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Fund Investors--Know Your Rights (Offerings)

We explain three different flavors of rights offerings for closed-end funds. 

Steven Pikelny, 08/03/2012

Closed-end funds are excellent income generators for several reasons, chief among them is that they are not subject to fund flows. For open-end funds, managers often need to keep large cash cushions to protect against the risk of forced liquidation driven by sharp and sudden outflows. Similarly, inflows can potentially dilute current investment streams. Take a small open-end fund that provides shareholders with attractive returns. It would likely attract a fair amount of attention from the investment community. As new shareholders rush in, such a fund might be hard-pressed to find an adequate amount of securities with the same risk/return profile as those held in the original portfolio.

In contrast, CEFs have an IPO, and thereafter work with a relatively stable amount of capital. This allows the fund to use leverage and invest in less-liquid assets. CEFs are especially popular vehicles for fixed-income strategies because of their ability to accumulate undistributed net investment income, or UNII. While inflows dilute this balance in open-end funds, CEFs have the advantage of using it to help stabilize distribution payments.

Because of this advantage, it is no surprise that many CEF investors are skeptical of follow-on offerings, in which a seasoned fund raises new capital by issuing additional shares. The benefits to the fund's parent company are fairly obvious: More assets equals more fees collected. But if CEFs' closed pool of capital serves as such a large advantage to investors, is creating more shares and increasing net assets good for existing shareholders? One type of offering scheme, at-the-market offerings, has come under particularly heavy fire as of late from the users on our CEF discussion board. Though this format of issuing new shares avoids the spotlight and appears much shadier than a typical follow-on rights offering, it does have its advantages. Let's take a closer look, first at the pros and cons of a traditional rights offering, and then at the less well-known at-the-market and overnight offerings. Although investors' suspicion is justifiable, there is no clear-cut answer to whether any of these offering tactics are always either good or bad for shareholders. Ultimately, it depends on the circumstances of the individual fund and often of the circumstances of the investor.

Traditional Rights Offerings
Consider a fund with 1 million outstanding shares, net assets of $7 million, and a share price of $10. In a follow-on offering, the fund will file with the SEC to offer discounted shares to existing shareholders over a designated period of time (usually three to four weeks). In a one-to-one offering, the fund offers shareholders one share for each share they currently own. Assuming the offer is fully subscribed, the fund ultimately issues another 1 million shares. If the fund issues shares at $9 each--higher than the $7 net asset value but lower than the $10 share price--net assets increase to $16 million and NAV increases to $8.

The first, most obvious effect of the offering is dilutive. In this example, the increased number of shares on the market would likely push prices toward the offering price, leading to an immediate capital loss for investors. But while the supply of shares increases, demand is also likely to increase in the long term because the fund has a higher NAV. In terms of the fund's distribution, a rights offering does decrease the fund's balance of UNII per share, but it can also increase the amount net investment income per share. However, the potential for increased income depends on the fund's ability to reinvest its newly raised assets.

Let's consider three scenarios, in which the fund's initial portfolio earns 4% in investment income (at an NAV of $7, this works out to a $0.28 per share annual distribution). If the fund has no trouble investing its new net capital at the same 4%, this is optimal for shareholders. Their distribution payments increase to $0.32 per share ((4% of $7 million + 4% of 9 million)/2 million shares). If the fund has difficulty finding adequate assets to invest the new net capital (due to lower coupon payments, market illiquidity, and so on), shareholders will likely see their distribution rates decline. Let's say the fund can only invest the capital at a 3% yield. This means it would be forced to lower its absolute distribution payment to $0.275 per share ((4% of $7 million + 3% of 9 million)/2 million shares). Finally, let's say the fund faces only minor difficulty investing the new capital and invests the $9 million at a 3.2% yield. At this rate, the fund can afford a modest increase in the distribution to $0.284 per share ((4% of $7 million + 3.2% of 9 million)/2 million shares).

Other benefits include increased trading volume (important for CEFs, which tend to be somewhat illiquid), potentially lower expense ratios, and the dilution of unrealized capital gains liability. But in short, the most substantial long-term benefits depend almost entirely on how large the fund's premium is at the time of the offering, and whether the fund can effectively invest the resulting proceeds. A few weeks ago, Mike Taggart discussed why shareholders bear the cost of rights offerings. And, back in 2010, Cara Esser discussed the mechanics of rights offerings and provided insight on why shareholders should always participate in a rights offering.

Shelf Offerings
Theoretically, rights offerings are a very neat process, and it's easy to determine whether it will benefit shareholders. In practice, there is a lot of guesswork and uncertainty on the part of the fund family: The fund does not know much more than the maximum number of shares that can be issued, the issue price, and when the offer expires. After the offering announcement, the quantity and timing of the new shares issued are determined by the market. Because the issue price is often determined as a percentage of the fund's share price at a specified date in the future, it is possible for shares to be issued at a discount to NAV. What's more, it may be difficult for many fixed-income funds to effectively invest the proceeds of the offering in the short duration of the offering.

In contrast to the traditional rights offering structure, a fund can choose to file for a prospectus for a shelf offering. As the name suggests, this gives the fund the option to "shelve" the offering of new shares and only offer new shares at the price and timing they see fit over the course of a designated time period (usually about three years). The actual mechanism of which shares are offered can take one of, or a combination of, two main forms: at-the-market offerings and overnight offerings. Shelf offerings must be filed with the SEC, so investors can find out if their funds have any shelf offerings outstanding.

At-the-Market Offerings
When funds issue shares at-the-market, they typically issue shares into the open market over a long time frame. Though this does not give existing shareholders the advantage of purchasing shares at a discount, the fund has greater control over ensuring that shares are sold at a premium. Because there is no pressing time constraint, the fund can simply choose to issue shares on days in which there is higher trading volume, and on days in which the premium is especially high. In doing this, the fund is not required to sell shares at a discount to share price and therefore raises more capital for each share issued.

In our opinion, this is the most flexible form of issuing shares. If shares begin trading at a discount to NAV, or if fewer investment opportunities present themselves, the fund can simply chose to not issue additional shares. Alternatively, if all the stars align and the fund's premium matches with the manager's view of investment opportunities, the fund can issue more shares. As an added bonus, this type of offering typically has the lowest fees associated with it, as there is no underwriting involved in the process.

Overnight Offerings
Less flexible, but more certain, are overnight offerings. A fund announces (after the market close) that it will be offering shares to a syndicate of underwriters and brokers that specialize in overnight offerings. The offering takes place at a set price (below the closing share price and above NAV), and shares begin trading the following morning. One disadvantage of doing this is that share prices typically take a significant hit. However, the fund can conduct this offering with a much higher level of certainty than the other two types of offerings and can even model the accretion to shareholders. This sort of offering structure is not very useful for funds that invest in illiquid assets, as it can be difficult to invest all its new capital at once. However, it can be useful for funds that invest in more-liquid asset classes.

Conclusion
In general, it is difficult to determine in advance of an announcement when a fund will conduct an offering. With this in mind, a certain amount of trust must be placed in the fund family to keep shareholders' best interests in mind, especially when an offering is conducted at-the-market or overnight. Our qualitative reports give an overview of how shareholder-friendly we believe each fund family to be, which may give some indication as to whether the fund family has the best intentions behind the offering. But still, it is the responsibility of the shareholder to keep an eye on fund filings and evaluate whether the proposed offering makes sense for the fund in question.

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

Steven Pikelny is a closed-end fund analyst at Morningstar.
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