April 2020 Australian Financial Review
The website for London-based investment firm Veritas Asset Management says most of its employees have been working from home since mid-March. That’s very sensible. But it’s also a pity, as it means they would have no chance to exchange high fives to celebrate the impressive success of their investment in hearing implant maker Cochlear. Of all the winners from Cochlear’s bargain-basement placement completed almost two weeks ago, Veritas – which is Latin for truth – stands out. Cochlear's raising was completed at its lowest price for almost three years. And as investors brace for an avalanche of capital raisings over the coming weeks – starting with the surprise raise from plumbing supplies giant Reece announced on Monday and the emergency placement from Flight Centre less than an hour later – the story of the winners and losers from Cochlear's deal will be important to keep in mind.
Cochlear announced on March 25 that it was raising $800 million via an institutional placement to help provide a liquidity buffer, as the company was squeezed by two forces – one general, and one specific. The general one was, of course, the coronavirus pandemic, which has halted elective surgery in many parts of the world, stopping implant sales in their tracks. But Cochlear’s specific liquidity issue is that it has been found to have done the wrong thing. Early last month, the company announced it had lost its penultimate appeal against a US judgment that found it had infringed a rival’s patent. Cochlear estimates it will be forced to pay out $483 million in damages, and potentially as much as $238 million in pre-judgment and interest costs. The company is still fighting both parts of that case, but is largely resigned to paying out at least the larger chunk of that legal loss.
The $800 million raising was accompanied by a $50 million share purchase plan for retail investors, and a new $150 million bank debt facility. Cochlear was clearly taking sensible, prudent action designed to give it a margin for safety and let it retain its employees and its vital research and development program. But despite the fact Cochlear's deal couldn’t be put in the same category as rescue raisings from Webjet and Kathmandu, the board and its advisers, JPMorgan, opted against raising via an entitlement offer, which would have helped to limit dilution but would have taken at least 14 days to complete. Instead, they opted for a placement in the interests of speed amid incredible volatility. The deal was priced at $140 a share; not only was this a 16.7 per cent discount to Cochlear’s price on the previous close, but it was the cheapest the stock has been since April 2017.
Veritas had very good reason to jump at the opportunity presented by the placement. A substantial shareholder notice lodged last week showed the firm had actually been buying since mid-February, grabbing $9.3 million of stock at about $215 a share on February 14, another $4.2 million parcel a fortnight later at about $208 a share and a $10.8 million parcel at $218 a share on March 3. As the Cochlear board and its advisers considered their options in the days before announcing their capital raising, Veritas was still buying. It bought $33.2 million worth of shares on March 23 at $159 a share and then $37 million on March 24 – the day before the raising – at $168 a share.
When the $140 a share price on the raising was announced, Veritas jumped in boots and all, spending $304.5 million on stock. Such was the British firm’s hunger that Cochlear increased the size of the placement by 10 per cent to $880 million. Veritas took more than 34 per cent of the expanded raising.
On March 26, Cochlear told the market the raising had met with "significant demand" for which chair Rick Holliday-Smith was "grateful and delighted”. But not as delighted as Veritas. By the end of that day, the $304.5 million of shares it took in the placement were worth $396.2 million, as Cochlear shares surged to close at $182.17. Veritas doubled down, spending a touch over $105 million – basically its profits on the placement – on Cochlear stock across March 30 and March 31, taking its stake to 5.6 per cent.
The delight from London’s truth seekers might not be shared by the retail investors who didn’t participate in the offering – and there will be plenty of them. While they will be pleased Cochlear’s balance sheet is shored up, and that its share price never got anywhere near the discounted raising price, the dilution they’ve suffered – upsized for Veritas and other institutions – will surely sting. They might well ask if demand was so "significant" because the price of the placement was too low. They might also ask if an entitlement offer involving a book-build, which would have provided a mechanism to adjust the price to demand, might have been a better way to ensure the required liquidity was secured with the minimum dilution. The institutional component could have taken just 24 hours, although the retail portion would have stretched over at least 14 days. They might also ask whether the board might have been prepared to take on the risk of a smaller discount or a more time-consuming raising via an entitlement offer given it paid JPMorgan at least $19.8 million (or 2.25 per cent of proceeds) to underwrite the deal.
Of course, this is all very well in hindsight. Investors must trust the Cochlear board, and JPMorgan would have weighed up all these factors and done what they thought was best in what are clearly trying circumstances. But as we prepare for an avalanche of capital raisings – many of which will take advantage of the temporary change in ASX listing rules that increases the cap on placement sizes from 15 per cent of shares on issue to 25 per cent – the Cochlear/Veritas example is worth keeping in mind. These deals happen largely behind closed doors, without the approval of shareholders and very much at the whim of the board and its advisers. And while there will be big winners – like Veritas and, to a lesser extent, JPMorgan – those gains typically come at the expense of retail shareholders. Value generally gets transferred from small investors to large.
It’s up to boards to make sure they do the right thing by all investors, especially in these difficult times.