Basics of Financial Investing – Part 9

Rights Offerings and Share Buybacks

Unlike mutual funds, which make a market in their own shares, closed-end fund share prices are determined by the interplay of supply and demand in the marketplace. Recall that mutual funds stand ready to buy back their shares at their net asset values (NAV). Thus mutual fund shares are forced by the funds themselves to trade at the level of their NAVs. Closed-end funds, in contrast, have a fixed number of shares outstanding. These shares must find their own price level in the marketplace. The interplay of supply and demand will determine the market price. Nothing forces that price to equal the NAV. The price could be either above or below the NAV. Indeed, closed-end funds very often trade at a discount from their net asset values (NAV). Some of the large holders of closed-end fund shares may pressure their fund’s managers to convert the closed-end fund into a mutual fund. Converting a closed-end fund to a mutual fund would result in the fund being required to stand ready to buy back its shares at its NAV and thereby eliminate the discount.

Like operating companies that are organized as corporations, both mutual and closed-end funds are organized as democracies, with each share of the fund having one vote. Accordingly, fundholders possess the ultimate power to hire and fire the managers of their funds. If enough fundholders vote for a new slate of directors, they can take control of the fund. Once in control, the new board can replace the old managers with those more willing to do the fundholders’ bidding. Mindful of this possibility, the existing managers of closed-end funds tend to listen to the views of their large fundholders.

While closed-end funds usually trade at a discount from their NAVs, mutual funds are structured to allow their shares to be sold back to the fund at their NAVs (less a modest redemption fee, in some cases). So, if a closed-end fund’s shares trade at a 20 percent discount from its NAV, converting to an open-end mutual fund could produce an instant 20 percent gain in its market value. Closed-end fund managers would, however, generally prefer to retain the advantages of their closed-end fund status. When a closed-end fund converts to mutual fund status, it must stand ready to redeem its shares on demand. Often the newly converted mutual fund will assess a 2 percent redemption fee for the first year after its conversion to mutual fund status. The fund justifies this redemption fee as needed to compensate for the cost of liquidating that part of its portfolio required to meet the demand for redemptions. The fee also has the effect of discouraging redemptions. Once the fundholders gain the right to redeem their shares at or near the fund’s NAV (a much higher price level than before the conversion), many are likely to do so. This rush-for-the-exit by fundholders could cause the fund to become much smaller very quickly. The management fees charged by the fund managers are based upon the dollar value of the fund’s assets. Redeeming shares reduces the amount of money under management and thereby reduces the management fees to be earned by the fund’s managers. That asset-fee relationship helps explain why closed-end mutual funds need to be pushed into converting to open-end mutual funds. Most fund managers are reluctant to take an action voluntarily that will reduce their fees, even if that action would benefit their fundholders. Some closed-end funds do eventually respond to fundholders’ pressure by converting to mutual fund status. Others try to ignore the problem, hoping it will go away. Still others try to placate their fundholders by offering to buy back a percentage of the fund’s outstanding shares at a price that is at or close to its NAV. A fund that agrees to undertake buybacks on a periodic basis is called an interval fund. The fund managers hope that these self tenders will buy out the holdings of most of the unhappy fundholders and, by reducing the supply of shares outstanding, allow the fund’s share price to be bid up.

A buyback may be structured as either a onetime transaction or as a series of periodic repurchases. Usually, the fund offers to purchase between 10 to 25 percent of the outstanding shares, at 95 to 98 percent of the NAV. Subscribers are allowed to tender as many of their shares as they would like. The fund then purchases the tendered shares on a pro rata basis. Thus, if the fund offers to purchase 10 percent of its outstanding shares and half of the fundholders participate, each participant would be allowed to tender 20 percent of his or her shares.

