010

Length of broker relationships Exactly n years At least n years 11 years N/A 23.2% 10 years N/A 27.0% 9 years 0.0% 35.4% 8 years 0.4% 37.6% 7 years 0.4% 43.3% 6 years 2.7% 51.3% 5 years 2.7% 58.6% 4 years 4.2% 63.9% 3 years 6.8% 70.0% 2 years 9.9% 81.7% 1 year 12.2% 87.8%

Source: Hemscott, OFT analysis.

6.13 There are a number of possible reasons why companies changed their

corporate brokers relatively infrequently. Of the 48 companies that responded to our survey, 14 said that establishing new relationships with corporate brokers made switching difficult. Almost as many (13) said the signal that it sent to the stock market about their company

80 For broking relationships that started and finished during the 11-year period from 2000 to 2011 it was possible to calculate the exact duration of the relationship. For relationships already in place in 2000 or still ongoing in 2010 (which applied to 36.5% of the relationships in the sample) we could only consider that they lasted ‘at least’ a certain number of years.

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made switching difficult. Only four respondents said that identifying suitable alternative providers made switching difficult.81

6.14 Many companies use competitive tendering processes to select their corporate brokers. Of the 48 companies that responded to our survey, 23 said that they appointed their corporate brokers by inviting a number of companies to pitch for the mandate in a competitive process known as a ‘beauty parade’. Competitive tendering processes have the potential to encourage rivalry between providers across a range of factors and to deliver benefits to companies in terms of the amount they pay and the quality of the services they receive.

6.15 The nature of the corporate broking role encourages investment banks to compete to win corporate broking positions. Becoming a corporate broker enhances opportunities to win other mandates, including equity underwriting work, by helping that corporate broker to develop in-depth knowledge of a company’s business and shareholder base and to develop relationships of trust with company executives. This knowledge and trust can then be used to win additional mandates, such as mergers and acquisitions advice and equity underwriting work.

6.16 The extent of competition amongst investment banks for corporate broking mandates is evident from the fact that investment banks commonly offer corporate broking services to companies free of charge (in effect, as a ‘loss leader’) in the expectation that they will then be offered other mandates when the need arises. Investment banks may also engage in ‘shadow broking’ - providing market related advice and similar services to companies for which they do not currently have broking mandates - in order to demonstrate to those companies the capabilities of the bank to act as a corporate broker and to position the bank as favourably as possible ahead of any possible beauty parade. Responses to our information request to investment banks suggest that

81 References to ‘difficult’ and ‘very difficult’ correspond to grades (4) and (5) on the scale outlined in Question 31 of the OFT’s survey of companies, where (1) denoted ‘not difficult’ and (5) denoted ‘very difficult’.

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many investment banks with corporate broking businesses engage in shadow broking to some extent.

Appointment of the underwriter(s)

6.17 When it comes to appointing an underwriter, company executives look for suppliers that are knowledgeable about the company, able to maintain confidentiality and able to ensure that the transaction is carried out quickly. The level of underwriting fee and share price discount are less important to them.

6.18 Of the 48 companies that responded to our survey, 32 said that the ability to maintain confidentiality was a ‘very important’ factor when it came to selecting an underwriter, 25 regarded the ability to ensure the transaction was carried out quickly as ‘very important’, whilst 19 considered the underwriter’s knowledge of their company to be a ‘very important’ factor. By contrast, only nine companies thought the level of underwriting fees had the same level of importance.

6.19 These priorities are reflected in the factors that banks say they used, or would use, to differentiate themselves from one another when pitching for equity underwriting work. Of the 21 investment banks that responded to our information request, 15 said they differentiated themselves from their competitors on the basis of their reputation for working successfully on similar transactions, 14 said that they emphasised their distributional capacity and relationships with key institutions, and 12 said that they highlighted the established relationship they had with the issuing company. By contrast, only six said that they differentiated themselves from competitors on the basis of fees charged for equity underwriting or for other services in respect of the transaction.

6.20 At the point when they come to select their underwriters, companies have relatively little negotiating power. Their preferences for speed, confidentiality and a successful share take-up tend to make them unmotivated to use competitive tendering processes. Such processes tend to be expected to raise practical concerns, in terms of time and resources spent, and to risk confidentiality breaches. Out of the 48

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companies that responded to our survey, only three said that they used formal competitive tendering mechanisms, such as beauty parades, when selecting equity underwriters on their most recent equity raising.

6.21 Most companies select their corporate brokers as equity underwriters. We examined 85 rights issues from the start of 2000 to the end of 2009 and, using data from Hemscott, we found that in 82 of the issues, corporate brokers were involved in transactions as underwriters.82

6.22 There may be a number of benefits from the same investment bank performing corporate broking and equity underwriting work. The knowledge and familiarity that a retained corporate broker gains through its relationship with company executives and shareholders can help it understand the position of the company and its equity capital needs, the likely response of shareholders to the share issue and the risks involved in underwriting the share issue.

6.23 There are also likely to be advantages in an investment bank handling the advisory and distributional aspects, and guaranteeing the proceeds, of the share issue. A detailed involvement in the advisory process may enable the underwriter to assess the risk of guaranteeing the proceeds of the issue better and thereby potentially charge lower underwriting fees. A commitment to underwrite may create an incentive for an institution to market the transaction effectively and may lend credibility to marketing initiatives and the quality of an institution’s advice. Finally, the involvement of the same investment bank in the advisory and administrative aspects and guaranteeing the proceeds can enhance consistency by ensuring that marketing messages are clearly presented and aligned with the transaction documentation.

82 The responses from companies to our survey is consistent with this trend to appoint brokers as underwriters. Of the 48 companies that responded to our survey, 38 said that they used their existing corporate brokers as underwriters in their most recent equity raising activity, 16 said they used their corporate lenders and only three companies used an underwriter from an investment bank that they did not previously have an existing relationship with.

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6.24 In addition to corporate brokers, lending banks can be in a strong position to win equity underwriting work. A company may wish to reward a lending bank for providing credit. We have also heard claims that lending banks have used the provision of credit to win equity underwriting work. Of the 48 companies that responded to our survey, 16 said that their corporate lender acted as an underwriter on their most recent equity raising.

6.25 Some organisations, known as universal banks, have integrated not just broking and equity underwriting work, but the full range of retail, commercial and investment banking activities. The universal banks have argued that this has been a response to companies’ preferences for a more holistic service83 but it may allow the banks to potentially cross-sell a number of different services.84

6.26 The way in which investment banks, as suppliers, respond to the incentives of companies may help to explain how the type of service that companies receive. Share issues which do not attract high levels of support are rare85 and when we asked companies about their satisfaction with the service provided by their underwriters, the two aspects of the service where their satisfaction was greatest were the speed of the process and the level of confidentiality maintained (although it should be noted that 9 out of the 48 companies that responded our survey told us they were aware of confidential information being leaked prior to the equity issue).

83 See, for example, the comments from the head of global capital markets at a European bank reported in efinancial news, ‘Consistency in investment banking league tables belies crisis-induced industry change’, 16 August 2010, www.efinancialnews.com/story/2010-08-16/league-table-consistency-despite-financial-crisis.

84 See for example, efinancial news, ‘Banks respond to a change in the in financial weather’, 16 November 2009, www.efinancialnews.com/story/2009-11-16/banks-respond-to-a-change-in-the-financial-weather.

85 In the last five years in the UK, only three rights issues have failed to achieve a subscription rate of higher than 90 per cent.

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Agreement of underwriting fees and discounts

6.27 Equity underwriters have an incentive to negotiate higher underwriting fees and discounts to the share price. The interest in increasing underwriting fees may be driven, in part and for some underwriters, by a desire to re-coup the costs of providing ongoing broking and advisory services for little or no charge. The interest in increasing the discount derives from the fact that, the lower the issue price, the more attractive the issued shares will be during the issue period and the less likely the underwriters will be called upon to purchase them. If the underwriters do have to purchase unsubscribed shares, deep discounts will allow them to obtain the shares at a better rate.

6.28 Other things being equal, companies have an incentive to hold down underwriting fees since this reduces the company’s equity-raising costs. However, as discussed in paragraph 6.5 above, companies’ priorities are confidentiality, speed and a successful transaction, rather than fee levels. The level of discount is important to company executives because of the signals it sends to the stock market about a company’s financial health and/or the credibility of the explanation for raising equity capital. These issues are discussed in more detail in Chapter 7.

6.29 When it comes to negotiating underwriting fees, the differing abilities of the companies and investment banks are likely to have a significant impact on the terms agreed. It is difficult for buyers in the market to understand whether they are receiving a cost effective outcome when they purchase equity underwriting services. Most company executives are not involved in raising equity capital frequently, which prevents them from building up sufficient experience of, and expertise in, the market to hold the underwriters fully to account. The complexity of the transaction also makes it difficult for buyers to make a full assessment of the value of the equity underwriting services being received. In particular, it is difficult for companies to understand how each element of the bundled equity underwriting service (advice on how and when to raise equity capital, the administrative and distributional work associated with the issue, and guaranteeing the proceeds) contributes to the total fee as fees are not typically broken down in this way. They may also find it difficult

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to assess the value of some of these individual elements and thus to judge what the overall fee should be.86 Finally, there are many factors that influence the success of a share issue and it is difficult for the buyers of the service to assess their underwriters' contribution to this success.

6.30 The differing abilities of companies and the investment banks cause an imbalance in fee and discount negotiations, and the timing for agreeing these terms exacerbates the imbalance. Whilst underwriting fees and discounts are discussed in broad terms at an early stage in the share issue process, precise levels are not usually finalised until later in the process (the exact timing varying on a case-by-case basis). Since underwriters tend to be appointed before fees and discounts are settled, issuing companies usually have little room for manoeuvre if they are unhappy with the terms offered. Companies sometimes face pressure to pay higher fees once the equity-raising process has started, and are constrained in the extent to which they can resist this. Similarly, if the share price discount is not finalised until the night before the issue is announced, this can also put companies at a substantial disadvantage.

6.31 Institutional shareholders are unlikely to have material influence on the level of the fee agreed at this stage. Generally speaking, their first involvement in the equity-raising process comes at the pre-marketing stage or once the issue has been announced.

Participation of sub-underwriters and agreement of sub-underwriting fees

6.32 Primary underwriters often invite institutional investors that have a significant holding in the company to participate in the equity underwriting process as sub-underwriters during the pre-marketing

86 For example, it can be difficult for companies to understand the level of risk that the underwriter is taking when it guarantees the proceeds of the issue.

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phase. Other shareholders and investors will usually be invited to participate once the issue has been announced.

6.33 In selecting their sub-underwriters, the investment banks look for institutions that are credit-worthy and have the capacity to purchase shares in the event of an under-subscribed issue. Primary underwriters generally remain liable for purchasing un-subscribed shares under the main underwriting agreement so they have an interest in ensuring that sub-underwriters do not default on their obligations.87

6.34 In deciding how much of a share issue to sub-underwrite, underwriters need to balance the advantages of retaining a higher proportion of the underwriting fee versus off-loading risk to sub-underwriters.

6.35 Sub-underwriters have voiced concerns that investment banks are holding back sub-underwriting business from them and holding on to a greater proportion of the underwriting fee than their risk of loss in a failed issue justifies.88 As sub-underwriters, institutional investors have an interest in ensuring that they receive a greater proportion of the overall underwriting fee.89

87 Other factors that banks are likely to take into account when selecting sub-underwriters include: whether or not the candidate institution it is an existing company shareholder, its existing profile of shareholdings, its reputation for investing in the sector, its history of participating in similar deals and the existing relationship between the institution and the investment bank.

88 See for example Institutional Investor Council, Rights Issue Fees Inquiry: Final Report, December 2010, p.22; The Economist, ‘Rights and wrongs: why price competition between investment banks is so feeble’, www.economist.com/node/16376936; Telegraph, ‘Myners calls for inquiry into bank fees’, 25 March 2010, www.telegraph.co.uk/finance/newsbysector/banksandfinance/7521410/Myners-calls-for-inquiry-into-bank-fees.html (accessed 16 December 2010).

89 As one institutional shareholder wrote in its response to our information request, ‘our starting point for negotiation is to get a bigger share of the ‘pie’ as opposed to mak[ing] the pie bigger itself’.

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6.36 Although primary underwriters engage sub-underwriters as a part of their strategy for managing risk, and payment is made from the proceeds of underwriting fees, companies have an interest in the level of sub-underwriting fees paid since they are likely to affect the overall underwriting fee. Sub-underwriters may end up becoming owners of un-subscribed new shares, so companies also have an interest in which sub-underwriters participate to ensure that sub-underwriters support the long-term interests of the company. Whilst companies lack formal power to determine sub-underwriter selection, we understand that companies are becoming increasingly involved in the selection of sub-underwriters of their share issues. Responses to our information requests suggested that, in many cases, investment banks recognised the need to discuss the allocation of sub-underwriting work with the issuer before making their final decision.

6.37 As with underwriting, the way in which the sub-underwriting process is structured can give investment banks an advantage in negotiations on terms and conditions. Whilst institutional shareholders are sophisticated market participants, their ability to negotiate better sub-underwriting terms may be limited by the way in which sub-underwriting fees are currently set.

6.38 Investment banks that responded to our information requests indicated that underwriters and companies tend to agree a starting point for the level of the sub-underwriting fee before the pre-marketing stage, having considered the risk profile of the transaction. Pre-marketing amongst a small group of selected institutional shareholders will be used to ascertain the overall sentiment of sub-underwriters for the proposed level of fees, which may confirm the initial proposal or lead to a revision of the fee level if appetite during pre-marketing proves insufficient. Some investment banks told us in their responses to our information request that the importance of securing the support of sub-underwriters during the pre-marketing phase has meant that, on occasion, some sub-underwriters have been able to negotiate a higher fee.

