Backstop Investor
In a direct rights offering, the issuer only sells shares to shareholders who exercise their rights in the primary subscription period and any oversubscription period; there is no backstop or standby purchaser. Issuers conducting a direct rights offering risk having an undersubscribed offering, which may limit the amount of capital they could raise. To eliminate this risk, issuers may wish to engage the services of a backstop investor, which is a third party (usually an investment bank or an affiliate of the issuer) that agrees to purchase any shares not purchased in the oversubscription period. The issuer typically enters into an agreement with the backstop investor prior to the commencement of the rights offering whereby the backstop investor commits to buying any shares not purchased in the oversubscription period. This arrangement guarantees that the offering will be fully subscribed and enables the issuer to raise the necessary capital.
Subject to the limited exception below, the backstop investor generally must be an existing shareholder in rights offerings that rely on Section 23(b)(1). In a non-transferrable rights offering, only existing shareholders can participate. In a transferrable rights offering, an investment bank or other purchaser is permitted to purchase the transferrable rights directly from the existing shareholders in the secondary market. While persons who purchased rights in the secondary market are permitted to participate in the primary subscription, they generally are not permitted to oversubscribe. By design, a backstop investor is expected to purchase unwanted shares in the oversubscription, which an investor cannot do in a non-transferable rights offering, and may not be able to do in a transferable rights offering, unless it is a shareholder on the record date.
An investment bank or any other purchaser that wishes to serve as a backstop investor can ensure its ability to participate in the oversubscription by buying shares of the issuer in the secondary market and becoming a shareholder before the record date of the rights offering. As long as the backstop investor becomes a shareholder by the record date, it may participate in both the primary subscription and the oversubscription periods.
However, as noted above, there is one narrow exception. Where a BDC has obtained shareholder approval to issue shares below NAV in reliance on Section 63(2) of the 1940 Act, an investment bank or other purchaser which does not otherwise own shares of the issuer may act as a de facto backstop investor by purchasing shares not acquired by existing shareholders in the rights offering at the discounted price directly from the issuer.
In the situation where a fund is relying on Section 23(b)(1), the fund may not compensate the backstop investor since funds cannot pay a fee to certain shareholders for purchasing shares because this would, in effect, result in the sale of shares to different holders on different terms.
To determine whether a backstop investor is needed, issuers are allowed to “test the water” with qualified institutional buyers and institutional accredited investors.