For Dialogue with Shareholders/Investors Concerning Capital Policy: Focusing on Recap CB March 17, 2017 Tokyo Stock Exchange, Inc.
Introduction The Stewardship Code and Corporate Governance Code urge constructive dialogue between listed companies and investors for the purposes of achieving sustainable corporate growth and increasing the mid- to long-term corporate value. There are, however, considerable discrepancies between their views of capital policy, and this fact often damages their trust relationships and may become an obstacle to constructive dialogue. The mid- to long-term investors, with which companies are supposed to have constructive dialogue, basically support capital policies that will theoretically facilitate continuous increase of corporate value: for instance, with regard to how a company uses its profits, they usually welcome reinvestment for growth by the company, rather than return to shareholders through dividend or share buyback. Furthermore, while they generally support retained earnings for reinvestment, they dislike retained earnings without clear purpose. Many listed companies, however, seem to recognize that shareholder returns are the most welcomed, and retained earnings are the most disliked by investors. Among such discrepancies, the most obvious case could be when a company raises funds by issuing new shares (equity finance). Since it involves possible dilution of earnings per share due to the issuance of new shares, unless investors are convinced that raised funds will generate profits commensurate with high financing costs for issuing new shares, they will have a doubt about the company s willingness to increase corporate value, which, in turn, may damage trust relationships being the foundation of dialogue, thus impeding constructive dialogue. It is a pressing issue to eliminate discrepancies in views of capital policies, and to promote mutual understanding. This paper titled For Dialogue with Shareholders/Investors Concerning Capital Policy: Focusing on Recap CB summarizes possible questions from investors, focusing on the topic of an equity finance scheme called Recap CB, and explains investors views on capital policy, with the intention that listed companies will more thoroughly consider the investors views and strengthen mutual understanding. Please refer to this paper when your company considers capital policy in general, let alone when considering other equity finance schemes, so that your company will strengthen trust relationships with investors, thus facilitating constructive dialogue. 1
About Recap CB Recap CB refers to a capital policy for recapitalization, where a company issues convertible bonds (CBs) to fund share buyback, thus increasing debt and decreasing equity. Since 2014, an increasing number of Japanese listed companies have engaged in this financial arrangement. Recap CBs result in a decrease of shareholders equity, thus decreasing the denominator of return on equity (ROE). Accordingly, it has the effect of increasing the value of ROE numerically. In the past, some companies carried out recap CBs with the objective to improve capital productivity, including ROE. On the other hand, Japanese and foreign institutional investors and others have expressed critical opinions that recap CBs do not necessarily contribute to increasing corporate value and thus cannot be welcomed from the standpoint of existing shareholders, while appreciating listed companies efforts for improving capital productivity. Taking recap CBs for example, we identified six (6) important points in order to have constructive dialogue with investors. For each point, the section titled Examples of possible questions provides a list of issues which investors may have questions about, or typical example questions. Furthermore, the section titled Explanation provides explanations about the idea of corporate finance behind investors questions. In case your company actually considers financing by issuing recap CBs or otherwise, making use of this paper in the following manner would facilitate dialogue with investors with such awareness: Examine all relevant points when considering financing arrangement; Concerning matters which are deemed important for winning the support of existing shareholders in light of your own circumstances, provide explanations in disclosure of financing arrangements; and As for matters which were not included in the disclosure, be prepared to answer possible questions from shareholders/investors. 2
Points to Be Considered Point 1. Rationality of share buyback Can you explain the proposed share buyback in accordance with your capital policy concerning growth investment and shareholder returns? Can you justify the timing of the proposed share buyback in the light of your current price of your company s shares? Under the recap CB scheme, a company issues CBs, and at the same time, repurchases its own shares. The first point is about share buyback itself. Share buyback is one of the forms of shareholder returns. In that sense, it is one of the capital policies generally favored by shareholders/investors. Nonetheless, you should keep in mind that it is not always received positively. From the standpoint of investors who intend to invest in a company over the long term, it would be considered better to use funds gained from business activities for a prospective investment opportunity to drive the growth of its main business, rather than for share buyback, thus increasing corporate value over the mid- to long-term. In this regard, Principle 1.3 of the Corporate Governance Code stipulates that companies