6.39 Institutional investors and investment banks told us that that generally there was no negotiation on sub-underwriting fees and that institutional

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shareholders were very often presented with a set of terms, on a ‘take-it-or-leave-it’ basis, that was uniform for all sub-underwriters. However, investment banks told us that the largest institutional shareholders tended to express a general expectation as to the level of fees they required for sub-underwriting, given the background level of market risk or volatility and the range of gross underwriting fees generally prevalent in the market. The investment banks said that the level of sub-underwriting fees proposed then tended to reflect these expectations. Institutional investors considered that, by the time they were involved in the process, it was often too late to start negotiations. One said, ‘in almost all instances we are consulted about our willingness to participate after the fee has been set, an arrangement we do not view as ideal’.

6.40 In 2010, one issuer, Resolution, formed a group of sub-underwriters from its top 10 shareholders and secured a formal commitment from them to sub-underwrite approximately 52 per cent of the rights issue, thereby reducing the risk involved in the transaction. Since the primary underwriters were taking on less risk, a greater proportion of the total underwriting fee than usual (nearly two thirds of the 2.72 per cent fee) went to Resolution’s existing shareholders.90 The success of this transaction suggests that if companies are able to maintain close relationships with their shareholders in the context of raising equity capital, they are likely to be in a stronger position to negotiate competitive equity underwriting terms. The RIFI report in 2010 encouraged issuers to talk to shareholders directly before matters reached the price-sensitive stage.91

Summary of issues identified

6.41 Our analysis of the equity underwriting market has uncovered a number of issues that suggest the market may not be working in the most

90 See efinancial news, ‘The Resolution way: a study in innovation’, 11 October 2010, www.efinancialnews.com/story/2010-10-11/resolution-innovation.

91 RIFI Report, p.27.

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efficient manner possible. These issues arise from structural features of the market, namely asymmetric information, issues on the demand side and supply-side issues.

6.42 In terms of structural features, there appear to be information asymmetries in the equity underwriting market which adversely impact upon competition. It is difficult for companies to assess whether they are receiving a cost effective outcome when they purchase equity underwriting services because most are not involved in raising equity capital frequently, which prevents them from building up sufficient experience of the market to hold their underwriters fully to account on fees. The complexity of the transaction also makes it difficult for companies to make a full assessment of the value of the equity underwriting services being received.

6.43 We found that there is limited transparency in the market over fees and discounts for equity issues. Underwriting fees and discounts are disclosed in prospectuses but this, together with the information asymmetries, leads to negotiations over fees and discounts based on a perceived ‘going rate’ related to other recent transactions, rather than the parties’ judgements on the overall value of the equity underwriting service being received on a transaction-by-transaction basis.

6.44 On the demand side of the market, we found that companies display limited price sensitivity when they purchase equity underwriting services. Their priorities tend to be speed, confidentiality and the successful take-up of new shares, and they rate the price of the service as less important. These priorities explain possibly why most companies select their existing corporate brokers as underwriters. They also explain why companies appear unmotivated to hold a competitive tender for equity underwriting services.

6.45 Institutional shareholders, as investors, are generally much more focused on the cost of raising equity capital but appear to have had little success in persuading companies to act on their concerns.

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6.46 The ways that investment banks, as suppliers respond to the priorities of companies and the nature of the corporate broking role help to explain why banks appear to compete hard for broking appointments but do not appear to need to compete strongly for equity underwriting mandates. Investment banks use corporate broking as a potential channel to win equity underwriting and other mandates.

6.47 In Chapter 5 we found that increased stock market volatility in the financial crisis and recession tended to increase both underwriting fees and share price discounts, and that while volatility fell quickly, discounts and underwriting fees have been exhibiting stickiness at higher levels. We found that a combination of the disclosure of underwriting fees and discounts in prospectuses, together with the asymmetry of experience, expertise and information inherent in the market, may help to explain these trends.

6.48 We also found that, since the onset of the financial crisis, there has been a relatively strong clustering of sub-underwriting fees, with fee levels being centred on 1.75 per cent in almost all instances in 2009 and in some issues in 2010. A potential explanation for this clustering of sub-underwriting fees may include the conduct of larger institutional shareholders and the conduct of underwriters. We found that large institutional investors may be able to indicate to investment banks an expected going rate for sub-underwriting and that primary underwriters tend to set the rates for sub-underwriting work on a ‘take it or leave it’ basis rather than creating competitive tension over sub-underwriting fees.

Potential ways to address these issues

6.49 The issues we have highlighted suggest that companies and institutional investors could take steps to achieve more cost effective outcomes, principally by applying greater pressure on underwriting fees and discounts.

6.50 We found that the complexity of the transaction, different experience, expertise and information of company executives and investment banks

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and dynamics at different stages of the equity underwriting process cause an imbalance of power between purchasers and suppliers of equity underwriting services. There are a number of sources of relevant advice available to Chief Financial Officers and Chief Executive Officers to assist in appointing and managing their underwriters. Company executives could also take greater advantage than they currently do of the knowledge and experience which their institutional shareholders and legal advisers will have of rights issues. Companies also have the option of obtaining independent advice,92 but only 17 of the 48 companies that responded to our survey did so.93

6.51 We also found a tendency for companies to appoint their retained corporate brokers as underwriters instead of arranging a competitive process for these underwriting appointments. A small number of companies have introduced additional underwriters into the transaction while the issue is being prepared - of the 48 companies that responded to our survey, 10 said that they brought in additional underwriters after making initial appointments in their most recent equity raising activity.

6.52 Options available to companies to improve competitive tension between investment banks pitching for equity underwriting appointments include:

• Requesting a breakdown of the underwriter’s proposed fees into constituent components. This could potentially help companies to apply downward pressure on fees on each element of the total underwriting fee. There may also be scope for awarding and agreeing fees for different aspects of the work at different times - for example awarding and agreeing the fees for the advisory, administrative and distributional work upfront, but awarding and agreeing fees for

92 Independent advice is defined here as advice from a party who did not underwrite the share issue.

93 Appointing independent advisers will of course entail a cost. Respondents to our survey that had used independent advisers had mixed views as to whether doing so had enabled the company to reduce the cost of the transaction overall.

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guaranteeing the proceeds of the share issue later in the process, as the risks involved become more clear.

• Inviting the investment banks with which they have an existing relationship, including corporate brokers and lenders, to compete with each other for certain elements of the underwriting work. The advantages of using competitive tendering for different aspects of the equity underwriting process have been highlighted in a number of reports.94 Tendering mechanisms have the potential to encourage rivalry between prospective suppliers and to deliver benefits to companies such as the reduction of issue costs, although there may be potential disadvantages which would need to be taken into account.95 However, where tendering is not possible it may still be possible to create competitive tension by inviting the banks that they have existing relationships with, including corporate brokers and lenders, to compete with each other for certain elements of the equity underwriting work.

• Increasing the number of banks that they have relationships with. This may enable them to increase the pool of potential providers and create greater competitive tension when they award equity underwriting or other transactional work.96

94 Office of Fair Trading, ‘Underwriting of Equity Issues: A report by the Director General of Fair Trading’, March 1995 (London: OFT, 1995), paragraph 6.21; Monopolies and Mergers Commission, ‘Underwriting services for share offers: a report on the supply in the UK of underwriting services for share offers’, available at www.competition-commission.org.uk/rep_pub/reports/1999/424under.htm#full, paragraph 4.23; RIFI Report, pp. 6, 7, 23 and 30.

95 Holding a tender process would incur costs for the company in terms of staff time and for the underwriters in preparing pitches, and the latter cost is likely to be passed on to companies.

96 Increasing the number of investment banks or corporate brokers with whom companies have a relationship can increase costs. This can arise from a reduction in economies of scale and scope from work being divided between more organisations. It may also increase management overheads and increases the possibility of conflicting advice from different investment banks.

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6.53 In December 2010, the IIC’s RIFI argued that improved transparency on underwriting fees would help to improve scrutiny of underwriting fee levels by market participants.97 Whilst we agree that greater transparency of the prices paid by other companies raising equity may reduce the informational advantages of investment banks, we are concerned that requiring companies to publish detailed information on equity underwriting fees could have unintended consequences. First, if companies mistakenly take the price that is published as an indication of the competitive price paid by all companies for equity underwriting services, increasing transparency could lead to reduced variation in the prices of transactions. Second, access to a detailed price list is likely to make it easier for investment banks to compare the fees charged by their competitors for specific elements of the service, which may create a focal point for prices.

6.54 Institutional shareholders appear to place a greater emphasis than companies on securing competitive fees and discounts but do not seem to have sufficient traction with companies or investment banks to achieve better outcomes. Options available to institutional shareholders include applying greater pressure on the companies they own shares in to reduce underwriting fees, for example by having regular discussions with company executives about the principles that they would like to see adhered to on future equity raising and by doing more to hold companies to account for the way in which the share issue is conducted and the fees and discounts agreed.

6.55 There may also be steps that institutional shareholders could take during the equity raising process itself that could contribute to a reduction in fees. They may be able to:

• commit where possible to sub-underwriting issues before they are announced, reducing the risk that the underwriter bears and thereby, potentially, reducing the total underwriting fee paid by the company, and/or

97 RIFI Report, p.25.

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• indicate that they are willing to accept lower sub-underwriting fees and, as a result, apply pressure for primary underwriters to bring down their fees to reflect the reduced cost of bearing the risk.98

6.56 We recognise that committing to sub-underwriting issues before they are announced involves a cost to sub-underwriters and may not be possible in all circumstances. Institutional shareholders committing to sub-underwriting involves them being taken inside the deal and can restrict their ability to trade in the shares until the deal is announced. In addition, a commitment to sub-underwrite at an early stage (when they do not have knowledge of the market appetite for the transaction) is likely to involve increased risk.

6.57 There are a number of potential regulatory reforms of the market that we have considered but rejected for the reasons set out below:

• Using regulation to unbundle the three elements of the equity underwriting service in order to create competition for each of those elements. This could lead to companies achieving greater accountability from investment banks over charges for each of the elements of underwriting. Nevertheless, there may be synergies that occur from equity underwriting services being bundled. For example, the knowledge and familiarity that a retained corporate broker gains through its relationship with company executives and shareholders can help it understand better the position of the company and its equity capital needs, the likely response of shareholders to the share issue and the risks involved in underwriting the share issue. Companies seem best placed to judge the benefits of underwriters providing a bundled equity underwriting service. We note, in addition,

98 According to the December 2010 RIFI Report, institutional investors were willing to sub-underwrite at lower fees if the risks were lower than average, but were reluctant to do this in the absence of a corresponding reduction in lead underwriting fees. See Institutional Investor Council, Rights Issue Fees Inquiry: Final Report, December 2010, p.22.

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that the RIFI noted ‘very limited appetite of listed companies to contemplate unbundling the remuneration of advisers’.99

• Using regulation to require full public disclosure of the detail of how underwriting fees break-down, including the level of sub-underwriting fees. This could reduce the apparent information asymmetry between underwriters and companies on how underwriting fees are made up. However, such detailed disclosure could also make it easier for investment banks to compare the fees charged by their competitors for specific elements of a bundled service offering, which may create a focal point for prices.

Conclusion

6.58 The way in which equity underwriting services are supplied reflects, to a great extent, the motivations, incentives and abilities of companies as purchasers. These motivations do not necessarily align fully with the priorities and incentives of company shareholders who tend to be more price sensitive. Our analysis suggests that institutional and other shareholders have not exerted sufficient pressure to achieve cost effective outcomes in the equity underwriting market.

6.59 We do not consider it appropriate to set out a set of specific measures that should apply in all cases to address the structural features, and issues on the demand and supply side of the equity underwriting market. The best approach will often depend on the particular circumstances of an equity issue. Instead we have identified a set of options that may enable companies to more cost effective outcomes, principally by applying greater pressure on underwriting fees and discounts. We also consider it important that institutional shareholders make better use of their leverage as shareholders and apply greater pressure on companies to achieve better outcomes when they raise equity capital. We have also set out actions which institutional shareholders could consider taking to

99 See RIFI Report, p. 25.

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reduce the costs of raising equity capital, by reducing the cost of sub-underwriting.

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7 CONFLICTING INTERESTS

7.1 The roles that both investment banks and institutional shareholders perform in the equity underwriting market create the potential for their respective interests to conflict with those of companies raising capital. If conflicts occurred, this could in turn have an impact on the efficient functioning of the market.

7.2 This chapter outlines the potential points of difference between the interests of companies and underwriters, and between companies and institutional shareholders, with respect to equity raising. Where interests do potentially diverge, we look at whether there are any factors which mitigate the consequences of this divergence, and consider whether any of these points of difference are affecting the efficient functioning of the market.

Alignment of interests between companies and underwriters

7.3 During a share issue, both companies and underwriters have an interest in maximising the take-up of shares. For underwriters, a fully-subscribed issue means they will not have to purchase any un-sold shares at the end of the process. Similarly, companies prefer a fully-subscribed issue with shares issued to long-term investors rather than underwriters who may sell-down any shareholding they are left with.100

7.4 There are also reputational reasons why a high take-up is important to companies and underwriters. For companies, low take-up will be regarded as indicating low shareholder support, which is likely to be perceived negatively by the stock market. For underwriters, low take-up may reflect poorly on perceptions of the investment bank’s ability to manage an equity raising successfully.

100 The market assumes the underwriter will seek to sell down its shareholding and factors this into the price of the issuers share price, depressing it.

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7.5 Investment banks emphasised strongly in their responses to our information requests that reputational risk is also a major factor in ensuring they do not put their own interests ahead of those of their client’s - an investment bank suspected of taking advantage of the trust of a client would be at significant risk of losing existing clients and could find it more difficult to win new clients thereafter.

