Jeannette Meyer, Corporate Associate at leading law firm, Faegre Baker Daniels, discusses whether share buybacks are as good as they seem.
Share buybacks are high on today’s business agenda and there has been an increase in share buybacks carried out by British companies, both public and private.
Whilst it is still more common for US companies to repurchase their own shares, over the last few years, the London Stock Exchange (LSE) has recorded more share buybacks than any other equity market, save for the US.
The recent announcement by British Land to allocate up to £300 million of capital to a share buyback did not, therefore, come as a surprise, although it will be the first such buyback by a real estate investment trust company for almost a decade.
Why have share buybacks become so attractive?
Firstly, the process is relatively straightforward, although shareholder approval is required.
A public company will generally effect a share buyback through a market, rather than an off-market, purchase, while a private company will enter into a specific buyback agreement with those shareholders whose shares are to be purchased.
A public company buyback must be funded from distributable profits as, unlike a private company, a public company is not permitted to purchase its shares out of capital.
Any shares bought back must be cancelled immediately or held in treasury and cancelled or sold back to the market in due course. In theory, a company could purchase all of its shares, except for one non-redeemable share that must remain in issue.
A listed company, however, must ensure that enough shares are still held by the public after the buyback to comply with applicable requirements and its issued share capital is not reduced below any legally authorised minimum (for a British company, this would be £50,000).
What are the effects of share buybacks?
By purchasing its own shares, a company returns cash to its shareholders and may allow them an exit from the company.
This can be particularly important for shareholders of private companies that do not have a liquid market for their shares, but may also be attractive to institutional investors in public companies who are looking to realise a return before a full exit is otherwise available.
At the same time, a share buyback reduces the number of shares in issue, which, if the same level of profitability is maintained, should lead to an increase in Earnings Per Share (EPS) – an important valuation measure for listed companies.
As EPS is often used as a metric to determine executive pay, some critics have interpreted the extensive use of share buybacks as a deliberate attempt by companies’ management to increase executive pay.
This seems unduly cynical, but is certainly something remuneration committees should bear in mind when assessing annual performance following a share buyback.
For the remaining shareholders of a company, the reduction in the number of shares means that they will end up with a greater percentage of ownership in the company.
Usually, there will also be a boost in share price (sometimes short-lived) due to a less available supply of shares and an increased short-term demand. Any long-term impact on the share price is much less predictable.
British Land’s buyback programme in 2007, for example, did not achieve a lasting effect on its share price. Notwithstanding the uncertainty about any long-term impact on share price, one of the main reasons why companies pursue share buyback programmes is because they believe their shares are undervalued and wish to increase their price.
A further motivation may be to consolidate ownership in the company. This is usually less relevant for listed companies, given the free float requirement, but there has been a trend amongst technology companies to purchase their shares in order to consolidate ownership and offset the dilutive effect of employee share awards.
Whilst there are benefits for shareholders, the negative aspects of share buybacks should not be ignored. As mentioned above, it is not possible to quantify what long-term impact a share buyback has on a company’s share price.
It is also relatively expensive for a company to purchase its own shares as it will be liable to pay stamp duty on the purchase price, although an exemption applies for shares in AIM companies.
It is, therefore, important that the company is in a healthy financial position and can sustain itself even if it faces unforeseen difficulties after the share buyback. This is particularly relevant if the company funds the buyback with debt, which may be a drag on future profits.
In some cases, a share buyback may be viewed as a lack of innovation. Many companies believe that repurchasing their own shares demonstrates to their shareholders, including external investors, that they are doing well financially.
Such a move can also be interpreted as management acknowledging a lack of alternative investment opportunities, which would help strengthen the business going forward. It is probably no coincidence that British Land announced its share buyback programme at a time when there is increasing uncertainty about the UK property sector, following the vote to leave the EU.
The hype surrounding share buybacks is not always justified and management should not reach for the buyback option as an easy way to calm restless shareholders in tough times.
If the company genuinely has excess cash that can be returned to shareholders, a better and more cost-effective solution may be to simply declare a dividend.
Even better, taking a longer-term view and putting the money to work by reinvestment in the business should be management’s first option, for the benefit of all stakeholders.
Jeannette Meyer is Corporate Associate at leading UK-US law firm, Faegre Baker Daniels.