Some investors may wish to hold on to all of their closed-end fund shares. They bought the shares because they liked the fund’s prospects. Perhaps they still view its prospects favorably. Such investors may therefore decide not to exercise their right to tender. Such a decision is very likely to leave some of their money on the table. If you are such an investor, you should consider the following strategy: Participate in the tender and then repurchase an equivalent number of shares in the marketplace. Implementing such a tender-and-repurchase strategy will leave your portfolio with the same number of shares as you started with, plus some extra cash. Alternatively, you can use all of the cash from the tender to buy more shares and thereby increase your fund holdings without spending any more of your own money. Either way, you come out ahead.

Closed-end funds that tender for their own shares usually do so because their shares are trading in a price range that is appreciably below the fund’s NAV. The fund’s managers hope that such buying of shares will narrow the discount. Suppose the shares are selling at a 20 percent discount (which is not unusual). If the fund offers to purchase 15 percent of the outstanding shares at 98 percent of its NAV, those who participate would probably be able to tender at least 20 percent of their holdings (because not all fundholders will tender). If the fund-holder can repurchase his or her shares (either shortly before or shortly after the effective date of the offer) at approximately the same 20 percent discount as the shares typically trade for, the sale-and-repurchase maneuver will achieve a gross gain of 18 percent (98% - 80%) on the 20 percent of the shares owned. That sum is equivalent to adding about 3.6 percent to the position’s return (.18 x .20 = .036). If the tender offer is made twice a year, the investor’s return on this fund position would be increased by 7.2 percent. If the tender takes place quarterly, the increase becomes 14.4 percent. Whether the return-enhancement is 3.6, 7.2, or 14.4 percent, that added return enhancement is in addition to whatever is the base return on the fund holdings.

So if the fund itself produced an 8 percent annual return, the total return on the investor’s position in the fund would be enhanced to between 11.6 percent (8% + 3.6%) and 22.2 percent (8% + 14.2%) by this tender-and-repurchase strategy. Since commissions will be incurred on the purchase, and the market price may be somewhat different between the tender and the time of the repurchases, the actual gain could be less (or more). Still, the ability to sell closed-end fund shares at 98 percent of NAV and repurchase them at a substantially lower percentage of NAV is an opportunity that should be too good to pass up. And yet, a substantial percentage of fundholders do not tender their shares when offered the chance to do so.

As previously noted, some closed-end funds, called interval funds, agree to repurchase a set percentage of their shares on a periodic basis. An interval fund might, for example, agree to purchase 10 percent of its outstanding shares each quarter. In such a situation, an investor who follows a tender-and-repurchase strategy could add substantially to his or her overall return. Note, however, that only if the market price of the underlying shares is stable or rises will the position show very much of a profit. Don’t buy an interval fund unless you like it as an investment on its own merits. On the other hand, if you do identify an interval fund with attractive potential, the ability to implement a tender-and-repurchase strategy makes it all the more attractive. If, for example, such a fund produces an annual return of 8 percent and a tender-and-repurchase strategy adds 4 percent, the overall return becomes 12 percent (8% + 4% = 12%).

We see from the above discussion how a tender-and-repurchase program enhances returns for the holder of interval funds. A similar type of opportunity arises when a company engages in a rights offering. A company wishing to raise additional equity capital may offer to sell shares to its existing shareholders at a discount from the current market price. Such companies do so by distributing rights to their shareholders. These rights are separate securities, which, like other types of options, allow the owner to purchase shares at a pre-specified price over a pre-specified time period. Sometimes the rights are listed on an exchange or NASDAQ. Such rights trade in the marketplace until they expire. Thus the shareholder who does not wish to purchase additional shares should just sell his or her rights. At other times, however, the rights may be structured so that they are not transferable. Under these circumstances, shareholders may be allowed to oversubscribe to the extent that other shareholders fail to exercise their rights. This type of offer also provides the shareholder with an opportunity. Suppose the rights allow the purchase of shares at 93 percent of the market price (a typical 7% discount). A one-for-twenty rights offering would allow the investor to subscribe for an amount equal to 5 percent of their existing shares at a 7 percent discount from the market level. An investor who does not wish to increase his or her position in this particular stock can nonetheless extract some value by subscribing to the rights offering and simultaneously sell an equivalent amount of his or her existing holdings. Capturing a 7 percent discount (less trading costs) on 5 percent of one’s holdings may not seem like much. Such a small profit opportunity may well not appear to be worth the trouble required to earn it. If, however, the offer includes the opportunity to oversubscribe, the investor could end up buying and reselling far more than 5 percent of his or her position. Regardless of the amount of stock potentially available for purchase in the rights offering, the opportunity to purchase stock at a 7 percent discount should not be passed up. Commissions on the resale would be a small portion of the 7 percent discount. Remember, investing is a game of inches.

