Understanding preference shares

RS2 Software plc had issued an announcement on 19 November 2020 in which it laid out the agenda for an Extraordinary General Meeting. During the two Extraordinary General Meetings held in December 2020, shareholders approved a number of changes to the company’s Memorandum & Articles of Association including the introduction of 60 million new non-cumulative, non-redeemable preference shares as part of RS2

Since the issuance of these new preference shares is the first issue of preference shares in Malta in a long number of years, today’s article is intended to help investors understand the concept of preference shares and how this type of capital differs from the more conventional ordinary shares that Maltese investors are accustomed to. Following the publication of the Prospectus of RS2 earlier this week after obtaining approval by the Malta Financial Services Authority, in next week’s article I will delve into the main findings of the document highlighting the business pipeline and the financial forecasts which are extremely important to enable investors to gauge the company’s near-term prospects.

This is not the first time that preference shares are being offered to Maltese investors and subsequently listed on the Malta Stock Exchange. In December 1995, Simonds Farsons Cisk plc had raised the equivalent of €9.78 million in two series of cumulative, redeemable preference shares which were used by the company to finance part of its significant capital investments over the years. Farsons had redeemed these shares (which provided a fixed annual dividend of 6% and 8.5%) in 1999 and 2002, and since then, no other Maltese company opted for this type of financing as part of its capital structure.

Although many investors might have been surprised by the decision of RS2 to opt for an issuance of preference shares, it is interesting to note that it is regular practice for several companies overseas to have a varied mix of capital including preference shares. This would normally reflect the controlling structure of the company as well as specific objectives that the company would need as part of its growth targets and financing requirements. As an example, both  German automakers Bayerische Motoren Werke AG (BMW) and Volkswagen AG have ordinary shares and preference shares in issue and investors wishing to buy shares in these renowned companies may opt to gain exposure to any of these securities.

There are various types of preference shares that a company may issue. Although preference shares are normally seen as hybrid instruments between ordinary shares and bonds, there are numerous variants in the possible features that such preference shares could have. For instance, a redeemable or callable preference share (which matures on a specific date such as a ‘plain vanilla’ bond) that would also have a fixed or floating dividend, or some other form of predetermined rate of return (which could either be ‘cumulative’ or ‘non-cumulative’), is considered to be closer to debt rather than equity.

Conversely, a non-redeemable (i.e. perpetual or non-callable), convertible or exchangeable preference share (i.e. one that may be exchanged for new ordinary shares upon the trigger of a specific event, for example) that does not provide a predetermined minimum level of return would be considered to be almost at par with equity. In this case, the preference share would have other features that distinguishes it from an ordinary share, such as ‘preference’ over any future dividend payments or else ‘preference’ over the company’s residual value in the case of liquidation. Indeed, preference shares might enjoy ‘preference’ in their ranking in the case of a winding down of a company, making them ‘senior’ to ordinary shares although remaining subordinate (or ‘junior’) to all debt holders and other creditors (including unsecured bondholders).

In the case of the preference shares that are being issued by RS2, these do not have any of the typical characteristics that are synonymous with debt. The new shares will in fact have ‘preference’ in the form of a ‘premium’ of at least 10% over any dividends that RS2 may declare in the future. Moreover, this ‘preference’ is ‘non-cumulative’, meaning that the non-payment of dividends in any financial year would be lost and not accrue in a future year. Preference shareholders would however still qualify in the same manner as ordinary shareholders when it comes to any bonus shares issued.

The new RS2 preference shares are ‘non-redeemable’ (the same as ordinary shares) unless bought back and cancelled by the company. Moreover, they do not have a fixed liquidation value (or par value), and only carry one voting right per share compared to the two voting rights per share of ordinary shareholders. Furthermore, whilst ordinary shareholders have the right to participate in full during shareholders’ meetings (such as Annual and Extraordinary General Meetings) , RS2 preference shareholders will only have the right to vote in the event of particular matters concerning the reduction of the company’s capital, the winding up of the company, where there are changes that directly affects the rights and privileges of preference shareholders, and when the dividend on preference shares is in arrears by more than six months.

An important consideration that investors ought to analyse in the context of the new capital structure of RS2 is related to the distinction between control interest and economic interest. This is particularly relevant in view of the somewhat restricted free-float (as in the case of most companies whose shares are listed on the Official List of the Malta Stock Exchange) since Information Technology Management Holding Limited (which is ultimately owned by RS2’s CEO Mr Radi Abd El Haj) and Barclays Bank plc are the majority shareholders of RS2 with a controlling interest of just over 68%. As a result, although existing minority ordinary shareholders would still have a greater say in the running of the company given their superior voting rights when compared to preference shareholders, in practice this does not translate into more effective control in view of the much larger interest of the two major shareholders. Moreover, since ordinary shareholders and preference shareholders have the same rights when it comes to the company’s assets, but preference shareholders have ‘preference’ over any profit distributions (i.e. dividends), preference shareholders may actually be in a better position than minority ordinary shareholders when it comes to the economic interest in the company. However, the real benefit for ordinary shareholders of RS2 may materialise in due course should strategic and/or financial investors seek to take a stake in the voting rights of the company.

As indicated in my article last week, RS2 has been the best performing equity over the years with a growth of over 1,100% since its IPO in mid-2008. Following the very strong growth in the market capitalisation of the company translating into a compound annual return of almost 22%, RS2 now ranks among the larger companies on the MSE. As such, the €50 million preference share issue announced earlier this week is a very important milestone for the Maltese equity market.

As economic conditions in Malta and across the world begin to recover following the significant negative impact due to COVID-19, it is expected that more companies will look at the local capital market as an important source of financing especially in view of the huge amounts of liquidity across the financial system. It is indeed imperative for all interested bodies to recognise the crucial role that the Malta Stock Exchange has as an enabler of renewed economic dynamism amid the significant transformation which is underway especially in the new areas of the economy such as payments and technological disruption. The new capital raising exercise of RS2 is further testament of the value that could be unlocked by companies through capital markets and bodes well for the continued development and sophistication of the local capital market in general.

 

Rizzo, Farrugia & Co. (Stockbrokers) Ltd is acting as Joint Sponsor to the preference share issue of RS2 Software plc.

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