Most closed-end fund investors are familiar with the mechanics behind a fund’s IPO but know decidedly less about rights offerings. To be sure, IPOs are more prominent and typically outnumber rights offerings in terms of both frequency and size, but when your fund announces a rights offering, what is it doing? And what should you, as a shareholder, do?
A rights offering allows existing shareholders to buy a proportional number of shares, based on how many they currently own, at a discounted price. Rights can be both transferable, meaning they can be traded on an exchange, and non-transferable. As a shareholder, you have the right – but never the obligation – to buy the additional shares. We believe investors should always exercise these rights.
If an investor likes the fund and want to allocate more capital to it, then exercising these rights are a no-brainer – simply subscribe to the offering. Some investors may not want to add more shares and, for those that don’t participate, their stake in the fund gets diluted. It would appear that such investors are caught between a rock and a hard place: They are either unable or unwilling to put more money into the fund, but don't want their current stake to be diluted. Well, you can have your cake and eat it, too.
The Dilution Solution
The right to buy shares has intrinsic value and represents a distribution to shareholders. Transferable rights can be sold on an exchange, generating additional investment income to offset any post-offering price decline. This assumes an efficient market, where the intrinsic value of the rights is equal to the price gained in the sale.
Table 1 below illustrates this transaction:
The above example is an easy solution for investors unwilling to buy more shares, but it only works with a transferrable rights offering. Non-transferable rights require investors to engage in arbitrage to offset dilution. The term arbitrage often conjures up frightening notions of financial hocus-pocus, but, in this case it's rather simple. Sell from your existing position the amount of shares you are eligible for in the rights offering, and use the proceeds from the sale to exercise the rights.
Let's look at an example assuming Fund ABC has a three-for-one non-transferable rights offering. This means that, for every three shares currently held, investors have the right to purchase one more. Let’s also assume the fund trades at considerable premium, though this example is the same for a fund selling at a discount. The offer price at which investors can buy new shares will be 90% of the share price at the close of the market on the offer’s expiration date, which we will assume is $10.75 per share. Finally, we'll assume that the investor currently owns 600 shares of the fund.
Table 2 illustrates this transaction as well as what happens when an investor does not exercise his rights:
The beginning account value was $6,450. Given that the investor has the right to purchase one new share for every three owned, the investor should sell one third of his position, or 200 shares. The $2,150 in proceeds goes toward exercising the rights at a price equal to 90% of the current market price, or $9.68 per share. The cost, then, is $1,936 to repurchase 200 shares. The investor is left with $214 in cash. Essentially, through this simple arbitrage, the rights holder is able to unlock the rights' intrinsic value. The subsequent share price in an efficient market would adjust the share price lower by the amount of the rights' value. This would result in a share price of $10.39. So, the ending value would be 600 shares at $10.39 per share, or $6,234 plus the $214 in cash leftover for a total of $6,448. While it looks like the investor lost $2, that's just a rounding variance in the calculations. Note that brokers typically charge transaction costs which have not been included in this example.
Now consider also the investor who does not exercise his rights, but allows the rights' intrinsic value to decay. That investor ends up with $6,234 – or $214 less than the investor who did exercise his rights. This is the dilution effect that the arbitrage offsets.
Capital Inflow: Undermining a CEF Benefit
The example above shows that investors can avoid immediate dilution with a simple arbitrage; but dilution of a fund's strategy is another story, and here timing is everything. One of the biggest benefits to CEF investors is that portfolio managers do not have to contend with constant capital inflows and outflows. Therefore, the fund avoids reinvestment risk – not having to invest new capital at market peaks or to be a forced seller near market bottoms. A rights offering undermines this CEF characteristic in the same way that a secondary offering does – by forcing managers to put the new cash to work in current market conditions, no matter what they are.
This isn't to be taken lightly because by putting new cash to work in a rights offering, investors are also assuming this reinvestment risk. A shareholder who defends his position by engaging in arbitrage may be better off than a shareholder who antes up additional cash. Take, for example, a fund that issued a rights offering in early 2008, after which asset prices declined significantly. The fund would have purchased securities at lofty market prices, only to see values plunge over the next year. Of course, this is a risk every time investors put new capital to work in any investment. We point it out here explicitly, though, because it's easy to overlook this, given all the other issues to bear in mind with a rights offering.
For investors faced with a rights offering, the question is not if the rights should be exercised but how they should be exercised. Long-term shareholders should appreciate the opportunity to purchase more shares at a discounted price. Those not interested in adding to their positions can still benefit from the offering by either selling their rights in the open market or by a simple arbitrage transaction. It is also important to understand how the influx of capital might affect the fund's strategy and the ability to make profitable investments in the prevailing market environment.