No transaction of these sorts is without risk. These two situations, self tenders and rights offerings, represent no exception to the general rule that something can always go wrong. You should be mindful of the following:

First, selling and repurchasing the same security usually has tax consequences (if the sell side of the trade is done in a Keogh or IRA, this issue can be ignored). Even though the position is quickly restored to its original level, the trade will probably result in a taxable event. If, for example, the closed-end fund’s shares are held at a gain, the initial sale will result in a tax liability even though the tendered shares are quickly replaced. If, on the other hand, the tendered shares are held at a loss, the sale back to the company will be subject to the wash sale rule. If the replacement shares are repurchased within thirty days of the date of the sale, the transaction is classified as a wash sale. Any loss on the transaction cannot be reported and used currently to reduce your tax liability. Under IRS rules, losses realized on a wash sale must be carried forward in the existing holdings. That is, the wash sale loss is reflected in a lower basis on the repurchased shared. Tax issues should not be ignored.

Second, prices may move adversely between the time of the initial transaction and the subsequent transaction. The investor may have tendered his or her shares at a point when the stock was depressed. By the time he or she gets around to replacing the tendered shares, the market price may have gone up (the price could of course have gone down, in which case the gain from the sale-and-repurchase would be greater). In order to minimize this risk of an adverse price movement, you should implement the offsetting trade as close as possible to the time when the tender is priced. Note, however, that a week or two may pass between the date when the purchase price is set and the time when the funds are received for the tender. Accordingly, one who wishes to replace the tendered shares soon after the purchase price is set may need an alternative source of funds to cover the time gap. The rules on payments for securities purchases do, however, provide you with a bit of leeway. Payment is not due on a stock purchase until three days after the order is executed.

Accordingly, if you know when you are to receive payment for your tendered shares, you can allocate the anticipated proceeds from the tendered shares to pay for the repurchase shares as early as three days prior to that payment day. Third, for large-size trades, the offsetting transactions may adversely impact the market price. Exercising these replacement strategies for a few hundred shares is likely to have little impact on the market. If, however, the investor needs to offset a transaction in the tens of thousands of shares, the very act of buying or selling shares could affect the market price. That is, the very act of trying to buy back (or to sell) a large block of shares may have the effect of pushing the price up (down). This impact may be mitigated by piecing the offsetting trades out over several days or a week or two. Such a piecing out approach, however, increases the risk of encountering an adverse price move before the offsetting transaction has been completed.

Notwithstanding these risks, tendering at above the market price and exercising rights at a discount (and oversubscribing when possible) are generally attractive strategies. The investor can almost always restore his or her position to its original level and come out ahead. Accordingly, I add two more rules to my list:

1. When a fund or company engages in a self tender at above the current market price of its shares, the investor who wishes to maintain his or her holdings should nonetheless participate in the self tender. As soon as possible thereafter, the investor should make an offsetting trade (repurchase the shares that were sold) in the open market.

2. When a company (or fund) engages in a nontransferable rights offering at a strike price below the current market level, the investor who does not wish to add to his or her holdings should nonetheless exercise the rights and as soon as possible thereafter make an offsetting trade (sell the purchased shares) in the open market. If the rights are transferable, a rights sale is indicated.

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