That’s just the way it is. Things will never be the same again: Why the new SEC Rule 78(c) on book-building will revolutionalize issuer-investor relations in the Nigerian capital market.

6th Jul 2009

That’s just the way it is. Things will never be the same again: Why the new SEC Rule 78(c) on book-building will revolutionalize issuer-investor relations in the Nigerian capital market.

Posted by : Obi T. Onyeaso in Investor relations

Tags: analysts, Banks, business strategy, Corporate Finance, corporate governance, Daisy Ekineh, Deal PR, Dotun Suleiman, Financial communications, Financial institutions, Financial PR, financial press, investor communities, Investor relations, M&A, Musa al-Faki, Nigerian investor relations, Professor Ndi Okereke-Onyiuke, secondary offering, Securities and Exchange Commission, shareholder communications, Shareholder engagement, Technical Committee for the Review of the Capital Market Structure and Processes

The recommendations of the Dotun Suleiman Committee for the Review of Capital Market Structures and Processes have received a lot of attention in the press. As a result of public concerns over certain perceived abuses and improprieties on the Nigerian Stock Exchange, those recommendations which touch on the oversight functions of the Securities and Exchange Commission (SEC) over the exchange have been in the spotlight. However, one recommendation, so far adopted, that has received far less attention, is the introduction of book-building method in securities sales transactions. Known as Rule 78(c) it will have significant long-term impact on the Nigerian capital market through its potential to fundamentally change the content of public offering communications, structure of ownership of companies, surveillance of corporate governance, review of corporate performance and the quality of issuer-investor relations. In this post, we examine the trends that have led to the rise of institutional investors in Nigeria and why issuers may actually prefer them at first countenance. Then we discuss the likely implications of their established dominance on share registers and its implications for companies planning to raise capital.

In a recent critical essay on the dereliction of duty by US money managers in the supervision of public companies whose securities they buy and hold on behalf of private citizens, John Bogle, founder of the Vanguard Group, the giant fund manager, underlines the risks to the financial system as markets have gradually but surely transformed from owner-governed to agent-dominated systems. However, beyond his criticism of the ineluctable trend to greater ownership of corporations by fiduciaries, Bogle identifies their central role in contemporary capital markets, not simply as conduits of capital, but as watchmen of corporate governance and performance.

As the dominance of agents has grown, the corporations who issue the securities and the regulators who monitor the market have recognized their influence and adapted to the new reality with acquiescent practices.

The term deretailization was first used by Brian G. Cartwright of the US Securities and Exchange Commission to describe ‘the dwindling percentage of retail investors in key markets’. According to him, this trend has been reinforced by the creation of institutions-only trading markets and institutions-only asset classes.

The de facto exclusion retail investors from the securities offering process raises several issues. In speech given at the Investment Company Institute in January 2009, Commissioner Luis A. Aguila of the US Securities and Exchange Commission, lists the four issues which this trend has thrown up as they will affect financial regulation:

Concentrated ownership and the accountability of agents: Will the increased number of institutional investors make it possible for issuers and underwriters to pay less attention to retail investors when raising capital? Do retail investors get the same opportunities in offerings when underwriters make allocations of shares?

Causes: What are the causes of these trends?

Regulatory arbitrage: Do tax laws regarding retirement savings encourage investing through institutions at the expense of direct investment?

Regulatory response: What should be the SEC’s response? Should SEC rules take into account the inadvertent creation of incentives for retail investors to invest through institutions rather than directly? Is that good or bad?

Curiously, even as regulators across the world are putting laws in place to ensure that retail investors have access to information on the same terms as institutional investors and other privileged persons, the de facto mechanisms of the market are set up to exclude them from the same markets.

While the implications of this trend have received the attention of regulators, as shown above, and researchers, the consequences of these trends on issuers has received scant attention. Although, distinctions are made among institutional investors we feel that considered as a group who receive regular and substantial inflows of funds to invest in markets their control of a majority bloc of ownership in public companies justifies the attribution of a common identity. We believe that because of their fiduciary obligations, the differences between institutional and retail investors are not just quantitative (number of shares held), but qualitative (approaches to governance, executive compensation, voting patterns, corporate performance, etc).

Even as the trend to institutionalization of markets has accelerated in developed markets over the past decades, in absolute terms, the number of retail owners has grown across the world. This has been most evident in emerging and frontier markets like Nigeria where the liberalization of markets, privatization, increase in household incomes and the spread of financial education, have led to big spurts in retail investor ownership.

