Cracking the honey pot

Costly capital is coming under scrutiny, says Peter Rodgers

What attack on the City could possibly unite leading lights in the Labour party, US investment bank Morgan Stanley, former Tory minister Francis Maude, Steve Robson, a senior Treasury official, John Mayo, finance director of Zeneca and Will Hutton, the polemical author of The State We're In?

The connecting thread is their apparent suspicion that investment managers are undermining British industry, by making it unnecessarily expensive to raise new capital. It's a suspicion substantiated by the fact that the Office of Fair Trading is now concluding an inquiry into the fees charged by the City for underwriting new share issues for companies. Expected to report later this year or early next, the OFT may well toss the whole issue over to the Monopolies and Mergers Commission for a full investigation.

The OFT has opened a wriggling can of worms. Underwriting fees are only a small part of the larger argument, but because fund managers' fees are hard to defend, they may find it difficult to fight off a wider inquiry.

While market forces are rampant in the City, underwriting fees have been curiously immune from competition. Fees are 2 per cent of the value of a share issue, with 0.5 per cent going to the merchant bank, 0.25 per cent to brokers, and 1.25 per cent to sub-underwriters (mainly pension and insurance funds) who guarantee to buy the new shares if no one else will. Not surprisingly, the OFT suspects a cartel is driving the gravy train.

To head off an MMC inquiry, the National Association of Pension Funds and the Association of British Insurers are trying to demonstrate to the OFT that it is possible to make fees more competitive and flexible. After a meeting with the London Investment Banking Association (LIBA) earlier this month, the NAPF and the ABI wrote to their members warning them to expect more flexible under-writing fees.

One suggestion, which came from Schroders, was to auction part of the sub-underwriting to introduce competitive pricing. But LIBA admits it is unlikely that such innovations will be in the market place in time to impress the OFT. But not only may the initiative be too late, it is proving impossible to treat fees in isolation because they link into three other areas about which investing institutions are extremely sensitive: pre-emption rights for shareholders, the high dividends paid by British firms compared with overseas rivals, and the overall cost of capital.

Some institutions wonder whether they are being fitted up by an unholy alliance of US investment banks, and the Treasury, which is encouraging the OFT to blow open the whole capital-raising process.

Thus Mr Maude, who now works for Morgan Stanley but also chairs the Government's deregulation panel, is allied with Mr Mayo of Zeneca - a former Warburg executive who advised on the demerger from ICI - in wanting a thorough overhaul of the capital raising system and a whittling away of pre-emption rights. Cheering them on are the other London-based US investment banks, and firms such as SBC Warburg. These critics claim that pre-emption rights restrict the ability to market UK company shares to foreign investors, creating a blockage on the supply of cheaper capital.

The argument supporting the claim that pre-emption rights are too expensive, rests on the sale of equity in rights issues to shareholders - the new shares are normally at a discount, which is equivalent to adding a free scrip issue of new shares into the pot. To offset this, companies ought to cut their dividends, otherwise their total cash payouts will rise, making new capital expensive. But in reality, companies are too afraid of shareholder reaction to make such cuts -a fact which undermines the defence of the pre-emption rights system.

The NAPF and the ABI have belatedly written to their members suggesting directors do cut dividends when they make rights issues. Yet the strongest defence of pre-emption rights is the simplest. Why remove these rights at a time when most people agree that big shareholders should start exercising a longer term and more thoughtful discipline over their companies? There is no better moment to influence a company than when it comes forward cap in hand.