7.6 Investment banks also pointed out that, pursuant to various FSA regulations, they have an overarching duty to act fairly, pay due regard to the interests of their customers and manage and avoid conflicts of interests.101 Investment banks often act as Sponsors in equity-raising102 and the UK Listing Rules specifically require them to disclose all conflicts of interest and to put measures in place to manage any such conflicts.103

7.7 In order to comply with these regulatory requirements, most investment banks indicated that they have detailed procedures and measures in place which ensure that the advice they give is not affected by the profits they stand to gain.

7.8 Notwithstanding the regulatory requirements on investment banks to manage conflicts of interest, the bundled service which equity underwriters generally provide to companies104 leads to the following potential conflicts of interest:

101 Principle 8 of FSA’s Principles for Business (PRIN); Chapter 10 of the FSA’s Senior Management Arrangements, Systems and Controls Sourcebook (SYSC) imposes specific requirements such as disclosure and management of conflicts of interest.

102 In large transactions, it is not uncommon for more than one investment bank to perform this role as joint Sponsors. See footnote 5 for an explanation of the role of Sponsor.

103 UK Listing Rules 8.3.7 to 8.3.10 provide that where a Sponsor is not reasonably satisfied that it will not be able to prevent conflicts from having an adverse effect on it performing its role, it must decline to act.

104 That is, providing advice, administration, compliance and distribution services and guaranteeing the proceeds of the share issue.

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• advising companies on whether to raise equity when, as underwriters they stand to earn substantial fees from equity raising,

• advising companies on the issue price for the new shares, when as underwriters they benefit from higher discounts as this decreases the risk of low take-up, and

• having an incentive to hedge their risk as underwriters, guaranteeing the proceeds of the share issue, when this may potentially have an adverse impact on their clients’ share price.

7.9 Each of these is considered in turn below.

Advising companies to raise equity

7.10 We have considered whether investment banks face a conflict of interest in advising companies whether or not to raise equity when they will be remunerated for underwriting the issue if the equity-raising goes ahead. Underwriting a share issue represents a significant revenue-earning opportunity for investment banks. It is common for them to provide on-going corporate broking and advice – including advice on whether to raise equity – to FTSE 350 companies for little or no remuneration in anticipation of being awarded future mandates such as advising on mergers and acquisitions or underwriting an equity issue.

7.11 While many of the companies we surveyed and independent advisors105 that responded to our information requests recognised this potential conflict, they also set out reasons as to why it does not result in practice in unnecessary equity raising. Aside from the reputational and regulatory factors outlined above, FTSE 350 companies are required to provide shareholders with full reasons for raising equity in the prospectus (where required), and (in any event) will need to provide a credible explanation

105 Twenty-one of the 48 companies that responded to our survey and all five of the independent advisors that responded to our information request identified this as a potential conflict of interest.

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for an issue when distributing the new shares, so it should be apparent where a company has been advised to raise equity unnecessarily.

7.12 Although one institutional shareholder suggested there had been instances where companies had either raised equity unnecessarily or raised too much equity, no evidence was provided to support this claim and no other respondents to our information request made this point.

7.13 In light of the above, we consider that, while there may be the potential for conflict between underwriters’ duties as advisor and their roles in advising on whether to raise equity, this does not appear to be resulting in unnecessary equity raising transactions.

Pricing the issue

7.14 We have considered whether investment banks face a conflict of interest in advising issuers on an appropriate discount at which to offer new shares, when they stand to benefit from higher discounts which reduce the risk they will have to purchase unsubscribed shares. This issue is most pronounced in the case of rights issues, where there is no limit on the discount at which new shares can be issued.106

7.15 Both companies and underwriters will want to ensure the discount is sufficient to attract shareholders to purchase new shares and to protect against a fall in the stock market price. Where the stock market price falls below the issue price there is no incentive for investors to take up the newly issued shares since it would be cheaper to purchase any further shares on the open market.

7.16 Both companies and underwriters will also be incentivised to discount sufficiently to make the issue attractive for potential sub-underwriters who, like underwriters, will want to ensure the discount allows sufficient latitude for a fall in stock market price of the shares. We were informed

106 Placings and open offers can be discounted to an unlimited extent in theory as well, but shareholder approval is required above 10 per cent: UK Listing Rule 9.5.10.

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by investment banks in their responses to our information requests that some institutional investors will not sub-underwrite a rights issue if the discount is not sufficiently large.107

7.17 Conversely, companies and underwriters will not want to discount a share issue too deeply, as this may be interpreted as a sign of weakness by the stock market. For example, the stock market may view a high discount as a sign that the company is in ‘distress’ and urgently needs capital to survive, or that the explanation of the share issue presented to potential investors is poorly developed or unconvincing.

7.18 Most of the investment banks noted in their responses to our information requests that, in principle, the level of the discount makes no difference to the amount that a company can raise. For example, where a company wishes to raise £200m, it will receive the same proceeds whether it issues 200 million shares at £1 each or 100 million shares at £2 each. Although a number of companies appeared to agree, over half108 of the companies which responded to our survey indicated that they in fact regarded the level of discount as either ‘important’ or ‘very important’. This was corroborated by other market participants who indicated that companies will not seek to price issues with a larger discount than offered in recent similar equity raising transactions without a good reason.

7.19 Various reasons were given for why companies attach such importance to the level of the discount for rights issues. One reason commonly cited was that, until quite recently, discounts were viewed by the stock market as a proxy for the risk associated with an equity-raising. Historically, a discount of 40 per cent may have been seen as a sign that

107 One investment bank indicated that some institutional shareholders will not sub-underwrite if the discount is not at least 30 per cent, while another indicated that some institutional investors would not sub-underwrite if the discount was not at least 40 per cent during the global financial crisis.

108 Of the 48 respondents to our company survey, 32 rated the level of discount as being either ‘important’ or ‘very important’ to them.

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a company urgently needed capital. More recently, however, discounts of 40 per cent or even higher have become more frequent. Indeed, almost all rights issues that have been discounted at 40 per cent in the past two years have received subscription rates of over 90 per cent.

7.20 Another reason given was high discounts can be unwelcome to shareholders because they disadvantage shareholders who do not subscribe to rights issues as a higher discount means a larger number of shares need to be issued to raise the required amount of capital, leading to a bigger dilution of the control of existing shareholders. As noted at paragraph 4.5 above, shareholders who do not take up their allocation in a rights issue are compensated via the trading of their nil-paid rights or via a share of the proceeds from the sale of rump shares. We were told, however, that these mechanisms do not always operate effectively in delivering full compensation to non-subscribing shareholders.109

7.21 We consider that while there may be potential for the interests of companies and investment banks to conflict in the context of the pricing of share issues, this does not appear to raise significant concerns in practice. Although we received a number of complaints from institutional shareholders that discounts levels are too high, we considered that there is little evidence that this is due to any potential conflict of interest between companies and investment banks. As noted in Chapter 5, the level of risk involved with raising equity has increased in the past five years, and was particularly high in 2008 and 2009. Furthermore, as we set out in Chapter 6, the differing abilities of companies and the banks cause an imbalance discount negotiations, and the timing for agreeing these terms exacerbates the imbalance. These appear to have been more dominant factors in explaining the increase in discounts.

109 A number of independent advisers commented in their responses to our information requests that the market for nil-paid rights during a rights issue can be illiquid, which makes it more difficult for shareholders to obtain fair value for their rights.

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Underwriters hedging their risk

7.22 We have considered whether underwriters face a conflict of interest given the incentive to hedge their risk as underwriters guaranteeing the proceeds of the share issue, when this could potentially have an adverse impact on their clients’ share price.

7.23 Occasionally share issues do not attract the expected level of shareholder support,110 which can result in the underwriters having to buy a proportion of unsubscribed shares. Underwriters may therefore have an incentive to hedge this risk by using various financial products. Companies will not want underwriters to engage in strategies that may have a negative impact on the company’s share price. An underwriter short-selling111 a company’s shares, for example, can itself have a negative impact on a company’s share price, and disclosure of this information to the stock market may have a further negative impact on the share price.112

7.24 Of the 48 companies that responded to our survey, 27 considered that this potential conflict exists, with only seven responding that they did not consider there to be a conflict.113 Investment banks, however,

110 In the last five years in the UK, only two rights issues have failed to achieve a subscription rate of higher than 70 per cent.

111 Short-selling is where a buyer borrows shares from a lender and sells them to a third party in anticipation of the price of the shares falling. When the price falls, the buyer purchases the shares again and returns them to the lender, making a profit on the difference between the sell and buy prices. Where a stock is short-sold without it actually first being borrowed, this is known as ‘naked short selling’. A number of countries, including the US, Germany, France and Australia have banned naked short-selling.

112 FSA regulations require the disclosure of a short position in a company of over 0.25 per cent, and so an underwriter which takes a significant short position in a company will need to notify the market of this. Where an underwriter engages in short-selling based on information not publicly available to the market, this may constitute ‘market abuse’ under section 118 of the FSMA.

113 The remainder answered ‘do not know’ or did not have an opinion.

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indicated in their responses to our information requests that that they do not regularly mitigate underwriting risk in this manner and do not consider there to be a conflicting interest.

7.25 While some investment banks advised that they had hedged against stock market volatility (for example, using FTSE 100 put options), others advised that they did not see these as effective ways to manage underwriting risk and were of the view that internal risk management controls and sub-underwriting are more effective. For example, we were advised that for a stock market index hedge to be effective, the company would need to comprise a substantial part of the index (over 10 per cent), which tends to constrain its use to equity issues involving very large companies.114

7.26 As regards hedging against the volatility of an individual company’s share price, the majority of the investment banks we surveyed indicated that such hedges – unless specifically sanctioned by companies – would probably be contrary to their obligation to manage conflicts of interest.115 We also found that many companies have inserted clauses limiting hedging activity in underwriting agreements. For example, we were told that most underwriting agreements now contain provisions which specifically prohibit hedging activity without prior consent from the issuer except in the ordinary course of business. In addition, responses to our information request indicated that more companies are starting to insist on similar restrictions for sub-underwriters of their equity issues.

7.27 In light of the above, we consider that while there may be a potential conflict of interest over possible hedging strategies available to investment banks, this does not appear to raise any significant concerns in practice. We did not find any evidence that hedging strategies have

114 Perhaps because of this, we were informed that underwriting agreements often have provisions which prohibit index hedges where a company accounts for a significant percentage of an index.

115 See paragraph 7.6, above.

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been used in ways which have harmed companies during issue periods, and consider that companies can protect themselves adequately through negotiating appropriate clauses in underwriting agreements.

Alignment of interests between companies and institutional investors

7.28 Institutional shareholders could have conflicting interests in their roles as investors (where they would like capital to be raised as cheaply as possible) and potential sub-underwriters (where they may have an incentive to press for higher sub-underwriting fees).

7.29 Of the 48 companies that responded to our survey, 20 considered that this was a potential conflicting interest. A number of institutional investors indicated that sub-underwriting fees are a small part of their business,116 and that they have an incentive to press for fees to be lower as this reduces the cost of capital.

7.30 We considered whether institutional shareholders would benefit from higher sub-underwriting fees on the transactions that they sub-underwrite. Broadly speaking, it is likely that sub-underwriters will only benefit from higher sub-underwriting fees when they sub-underwrite a proportion of the transaction greater than their existing shareholdings.

7.31 Two institutional investors provided data showing recent equity raisings they had underwritten and the respective values of their sub-underwriting obligations vis-à-vis their prevailing shareholdings. In several cases institutional investors have sub-underwritten a proportion greater than their shareholding. In addition, most of the institutional shareholders which responded to our information request advised that they are prepared to sub-underwrite a value in excess of their prevailing shareholding in a company. As such, we consider it theoretically possible that institutional investors may, in some circumstances, benefit from higher underwriting and sub-underwriting fees.

116 Data we received from two institutional investors showed that sub-underwriting fees represented less than 0.1 per cent of their total retail and institutional funds under management.

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7.32 We then looked at the ability of sub-underwriters to negotiate increases in underwriting fees. Institutional investors told us that they have limited ability to do this and they typically sub-underwrite at the price offered to them by underwriters. However, while a number of investment banks told us that sub-underwriters usually accept the fee they are offered, others told us the importance of securing the support of sub-underwriters during the pre-marketing phase has meant that, on occasion, some institutional shareholders have been able to negotiate a higher fee.

7.33 We examined whether there are strategies available to companies to overcome the effects of this potential conflict. One option is for companies to become more involved in the selection of sub-underwriters of their share issues, and the terms on which they sub-underwrite, and we understand this is increasingly happening. Companies could also employ independent advisors. One further option may be to restrict the amount of sub-underwriting any one institution receives, and therefore its bargaining power in negotiating its sub-underwriting fee, but this may not be possible where there is limited sub-underwriting capacity.

7.34 In light of the above, we consider that while there may be a potential conflict of interest over the level of sub-underwriting fees, there is limited evidence that this is leading to higher sub-underwriting fees. We have found that institutional shareholders, as a group, do not have an incentive to lobby for higher sub-underwriting fees and have only a limited ability to negotiate higher sub-underwriting fees on a case by case basis.

Conclusion

7.35 The interests of companies, underwriters and institutional investors broadly align: all have an interest in equity issues being efficiently conducted with a high level of shareholder support. While the interests of companies may diverge from those of their underwriters, and their institutional shareholders, on the issues discussed above, we have seen little evidence that these differences are significantly affecting the efficient operation of this market.

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7.36 For each potential conflicting interest which investment banks face, there are measures available that companies can take to mitigate their effects, for example, by including provisions in underwriting agreements. In addition, underwriters have duties to manage conflicts between their interests and those of their clients.

7.37 Regarding institutional investors, while they may in some circumstances benefit from increased sub-underwriting fees, they have advised that they would prefer to see companies minimising the cost of capital. Although there may be some specific situations where higher sub-underwriting fees can be negotiated, in general there is limited evidence of sub-underwriters pressing for higher sub-underwriting fees.

