R Jagannathan: Rewarding shareholders right

MICROVIEW

A couple of weeks ago, two banks""Karnataka Bank and ING Vysya""sent punters into a feeding frenzy by announcing extremely low-priced rights issues.

In the case of the former, the rights price was set at Rs 20 when ruling market prices were five or six times higher; not surprisingly, soon after the announcement of a 2:1 rights, the Karnataka Bank scrip exploded. Both in price and volumes.

The point of debate is simple: why should a bank's board""or any company's board, for that matter""deliberately underprice a share issue when the market is willing to pay a lot more?

Doesn't this work against the long-term interests of the company and its shareholders? The answer to the second question is no. In the case of a rights issue, the benefits of an underpriced issue go only to its existing shareholders, and so there is no question of any injustice being done to them.

In effect, the owners of a company are rewarding themselves""as is their right. The company doesn't suffer, either, because the total size of shareholder funds""equity plus reserves""remains the same, whatever the premium.

The only difference is that in a high-premium issue, the equity base is lower; in a low-premium issue, the equity is higher. But since the aim of management should be to improve total returns on shareholder funds, it doesn't matter much whether it's designated as equity or reserves. Both belong to the shareholder.

On the other hand, look what a low-priced rights issue does to shareholder returns. For a share quoting at a low price-earnings multiple (P/E), the Karnataka Bank rights offer suddenly gave shareholders an instant return""narrowing the P/E gap with other, more fancied banks.

This is as good a way as any to reward shareholders of low P/E companies; I wonder why more managements do not use rights, bonuses, buybacks and dividends as strategic tools to reward shareholders better when the markets are not doing so.

The problem is that managements take a very static view of shareholder returns. They prefer to traverse the beaten track, favouring steady, slowly rising dividends instead of taking a more holistic and dynamic view.

Let's start with basics. How are shareholders rewarded? We all know about bonuses and dividends, but the most important reward mechanism is the stockmarket. If a management produces results, the market rewards all shareholders for this performance.

The problem, though, is that the market rewards performance unevenly in the short to medium term; companies with similar levels of performance get different P/Es.

This is obvious from the fact that for much of the 1990s, most public sector shares were underpriced despite good financial results; most early investors in public sector shares thus could not have made much money by owning them.

This got corrected in 2002 and 2003, when almost all public sector shares were rerated by the markets, but the point I am making is different: should managements just sit on their hands and wait for the market to reward shareholders in its own sweet time? I believe they can do more.

And the Karnataka Bank rights issue shows how. Broadly speaking, managements should opt for a counter-cyclical rewards policy where payouts and rewards should be low or moderate when the markets are on a bull run; it should be the other way around in bear markets.

Put another way, shareholder rewards should be seen in totality, and include not just dividends, bonuses and rights issues, but also the state of the markets.

So how would this work in practice? It would mean that if the markets are rewarding shareholders well, company payouts can remain moderate. But if the reverse is true, company managements have to pay out higher dividends and offer buybacks and generous bonuses.

If they are in need of capital for growth, low-priced rights issues are also par for the course.

Indian managements are still stuck with the share premium culture where it is seen as macho to demand a higher premium. While there is nothing wrong in doing so in a public issue, the logic differs when you want to do it in a rights issue.

It may make sense to demand high prices from your own shareholders if the business requires the money, and you want the equity base to remain low. But, if adding to equity will improve liquidity, or will reward shareholders better in a downturn, there is no reason why prices cannot be low.

Given the current tax regime, paying out dividends costs companies more than offering rights and bonuses; from a shareholder perspective, dividends look tax-effective, but only if they do not see themselves as long-term owners of the share.

Companies, therefore, have to work out a rewards mix that is both tax-efficient and appropriate""given market conditions. Trying to reward shareholders independent of market conditions is not optimal any more.

rjagann@business-standard.com