The 3-for-7 Rights Issue: TERP, Control, and the Retail Holder's Choice
Meridian Logistics Ltd trades at HK$4.80. Before the open it announces a 3-for-7 rights issue at HK$3.20 per new share, raising roughly HK$1.9bn to repay a syndicated facility maturing in 14 months; net debt/EBITDA is 4.1x before the raise. The founder holds 385m Class A shares out of 700m total, each carrying 10 votes; Class B shares carry one vote. He has irrevocably undertaken to take up his full entitlement. The shares go ex-rights in eight trading days and the nil-paid rights will trade for five days. A retail client holds 14,000 Class B shares bought six months ago at HK$5.10. Her broker charges HK$120 per subscription instruction and will not accept an instruction to sell nil-paid rights, only to subscribe or let them lapse. She asks whether she should 'pay up to avoid being diluted'. Two weeks ago a newspaper reported that a strategic buyer had made an approach; the company has not confirmed it.
1. Calculate the theoretical ex-rights price and the value of the nil-paid right per existing share. Then quantify the client's wealth outcome under three choices: subscribe in full, sell the rights, or let them lapse.
Read the worked answer
TERP: 7 existing shares at HK$4.80 = HK$33.60, plus 3 new shares at HK$3.20 = HK$9.60, giving HK$43.20 for 10 shares, or HK$4.32 per share.
Value of the right: each new share is worth 4.32 − 3.20 = HK$1.12, so per existing share 1.12 × 3/7 = HK$0.48. Cross-check: 4.80 − 0.48 = 4.32.
Her 14,000 shares carry an entitlement of 6,000 new shares.
- Subscribe: pay 19,200 (+120 fee), hold 20,000 × 4.32 = 86,400. Pre-decision wealth was 14,000 × 4.80 = 67,200 plus 19,200 of cash = 86,400. Net change: zero, less the HK$120 fee. The only real effect is that she owns more of the same company.
- Sell rights: rights 14,000 × 0.48 = 6,720; shares 14,000 × 4.32 = 60,480; total 67,200. Net change: zero.
- Lapse: shares worth 60,480, a loss of 6,720, or 10% of her holding.
Subscribing and selling are economically equivalent at the theoretical price; only lapsing destroys value. The decision is therefore a portfolio question - does she want another HK$19,200 of Meridian exposure? - not a dilution-avoidance question. Note also that the realised ex-rights price is often below TERP once arbitrageurs short the stock against the rights, so HK$4.32 is an anchor, not a floor.
2. Assume non-founder shareholders take up only 40% of their entitlements. Calculate the founder's post-issue shareholding and voting power, and explain what the irrevocable undertaking signals.
Read the worked answer
Founder pre-issue: 385m of 700m = 55% of the capital, 385 × 10 = 3,850m votes of 4,165m total = 92.4% of votes.
He subscribes 385 × 3/7 = 165m new shares. Non-founders hold 315m shares and receive 135m rights; at 40% take-up they subscribe for 54m.
Shares in issue after: 700 + 165 + 54 = 919m. Founder: 550/919 = 59.8% of the capital.
Votes: 550 × 10 = 5,500m versus 369m, so 5,500/5,869 = 93.7% of votes, up from 92.4%.
So partial non-participation transfers roughly 4.8pp of the equity - 44m shares, about HK$190m at TERP - from lapsed retail holders to the founder, and adds to his already dominant vote. If everyone took up fully he would remain at 55% and 92.4% of votes.
Two readings of the undertaking. Positive: the controlling shareholder is funding his pro-rata share, which is the single most informative signal available in a discounted rights issue. Cautionary: with 10-vote shares, he acquires that increased economic stake cheaply at HK$3.20 while an absent public shareholder is diluted on both capital and control. The undertaking is a control feature as much as a confidence signal, and an analyst should treat the two as inseparable.
3. The rights price is 33% below the cum-rights price. Advise the client, and explain what the discount, the leverage and the takeover rumour imply for an equity holder.
Read the worked answer
The 33% discount to HK$4.80 (26% to TERP) is deep. Deep discounts usually mean the issuer or its underwriter wants certainty of take-up - consistent with 4.1x net debt and a facility maturing in 14 months. They are not, by themselves, a sign of value.
Three implications for the holder. First, the discount is a transfer device, not a gift: at TERP her wealth is unchanged whether she subscribes or sells, so the phrase 'pay up to avoid dilution' mis-frames the choice. Dilution in share count is irrelevant if she sells the rights or is compensated by the discount on the shares she buys. Second, deep discounts invite delta-one arbitrage: short the parent, buy the rights. That pressure can push the traded price towards or through TERP in the five days the nil-paid line trades, so the 'HK$0.48 of value' may not be realisable. Third, the unconfirmed approach changes the strategic picture: a bidder would be negotiating with a holder whose vote rises to 93.7% after the issue, and cash raised to repay debt makes the target cleaner but also more expensive.
Practical advice: if she wants the exposure, subscribe, but note the HK$120 fee is 0.6% of the cheque - material for a small holder. If she does not, sell the entire holding around the ex-date or before. Lapsing is the only outcome that is certain to destroy value. Her HK$5.10 cost is a sunk fact and should not enter the decision.