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8 CONCLUSION AND NEXT STEPS

8.1 The equity capital market is an important source of funds for both new and established companies in the UK, and the long-term growth of UK economy partly depends on the ability of companies to raise equity capital efficiently. Since the onset of the financial crisis there has been a significant increase in the level of equity underwriting fees, with the average fee for rights issues rising to more than 3 per cent in 2009 from around 2 to 2.5 per cent in the period from 2003 to 2007, prompting concerns from companies raising equity capital and institutional shareholders.

8.2 This market study has examined equity underwriting services for the different types of follow-on share issues used by FTSE 350 listed companies to raise capital in the UK. We have looked at how equity underwriting services are purchased, how they are provided, and how the regulatory environment affects their provision, with the aim of understanding how the market works and identifying any concerns that arise. This chapter starts with an outline of our key conclusions. It then considers the issue of an MIR, including a more detailed summary of the issues identified in this market study. Finally, it sets out some next steps.

Key conclusions

8.3 An optimal, efficient equity underwriting market requires companies, as purchasers, to drive competition. This, in turn, relies on those companies having the right incentives and capability to enable them to act as effective purchasers. In this context, where relevant, it is important that shareholders (in particular, institutional shareholders) use their leverage to ensure that their interests as shareholders are safeguarded when the company raises equity capital. Our analysis suggests, however, that companies do not always negotiate cost effective outcomes with investment banks; and institutional shareholders do not always put sufficient pressure on companies to reduce costs.

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8.4 Although in principle, companies may be able to choose between raising equity capital and other forms of capital raising such as debt or internal funding, and there appears to be range of options for raising equity capital, in many cases the type of capital raised and the method used will be dictated by the company’s reason for raising capital, the amount that needs to be raised and the particular circumstances of the company.

8.5 Companies also typically do not consider a range of options when appointing equity underwriters - predominantly, they select their corporate brokers for the reasons outlined in Chapter 6. As a result, there is little competitive tension between investment banks for equity underwriting appointments. Instead competition is focused on securing roles as corporate brokers which enhances the ability of the investment bank to secure future mandates.

8.6 We have also found that companies, albeit sophisticated purchasers of services generally, typically lack regular, repeated experience of equity-raising and are, in any event, not focused principally on the price they are paying for equity underwriting services when they issue shares. Companies are also often in a weak negotiating position when they come to agree fees and discounts, usually at a late stage in the process, because it can be difficult to change underwriters once an issue has begun.

8.7 We have set out in the report a number of options that may be available to companies and shareholders to achieve more cost effective outcomes in this market. These include a number of broad proposals to increase the knowledge, and improve the bargaining position, of companies involved in equity capital raising. They also include some more specific proposals that may be appropriate in certain cases, particularly relating to the scope for institutional shareholders to commit to sub-underwriting prior to the announcement of an issue. These options, and the analysis that underlies them, are discussed in more detail in Chapter 6.

8.8 This market study has also provided a detailed analysis of equity underwriting fees and discounts and sub-underwriting fees. We have found that the significant increase in underwriting and sub-underwriting

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fees since 2007 can be explained, at least in part, by the increase in stock market volatility and therefore risk in this period. However, our analysis suggests that fees and discounts have been slow to fall in line with subsequent reductions in risk, in particular from lower stock market volatility. Our analysis suggests that this may be the result of companies not negotiating cost effective outcomes with investment banks and shareholders not putting sufficient pressure on companies to reduce costs.

8.9 We also considered whether the equity underwriting process raises potential for the interests of both institutional shareholders and investment banks to conflict with the interests of companies raising capital. However, we have found little evidence to suggest that the potential conflicts that we had initially identified are preventing companies from achieving cost effective outcomes.

8.10 Institutional shareholders could have conflicting incentives given their roles as both investors (where they would like capital to be raised as cheaply as possible) and potential sub-underwriters (where they may have an incentive to push for higher sub-underwriting fees). However, we consider that, while there may be a potential conflict of interest over the level of sub-underwriting fees, this does not appear to raise any concerns in practice. We have found that institutional shareholders, as a group, do not have an incentive to press for higher sub-underwriting fees and have only a limited ability to negotiate higher sub-underwriting fees on a case by case basis.

8.11 There are a number of areas where investment banks’ incentives may not always fully align with those of their clients. However, underwriters are under a general legal obligation to manage conflicts of interest, and the underwriter who acts as the nominated Sponsor117 on the transaction has a specific duty to identify and manage existing conflicts. Importantly, many companies raising equity seem to be aware of these

117 Broadly, the role of Sponsor is to ensure that a company complies with all its obligations under the Listing Rules, and vouch for this before the FSA.

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potential conflicts and have taken steps to address them - for example, it is now common practice for companies to restrict the hedging activity of their underwriters within underwriting agreements and a number of companies engage independent advisors to provide guidance on both when to raise equity and the appropriate fees and discounts.

8.12 We have also set out in detail the processes involved in equity capital raising. This should assist companies in understanding the process and achieving better outcomes.

Market investigation reference

8.13 One of the actions that can result from a market study is a market investigation reference to the Competition Commission (CC). The OFT will make a reference to the CC only when the reference test set out in section 131 of the Enterprise Act 2002 is met, and when it is satisfied that a reference to the CC would be the most appropriate way of proceeding.118

Application of the Section 131 test

8.14 Under section 131 of the Enterprise Act, the OFT may make a market investigation reference to the CC where it has reasonable grounds for suspecting that any feature, or combination of features, of a market in the United Kingdom for goods or services prevents, restricts, or distorts competition in connection with the supply or acquisition of any goods or services in the UK or a part of the UK.

8.15 Section 131(2) states that a feature of a market is to be construed as a reference to:

• the structure of the market concerned or any aspect of that structure

118 See OFT guidance on Market Investigation References (‘MIR guidance’), paragraphs 1.6 and 1.10. www.oft.gov.uk/shared_oft/business_leaflets/enterprise_act/oft511.pdf.

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• any conduct (whether or not in the market concerned) of one or more than one person who supplies or acquires goods or services in the market concerned, or

• any conduct relating to the market concerned of customers of any person who supplies or acquires goods or services.

‘Conduct’ includes intentional or unintentional failure to act and other unintentional conduct.119

8.16 We consider that there are a number of features of the equity underwriting market which provide reasonable grounds for suspecting that competition for equity underwriting services is prevented, restricted or distorted. These features are:

• information asymmetries which adversely affect the ability of companies raising equity capital from negotiating more cost effective outcomes

• limited price sensitivity of the part of buyers, and

• supplier conduct that tends to encourage underwriting fees and sub-underwriting fees to be set on the basis of a ‘going rate’.

8.17 Taken together, these features may have contributed to trends identified in this report towards higher levels of equity underwriting and sub-underwriting fees and discounts, and the greater clustering of the level equity underwriting fees in the period that followed the onset of the financial crisis in 2008.

8.18 In terms of structural features, we do not have significant concerns over the number of available providers of equity underwriting services However, when applying the Section 131 test, the OFT generally

119 See MIR guidance, paragraphs 1.8 and 6.1.

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interprets structural features broadly to include features such as government regulations and any information asymmetries.120

8.19 We have found that there are information asymmetries inherent in the equity underwriting market which adversely impact upon competition. It is difficult for companies raising equity capital, the buyers in the equity underwriting market, to assess whether they are receiving cost effective outcomes when they purchase equity underwriting services. Most buyers are not involved in raising equity capital frequently, which prevents them from building up sufficient experience, expertise and information to hold their underwriters to account on fees. Furthermore, the complexity of each transaction, and the fact that investment banks do not provide a detailed breakdown of the fees charged to the companies that they supply services to, makes it difficult for buyers to make an assessment of the value of the services being received.

8.20 We have also found that buyer conduct may be having an adverse affect on competition.121 Companies display limited price sensitivity when they buy equity underwriting services. When companies issue shares, their priorities tend to be speed, confidentiality and a successful take-up and they rate the price of the service as less important. These priorities reduce the motivation for companies to create competitive tension between prospective underwriters over the level equity underwriting fees. In general, companies select their corporate brokers as underwriters, possibly because the corporate brokers have a strong working relationship with the company and in-depth knowledge of its position which is difficult for other prospective underwriters to match. Holding a competitive tender for equity underwriting services is also perceived to increase the chance of a leak occurring as it increases the number of parties who know about the issue pre-launch.

120 See MIR guidance, paragraphs 5.1, 5.17-5.19 and 5.21-5.22.

121 See MIR guidance Chapter 7 on ‘Conduct of customers’.

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8.21 In terms of supplier conduct, while investment banks do not appear to be competing strongly for equity underwriting work itself, this may be largely the result of the priorities and motivations of buyers in the market, as set out above. Also, investment banks do appear to compete more strongly to win corporate broking mandates, as this provides a potential channel to winning equity underwriting and other advisory work. However, the disclosure of underwriting fees in prospectuses, together with information asymmetries between investment banks and companies raising equity capital, allows scope for investment banks to point issuing companies towards a ‘going rate’ for underwriting fees. Negotiations on the level of equity underwriting fees tend to be based on a perceived ‘going rate’ rather than the parties’ judgments on the overall value of the specific services being provided.122

8.22 We also consider that the way that sub-underwriting fees are being agreed between equity underwriters and sub-underwriters may be having an adverse affect on competition. Our analysis of sub-underwriting fees shows that during 2009, sub-underwriting fees of 1.75 per cent were agreed between underwriters and sub-underwriters on almost every share issue (see Chapter 5).

8.23 This clustering of sub-underwriting fees in 2009 may have emerged because some larger institutional shareholders are involved in a significant number of sub-underwriting arrangements and this may enable them to indicate to underwriters, during the pre-marketing stage of an issue, a ‘going rate’ that they expect for sub-underwriting. Alternatively, the cause of the clustering may be that underwriters are not attempting to create competitive tension over sub-underwriting fees. Instead underwriters may be offering sub-underwriting on a ‘take it or leave it’ basis for an accepted ‘rate’, knowing that these costs can simply be passed on to the buyer in the overall underwriting fee.

122 See MIR guidance, paragraphs 6.12-6.14 on ‘Custom and practice’.

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Exercise of the OFT’s discretion

8.24 The OFT has the discretion, rather than a duty, to make an MIR where, as in this case, the statutory criteria set out above appear to be met. The OFT’s guidance on the exercise of this discretion sets out four criteria, all of which must, in its view, be met before the OFT decides to make a reference:

• Alternative powers: it would not be more appropriate to deal with the competition issues identified by applying the Competition Act 1998 or using other powers available to the OFT or, where appropriate, to sectoral regulators

• The scale of the suspected problem: the adverse effect on competition is significant, such that a reference would be an appropriate response to it

• Availability of remedies: there is a reasonable chance that appropriate remedies will be available, and

• Undertakings in lieu: it would not be more appropriate to address the problem identified by means of undertakings in lieu of a reference.123

8.25 In relation to the use of alternative powers, we have concluded that the features identified above can be tackled most effectively by companies and shareholders doing more to achieve more cost effective outcomes, and potential options that are available to them are set out in Chapter 6 of this report. We consider that such provision of information (under sections 5 and 6 of the Enterprise Act) is more appropriate than an MIR. We also note that we have found no evidence in the course of the market study of anti-competitive agreements or unilateral conduct that it

123 See MIR guidance, paragraph 2.1.

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would appear appropriate to investigate under the Competition Act 1998. 124

8.26 In relation to the scale of the problem, we consider that, although the market is large and the issues identified apply across the market, it is questionable whether the features identified will persist.125

8.27 In late 2008 and 2009, equity capital raising took place on an unprecedented scale, as many companies sought to repair their balance sheets. In 2009, FTSE 350 companies raised an estimated £50 billion of equity capital in the UK, paying an estimated £1.4 billion in fees for equity underwriting services. The value of the equity underwriting market is likely to fall significantly over the next few years as equity capital raising returns to more typical levels (between 2000 and 2007 around £20 billion a year was raised by the FTSE 350 although this remains a significantly sized market.

8.28 The equity underwriting market has been through what appears to be potentially an exceptional period, and it is difficult to assess at this stage how it is adjusting as it returns to more typical conditions. This report has set out a number of options that companies and institutional shareholders could consider using to address the concerns identified above. In addition, the details and scope of the analysis set out in the report should raise companies’ and institutional shareholders’ awareness of many of the issues identified in the equity underwriting market - this increased understanding may itself incentivise greater shifts in the conduct of companies raising equity capital and institutional shareholders.

124 Under section 5(1) of the Enterprise Act 2002, the OFT has the function of obtaining, compiling and keeping under review information about matters relating to the carrying out of its functions. Under section 6(1) of the Enterprise Act, the OFT has the function of making the public aware of the ways in which competition may benefit consumers in, and the economy of, the UK, and giving information or advice in respect of matters relating to any of its functions to the public.

125 For an outline of the OFT’s approach to considering the scale of the problem see MIR Guidance, paragraphs 2.27 and 2.28.

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8.29 While we have not given detailed consideration to the issue of the availability of remedies, there are a number of potential regulatory reforms of the market that we have considered but rejected.126 We considered whether regulation could be used to unbundle the three elements of the equity underwriting service in order to create competition for each of those elements, but concluded that there may be synergies that occur from equity underwriting services being bundled and that companies seem best placed to judge the benefits of underwriters providing a bundled equity underwriting service. We also considered whether regulation could be used to require full public disclosure of the detail of how underwriting fees break-down, including the level of sub-underwriting fees, but concluded that such detailed public disclosure could also make it easier for investment banks to compare the fees charged by their competitors for specific elements of the service, which may create a focal point for prices. Other remedies may be available but, as set out above, we consider that the most appropriate way to resolve the issues identified is through companies and shareholders doing more to achieve more cost effective outcomes.

