shih-wei
shih-wei
Rights offerings for closed-end funds have always been a bit of a conundrum. Not exercising your right to increase your shares could potentially (but not always) dilute your stake in the investment company. But to exercise your right can be a bookkeeping headache. Side-stepping the offering by selling your shares and buying back in afterward is just as much of a gamble. I tried that and ended up with fewer shares for my money than had I just sat on it.
As an income investor, my question is: why should I care about rights offerings?
Closed-end funds are unique in that they have a set number of shares available on the open market, determined at their IPO. Unlike traditional mutual funds (which are open-end funds), they do not create new shares whenever investors want to buy more. If the investment company that manages a closed-end fund wants to raise capital, one way to do that is to increase the number of shares available to sell on the market. A rights offering, also known as a subscription right, is when a closed-end fund offers existing shareholders the opportunity to buy additional shares of the fund in proportion to the number they already own before any new shares are made available to the public. These offers are usually mandated by the corporate charter.
According to The Free Dictionary:
“To act on the offering, you turn over the rights you receive, typically one for each share of stock you own, and the money needed to make the purchase within the required period, often two to four weeks. The amount of money that’s required is known as the subscription price.
“You don’t have to buy the additional shares, and you can transfer your rights to someone else if you prefer. But buying helps you maintain the same percentage of ownership you had in the company before the new shares were issued rather than having that percentage diluted.”
Simply put, a rights offering allows shareholders to purchase additional shares, usually at a discount to market price. The holdings of shareholders who do not exercise their subscription rights are usually diluted by the offering. Rights offerings are utilized by closed-end funds because they cannot otherwise issue additional shares.
Dilution occurs when an investment company issues more shares, resulting in a decrease in the percentage of ownership held by the existing shareholders. A person who purchases a closed-end fund has equity ownership in that fund. If the fund decides to issue additional shares in a rights offering, the total number of shares outstanding increases and the percentage of shares held by the initial shareholders decreases. Each shareholder then owns a smaller piece of the pie: the pie just got a lot bigger but their piece of it did not.
The biggest argument for exercising your subscription rights is to avoid diluting your shares. But again I ask, why should we care? I am not an activist investor, so I really don’t care if my stake in the company is reduced, and my voting rights reduced with it. If my aim was to own 10% or 20% of a company so that I could earn some kind of say in how matters are handled, then that would be different. But I have no such aim, nor the desire to gain that sort of prestige. Therefore, decreasing my ownership stake in the fund is of no consequence.
However, the potential reduction in Earnings Per Share after a rights offering bears much more weight with me. With more shares on the market after the issuance, earnings have to be distributed among more pieces of the pie. If earnings don’t grow fairly quickly after new shares are issued, the reduced EPS may lead to a decrease in the distribution. That means more to me than reducing the ability to “throw my weight around” with the investment company.
So, this makes rights offerings look a lot more like a potential distribution cut. Being a long-term closed-end fund investor, distribution cuts don’t bother me much. The purpose of both rights offerings and distribution cuts is to raise capital for the CEF to further its investment strategy. When a solid fund has the means to increase its working capital and pay down debt, shareholders benefit, and the distribution becomes more stable.
Another thing to note is that if the distribution does get cut because earnings don’t increase, then it gets cut whether or not you exercised your right to buy more shares. And remember, you don’t magically acquire more shares through a rights offering, you buy them. Yes, you agree to buy them at a particular (lower) price, but you can do that with a limit order too. The difference in the price you can achieve via the offering or via the open market is always a bit of a gamble no matter which way you decide to play it.
Another argument for exercising your right is that you’ll acquire more shares and thereby increase your distribution, mitigating any distribution cuts that may possibly occur down the line. However, buying more shares on the open market after the inevitable post-cut pullback would do the same thing. So I ask, what have you really gained?
If you get out of the fund after the offering is announced to side-step the whole situation, you could miss out on a month or two’s worth of distributions, which could negate any benefit you think you might have gained. If you buy back the same number of shares, you still own the same investment as if you’d kept it, earn the same distribution, and your equity is still diluted. If you’re able to buy more shares for your original investment (at a lower price), then you’ve made some headway! But as I’ve learned through personal experience, buying back in at a better price doesn’t always pan out. Sometimes you have to buy back in at the same price or higher. Is your crystal ball working?
I’m not an expert on rights offerings, by any means. But I’ve never been able to wrap my mind around why they should be of any concern for my investment objectives. Many investors dump their investment after a rights offering is announced and the share price declines. This sounds to me like a good time to pick up more shares to make up for any dilutive repercussions like a distribution cut.
Thus, I’m back to my argument that a rights offering is basically like an announcement for a potential cut to the distribution. The way I’ve always handled distribution cuts is to decide if it’s time to trade out to a similar fund, or invest more when the price inevitably drops. Either way has worked for me. Because none of my holdings is more than 5% of my portfolio, a minor glitch with one of them doesn’t affect the whole. And there is value in not worrying about what to do.
I have ignored rights offerings and suffered no apparent consequences for it. I still owned the same number of shares earning the same distribution after the offering as before. Owning a smaller stake in the fund has borne no consequence to me. On the other hand, when I’ve tried to side-step an offering, I came out worse off. As mentioned before, the hope was to be able to buy back in at a lower price, but that opportunity never arose. I believe it’s a gamble.
I don’t want to concern myself with how to handle rights offerings when they come up. That way I can avoid playing a game I don’t like playing. I view a negative rights offering result just the same as if I happened to buy a fund but the price dropped afterward, leaving me in the red for a while until the price increased again and/or my distribution income made up the difference. I think trading in and out of funds is a fool’s errand (when your objective is generating income), and so is jumping through hoops whenever a rights offering is announced on one of your holdings.
In all my years of investing in closed-end funds, I have yet to hear anyone else say, “Who cares?” when it comes to rights offerings. It’s always about whether to exercise your rights to more shares or to avoid it altogether. It has not been my experience that either game is more successful than just waiting it out and picking up more shares if the price drops.
In my opinion, the risks and benefits of exercising your rights to add shares, of side-stepping the offering, or of just waiting it out are pretty much the same. But I prefer not to borrow trouble by worrying about it.
Of course, I could be wrong. Like most of my fellow investors here on Seeking Alpha, I am an analytical thinker with my own share of cognitive bias. I welcome any discussion.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: DISCLAIMER: I am not an investment professional. I am an investor/author who likes to share and discuss investing ideas based on research and personal experience. Please do your own due diligence before committing to any investment strategy.
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