Right issue

For hedge fund and mutual fund accounting, what can go wrong with a rights issue? The issue could be missed, processed incorrectly (for example, 4 for 1 instead of 1 for 4) or there could be an error in pricing the rights. Let’s walk through an example of what should happen in fund accounting for a rights issue and consider how this affects, or doesn't affect, the net asset valuation (the NAV).

A fund holds 100,000 Quicktek shares. Market price on Friday 17th July is €3.28. Quicktek has a rights issues on 20th July. Shareholders get 1 right per share. So the fund gets 100,000 rights.

The terms of the rights are as follows. For every 9 rights held, an investor can buy 4 shares at a subscription price of €2.15. The subscription period ends on 3rd August.

QTY	ID	PRICE	MV
1,00,000	RIL	$3.28	$328000
QTY	ID	PRICE	MV
1,00,000	RIL	$2.88	$288000
1,00,000	RIL	$0.36	$36000
		TOTAL	$324000

We’ll just look at what happens around the issue date. Let’s consider prices and market values. Here are valuation extracts from before and after the issue. In aggregate, the valuations are comparable. And in fund accounting, we like that!

So there is no significant NAV impact as a result of the issue.  Any market reaction to the news of the rights issue happens before the actual issue. So all is good here.

But what if we can’t get a price to mark the rights to market? What if the €0.36 above is unavailable?  Or needs to be validated. Fund accounting needs to be able to calculate the theoretical ex-rights price (TERP).

Theoretical ex-rights price (TERP)

Imagine Quicktek had 1 billion shares in issue. The total market capitalisation was €3.28 billion. Then it issued rights that would, ultimately, allow investors buy more shares, raising almost €956 million.

So with the original market capitalisation plus the additional cash raised, one would expect, theoretically, the value of equity to be almost €4.236 billion.

And if the issue is taken up the number of shares increases to 1,444,444,444. So, one would expect the price of a share immediately after the rights issue to be €2.93. €2.93 is the theoretical ex-rights price of the share. And if every 9 rights allow an investor buy 4 shares one would expect the rights to be worth

(2.93 – 2.15) x 4 /9 = €0.35. That is the theoretical price of the rights.

We can see that it’s pretty close to the price we used in our valuation on the 20th. So, happy days!

Bottom line

As at the close of business on the day of issue

Make sure the market value of the shares plus the rights is comparable to the value of the shares the day before the issue.

Calculate TERP to validate the price used to mark the rights to market