The Nigerian case deserves special attention because of the circumstances under which the public offering market and mass retail ownership ‘took off’. In July 2004, Professor Charles Chukwuma Soludo, the former governor of the Central Bank of Nigeria, announced that the regulator had taken a decision to raise the minimum capital required for the operation of a universal banking license from N2 billion to N25 billion. With the deadline for meeting this target set for December 31, 2005, the country’s eighty-nine banks had less than eighteen months to increase their capital by over 1,200%. All of a sudden, investment bankers had to think of creative ways to attract the necessary funds. In what may be described as a feat of marketing, twenty five banking entities successfully beat the deadline. In the process, a powerful truth had been discovered: retail investors had been the linchpin in the success of the mandated-IPO torrent.

Just as the banks were scurrying to meet the deadline, the federal government passed the Pension Reform Act of 2004, which was characterized by a transition from the defined benefit to defined contribution model, which would be managed by private institutions. These reforms would have important implications on the future development of financial markets in the country and savings patterns of workers. Ultimately, the results would be an increase in demand for securities in which to invest, and asset classes that would suit the liabilities of the new fund managers. This need would only grow with time.

When the consolidated banks emerged with robust balance sheets they were now faced with the challenge of expanding their products offerings to remain competitive in the evolved landscape. One natural candidate has been funds targeted at retail investors. In addition to these retail focused funds, the banks set up asset management houses, custodian agencies and trustee companies to offer services and products to various contribution schemes.

To these two factors, a third may be added. During the 2004-07 offering boom, stockbroking firms built up large clienteles. As financial education spread and the risks of investing on the stock market became evident, these clients came to recognize the benefits of professionally managed portfolios that offered a diversification of portfolio risk , reduced costs and optimal returns. Soon, the firms began to offer more funds to meet these demands.

Finally, in recognition of its rising oil revenues, market reforms and banking consolidation the country received stable BB- credit rating from both Fitch and Standard & Poor’s, the global ratings agencies, which put it on the same risk standing with emerging market leaders like Brazil and Turkey. Instantly, Nigeria began to pop up on the Bloomberg screens of fund managers, not only as a source of crude oil, but an attractive destination for investment. Funds whose policies excluded them from investing in markets with non-investment grade ratings began to look for opportunities in Nigeria, taking strategic stakes in public companies and driving up valuations in the process.

Therefore, concurrent with the discovery that retail investors were an important source of funds for offering success, counter trends appeared which strengthened institutions as an attractive source of funds for issuers.

One consequence of the aggressive marketing that characterized the banking consolidation public offerings was the high cost of publicity to reach and attract retail investors. In addition to other fixed costs of bringing an issue to market, the relative exorbitant charges for publicity became a burden for issuers. Furthermore, the cost of maintaining effective communications with all these dispersed and marginal owners whose trading decisions can generate a momentum, particularly during events which can have adverse effects on the share price, deducts from the appeal of retail investors as preferred equity owners. Moreover, because of their individual, marginal and non-fiduciary stakes in each company in their portfolio, retail investors hardly need an explicit statement on their investing principles, making it hard for management to identify a long-term alignment between its goals and theirs.

In effect, issuers were faced with two issues:

From which group can we most cheaply raise the funds we need at a competitive valuation?
Among which of these groups are we most likely to find investors that will be supportive of management strategy, or at least, who have the patience to adopt a longer-term horizon?

However, answers to these would mean nothing if there was no legal method of controlling which groups have access to the shares offered in these equity sale events.

One issuance mechanism, book-building, offers both informational efficiency in pricing and the allocational discretion sought after. In fact, neither auction and fixed price issuance mechanisms, the other methods, exclude informational efficiency since roadshows and requests for indications of interest may be sought . But they limit the discretion of the underwriter in allocating shares to particular investors. By playing a role in the determination of their ownership and right of participation in the future cash flows they will generate issuers can demand an implicit long-term ownership commitment from these investors.

Thus, it is surprising that the Securities and Exchange Commission omits to include this defining characteristic of book building in its definition and description of the new rule:

‘Book-building’ shall mean a process of price and demand discovery by which an issuing house/book runner, attempts to determine at what price a public offer should be made, based on demand from qualified institutional and high net worth investors.

