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Paying the Price for Rights Offerings

Despite regulations to stem abuse, the fact remains that investors pay the economic costs associated with rights offerings--whether those investors participate or not.

Mike Taggart, CFA, 07/06/2012

One of the advantages of closed-end funds, or CEFs, is that after their initial public offering, a fund's capital is essentially captured: It is not subject to the daily inflows and outflows that occur at open-end funds; there is no creation and redemption feature as there are with exchange-traded funds. Except for distributions, if any, the expenses of running the fund, and the ups and downs that come with managing investments, the capital is locked in.

At times, though, a CEF's management team or executive officers may wish to raise more capital. If the CEF is trading at a premium, this really isn't a problem. There is nothing except market demand standing in the way of a secondary offering of shares. However, if the fund is trading at a discount, managers face a regulatory obstacle. According to section 23(b) of the Investment Company Act of 1940 (as amended), "No registered closed-end company shall sell any common stock of which it is the issuer at a price below the current net asset value of such stock, exclusive of any distributing commission or discount) ... ." (Click here to read the '40 Act.) This is why there are so many CEFs that are very similar to another fund from the same fund family: At the time of the second fund's IPO, the initial CEF was likely trading at a discount, and executives opted to essentially clone the existing fund rather than maneuver around this regulation to raise more capital for the existing fund.

As with most regulations, there are a few exceptions to section 23(b), rights offerings (a special type of secondary offering) being one. Such offerings give current shareholders the right to invest additional capital into the fund in exchange for newly issued shares. The regulation is set forth to protect existing shareholders from dilution. Note the theoretical case where a fund's net asset value is $10 per share and its share price is $7.00; prior to the Investment Company Act of 1940, there was nothing stopping dodgy funds--and they were prevalent in the 1920s and 1930s--from issuing new shares at $7.00 to friends and family, effectively diluting the fund's capital while ripping off existing investors. That sort of behavior is what section 23(b) put an end to.

However, even with this regulation, investors need to be careful when it comes to rights offerings. You're still better off if your fund's management didn't decide to do a rights offering, as we show below. Essentially, a rights offering allows a CEF to raise more capital and have current investors pay the associated costs. There's simply no getting away from this fact, as we lay out below.

If you own a CEF that announces a rights offering, you have two decisions to make. First, should you remain invested in the fund? If not, after taking into account your overall portfolio objectives and tax considerations, you may want to sell your shares as soon as possible, along with any transferable rights you may receive from the offering. Most rights offerings have nontransferable shares, in which case you're simply abandoning ship before the effects of dilution set in (see below).

If you decide to stay in the fund, then the second decision is whether or not to participate in the rights offering. If you want to suffer the full effects associated with the costs of the rights offering, do not participate. However, if you are a savvy investor, you will participate--eagerly.

Dilution and Accretion
Back in 2010, Morningstar CEF analyst Cara Esser wrote an article detailing the importance of participating in a rights offering and how to go about it without necessarily investing new capital. Without delving into the details, the important thing to note is that CEF shareholders bear the cost of the rights offering. These costs come from the offering's actual expenses (regulatory filing fees, prospectus printing, legal fees, and more) and, if the fund is trading at a discount at the time of the offering, the dilution to the net asset value.

Dilution comes about from simple math. Let's take our theoretical fund with a NAV of $10 and a share price of $7. Let's assume there are 1 million shares outstanding, so the portfolio is worth $10 million ($10 per share multiplied by 1 million shares). Now, let's assume that a 1:1 rights offering occurs, giving investors the right to buy one new share for every share they currently own, and that the offering is fully subscribed, meaning that everybody participates. The rights offering gets priced at $7 per share and $7 million is raised ($7 per share multiplied by 1 million additional new shares). The portfolio is now worth $17 million with 2 million shares outstanding, or $8.50 of NAV per share. Taking the NAV prior to the offering ($10) and subtracting the post-offering NAV ($8.50) gives us a dilution per share of $1.50--and that excludes the costs of the offering. Note that dilution only arises when the shares trade at a discount to NAV and it is this dilution that section 23(b) seeks to curtail.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.
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