8.30 Under section 154(1) of the Enterprise Act 2002, the OFT has the power to accept undertakings in lieu of a reference if it considers that it has the power to make a reference under section 131 and otherwise intends to do so. However, in this instance, we are minded to decide not to make a reference, for the reasons set out above and will not, therefore, have the power to accept undertakings in lieu.

Provisional decision on MIR

8.31 In the light of our findings, we have provisionally concluded that an MIR would not be appropriate in this instance. The equity underwriting market has been through an exceptional period, and it is difficult to assess at this time how the market is adjusting as it returns to more typical conditions. To the extent that the concerns we identified persist,

126 See paragraph 6.56 above.

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we consider that they can be tackled most effectively and efficiently by companies and institutional shareholders doing more pro-actively to achieve more cost effective outcomes, principally by applying greater pressure on underwriting fees and discounts. The regulatory remedies that we have considered appear to be too rigid or pose a risk to the competitive process. In these circumstances, and taking account of the public resources required, and the cost to business, we do not consider that an MIR is justified at this time.

Next steps

8.32 We are consulting on our provisional decision not to make an MIR. Responses should be emailed to: equityunderwriting@oft.gsi.gov.uk by Friday 11 March 2011. Alternatively, they can be sent to:

Equity underwriting market study Fourth Floor Office of Fair Trading Fleetbank House 2-6 Salisbury Square London EC4Y 8JX

8.33 We will consider any responses received and then publish our final decision on an MIR in due course.

8.34 We will send a copy of our report to the Independent Commission on Banking (ICB). The ICB will be making recommendations, due by end of September 2011, on structural and related non-structural reforms to the UK banking sector to promote financial stability and competition.

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A GLOSSARY

Glossary of terms relevant to the OFT market study on equity underwriting and associated services

Accelerated bookbuild. A share offering made on a compressed timetable, usually in one or two days, where a bookbuilding exercise is undertaken to inform the pricing of new shares.

Balance sheet. A statement of the financial position of a company at a particular date, usually at the end of its financial year. The balance sheet (also referred to as a statement of financial position) is one of the most important statements in a company's accounts. It shows what assets and liabilities the company has and how it is funded (the financial structure of the company).

Balance sheet repair. The term 'balance sheet repair' is often used as a shorthand way of describing the process of improving the financial health of a company. This would usually involve raising equity capital in order to improve the value of a company's assets relative to its liabilities and to ensure that both short and long term liabilities can be met.

Beauty parade. An informal term used to describe a process in which a purchaser selects a provider by asking potential providers to submit a tender (or bid). Strictly speaking, the term refers to the series of presentations given to the client by short-listed providers after the submission of their tender or bid documents. See also tendering.

Bookbuilding. The process of generating a book of investor demand for new shares. The bookrunner collects indications from potential investors as to their level of demand at any given price, so that the price of issued shares can be determined by reference to demand.

Bookrunner. An institution, normally an investment bank, that acts as a go-between with investors on one side and the company that wishes to raise equity capital on the other. A bookrunner's roles include providing detailed shareholder feedback during pre-marketing and, where a bookbuilding process is used, the bookrunner will be in charge of this. See also lead manager.

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Circular. In the context of a rights issue, this term refers to the document sent to shareholders which contains the terms of the issue and, if there is to be a general meeting, the notice of the meeting. More generally the term can refer to any document (excluding listing particulars, prospectus, annual reports and accounts, interim reports, proxy cards and dividend or interest vouchers) issued by a publicly listed company to its shareholders. The Listing Rules set out the requirements for the content and approval of circulars and also the circumstances in which they must be prepared.

Clawback. The right of a company to scale down the number of shares conditionally placed with entities that are not part of a company's existing shareholder base, depending on the level of applications for shares received from a company's existing shareholders. See placing.

Convertible bonds. Convertible bonds are debt finance that is sold with a conditional option which allows it to be converted into equity at a particular time and price in the future.

Corporate broker. An agent and adviser to a client company. In essence, the broker acts as a communication channel between a company and its shareholders. During a capital raising, the broker will attempt to convince shareholders of a proposal's merits and relay investor sentiment back to the company. Services provided by brokers may include: acting as the 'eyes and ears' of the board, market making, providing a sales function, research and corporate advice.

Deep discount. A deep discount is an offer of shares at a price far below the current market price, or theoretical ex-rights price, such that any subsequent movement in stock prices is less likely to eliminate the shareholders' incentive to take up those shares. This approach was suggested by the MMC in its report on underwriting as an alternative to having a share issue underwritten. Among the different types of equity capital raising, deep discounts are only used for rights issues as there are restrictions on the level of discount allowed for open offers and placings.

Discount. A discount is an offer of shares at a price lower than their current market price to incentivise shareholders to exercise their rights to take up those

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shares. A discount may be set by reference to several different measures of price, such as the mid-market price, as well as to the theoretical ex-rights price (TERP).

Equity capital. The value to a company of its ordinary shares issued in the market. Additional equity capital can be raised when a company wishes to fund the acquisition of another company or make some other major investment, to fund general expansion or to restructure its finances.

Equity underwriting. An arrangement whereby an underwriter agrees to purchase shares at a specified price if they are not subscribed for by anyone else by a certain date, thus guaranteeing that the company will receive the proceeds of the share issue. The underwriter will charge a fee for this service. See underwriter.

Financial Services Authority (FSA). An independent non-governmental body and company limited by guarantee, the FSA is the main statutory regulator for the UK financial services industry. It was created by the Financial Services and Markets Act 2000 (FSMA), the primary piece of legislation from which it derives its powers and functions. Rules and guidance in the FSA Handbook are made by powers found in FSMA. The FSA took over the role of UK Listing Authority (UKLA) from the London Stock Exchange on 1 May 2000.

Follow-on offer. This term describes the process where a company with shares already trading publicly, offers additional shares for sale. Types of follow on offer include: rights issues, placings and open offers.

Hedge fund. No formal, all-encompassing definition of the term 'hedge fund' currently exists but such funds tend to share a number of similar characteristics. Hedge funds might be described as privately offered investment vehicles that pool the contributions of investors in order to invest in a variety of assets. They are typically aimed at professional investors and are not marketed directly to the public. They often use advanced investment techniques or invest in specialist asset classes in order to maximise the return on investment.

Hedging. In relation to equity underwriting, hedging involves an underwriter engaging in a strategy to reduce its exposure to the risk of an adverse price movement in the issuer's share price.

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Independent advisers. Regulated companies that provide advice to the executives of issuing companies but do not provide capital or underwrite client companies' share issues.

Independent Commission on Banking (ICB). The ICB was established by the Government in June 2010 to consider the structure of the UK banking sector and to look at structural and non-structural measures to reform the banking system and promote competition. The ICB, which reports to the Cabinet Committee on Banking, is due to make recommendations by the end of September 2011.

Initial Public Offering (IPO). This is a company's first offer of shares on a listed stock market. Also known as a flotation.

Institutional shareholder. Institutional shareholders are generally large scale asset managers acting on behalf of their clients, but the term can also refer to large asset owners. Examples of institutional shareholders in the UK are pension funds, insurance companies and investment trusts.

Institutional Investors Council (IIC). A body established by the Institutional Shareholders Committee (ISC) to represent the institutional shareholder community and strengthen its profile. The IIC's objectives include: working closely with the Financial Reporting Council in promoting the new Stewardship Code for shareholders, facilitating collective engagement by institutional shareholders with companies particularly in times of stress, and providing industry-wide senior practitioner input to the authorities on issues relating to investments. The IIC's first act was to commission and oversee an enquiry by investors into the fees paid to investment bankers on rights issues. This enquiry, known as the Rights Issue Fees Inquiry (RIFI), published its final report in December 2010.

Investment bank. The core activities of investment banks are raising capital for companies and advising large companies and government organisations on financings, mergers and acquisitions, privatisation and other financial matters. Investment banks also undertake a variety of other activities including (but not limited to): securities trading (both for the investment bank itself and on behalf of clients), asset management and private wealth management, public private

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partnerships work, private equity or venture capital, prime brokerage services (such as lending hedge funds money to provide leverage and liquidity and securities that enable them to cover short positions), lending (credit), structured finance and the establishment of structured investment vehicles (SIVs). For a share issue, an investment bank acting for a company will often fulfil a number of different roles including corporate broker, sponsor, bookrunner, lead manager and underwriter.

Lead manager. The financial institution, typically an investment bank, with overall responsibility for arranging a new share issue including its coordination, distribution, and related administration.

Market Investigation Reference (MIR). This is one of the actions that can result from a market study by the Office of Fair Trading (OFT). The OFT will make a market investigation reference to the Competition Commission only when the reference test set out in section 131 of the Enterprise Act 2002 is met, and when it is satisfied that a reference to the Competition Commission would be the most appropriate way of proceeding.

Monopolies and Mergers Commission (MMC). Former UK body responsible for conducting investigations into anti-competitive practices. The Competition Commission replaced the MMC on 1 April 1999.

Nil paid rights. When a company undertakes a rights issue, existing shareholders have the right to subscribe for new shares pro rata to their existing shareholding. 'Nil paid' refers to the fact that the amount payable on acceptance of the offer of the new shares has not yet been paid. Where a shareholder does not wish to take up all or some of its entitlement to new shares, it may be able to sell these nil paid rights.

Open offer. An open offer is an invitation to existing shareholders to subscribe for, or purchase, shares in proportion to their existing holdings. To the extent that existing shareholders do not take up their entitlements, they may be taken up by others (both parties that do not currently hold shares in the company and existing shareholders that wish to acquire further shares in addition to their entitlement to new shares). The offer is made by way of an application or entitlement form which, unlike nil paid rights, cannot be traded during the offer

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period. An open offer is sometimes accompanied by a conditional share placing (a 'placing and open offer') whereby shares are conditionally placed with new investors subject to existing shareholders exercising their rights to apply for the new shares in the open offer.

Placing. An issue of shares on a non pre-emptive basis (see pre-emption rights) to a specific group of investors rather than to the public or to existing shareholders generally. As a placing involves the offer of new shares to a limited number of purchasers it can be executed faster than a rights issue. A firm placing is a type of placing in which the placees commit unconditionally to acquire the shares. In a conditional placing, shares may be subject to claw back if (and to the extent that) shareholders exercise their option to take up the new shares . Some placings combine elements of firm and conditional placing.

Pre-emption rights. Shareholders' pre-emption rights protect existing shareholders in a company against the dilution of their ownership that could otherwise follow. Section 561 of the Companies Act 2006 provides that, when a company issues new shares, it must give its existing shareholders the opportunity to subscribe for the new shares pro rata to their existing shareholding, before they are offered to other new potential shareholders (with certain exceptions).

Pre-marketing. The practice of contacting and briefing selected investors on a confidential basis to get an indication of interest in a forthcoming share issue before its launch. Pre-marketing usually occurs a few days before the launch of the issue. The selected investors are typically institutional shareholders that already own a significant number of shares in the company, although non-shareholders may be briefed at the same time. Investors who agree to take part in the pre-marketing stage are said to be wall-crossed and cannot trade on, or disclose, information they receive until the issue is made public.

Prospectus. This provides detailed information about a forthcoming share issue and the company concerned. It covers the financial details of the issue, the company involved and the reasoning for the issue among other matters. The FSA's Prospectus Rules set out the form, content and approval requirements for prospectuses. A prospectus is required, unless an exemption applies, whenever there is either an offer of transferable securities to the public in the UK or a

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request for the admission to trading of transferable securities on a regulated market in the UK.

Rights issue. A rights issue is a method by which a listed company can issue new shares. When a company undertakes a rights issue, the entitlement to buy new shares at the offer price can be traded, and shareholders who do not take up their rights are compensated for the dilution to their holding (see nil-paid rights). Rights issues are typically used where significant amounts of equity capital need to be raised.

Rump. Where shareholders do not take up the right to subscribe for shares under a rights issue, the unsubscribed shares are referred to as 'the rump'.

Short-selling. Short-selling involves one party borrowing shares from a counter-party and then selling them to a third party in anticipation of the price of the shares falling. When the price falls, the first party purchases the shares at the lower price and returns them to the counter-party, making a profit on the difference between the sale and subsequent purchase price. Where a stock is short-sold without it actually first being borrowed, this is known as 'naked' short selling. A number of countries, including the US, Germany, France and Australia, have banned naked short-selling.

Sponsor. A Sponsor is an adviser who is approved by the UK Listing Authority (UKLA) to provide certain services to issuers. While issuers are responsible for their compliance with the rules made under the Part 6 of FSMA (the Part 6 Rules),127 Sponsors assist by advising them on their obligations. They also help the UKLA meet its regulatory obligations by providing assurances that issuers have complied with the Listing Rules. While an issuer is not required to use a Sponsor on all transactions, it is required to use one on major transactions such

127 The 'Part 6 Rules' is a collective term which includes the Listing Rules, Prospectus Rules, Disclosure Rules, Transparency Rules and Corporate Governance Rules (the last of these by virtue of section 89O of FSMA)

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as an IPO, or a Class 1 transaction where an issuer acquires or disposes of significant assets outside the ordinary course of business.128

Stick. Shares which have not been subscribed for by shareholders and which underwriters have been unable to place during the Rump placement period, are known as the 'stick'. These shares must be acquired by the underwriters and sub-underwriters.

Sub-underwriter. A person or institution which agrees (in exchange for a fee) to meet part, or all, of the underwriters' obligations to buy shares that are not taken up during the period of the share issue. This allows underwriters to reduce the amount of risk they run during the equity raising period. Sub-underwriting can be performed by a number of different entities including institutional shareholders that already hold shares in the issuing company, other institutional shareholders, investment banks, lending banks and hedge funds.

