Traditional corporate equity warrants

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3. The warrant market

History

Size of the market

Warrants first appeared in the UK in the 1970s, but the market took some time to develop. In fact, the total number of warrants in issue fell from 50 at the start of 1974 to just 23 by 1981. But then, from 1982, the market started growing steadily. They tend to be "bull market instruments" - warrant issuance thrives when the market's rising, and goes quiet in bear markets.

The market peaked in the late 1990s, with some 250 warrants listed on the London Stock Exchange. By 2001 the number of warrants listed on the LSE had fallen to around 130, with the average market capitalisation of each issue being around £2m.

Profile of the market

Up to about 1981, the warrant market was dominated by big-name commercial companies such as: National Westminster Bank, Burton Group, Grand Met, Lex Services, Trafalgar House, Rio Tinto Zinc. Since then, there have been two significant changes.

1. The big names have all but disappeared. Today's list of commercial companies with warrants is dominated by smaller companies, many listed on AIM.
2. But the more significant change has been in the change in the profile of the type of company issuing warrants. Today, 75% of all listed warrants have been issued by investment trusts, not commercial companies.

This great preponderance of investment trust (IT) warrants, means that the short-term future of the warrant market is heavily dependent on the fortunes of the IT sector.

Why companies issue warrants

Warrants are very flexible instruments, and as such can be useful in corporate finance. From the point of view of the issuer, they are cheap to issue and offer very low initial servicing costs.

They can be used as a "sweetener" to aid capital issues, often at a time of takeover, or an awkward corporate restructuring. They can also actively reduce the cost of more expensive forms of finance. For example, when attached to loan stock, they can help to lower the coupon - the rationale behind the huge issues of Japanese warrants in the 1980s.

In the UK, most commercial warrants are not attached to other instruments now, but are given 'free' to shareholders on a scrip basis. The general attractions of this for companies are seen as being-

• Positive publicity can result from the expression of confidence in the company by warrant purchasers, who are buying the right to subscribe for shares at a price higher than the prevailing market price.
• A warrant issue can add spice to an otherwise dull company. Thereby helping to broaden its shareholder base - particularly among individual investors.
• The sensitivity of the premium on the warrant can provide valuable intelligence on the confidence in the share price, and the company itself.

Deferred rights issue

Besides the rather intangible benefits listed above, an important part of a warrant issue is as a capital raising exercise. Whenever a warrant holder exercises a warrant's subscription rights, they pay money to the company (who then issues new shares). Those monies received can be very important to a company. In this respect, a warrant issue can be regarded as a deferred rights issue. But there are certain advantages over an ordinary rights issue -

• The costs of a warrant issue are usually much smaller than that for a rights issue.
• Although a rights issue has the benefit of immediacy, it is not always easy to launch a rights issue when the market is weak.
• As long as the share price is above the exercise price at expiry (i.e. it is in-the-money), it is guaranteed there will be a 100% exercise of the warrants, and therefore the expected capital will be raised. This cannot be said for a rights issue.

Warrants can therefore provide a useful contribution to a company's capital requirements, while being less disruptive than a rights issue if the capital is not required immediately.

Rights issues often carry negative side effects, alienating some shareholders, and casting a bearish shadow over the shares, but warrants avoid these problems. Indeed, the impact of a warrant issue can be quite the reverse. Warrants are appreciated as a 'free gift' from the company to its shareholders, seemingly creating value at a stroke. Obviously this is just a temporary, and slightly deceptive, impression; one that exists because the share price often fails to take immediate account of the future equity dilution that will result from exercise of the warrants.

1. Introduction 2. What is a warrant? 3. The warrant market 4. Advantages of warrants over shares - the magic of gearing 5. Further attractions of warrants 6. Disadvantages of warrants 7. Fundamentals - warrant terms 8. Fundamentals - intrinsic value and parity ratio 9. Basic analysis 10. Analysis - time value and premium 11. Analysis - gearing 12. Analysis - break-even and capital fulcrum point 13. Analysis -sample spreadsheets 14. Analysis - summary 15. Investing strategies 16. Dealing in warrants 17. Warrant exercise 18. Further topics 19. Further information 20. Conclusion

• Andrew McHattie on Covered Warrants