You can usually tell when you are about to be asked for cash by one of the companies whose shares you own. A typical herald of a rattling collection tin heading your way was contained in this trading update from our holding XP Power in early October: ‘We are also exploring other near-term options to strengthen the balance sheet.’

A month later the group successfully raised £44m in a share placement. We saw many statements like this during the first phase of Covid. Understandably, companies – particularly in the most impacted sectors, like hospitality – had not factored into their budgeting all their customers and staff being forced to stay at home in a national lockdown.

Back then we supported ten-pin bowling operator Hollywood Bowl as it raised £10.9m to tide it over. We also backed Scotland’s version of ITV, STV, when it raised £16.2m to keep its finances in order at a point when advertisers were nearly all pausing spend.

Recession?

We are seeing these statements with increasing frequency again. While the UK economy seems to have avoided a technical recession last year, there are pockets of the global economy that are in a steep downturn. In XP Power’s case, the semiconductor end market has been weak.

And there are always surprises. Videndum, which makes production equipment for use in TV and film, raised £125m in November. The drama there was a result of the Hollywood strikes hitting demand – an entirely external event and difficult to foresee.

A cash raise can be a signal that it is time to quit and run. But not always. We felt some of the companies that raised capital during Covid would emerge stronger because their competition would be diminished. On other occasions the raise is to fund strategic acquisitions or plant construction that will add value later. It is easy to forget, but this is the purpose of equity markets: to channel the necessary capital to the best companies to enable them – and, ultimately, their shareholders – to prosper.

The shares in a capital raise are usually sold at a discount, which can make them attractive. Meanwhile, not participating can water down the value of your existing holding, which can sometimes feel like a veiled threat!

Opportunity?

Clearly, we have to ask some serious questions before parting with more investors’ money:

How much does the company realistically need to raise? Most companies have an idea of where they want debt to sit relative to their earnings. In the same trading statement, XP Power made clear it wanted leverage to return to its target range of 1-2 times net debt/adjusted Ebitda. This can give you a steer as to how much a company needs.

If it does manage to raise that amount, what does this do to the number of shares outstanding in the company? Where might this leave earnings per share on the other side of the cash raise? This is important, as it helps you get a sense of the valuation that you are potentially putting new money in at. If you are contributing new funds at a substantially lower than historic average valuation, there is potential to enjoy the powerful compounding effect of earnings recovery and a valuation recovery.

Are management participating in the raise? All executives are in different financial situations, but it could be a positive sign if management are putting sizeable sums of their own cash into the raise – these are the people who know the business best.

Beyond the cash raise, how will the company be positioned? Are its end markets showing tentative signs of recovery, offering a promise of imminent earnings recovery (combined with lower debt)? Could this leave the company in a very different position, say, one or two years out? These are in our view the most attractive opportunities. A cash raise at an opportune point in the cycle can leave a company on the front foot in a recovering end market.

On the other hand, there are some warning signs to watch out for.

Has the debt position become so large relative to equity that the company cannot raise as much money as it would ideally like? In other words, even after the raise, is it in a difficult position – possibly close to covenant levels or hobbled by very expensive debt? If this is the case then it might not be left in a good position to take advantage of an end market recovery. This often requires investment in working capital, which may not be possible if a company is trying to preserve cash.

If I see weird and unusual funding instruments being used – a convertible loan note, for example – this can be a warning sign that the company is straining every sinew to raise the money it needs. Normally, the simpler the better.

It is not ideal when a company has too much debt and needs to raise additional cash at short notice. For a long-term investor, however, these moments can present an opportunity.

Of course, we do not always get it right. It is satisfying when we do. STV issued shares at £2.30. As I write they are just below £2. But we bought Hollywood Bowl’s new shares at £1.45. Today they are nearly £3.

Laura Foll is co-manager of the Henderson Opportunities Trust (HOT ), Law Debenture (LWDB ) and Lowland Investment Company (LWI ).

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