December 5, 2023
Understanding the basics of Capital Raisings
Capital raisings can be for listed or unlisted businesses. Both pathways may suit you, but first lets understand how they work
Entry to capital raisings is a chance to get in on the ground floor of an investment opportunity. It can be a profitable way to experience capital growth, but like any investment there are risks, and understanding what the money is to be used for and any obstacles to success is vital.
Understanding the investment options
Capital raisings take a variety of forms, and you should understand the investment vehicle you are investing in. There may also be implications on how you choose to exit the opportunity, so you need to ask yourself ‘what is the strategy for my investment’?
- Private capital raisings – Companies start off as private vehicles that take on capital as they grow or progress a concept. Initially they may seek out private capital investments in the form of ‘angel’ or ‘seed’ investing. There may be a few rounds of this type of funding, and it can be supplemented by private placements to identified investors to expand the capital base. If the company needs additional capital to expand and a wider investor base, it may seek to do an Initial Public Offering (IPO) and swap its ‘private’ status to become a listed company on an exchange, like the ASX.
- IPO – If a company meets listing requirements and decides to raise capital and list on a stock exchange as a public company it will put out a prospectus to enable investors to participate in the offer. The prospectus will provide the information needed to make an investment decision. This would include areas like the experience of the board of directors and key management, purpose of the funds raised and the business plan for growth and success, as well as key risks to the business, and details of the offer, including pricing of the shares on offer, timings, and entitlements.
- Rights issue – A listed company may require additional funds to progress the business, make acquisitions, or restructure in more challenging times. Investors will be asked to participate in the issue and will be provided with details of the issue and the purpose for the funds raised.
Where is the best entry point?
There is no cut and dried entry point that works for all investors. Traditionally, IPO’s and rights issues were the preferred entry point. Seed or angel investing used to be in the province of wealthy and sophisticated investors, however, even is this space there are entry points through specialised funds and newer avenues like crowd funding. Private placements are an area of growth as increasingly, businesses seek other ways to grow outside of a public listing.
Although capital raisings typically result in equity ownership of the business, the variation in risk can be considerable. A start-up business with no track record is a different proposition to one that has been trading for 10 years or more and has a history of performance and growth. As with any investment, rigorous research is required to ensure the opportunity meets an investors risk tolerance and return expectations.
- Managed funds or trusts – Investors become a unit holder in a vehicle that invests in an underlying asset, such as equities, bonds or property. Unit holders do not have direct ownership of the underlying investments but are the beneficiaries of those assets. The trust or fund distributes earnings achieved to unit holders. If the fund is listed, investors can exit by selling units on a stock exchange. If the fund is unlisted, then they can exit by redeeming their money directly from the fund or trust, depending on conditions contained in the fund’s mandate. Property funds typically only facilitate redemptions during specified period of withdrawals.
- Corporate debt/bond – Investors can access company debt through the corporate bond market raising or through a private debt raising. Investors are entitled to periodical interest payments and repayment of initial capital invested when the debt matures. Debt capital raised from the Over The Counter (OTC) bond market has higher liquidity as holders can exit by selling their holdings prior to maturity. Private debt has lower levels of liquidity. Corporate bonds have different seniorities, which stipulate their priority of repayment if the company becomes insolvent. Senior bonds take priority before junior/subordinated bonds. Some hybrids bonds can also be listed, that is, companies raise the proceeds from a hybrids IPO raising. Listed hybrids can be sold on a stock exchange.
- Limited Partnership (LP) in a private equity fund – Many private equity funds operate through partnerships and investors who are not involved in the daily operation of the fund will become limited partners. Limited partners usually exit the fund when the fund reaches its investment horizon, or as per a Limited Partner Agreement.
How to assess a capital raising
The range of investments available through capital raisings is large, and individual opportunities may require the investor to spend considerable time accessing and analysing available information. If you have questions that your research does not answer, seek professional advice. Key pieces of information to analyse include:
- Financial statements – A company’s financial record provides a balance sheet to examine the health of the company seeking capital. Details within the financial statements can be used to calculate some important qualitative metrics.
- Interest coverage ratio (ICR) – Measures a company’s ability to pay interest on its debt from earnings. To be of investment quality, an ICR of at least two is broadly considered the minimum acceptable. The ratio is calculated by dividing earnings before interest and tax (EBIT) by the company’s interest expense.
- EV/EBITDA Ratio – A method of determining value is through an enterprise value (EV) to earnings ratio. It is a valuation tool used to compare how a company is priced compared to its peers and the market as a whole. It is determined by dividing the EV of a business by its earnings before interest, tax, depreciation and amortisation (EBITDA). The EV is determined by adding the market capitalisation of a company and the market value of its debt, while subtracting cash and cash equivalent holdings.
- Who is leading the business? – The board of directors and senior management are crucial in setting a company’s strategic direction and capital expenditure. Understanding the skill sets and track record of those directing a company, fund or trust provides investors with a level of comfort that there placing their funds in trusted hands.
- Use of proceeds – Not all capital raisings are the same, as companies need funds for a variety of reasons. Some capital raisings are special purpose, such as capital notes. Financial institutions raise capital notes to satisfy regulatory requirements, and there is a risk that the notes may be converted to equity or simply absorbed by the institution if needed to meet funding requirements. It is vital to understand the risks of any investment. In other situations, the purpose of a capital raising can also reveal the financial stability of a company. For example, raising capital for expansion or to restructure debt to stave off insolvency have very different connotations for investors. Most will seek the former situation, but other investors may seek the latter if the reward for the risk involved meets their investment criteria. If the use of proceeds cannot be articulated or are not convincing, it is usually a red flag.
- Fees – It costs money to raise money. If the fees a company is paying to raise capital is unusually high, it can be an indicator of corporate stress, as the companies may not be in a position to negotiate will the facility providers. Debt or equity public market raisings are more regulated, and fees must be disclosed. In private market raising, being transparent on fees also indicates good governance practice.
- Terms of investment – If not directly related to pricing and valuation, the terms of the investment sometimes tend to take a back seat and be overlooked, but they can be equally if not more important. For instance, many equity IPOs have terms to prohibit senior management from selling their shares for a certain period. If there is a flurry of sales by executives post that period, it can dramatically impact a company’s share price. In other examples, raisings for convertible notes usually specify terms under which conversion rights can be exercised, and corporate bonds raisings may also include covenants which restricts certain corporate actions. Investors should read all relevant disclosure documents and investment agreements to understand what events may impact their investment.
Picking capital raising opportunities ultimately comes down to an investors’ goal. Capital raisings stretch across growth and income opportunities. A high growth IPO in the technology sector may not be ideal for a conservative investor, and equally an illiquid property fund raising may not suit an investor who has unpredictable cash flow needs. After all, capitals raisings are part of your portfolio, and opportunities need to be weighed against overall portfolio risk, time horizons and returns.
The information contained in this article is gathered from multiple sources believed to be reliable as at November 2023 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. NAB recommends that you seek independent legal, property, financial and taxation advice before acting on any information in this article. Past performance is not necessarily indicative of future results. No warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither NAB or any of its related entities accept liability to any person for loss or damage arising from the use of this information. ©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.