should explain their basic principles of capital policies: Principle 1.3 Basic Strategy for Capital Policy Because capital policy may have a significant effect on shareholder returns, [listed] companies should explain their basic strategy with respect to their capital policy. Investors who are interested in the company s sustainable growth may ask you questions about your policy concerning growth investment and shareholder returns: specifically, they may ask questions as to, under what circumstances, which your company gives priority to. Therefore, you may want to organize your thoughts in advance. It is also necessary to pay attention to investors views on share buyback. Share buyback is a company s act of repurchasing its own shares by using its own funds. Therefore, it is said that there is a signaling effect of share buybacks; an announcement of share buyback delivers a signal to the market, showing that the top management team of the company, 3
which makes such a decision, recognize that the current share price is undervalued, and the share buyback will yield a higher return than growth investment. Investors evaluate share buybacks from such a perspective as well. Accordingly, when a company plans to repurchase its own shares under the circumstance where investors perceive that the share price is relatively high, they are interested in whether the management still judged that the company s shares are undervalued, and on what basis the management made such a judgment. Therefore, in case a company plans to repurchase its own shares, regardless of whether or not doing so at the same time of issuing CBs, it would be recommended that the company compare its fundamental corporate value, which is internally computed using the DCF method, etc., and its market cap computed based on the current share price, and verify the following points in advance: whether the fundamental corporate value exceeds the market cap ; and in the light of the deviation of these two, whether it can be said that the planed share buyback is an investment with a rate of return exceeding its capital cost. Point 2. Appropriateness as a method to fund share buyback While recap CB is an approach using CBs for funding share buyback, What are the reasons for not using cash on hand? What are the reasons for not taking bank loans? What are the reasons for not issuing straight bonds? The second point is a question whether CBs is appropriate as a method to fund share buyback. There are various methods for listed companies financing. When they need funds for business activities, they may use cash on hand, take bank loans, issue straight bonds, or issue new shares: they use such different methods depending on the respective situations. According to the theory of corporate finance which investors keep in mind, it is considered that there are priorities among these methods. In case of financing by listed companies, in principle, priorities are given as follows: (1) cash on hand, (2) debt, and (3) shareholders equity. This order is referred to as pecking order. Basically, the cost of financing 4
becomes larger in this order (1) the cash on hand as the lowest and (3) the equity financing as the highest. So if companies have sufficient cash on hand, they should use cash first; if there still is a shortage, then they should take bank loans or use straight bonds only to the extent that they can maintain financial soundness; and finally, they may raise funds in a way to increase shareholders equity. This order is understood to be economically rational. Furthermore, from the viewpoint of existing shareholders, companies are expected to use cash on hand or debt financing, which will not cause dilution of share value, prior to equity finance. In such priorities, where are CBs positioned? Because CBs are debts which can be converted to shares, CBs are positioned between (2) debt and (3) shareholders equity (2.5). Therefore, it should be given consideration after (1) cash on hand, and (2) debt. Accordingly, for example, if a listed company, which has sufficient (1) cash on hand, wants to gain acceptance of existing shareholders for issuing recap CBs, the company will be required to provide the existing shareholders with clear explanations about reasons why it is not appropriate to use cash on hand for the share buyback, and positive reasons why it is best to use CBs. Furthermore, from the perspective of the pecking order, it is also expected that financing methods using such ordinary debts as bank loans or straight bonds should be considered prior to CBs. So companies are required to provide clear explanations about reasons why they thought it was appropriate to issue CBs, rather than using such ordinary debts. Typical reasons why listed companies choose the issuance of CBs are as follows: in case of issuing CBs, the companies can raise funds without interest payment (zero coupon). In other words, the fact that they can raise funds without the interest burden is an advantage over taking bank loans or issuing straight bonds, in terms of low financing costs. However, CBs are dilutive shares, which may be converted to ordinary shares. So from the standpoint of existing shareholders, actually the cost is not zero. It is pointed out that listed companies can raise funds without bearing interest burdens, because they provide CB purchasers with the option premium which yield sufficient profits despite zero interest rate. Furthermore, in the current environment with low-interest rates, the advantage from raising funds by using zero coupon bonds is small. Therefore, some argue from the viewpoint of existing shareholders that option premium sold to CB purchasers in exchange for it may be disproportionate. When explaining reasons for using CBs as the financing method, it would be necessary to provide explanations taking such views into account (Please also refer to Point 5). In case of using financing methods other than CBs, exploring issues according to the above-mentioned priorities would facilitate smooth communication with investors. 5