Tendering. Competitive tendering is a mechanism by which a purchaser invites prospective suppliers to put in competing bids for the goods or services it requires.

Theoretical ex rights price (TERP). The theoretical ex-rights price (TERP) refers to the market capitalisation of the company before a rights issue takes place plus the amount to be raised in the share issue, divided by the number of shares, both the existing ones and those added by the share issue. This is calculated using the price just before the share issue is announced.

UK Listing Authority (UKLA). The Financial Services Authority (FSA) currently acts as the UKLA. The UKLA is a securities regulator, responsible for the companies which issue securities traded in financial markets. It is responsible for vetting prospectuses when there is an offer of transferable securities to the public in the UK or a request for the admission to trading of transferable securities on a regulated market in the UK, and for monitoring all FTSE-listed

128 A Class 1 transaction is a major transaction for a listed company, the size of which results in a 25 per cent threshold being reached under any one of the class tests set out in Listing Rule 10, Annex 1.1.

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companies' disclosures to the markets. By enforcing the Disclosure and Transparency Rules, the UKLA plays a significant role in ensuring that equity markets function in a fair and orderly manner. The FSA took over the role of the UKLA from the London Stock Exchange on 1 May 2000.

Underwriter. In the context of raising equity capital, an underwriter is an institution which agrees to purchase shares to be issued at a specified price, if the shares are not subscribed for by anyone else by a certain date, thus guaranteeing that the company will receive the proceeds of the issue.

Universal bank. A universal bank is one that integrates all of the major banking functions within one entity, including retail, commercial and investment banking.

Wall-crossing. The practice of informing an investor of a forthcoming share issue on a confidential basis before its launch. The investor, having access to inside information, is said to be brought over the wall and made an insider. An investor that is brought over the wall cannot trade on or disclose the information they receive until the issue is made public. See pre-marketing.

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B RESPONDENTS: PARTIES CONSULTED

Aegis Group plc

AEGON Asset Management UK plc

Anglo American plc

Professor Seth Armitage, University of Edinburgh

Ashtead Group plc

Association of British Insurers

Association of Private Client Investment Managers and Stockbrokers (APCIMS)

Aviva plc

Baillie Gifford & Co

Balfour Beatty plc

Bank of England

Barclays Bank plc

Barclays Capital

Barratt Developments plc

The Berkeley Group Holdings plc

BlackRock Investment Management (UK) Limited

Bovis Homes Group plc

Brewin Dolphin Holdings plc

Britvic plc

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Capital Shopping Centres plc

Chaucer Holdings plc

Chemring Group plc

Citigroup Global Markets Limited

Collins Stewart Europe Limited

Commerzbank AG

Cookson Group plc

Credit Suisse Group AG

Croda International plc

Dairy Crest Group plc

Dana Petroleum plc

Department for Business, Innovation and Skills

Deutsche Bank AG

Dexion Trading Limited

DRAX Group plc

Eaga plc

Expro International Group Limited

FIL Investment Services Limited (UK)

Financial Services Authority

Gartmore Group Limited

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GKN plc

Gleacher Shacklock LLP

Grainger plc

Great Portland Estates plc

Greenhill & Co International LLP

Henderson Global Investors Limited

Heritage Oil plc

Hermes Fund Managers Limited

HM Treasury

HMV Group plc

HSBC Bank plc

Independent Commission on Banking

ING Bank NV (London)

Institutional Investor Council

Investec plc

Investment Management Association

JJB Sports plc

Johnston Press plc

JP Morgan Cazenove

Ladbrokes plc

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Land Securities Group plc

Lazard Limited

Lloyds Banking Group plc

Logica plc

Lonmin plc

M&G Investment Management Limited

Professor Paul Marsh, London Business School

Marston's plc

Meggitt plc

Moneysupermarket.com Limited

Morgan Stanley & Co International plc

National Grid plc

Newton Capital Management Limited

Nomura International plc

Numis Securities Limited

Oriel Securities Limited

Panmure Gordon & Co plc

The Paragon Group of Companies plc

Punch Taverns plc

RBC Capital Markets

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Reed Elsevier Group plc

Resolution Financial Markets LLP

Rightmove plc

Rio Tinto plc

Rothschild

The Royal Bank of Scotland Group plc

Royal London Asset Management

Salamander Energy plc

Schroders plc

Scottish Widows Investment Partnership Limited

SEGRO plc

Seymour Pierce Limited

Shaftesbury plc

Société Générale SA

Spectris plc

Speedy Hire plc

Standard Chartered plc

Standard Life plc

State Street Global Advisors

Thomas Cook Group plc

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Threadneedle Asset Management Limited

Travis Perkins plc

Tullow Oil plc

UBS Global Asset Management (UK) Limited

The Unite Group plc

William Hill plc

Wolseley plc

WPP Group plc

Xchanging plc

10 other parties: eight organisations129 and two individuals.

129 'Organisations' should be understood as meaning companies, institutional shareholders, investment banks, independent advisors or other organisations relevant to this market study.

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C COMPANY SURVEY RESPONSES

Introduction

C.1 In September 2010, the OFT sent a survey to FTSE 350 listed companies that had raised follow-on equity capital between 1 January 2006 and 31 August 2010. The objective was to gather views on:

• the procurement of equity underwriting services, including the role of third-party advice

• their satisfaction with the service provided by investment banks

• the potential for conflicts of interest to arise during the equity raising process, and

• their relationships with corporate brokers.

C.2 Companies were asked about their views and experiences of the equity underwriting service they received in their most recent deal. The survey comprised four sections: the decision to raise equity, the underwriting process, conflicts of interest and the corporate broking relationship. We received 48 responses from companies to this questionnaire.

Methodology

C.3 The questionnaire was comprised mainly of closed questions with multiple-choice options for recipients. At certain points, the survey included the opportunity for respondents to add qualitative comments, which a limited number of respondents took up. In most cases these comments are not presented in this annexe, but they have informed the market study more generally.

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Questions and results

Decision to raise equity

C.4 This section asked for information on the decision to raise equity, previous experience of equity raising, any advice that companies took during the process, and the level of satisfaction with the advice received.

1. What was the objective of your equity raising? Please tick the appropriate box below:

to fund an acquisition 15

to fund a specific investment (excluding acquisition) 0

balance sheet repair 15

to fund general corporate activity 10

other (please specify) 8

total 48

2. Would you have been able to fund this activity using other forms of capital raising (such as a debt issue)? Please tick the appropriate box below:

yes no don't know total

13 32 3 48

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3. To what extent are you currently satisfied with the equity capital raising process? Please tick the appropriate box below:

very satisfied 5

satisfied 23

neither satisfied or dissatisfied 10

dissatisfied 8

very dissatisfied 2

don't have a view on this issue 0

total 48

4. Did you receive advice from the following parties before deciding to embark on the process of raising equity? If so, please indicate (by rating between 1 and 5) how satisfied you were with the advice, where 1 is extremely dissatisfied and 5 is extremely satisfied.

1 An advisor who did not underwrite the share issue

If yes, how satisfied were you (where 1 is extremely dissatisfied

and 5 is extremely satisfied)

yes no don't know

total

1 2 3 4 5

corporate broker or their associated investment bank

42 6 0 48 0 2 15 17 8

corporate lender or their associated investment bank

9 39 0 48 0 1 5 2 1

independent advisor1 19 29 0 48 1 0 2 12 4

institutional shareholders 8 40 0 48 0 0 2 4 2

your lawyers 32 16 0 48 0 1 1 20 10

other (please specify) 2 46 0 48 0 0 0 1 1

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5. Did you receive advice from the following parties after the decision was taken to raise equity, but before the beginning of the issue? If so, please indicate (by rating between 1 and 5) how satisfied you were with the advice, where 1 is extremely dissatisfied and 5 is extremely satisfied.

If yes, how satisfied were you (where 1 is extremely dissatisfied

and 5 is extremely satisfied)

yes no don't know

total

1 2 3 4 5

corporate broker or their associated investment bank

38 10 0 48 0 4 10 17 7

corporate lender or their associated investment bank

13 35 0 48 0 2 8 1 2

independent advisor1 17 31 0 48 1 0 2 10 4

institutional shareholders 14 34 0 48 0 0 3 7 4

your lawyers 36 12 0 48 1 1 2 20 12

other (please specify) 4 44 0 48 0 0 2 2 0

1 An advisor who did not underwrite the share issue

6. If you used an independent advisor (that is, an advisor who did not underwrite the share issue), did they advise on the following?

yes no don't know

no answer

total

the options available to raise finance 22 2 0 24 48

which underwriters to appoint for the equity raising

8 11 0 29 48

the level of underwriting fees 16 4 0 28 48

the level of discount on your company's share price

18 5 0 25 48

other (please specify) 1 0 0 47 48

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7. If you used an independent advisor (that is, an advisor who did not underwrite the share issue), how do you think their presence affected the value for money your company received in the equity raising process?

increased Decreased no effect don't know total

8 0 15 25 48

8. Did the following members of your board have previous relevant experience of raising equity capital at the time of your issue?

yes no don't know no answer total

CEO 34 12 1 1 48

Finance Director/CFO 35 10 1 2 48

other executive 24 15 3 6 48

non executive directors 45 1 0 2 48

9. Please rate the importance to your company of each of the following

factors at the time when you came to raise equity capital. Please rate each factor between 1 and 5 where 1 is not important and 5 is very important:

1 2 3 4 5 no answer total

fee paid for underwriting services 2 2 17 13 12 2 48

discount to TERPs/share price (as appropriate)

2 3 9 16 16 2 48

speed with which equity could be raised

0 2 9 16 21 0 48

maintenance of confidentiality throughout the process

1 1 3 11 32 0 48

success in attracting shareholder support

0 0 1 10 36 1 48

other (please specify) 0 0 0 0 0 48 48

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10. When you last raised equity, were you aware of any confidential information being leaked prior to the equity issue?

yes no don't know total

9 33 6 48

Underwriting process

C.5 In this section we asked for information on the underwriters of share issues, including the types of organisations that companies appointed, the method used to appoint them, the factors that influenced companies' decision making and the companies' views on underwriting fees, discounts and the service that underwriters provided.

11. In your recent equity raising did your existing corporate broker/s act as underwriter/s? Please tick the appropriate box.

yes no don't know total

38 10 0 48

If yes, what impact did this have on the following areas?

increased decreased no effect

don't know

no answer

total

underwriting fees 7 3 24 5 9 48

level of discount to TERPs/share price (as appropriate)

5 3 23 7 10 48

value for money received in the process

13 4 17 5 9 48

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12. In your recent equity raising did your corporate lender act as an underwriter? Please tick the appropriate box.

Yes no don't know total

16 32 0 48

If yes, what impact did this have on the following areas?

increased decreased no effect

don't know

no answer

total

underwriting fees 1 7 9 0 31 48

level of discount to TERPs/share price (as appropriate)

0 1 15 1 31 48

value for money received in the process

7 1 9 0 31 48

13. Did you use an underwriter from an investment bank who you did not have a previously existing relationship with?

yes no don't know total

2 46 0 48

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If yes, what impact did this have on the following areas?

increased decreased no effect

don't know

no answer

total

underwriting fees 1 1 0 0 46 48

level of discount to TERPs/share price (as appropriate)

0 0 2 0 46 48

value for money received in the process

1 1 0 0 46 48

14. Which of the following methods did you use when deciding on which

underwriter to appoint?  

yes no don't know

no answer

total

advice from broker(s) 24 12 0 12 48

advice from independent advisor(s) (that is, an advisor who did not underwrite the share issue)

12 19 1 16 48

formal tendering mechanisms (such as beauty parades)

3 28 0 17 48

approached investment banks that you had previously worked with

22 11 1 14 48

unsolicited pitches from investment banks

8 24 0 16 48

other (please specify) 5 3 0 40 48

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15. Did you bring in additional underwriters after making your initial appointment(s)?

yes no don't know total

10 38 0 48

16. Please rate each of the following factors between 1 to 5 in terms of importance at the point when an underwriter is selected (1 is not important and 5 is very important):

not important

1

2

3

4

very important

5

no answer

total

underwriter's ability to maintain confidentiality

1 0 4 5 32 6 48

underwriter's ability to ensure transaction is carried out quickly

0 1 1 15 25 6 48

underwriter's balance sheet/financial position

0 1 11 17 13 6 48

underwriter's knowledge of your company

1 0 7 15 19 6 48

underwriter's knowledge of the sector your company operates in

0 1 14 13 14 6 48

underwriting fees charged

0 3 11 19 9 6 48

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16. At what point during the process did you agree the discount to TERPs/share

price (as appropriate)?

at the point when the decision was taken on how to raise equity 4

after the decision was taken to raise equity but prior to the beginning of the pre-marketing phase

8

after the pre-marketing phase had been completed 23

other (please specify) 6

no answer 7

total 48

17. At what point in the process did you agree the underwriting fee with your underwriter?

at the point when the decision was taken on how to raise equity 4

after the decision was taken to raise equity but prior to the beginning of the pre-marketing phase

30

after the pre-marketing phase had been completed 6

other (please specify) 1

no answer 7

total 48

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18. Please indicate how satisfied you were with the following aspects of the service provided by your underwriters. Please select between 1 and 5, where 1 is extremely satisfied and 5 is extremely dissatisfied.

extremely satisfied

1

2

3

4

extremely dissatisfied

5

don't know

no answer

total

advice received on how to execute the transaction

4 16 9 7 6 0 6 48

level of underwriting fees charged

1 11 11 12 7 0 6 48

level of discount on your company's shares

1 13 16 4 7 0 7 48

level of confidentiality maintained

17 10 3 6 6 0 6 48

speed of the process 16 10 5 5 5 1 6 48

helping to develop a message for the market on the transaction

3 13 14 6 6 0 6 48

administration and organisation (for example, prospectus for share offering)

7 12 12 5 6 0 6 48

book building 7 14 7 7 7 0 6 48

information provided on the process

6 10 13 8 5 0 6 48

overall level of service 1 16 11 9 5 0 6 48

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Conflicts of interest

C.6 This section asked for information on conflicts of interest. We asked about the potential conflicts of interest which may arise during the equity raising process and the steps which companies took to mitigate the effects of these conflicts.