SEC recognizes the following as qualified institutional investors (QII):

Fund Managers
Pension Fund Administrators
Insurance Companies
Investment/Unit Trusts
Multilateral and Bilateral Institutions
Registered and/or Verifiable Private Equity (PE) funds
Registered and/or Verifiable Hedge funds
Market Makers
Staff Schemes
Trustees/Custodians
Stock broking firms

To this list, the SEC also adds high net worth individuals, described as those with liquid assets of no less than N300 million.

The same document requires that twenty-percent of book-built offerings are reserved for retail investors but stipulates that in the case where they are unable to take up this amount, institutional investors can assume it. Since the offering price determination process admits only institutional investors, they have an informational advantage over retail investors in the underlying value of the shares offered, and as a group, which also has a unique investment horizon, can bid for shares at a price that makes it less attractive for retail investors who often have more speculative interests, leading to their hesitation to take up the full twenty-percent.

Up until now, the significance of this definitive shift from retail to institutional markets for the issuers has been largely ignored. Having discussed the implications on ownership structures, we now discuss how majority institutional ownership will:

Change in the content of public offering communications
Surveillance of corporate governance
Review of corporate performance and
The quality of issuer-investor relations.

Change in the content of public offering communications: In the past, media campaigns that heralded public offerings in Nigeria have often been characterized by the types of stunts and publicity which are better suited for lotteries or the launch of a new consumer brand. As we have already noted, this is a carry over of the mass-outreach necessity of the 2004-05 banking sector consolidation offerings. Increasingly as the markets become more sophisticated and institutions replace retail investors as the primary audience for offering communications, one would expect the focus to shift to a rigorous elaboration of the issuer’s business with equal emphasis on its risks and opportunities. Likewise, the emphasis of brand-centric messages in the design of offering communications will decline.

Surveillance of corporate governance: Although the jury is still out on the sustained commitment of institutional investors to the active supervision of boards, there is no denying the fact that when they do decide to become activist or privately press for certain actions, they can be an effective catalysts of change. In the United States, the rise of proxy advisory firms like Glass, Lewis, Egan-Jones, RiskMetrics, and Proxy Governance have created influential pressure points on the voting decisions of institutional investors becoming important allies in proxy contests for both activists and boards. We fully expect that as the shift in ownership patterns moves in favour of institutions investing on the Nigerian Stock Exchange they would either take a serious interest in the oversight of boards on their own volition and/or service providers like the proxy advisory firms, whose business model requires clients with significant blocs of shares to subscribe to their services, will appear to scrutinize the board proposals and governace practices in public companies.

Review of Corporate Performance: By definition and law, institutional investors as professional fiduciaries have a duty and ethic to monitor the performance of their portfolio companies. Since they do not have their own capital but depend on upstream investors to provide those funds, they are vulnerable to a shutdown if they fail to attain acceptable returns. they must ensure that their portfolios generate enough alpha to cover their administrative and trading costs in addition to providing a competitive return for investors. Due to their non-negligible stake, and hence much greater ability to affect prices by their buy-sell decisions, they can demand the attention of management to explain the quality of financial results and strategic business decisions.

Quality of issuer-investor relations: It used to be that Nigerian companies would boast about having several thousands of shareholders. In a retail-focused market, this would necessarily be so. However, as ownership moves to more concentrated owners, such large numbers on the share-owner register would become a thing of the past. Naturally, as the numbers of owners decline, with a weighting towards investors who own a not-insignificant amount of shares, a good number of whom have been owners of the company stock since its IPO, the intimacy of issuer-investor relations are bound to become more intimate and hopefully, productive to the maximization of shareholder returns. In fact, we strongly believe that the prioritization of these relations will be the decisive determinant of capital markets success going forward, both for new and seasoned issuers.

Issuers need to recognize that the trend to institutional predominance on their share registers will place a bigger responsibility on them even as they become the second step in the accountability chain (the institutional investors as representatives of the indirect owners of these companies are on the first step). There is a big difference between treating a letter delivered by NIPOST from an upcountry investor demanding the status of his share certificate or an email from an investor wanting to know if dividend warrants have been mailed, on the one hand, and the rigours of institutional owner inquiry, on the other. It is in the best interest of companies to begin to prepare for this brave new world. After Rule 78(c) things will never be the same again and it’s all for the good of all.