Point 3. Consistency with basic strategy of capital policy What indicators do you present as targets concerning profitability, capital productivity, etc.? What measure do you implement to achieve the targets? How are financial strategic measures positioned in that framework? If you intend recapitalization (optimization of debt/equity ratio) through recap CBs, what kind of capital structure (debt/equity ratio, etc.) do you plan to achieve? In case of recap CBs, there is a possibility that the effect of recapitalization will be nullified, if the share price rises and CBs are mostly converted to shares. What do you think about this possibility? It is considered that efforts to improve capital productivity will be welcomed by investors as well, but unless capital productivity is continuously improved, it will not lead to sustainable increase of corporate value. Furthermore, some argue that it is preferable to give priority to improving margin (net profit/sales), rather than increasing leverage (total assets/shareholders equity) by using financial methods, including recap CBs. Taking it into account, if companies explain what targets are set with regard to their profitability, capital productivity, etc. (Please refer to Principle 5.2 of the Corporate Governance Code), what they implement to achieve the targets, and what roles proposed financial strategic measures play in that context, it will become easier to gain investors understanding. Principle 5.2 Establishing and Disclosing Business Strategy and Business Plan When establishing and disclosing business strategies and business plans, companies should articulate their earnings plans and capital policy, and present targets for profitability and capital efficiency. Also, companies should provide explanations that are clear and logical to shareholders with respect to the allocation of management resources and specific measures that will be taken in plans and targets. For example, if you claim that the recapitalization by using recap CBs will contribute to largely optimizing capital structure and increasing capital productivity (ROE, etc.), you should present the level of the optimal capital structure (debt/equity ratio, etc.) for your 6
company in advance, and be able to explain that you chose recap CBs as a means to move toward it. Then, it would become easier to convince investors. As mentioned earlier, if you implement recap CBs, equity will decrease and debt will increase. However, in the future, if your company s share price exceeds CB conversion price, it is expected that CB holders will actively convert their CBs to shares, thus resulting in a decrease of debt and increase of equity. As purposes of implementing recap CBs, some listed companies refers to the improvement of capital productivity through the recapitalization, but recap CB is the method with the potential that the effect of the recapitalization may revert to the initial state, if the share price rises. So some cast doubts about the recapitalization by using this scheme. Some may ask like this: if CBs are actively converted and the debt/equity ratio returns to the initial level, it will become necessary to repeat recap CBs. It would be recommended to organize your thoughts on how to address such cases, including the one above (whether to carry out recap CBs once again, etc.). Point 4. Specific circumstances for combining CBs and share buyback For instance, do you have an intention to buy back your own shares for mitigating the impact on share price at the time of issuing CBs, or do you issue CBs for the purpose of promptly repurchasing your own shares? Recap CBs consists of raising funds by issuing CBs and share buyback. If there are any specific circumstances as reasons for carrying out these two at the same time, it is important to clearly explain the context in order to gain investors understanding. As examples of specific circumstances, roughly speaking, two cases are considered. One is the case where a company buys back its own shares simultaneously for the purpose of smoothly raising funds by issuing CBs, and another is the case where a company issues CBs simultaneously for the purpose of smooth share buyback. In the first example, raising funds by issuing CBs is the main transaction, and in order to smoothly implement the transaction, the company in question also carries out share buyback at the same time. Purposes of raising funds by issuing CBs are similar to those of ordinary issuance of CBs, including capital investment, but a part of funds raised is allocated for share buyback. 7