19. During the underwriting process, do you feel that the interests of the underwriter(s) and your company were aligned?

20. Do you think that there is a conflict of interest arising from the following?

always usually sometimes never don't know no answer total

5 20 15 0 1 7 48

yes no don't know

no opinion

no answer

total

banks advising companies on whether to perform equity raising activity that they will be remunerated for underwriting, should it go ahead.

24 8 1 10 5 48

banks advising on how far to discount a share issue that they are underwriting

33 7 0 3 5 48

banks potentially having the incentive to hedge (excluding sub-underwriting) their exposure on an underwriting deal

27 7 2 7 5 48

other (please specify and explain why you consider this factor to give rise to conflicts of interest)

3 0 0 0 45 48

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21. Do you think that there is a conflict of interest between institutional shareholders incentives, as a shareholder, to encourage companies to negotiate low underwriting fees when raising equity and their incentives as a sub-underwriter, to maximise the fee that they receive on a deal?

22. If you have answered yes to any of the questions 22 and 23 above, please give details of what steps you take (if any) to mitigate these conflicts of interest. The following key themes emerged from responses:

• Eleven respondents took advice from an independent adviser.

• Four respondents relied on market intelligence, benchmarking across transactions and research on market practices.

• Four respondents considered that they had been keeping options open as long as possible and creating competition for various roles in the equity issue.

• Four respondents stressed the benefits of setting separate and discretionary fees for the various elements of service received.

yes no don't know no opinion no answer total

20 4 5 14 5 48

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Corporate broking relationships

C.7 This section asked for information on corporate brokers and the relationships they develop with companies.

23. How many corporate brokers do you retain on an ongoing basis?

0 1 2 more than 2 no answer total

0 10 35 2 1 48

24. Which of the following mechanisms did you use to appoint your current

corporate broker(s)?

Yes1 no don't know

no answer2

total

invited a number of firms to pitch and selected between them (a 'beauty parade')

24 6 3 15 48

invited a particular firm (or firms) to pitch and considered whether they were preferable to the incumbent broker(s)

8 16 3 21 48

appointment made following a recommendation through personal contacts

5 14 3 26 48

appointment made following an unsolicited pitch

2 19 3 24 48

other (please specify) 3 1 4 40 48

1 Five respondents indicated that they had used two of the methods listed, and 32 indicated that they had used one of the methods listed. 2 11 companies chose to provide no answer in response to each of the five options in this question.

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25. Please rate each of the following factors between 1 to 5 in terms of importance at the point when a corporate broker is selected (1 is not important and 5 is very important):

not important

1

2

3

4

very important

5

no answer

total

existing relationship with the individual broker

1 3 8 16 19 1 48

reputation of the broker in your sector

1 1 2 21 22 1 48

reputation of the broker's investment bank in your sector

2 6 12 18 9 1 48

reputation of the broker's investment bank for executing major transactions

2 9 15 14 7 1 48

broker's established research capability

1 2 12 24 8 1 48

broker regularly trades your shares

1 3 12 24 7 1 48

level of fees charged by broker for broking services

1 11 20 13 2 1 48

level of fees charged by broker's investment bank for executing major transactions

5 12 16 10 4 1 48

level of fees charged by broker for ancillary services (please specify which services)

5 8 20 7 1 7 48

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26. On average, how regularly will the following people within your business have contact with brokers?

weekly monthly quarterly annually less than

annually

don't know

no answer

total

Chief Executive Officer

12 31 3 0 0 0 2 48

Chief Financial Officer/Finance Director

27 18 0 1 0 0 2 48

Chairman 0 9 30 5 1 2 1 48

Other executive directors

0 8 19 6 6 2 7 48

Other non – executive directors

0 0 15 21 6 5 1 48

Group financial controller

2 8 16 7 9 2 4 48

Head of investor relations

26 9 3 0 0 3 7 48

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27. Which of the following services have your corporate brokers provided for you?

yes no don't know

no answer

total

strategic advice to your board 41 6 0 1 48

corporate finance advice 42 5 0 1 48

helping to develop a message for the market (for example, around year end results or a particular transaction)

47 1 0 0 48

providing market intelligence/feeding back market views on your company

46 1 0 1 48

sales and trading platform 38 7 1 2 48

roadshow organisation 44 3 0 1 48

investor targeting 45 2 0 1 48

other ancillary services (please specify) 29 1 1 17 48

28. Do you pay identifiable charges for your corporate broking services?

yes – hourly rate

yes – retainer

yes – other mechanism

no no answer total

0 17 3 27 1 48

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29. Please rate the difficulty presented by each of the following when switching your broker (between 1 and 5, where 1 is not difficult and 5 is very difficult):

not difficult

1

2

3

4

very difficult

5

no answer

total

Identifying suitable alternative providers

14 18 7 2 2 5 48

Establishing new relationships with brokers

4 12 14 13 0 5 48

Protecting confidentiality 7 10 18 8 0 5 48

The signal switching sends to the market about your company

3 9 17 12 2 5 48

Maintaining continuity during the 'handover' period

5 15 14 8 1 5 48

Other (please specify) 0 0 0 0 0 48 48

30. Would you be willing to speak to us in greater detail about any of the issues raised in this survey?  

yes no No answer total

33 13 2 48

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D LEGAL AND REGULATORY BACKGROUND

Introduction

D.1 There are a number of different legislative and regulatory requirements which govern the activities of companies and financial intermediaries in relation to raising equity. The dominant theme running through these provisions is the protection of shareholders' 'pre-emption' rights: that is, the protection of investors from dilutions in their shareholdings.

D.2 In addition, various industry groups have published guidance for companies when seeking authorisation from shareholders to raise equity.

D.3 This Annexe sets out the key sources of legislation, regulations and guidance which govern the process of equity raising in the UK, and the conduct of financial intermediaries providing underwriting services to companies. It also details the key requirements within each of these.

Legislation

D.4 The key legislative provisions governing equity raising, and the conduct of financial institutions providing underwriting services, are found in the Companies Act 2006 and the Financial Services and Markets Act 2000 ('FSMA').

The Companies Act 2006

D.5 The Companies Act 2006 makes provisions relating to companies, business names, directors' disqualification and other matters related to the operation of companies. The provisions of the Companies Act 2006 that relate to equity raising are found in Part 17A, 'A company's share capital'.

D.6 Section 551 of the Companies Act 2006 gives companies the power to allot new shares, provided this is authorised by the articles of the

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company or by a resolution of shareholders at a general meeting.130 Under section 561 of that Act, shareholders must be given first opportunity to subscribe to new shares pro rata to their existing shareholding on terms the same as, or more favourable than, those offered to new shareholders. When companies issue new shares, this necessarily results in a dilution of existing shareholders' ownership in a company. Section 561(1) offers shareholders some protection against this type of dilution.

D.7 Pre-emption rights can be modified or waived ('disapplied') to allow the directors of a company to offer new shares to non-shareholders, provided they are authorised to do so by the company's articles or by a special resolution.131 This allows them to raise equity on a non-pre-emptive basis (for example, via a placing).132

D.8 The Companies Act 2006 provides for two processes for gaining shareholder approval for an equity-raising under which pre-emption rights are disapplied: a general permission and a specific permission. Section 570 deals with companies acting under a general authorisation from its shareholders. This authorisation is usually obtained at the company's annual general meeting, and allows the company to raise new equity up to a specified value and to disapply pre-emption rights without the need to obtain further permission from shareholders.

D.9 Section 571 makes provision for a company to seek specific permission from its shareholders (by a special resolution of its shareholders) to disapply pre-emption rights. This might be done where a company wishes to raise more equity than it has a general authorisation for.

130 Companies Act 2006, section 551(8).

131 Companies Act 2006, sections 570 and 571. A special resolution must be passed by a majority of at least 75 per cent of shareholders: Companies Act 2006 s.283(1).

132 Companies Act 2006, sections 570 and 571.

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D.10 The Companies Act 2006 also specifies the minimum time period which a pre-emptive offer of new shares must remain open to shareholders (14 calendar days).133

D.11 Where a general meeting is required to authorise a particular share issue, the provisions governing the convening and conduct of a general meeting found in Part 13 will be applicable.

The Financial Services and Markets Act 2000

D.12 The Financial Services and Markets Act 2000 (FSMA) regulates the provision of financial services and markets. The scope of the activities to which the FSMA applies is broad, and covers the activities of financial advisers, brokers and underwriters.

D.13 Various sections of the FSMA are relevant to underwriters and other financial institutions involved in equity underwriting, and empower the FSA to take action against persons found to have engaged in 'market abuse'. Market abuse is behaviour relating to investment decisions which are either based on relevant investment information not publicly available, behaviour likely to be interpreted as giving a false or misleading impression about the price or value of an investment or behaviour which is market distorting.134 Insider trading, for example, is prohibited under this provision.

D.14 The FSA is empowered to seek an injunction restraining market abuse135 or impose financial penalties.136 Alternatively, it can bring criminal action for insider dealing before the courts.137 A person found guilty of

133 Companies Act 2006, section 562(6).

134 FSMA, section 118.

135 FSMA, section 381.

136 Companies Act 2006, section 123.

137 FSMA, section 402.

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engaging in insider dealing by a court is liable to a fine or imprisonment.138

Regulations – FSA Handbook

D.15 The FSA Handbook ('Handbook')139 sets out the FSA's rules and guidance under the FSMA. It is divided into seven 'blocks', which are in turn divided into modules. The modules most relevant to equity underwriting are the Principles for Business, the Senior Management Arrangements Systems and Controls, Disclosure and Transparency Rules, the Listing Rules, the Prospectus Rules, and the Disclosure and Transparency Rules. Each of these modules contain provisions concerning the conduct of financial institutions which investment banks need to abide by when providing financial services – such as underwriting – to companies.

D.16 The Principles for Business (PRIN) is the first module of the FSA Handbook. It sets out the fundamental obligations of all regulated companies and sets the foundation for other rules and guidance in the Handbook. The principles cover managing conflicts of interest, acting with due care and diligence, and treating customers fairly.

D.17 The Senior Management Arrangements Systems and Controls (SYSC) module outlines the FSA's management requirements for the companies it regulates. It focuses on the responsibilities of directors and senior management to ensure companies have appropriate control, supervision and accountability systems in place.

D.18 The Disclosure and Transparency Rules are the requirements for companies listed on, or seeking admission to trade on, an exchange regulated by the UK Listing Authority (for example, the London Stock Exchange). These include the rules that apply to a Sponsor and a person

138 Criminal Justice Act 1993, section 52.

139 Available online at http://fsahandbook.info/FSA/index.jsp.

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applying for approval as a Sponsor, along with the prospectus and disclosure document requirements.

D.19 The Listing Rules contain a number of requirements relevant to all companies when raising equity, including those which have modified or disapplied shareholder pre-emption rights:

• Chapter 8 requires a company with a Premium Listing (all FTSE 350 companies are required by index eligibility rules to have a Premium Listing) to engage a Sponsor whenever it undertakes a transaction requiring the preparation of a prospectus,140 such as a rights issue or open offer. Sponsors are required to identify and manage conflicts of interest which could affect the ability of the Sponsor to perform its duties and, where a conflict cannot be mitigated, decline to act as a Sponsor.141

• Rule 9.5.4(1) provides that any premium made on the issue of shares under a rights issue142 is to be held on account for the holder of those shares, unless the total value of the premium on the sale of the shares is less than £5. This ensures that shareholders who did not take up their entitlements receive the difference between the issue price and the rump placement price.

• Rule 9.5.6 states that a rights issue must remain open for acceptance for at least 10 business days. Thus, where a company has disapplied shareholders' pre-emption rights pursuant to s.570 or s.571 of the Act, it must still ensure a rights issue remains open for at least 10 business days.

140 Listing Rule 8.2.1(1)(a) requires a Sponsor to be appointed whenever a company does something requiring the publication of a Prospectus.

141 Listing Rule 8.3.11.

142 Note that there is no analogous provision relating to open offers.

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• Rule 9.5.10 provides for open offers and placings to be made at a discount of not greater than 10 per cent of the middle market143 price of the shares without prior shareholder approval.

D.20 The Prospectus Rules specify the circumstances in which a company needs to issue a prospectus, the information which prospectuses must contain, and the process for obtaining UK Listing Authority approval of prospectuses.

D.21 The Disclosure and Transparency Rules contain rules and guidance on listed companies' obligations to disclose and control market sensitive information and notify transactions.

Industry guidance

D.22 A number of industry bodies have published guidance for companies regarding equity-raising. Although non-binding, our enquiries revealed that companies tend to follow this guidance very closely. The two key pieces of guidance are the Pre-emption Group Statement of Principles and the Association of British Insurers Guidelines.

D.23 The Pre-emption Group is made up of listed companies, investors and financial advisors. In July 2008 the Group published a set of principles to clarify the circumstances and relevant factors when a company is considering a disapplication of shareholder pre-emption rights.144

D.24 The Principles provide that issues of an amount of up to five per cent of a company's issued share capital in one year are likely to be regarded as 'routine' and that no more than 7.5 per cent of a company's issued share capital should normally be issued non-pre-emptively in a rolling three year period.

143 A security’s middle market price is the mean of its ‘offer’ (sell) and ‘bid’ (buy) prices on an exchange. In the case of a FTSE350 company, this exchange is the London Stock Exchange: Listing Rule 9.5.10(2).

