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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.

For fund's trading at a premium at the time of a secondary offering, the reverse is true. The new shares, whether from a rights offering or, more generally, from a typical secondary share offering (to any investor, not just current shareholders), will be accretive to existing shareholders. Let's flip our example above and assume that another CEF is trading at a premium, with a NAV of $7, a share price of $10, and 1 million shares outstanding. A similar rights offering occurs and is fully subscribed. The result is the same: a portfolio of $17 million with 2 million shares outstanding. However, the NAV prior to the offering was $7 per share, and after the offering it is $8.50. In this case, the $1.50 difference is to the benefit of the initial shareholders. This accretion, though, is no reason to jump at secondary offerings for premium-priced CEFs, as we believe investors should avoid high premiums when purchasing funds.

The 2011 Lesson of Gabelli Global Multimedia
Most funds that have rights offerings, in my experience, trade at a premium at the time of the offering. That's what makes the case of Gabelli Global Multimedia GGT so interesting. At the time of its rights offering in March 2011, it was trading at a discount to NAV. Now, I want to be clear that I am not picking on this fund, I am not analyzing this fund, and I am not casting aspersions on this fund. I know how the Comments section can get filled with opinions about what I don't state. The only reasons to choose GGT as the example is that it was trading at a discount at the time of its rights offering and that it shows the costs to investors of a rights offering.

The fund issued one transferable right (investors could sell the right to nonshareholders) for every share owned, and it took three rights to purchase one new share at the price of $7.00 per share (subscription price). Rights were distributed to shareholders of record as of March 29, 2011. At the close of business of March 24, 2011 (the last day to purchase the shares and be considered a shareholder of record as of March 29, as it takes three business days for trades to settle, or to be finalized), the fund's net asset value was $9.41 per share and the shares closed at $8.44, making for a 10.3% discount. Note that even though the shares were already trading at a discount, the subscription price was an even more heavily discounted $7 per share.

The implied value of the rights was $0.48 per share (($8.44 – $7.00)/3). Shareholders who did not participate in the rights offering or who did not sell the transferable right to another investor thus lost money through their own inaction. Participating shareholders effectively realized the value of the right.

The cost of dilution from the rights offering has to be figured in. According to the fund's 2011 annual report, "the NAV per share of the Fund was reduced by approximately $0.76 per share as a result of the issuance of the shares below NAV."

The expenses associated with the rights offering totaled $456,781, again according to the annual report. Prior to the offering, according to our calculations, there were 13,555,169 shares outstanding. Thus, there turned out to be $0.03 in expenses for every pre-offering share.

Shareholders who participated in the rights offering thus had costs of about $0.31 per pre-offering share associated with their participation. These costs came from about $0.03 in expenses, plus $0.76 from dilution, minus the $0.48 they gained from exercising the value of their rights. In other words, they effectively paid 3.7% for participating in the rights offering ($0.31 divided by $8.44 share price the day prior to the offering).

Nonparticipating shareholders paid substantially more. The cost of their inactivity was $0.79 ($0.03 from expenses they incurred and the full $0.76 from dilution). Because they didn't exercise their rights, they forfeited the $0.48 per-right value. The cost of the rights offering for nonparticipating shareholders was 9.4% ($0.79 divided by $8.44). And to think of the brouhaha surrounding the 4% or so costs of an initial public offering!

Unfortunately, according to the press release announcing the rights offering's conclusion, only 79% of shareholders participated. Now, to be sure, the offering had language such that if not all shareholders participated, those who did could pick up additional shares for $7.00, and they did. After all, investors savvy enough to understand the importance of participating in rights offerings are going to understand that they can pick up more cheap shares while having nonparticipating shareholders effectively pay for their largesse. But the fact remains that 21% of shareholders either knowingly or unknowingly suffered a 9.4% hit to their investments by not participating in the offering.

Footing the Bill
Rights offerings can be a pain for long-term shareholders. Even with regulations meant to curb abuses, all shareholders foot the bill so that their fund's asset base can grow. If your discount-priced fund announces a rights offering and you decide to stick around, your subsequent actions will depend on whether you want the offering to hurt your portfolio a little or a lot. Because once you decide to stay in the fund, you will pay for its capital inflow one way or another.

Click here for data and commentary on individual closed-end funds.

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