The issuance of CBs creates a possibility where subscription warrants will be exercised in the future, and the number of shares issued will increase, thus diluting existing shareholders interest per share. In addition, among investors in CBs, there are some investors who hedge the risk of share price drop by short selling of shares at the same time of purchasing CBs. Such short selling of shares affects demand and supply. Therefore, it is said that the announcement of the issuance of CBs tends to cause a tentative drop of the share price. If the share price drops, it will negatively affect a decision on terms and conditions of CBs. So it is said that there are some cases where companies repurchase their own shares at the same time of issuing CBs, with an intention to offset (a part of) negative impact of short selling for hedging purposes on demand and supply by share buyback, in order to prevent or relieve downward pressure on their share prices before the determination of the terms and conditions of CBs. In this case, companies are more likely to be able to convince existing shareholders by providing explanations about not only the rationality of the use of funds raised by issuing CBs, but also expected degree of negative impact of short-selling of shares on share price (and terms and conditions of issuing CBs), and reasonableness of simultaneous share buyback as a countermeasure. In the second example, share buyback is the main transaction. In order to smoothly repurchase their own shares, companies issue CBs at the same time. There are various motives for share buybacks, including, but not limited to, returning surplus funds to shareholders, adjusting their capital structure by reducing equity through share buybacks, and offsetting a demand-supply gap at the time when a large shareholder sells off its shares to unwind cross-shareholdings (See Point 1). However, in reality, a company may not always be able to promptly repurchase as many of its own shares as it wants in the market. In case the company intends to repurchase a larger number of its own shares compared to the liquidity of the shares in the market, since that many shares are not sold in the market, it may take time to complete the share buyback. In such a situation, some companies have issued CBs for the purpose of inducing short-selling of shares by CB investors as mentioned earlier, and thus completed repurchasing a large number of their shares, which exceeded the normal liquidity in a short period. Accordingly, companies are more likely to be able to convince shareholders by explaining reasons why they need to complete share buybacks in a short period of time, and policies articulating their views on potential increase of shareholders equity by an increase in the number of shares issued in the future, in an easy-to-understand manner. 8
Point 5. Appropriateness of decision on CB conditions Is the advantage from the fact that a listed company is able to issue non-interest bearing CBs (zero coupon) matched to option premium on the CBs? Points 5 & 6 should be kept in mind with regard to CBs in general, not only recap CBs. Under the Companies Act, CBs are classified as bonds with stock acquisition rights, and thus the issuance of the CBs is subject to regulations on favorable issuance (associated with stock acquisition rights). Accordingly, conversion prices are generally determined by a book building process in case of public offering, and by obtaining a calculation statement issued by an independent calculation agent in case of private placement. Nonetheless, the measure to valuate option premium is complicated. Even if a company follows a reasonable process, it is not always possible to convince all shareholders/investors with regard to the adequacy of pricing. According to the pecking order as mentioned in Point 2, CB is an instrument with possible dilution in the future, thus being a financing method close to equity financing, so it is understood that its financing cost is larger than the cost of such debts as bank loans and straight bonds. If that is the case, even though companies can raise funds with zero coupon, it is also possible to consider that the only advantage is the zero-interest on the debt portion, and that is disproportionate to the cost. Concerning the adequacy of decision on terms and conditions of CBs, it is desirable to provide thorough explanations, taking such views into account. 9
Point 6. Message of CB s surplus rate Does the fact that the conversion price is set at a high level to prevent possible dilution mean that the management considers that the share price will not rise up to that level? There are quite a lot of cases where a conversion price is set at a higher level than the share price at the time of issuing CBs in order to avoid possible dilution by the conversion of CBs into shares in the future. The percentage increase of the conversion price compared to the share price at the time of issuing CBs is called surplus rate. If the surplus rate is large, the possibility of conversion in the future will be lower, and the number of shares to be issued for the conversion will be smaller. In that sense, setting a certain surplus rate at the time of issuing CBs can be deemed as consideration for existing shareholders concern about possible dilution. In disclosure documents of listed companies issued upon implementing recap CBs, some companies have explained that they intended to prevent possible dilution by setting a high surplus rate. However, looking from the viewpoint of existing shareholders, you should keep in mind that setting a conversion price higher than the current share price to prevent possible dilution is not always favorably received. Looking at the fact that the management believes such a conversion price can prevent possible dilution from a different perspective, it could be interpreted as indicating that the management believes its share price is unlikely to reach the level of such a conversion price. In this way, shareholders may receive it as the message that the conversion price is the ceiling or target price of the shares. Giving due consideration to such views would contribute to constructive dialogue with investors. 10