144 Available online at www.pre-emptiongroup.org.uk/principles/index.htm.

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D.25 The Principles also discuss a number of considerations for a company to bear in mind when seeking to disapply pre-emption rights. These include the availability of alternative finance and the level of shareholder dilution involved.

D.26 The second important piece of guidance is that published by the Association of British Insurers (ABI). The ABI represents a significant body of institutional shareholders in public companies in the UK.

D.27 On 2 January 2009, in response to the Report of the Rights Issues Review Group,145 the ABI published revised guidance to companies when seeking general authorisation to raise share capital on both a pre-emptive and non pre-emptive basis ('Guidelines').146

D.28 The ABI's Guidelines advise that ABI members will consider as 'routine' requests under section 561(1) of the Companies Act 2006 to issue share capital equal to a further one third of its existing issued share capital plus an additional one third for rights issues only, and subject to certain safeguards, and – consistent with the Pre-Emption Group's guidance – a total five per cent per year, and 7.5 per cent in any rolling three year period, on a non pre-emptive basis (that is, via a placing).

145 Available online at www.afme.eu/assets/0/386/524/7cbcd2ec-0a18-4aa1-bf2d-72196958c1f2.pdf.

146 Available online at www.ivis.co.uk/PDF/1.1_Directors_powers_to_allot_shares.pdf.

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E DATA SOURCES AND ECONOMETRIC ANALYSIS

Introduction

E.1 This annexe describes the data we have obtained, and the econometric analysis presented in the report.

Data Obtained

E.2 The main data sets we obtained were:

• details of follow-on equity issues in the UK covering the period from 1 January 2000 to 24 November 2010, obtained from Dealogic147

• the membership of the FTSE 350148 on a quarterly basis from the start of 2000 to the end of 2010, obtained from FTSE

• the corporate brokers used by companies in the FTSE 350, for September of each year from 2000 to 2010, obtained from Hemscott,149 and

• data on the fees for sub-underwriting for a sample of issues between 2006 and 2010, provided by two of the institutional shareholders that responded to the OFT's information request.

E.3 We also obtained:

147 Dealogic is a provider of Global Investment Banking analysis and systems.

148 The FTSE 350 is a market capitalisation-weighted stock market index incorporating the largest 350 companies which have their primary listing on the London Stock Exchange.

149 Hemscott provides public company data including financial information on publicly listed companies in the UK, Ireland, the USA and Canada.

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• information on historic adjusted closing share prices of the individual companies and the adjusted closing price of the FTSE 350 index from 2000 to 2010 from Yahoo finance,150 and

• monthly data on the consumer price index (CPI), used to deflate all nominal variables, from the Office for National Statistics.

E.4 In order to ensure that we only selected equity issues by FTSE 350 companies, individual equity issues from Dealogic were matched to historical lists of the FTSE 350. Issues were matched using standard share ticker symbols and announcement date.151 An equity issue was considered to have been performed by a FTSE 350 company where the company featured in the FTSE 350 at the beginning of the quarter in which the deal was announced.

E.5 Shares sold by individual investors and shareholders in FTSE 350 companies were excluded. We used the classification of deal types in Dealogic to identify placings, open offers and rights issues.

E.6 Data on underwriting fees (as a percentage of deal value) and discount to TERP were not listed in Dealogic for all rights issues. Of the 87 rights issues that took place between 2000 and 2010, underwriting fees were listed in Dealogic for 59 issues and discount to TERP figures were provided for 79 issues. Fee and discount data was also incomplete for placings and open offers, and this data is not considered in the report.

Econometric analysis of underwriting fees

E.7 This section sets out our econometric analysis of underwriting fees. We looked at the evolution of fees over time, with and without controlling for changes in risk drivers. We found some evidence indicating that fees

150 Adjusted closing prices take into account dividends and splits.

151 Manual checks were also undertaken where matching data was unavailable for particular issues.

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rose and remained at higher levels despite falls in stock market volatility in the same period. We describe this analysis in detail below, discussing in turn the data used, methodology employed, results of our analysis and limitations of this work.

E.8 The main source of data was Dealogic, which provides various pieces of information on specific rights issues. A full list of the Dealogic variables used is set out in Table E1 below.

Table E1: Variables from Dealogic

Variable Variable definition or interpretation

Gross Fee (%) Underwriting fee as a percentage of the offer price Discount to TERP Discount to the theoretical ex-rights price Issuer Name Full name of the issuer Ticker Symbol Ticker symbol of security Announcement Date Date registration information was announced Deal Value ($) Total amount offered Market Value ($) Indicates the issuer's market capitalisation upon completion of the offer Exchange Rate ($) The local currency exchange range compared to US dollars Currency The currency that the issue is traded in Use of Proceeds Use of the capital raised through issuing the security Use of Proceeds Note Description to how the funds raised in the issue will be used

E.9 We used this data to construct the additional variables defined below:

• Issuer's share price volatility for the two months before the announcement date of the issue (issuer volatility).152 The issuer's share price volatility measured by the standard deviation of changes in the share price (calculated as the percentage change in the adjusted closing price relative to the previous day) for the two months before the announcement date (not including the announcement date). If no data were available, the value of this variable was set to zero and the

152 This term and similar ones below refer to the exact variables used in our model. This is relevant for the detail presented in Table D10 and D11 in the Appendix.

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indicator variable for missing issuer volatility set to 1, acting as a dummy variable. (missing issuer volatility).

• An indicator variable equal to one if the proceeds from the issue are to be used for an acquisition, and equal to zero otherwise (acquisition). This variable was created using the Dealogic 'Use of Proceeds' and' Use of Proceeds Note' variables.

• An indicator variable equal to one if the proceeds from the issue are to be used for balance sheet repair, and equal to zero otherwise (balance sheet repair). This variable was created using the Dealogic 'Use of Proceeds' and 'Use of Proceeds Note' variables.

• Inverse of deal value (in pounds and in real terms) (inverse deal value). The Dealogic variable indicating the value of the issue (Deal Value ($)) was converted to sterling using the prevailing exchange rate, also obtained from Dealogic. Nominal values were converted to real terms using the CPI.

• Issuer's deal value divided by market value (relative deal value). Both market value and deal value were obtained from Dealogic.

E.10 As noted above we only had data on underwriting fees for 59 of the 87 rights issues in this period, and we therefore used these 59 rights issues in our analysis.

E.11 As discussed in Chapter 5, we examined the evolution of fees and discounts from 2000 to 2010, and compared this to the volatility of share prices of the FTSE 350 index over the same period to illustrate market-specific risk factors that are likely to have influenced the cost of underwriting at that time (see Figures 5.6 to 5.9). These Figures show that both underwriting fees and discount to TERP increased at the time of the financial crisis and recession and clustered at this higher level during 2009, despite a pronounced fall in market volatility during that year. There are some indications from the limited number of issues in 2010 of a reduction in the level of underwriting fees, although it is difficult to determine at this time the extent to which these share issues are representative of a decreasing trend.

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E.12 We sought to examine whether these observations have been driven by other factors influencing the cost of underwriting deals that also changed around the time of the financial crisis and recession. To do this we used regression techniques to control for other potential factors that may have been causing fees to increase and cluster at higher levels. To inform this analysis, we reviewed the existing academic literature modelling the determinants of equity underwriting fees. There have been a number of such studies in the USA. One recent example is that of Kim, Palia and Saunders (2008),153 which analyses the effect of the entry of commercial banks on underwriting fees for approximately 7,000 follow on issues over a 30-year period (1975-2004) in the USA. It models the direct costs of underwriting as a function of: type of bank underwriting (commercial compared to non-commercial), market share of underwriter, inverse deal size, the ratio of market value to issue size, the number of issues that year, industry controls, type of issue, and issuer profit,154 debt, investment grade and share price volatility.

E.13 We based our analysis on the Kim, Palia and Saunders model but excluded a number of financial variables (such as debt and profitability) that were included in the original paper. This was because we considered that over the period of interest, shorter-term share price volatility was a more accurate gauge of risk than these financial variables: in particular, companies adversely affected by the financial crisis and recession may have filed healthy financial returns in the previous year and yet underwriting their share issue may still have been very risky at the time of issue. We also included variables to capture the fact that there was a systematic difference in the main reason for equity issues before and after the financial crisis, with a large number of balance sheet repair issues happening following the onset of the financial crisis and recession.

153 Kim, Palia, and Saunders, 2008, 'The impact of commercial banks on underwriting spreads: Evidence from three decades', Journal of Financial and Quantitative Analysis, Vol. 43, No. 4, pp. 975-1000.

154 Defined as the ratio of operating profit before depreciation to total assets.

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E.14 We estimated the following equation for fees using ordinary least squares regression:

Fee = β0 + β1 issuer volatility + β2 missing issuer volatility + β3 acquisition + β

balance sheet repair + β5 inverse deal value + β6 relative deal value

E.15 The results are presented in Table E2 below. We found that only issuer share price volatility and the inverse deal value have a statistically significant effect on underwriting fees, although all variables have the expected signs. We found that an increase in volatility is associated with an increase in fees, as are increases in the inverse deal value and the ratio of deal value to market value. Balance sheet repair issues are associated with higher fees and issues undertaken to raise capital for acquisitions are associated with lower fees. Summary statistics and correlation statistics are set out in Tables E3 and E4 respectively.

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Table E2: Regression results

Dependent variable: Gross Fee - as a percentage of deal value

Explanatory Variable Coefficient

(p-value in parentheses) Issuer volatility 13.1140 ** (0.0324) Missing issuer volatility -0.0184 (0.9573) Acquisition -0.2107 (0.4197) Balance sheet repair 0.2720 (0.2228) Inverse deal value 36,617,087 * (0.0812) Relative deal value 1.2547 (0.1005) Constant 1.8614 *** (0.0000) Number of observations 59 R-squared 0.3641 Adjusted R-squared 0.2907 *** coefficient significant at the 99% level of confidence. ** coefficient significant at the 95% level of confidence. * coefficient significant at the 90% level of confidence.

Table E3: Summary statistics

Variable Observations Mean Std Dev Min Max Gross Fee 59 2.792729 0.7884066 1.188 4.5 Issuer volatility 59 0.0303318 0.0216895 0 0.0904866 Missing issuer volatility 59 0.1525424 0.3626321 0 1 Acquisition 59 0.2033898 0.4059752 0 1 Balance sheet repair 59 0.3898305 0.4918981 0 1 Inverse deal value 59 4.48e-09 5.02e-09 8.33e-11 2.91e-08 Relative deal value 59 0.2571832 0.1304374 0.0637546 e.6207526

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Table E4: Correlation statistics

Gross Fee equation correlations, 59 observations

Gross Fee

Issuer volatility

Missing issuer volatility

Acquisition Balance sheet repair

Inverse deal value

Relative deal value

Gross Fee 1.0000 Issuer

volatility 0.5101 1.0000

Missing issuer

volatility -0.2305 -0.5984 1.0000

Acquisition -0.3053 -0.2717 -0.0973 1.0000 Balance

sheet repair 0.3923 0.4768 -0.3391 -0.4039 1.0000

Inverse deal value 0.1095 -0.0847 0.1890 -0.1090 -0.1325 1.0000

Relative deal value 0.2648 0.2503 0.0022 -0.0372 0.1552 -0.2965 1.0000

E.16 If fees increased following the onset of the financial crisis and recession and remained at this level for reasons unrelated to the risk of rights issues, we would see an increase in the proportion of fees unexplained by the model (the regression residuals) for this period. To see whether this was the case, we plotted the residuals over time, shown in Figure E1 below. This Figure shows that the residuals increase over time and in particular are mainly positive from 2009 onwards. Our estimates systematically under-predicted fees since the onset of the financial crisis and recession - actual fees were consistently higher than our model would suggest given the risk of the deals. In contrast, for the period before the financial crisis, the difference between predicted and actual values showed no clear pattern.

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Figure E1: Regression residuals

-2-1

01

2R

esid

uals

(Fee

s)

01jan2000 01jan2002 01jan2004 01jan2006 01jan2008 01jan2010AnnouncementDate

Residuals over time

E.17 There are a number of limitations to this analysis and its findings. This model explains only 30 per cent of the variation in fees and just two explanatory factors are found to have a statistically significant effect. This suggests there are likely to be some important determinants of fees that were not included in our equation. If these omitted variables are not systematically related to the period following the onset of the financial crisis and recession, then our analysis and findings will still be valid. While the systematic under-prediction of fees since the onset of the financial crisis and recession could be explained by omitted variables, we consider that the variables included in our model (in particular issuer volatility) should account for a large proportion of any systematic risk factors.

E.18 We note that there is a possibility that the fees and discounts data we obtained may be simultaneously determined. If this were the case, our estimates would be biased in an indeterminate direction but nonetheless in a way that would be constant over the whole sample period. This would mean that inferences based on patterns in residuals would still be valid.

E.19 To investigate whether there was any relationship between fees and discounts, we plotted fees and then residuals from our fee equation against the discount to TERP. These are shown in Figures E2 and E3

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respectively, below. Both show a positive association, consistent with fees and discounts being simultaneously determined. However, such positive associations could also be expected where fees and discounts are both related to explanatory factors excluded from our model. It is possible this is the case, although we note that most risk factors should be reflected in the controls that we included in our model and in particular by issuer volatility and the reason for issue.

Figure E2: Underwriting fees and discount to TERP

12

34

5G

ross

Fee

% (D

isc)

0 10 20 30 40 50Discount to TERP

Gross Fee % vs Discount to TERP

Source: OFT internal analysis of Dealogic data

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Figure E3: Regression residuals and discount to TERP -2

-10

12

Res

idua

ls (F

ees)

0 10 20 30 40 50Discount to TERP

Residuals vs Discount to TERP

Source: OFT internal analysis of Dealogic data

E.20 As a result of these limitations, we note that our findings should be interpreted with caution and are indicative rather than definitive.

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