Watch those unexercised options in LICs
Listed Investment Companies have enjoyed great investor support in the last year, but the structure usually comes with ‘free’ options to buy more shares. The impact of these options can trap the unwary.
Any investor wanting a broad exposure to the market in a single investment has three main alternatives: managed funds, listed investment companies (LICs) and exchange traded funds (ETFs). There are hundreds of choices, and each structure comes with strengths and weaknesses. Supporters of each will tell you about the strengths, but this series of articles is about the shortcomings.
To show neither fear nor favour, we will focus on one significant weakness in each of these three product types, which could materially affect whether the investment is appropriate. This week, we look at LICs.
A brilliant solution to a problem
LICs have become the darlings of the funds management industry in the last couple of years, with well-established unlisted fund managers such as Investors Mutual and PM Capital turning to the listed space for the first time. But it was not always so, as the initial issuing process had a fundamental problem. A LIC would be issued at $1 but after paying broker fees, legal costs, listing fees, marketing and printing, only 97 cents would be left to invest. So the opening Net Asset Value (NAV) was already 3% below the issue price, so why would anyone invest?
Then a brilliant solution was adopted. At issue, the LIC would offer a ‘free’ option to buy more shares in the LIC at $1, with an expiry date on the option of say 18 months. As an ‘at the money’ option with decent time value, this was ‘valued’ by the lead broker using Black-Scholes methodology at about 7 cents. Problem solved. Cost $1, NAV $0.97, option $0.07, immediate profit 4 cents. Where do I sign? Even if I don’t care for the investment, I’ll just flip it.
Almost every LIC uses this same issuing method. It seems like magic. Value has been created and everybody is happy, so what’s the problem? Beware the implications of that ‘free’ option.
Impact of unexercised options
The problem is the future dilution in the value of the shares if the market rises and the options are exercised. Here is a simple example, assuming:
Initial Public Offering (IPO) of 100 million shares at $1 each
includes 100 million options exercisable over next 18 months at $1
issue costs of $3 million
market then rises 30% over next 18 months
all options are exercised just before expiry
shares always trade at NAV and stock selection matches the market rise
Without the options, the NAV per share rises from $0.97 to $1.261 ($0.97 * 1.3). With the market up 30%, the LIC investor is up 26.1%. Not bad but it never fully recovers from the impact of the initial costs.
With the options, the NAV per share rises from $0.97 to $1.13 (now 200 million shares on issue and NAV of $126,100,000 + $100,000,000 or $226,100,000). That’s only half the NAV because only half the money was invested at the start. The outcome is not too bad for the investors who held and exercised the option. They gain on exercise of the option what they lost on dilution of their shares.
Some investors are disadvantaged
There are two types of investor who miss out. First, those who sell their options early or forget to exercise. As the market rises, the LIC underperforms when the future impact of the dilution is factored into the share price. The investor does not have the $1 option in his back pocket to compensate for the LIC underperformance.
The second type is the investor who buys the shares in the secondary market, unaware of the coming dilution. With few exceptions, LIC managers report their NAV excluding the impact of the options. The day before all the options are exercised, an investor on the ASX may have checked the NAV and seen it reported as $1.26 when only 100 million shares were issued. A few days later, the NAV is down to $1.13 and they lose 13 cents, or over 10% ($0.13/$1.26).
Those who have the time to watch or know the exercise pattern of option holders will understand that the stated NTA of $1.26 is unrealistic, and will be willing sellers to those who don’t know. If they bought during the IPO, they probably hold options which they can exercise to maintain their overall exposure.
The example makes the assumption of exercise just prior to expiry of the option, which is the most efficient time to do it, but in practice, some options are exercised earlier.
What do LIC managers tell investors?
There is a varying level of disclosure on this issue among the dozens of managers of LICs.
An example of the best type of disclosure is the Magellan Flagship Fund, ASX code MFF. A copy of the recent weekly report of NTA is linked here. It states:
“Note that no adjustments are made for the future exercises of the MFF 2017 options (exercise price $1.05 per option). The approximate pre-tax NTA would have been reduced by approximately 10.5 cents per share if all of the MFF 2017 options had been exercised on Friday, 22 August 2014).”
This makes the investor aware of the heavy dilution impact. At time of writing, the undiluted NTA was $1.51, shares were trading at $1.51 while the options were at $0.45.
An example of the second-best type of disclosure is Wilson Asset Management’s fund, WAX:
“The above figures are after 5,090 options exercised during the month and have not been adjusted for the remaining options on issue.”
At least the issue is on the table, even if it is not quantified. However, many other LIC managers do not mention the dilution impact on the NTA in their regular reports to shareholders.
There’s another wonderful side to all these options, for the manager if not the investor. The exercise of the options creates a massive uplift in the size of the fund, potentially doubling the fees the manager collects. It’s a great way to build a business over time.
Check unexercised options before buying
What’s the lesson? Before investing in any LIC, find out how many unexercised options exist, the strike price and the remaining term, and make a judgement on the possible dilution of NAV if the options are exercised. Note also that options are not only created in the IPO stage, as many LICs continue to fund raise with options attached.
Graham Hand was General Manager, Capital Markets at Commonwealth Bank; Deputy Treasurer at State Bank of NSW; Managing Director Treasury at NatWest Markets and General Manager, Funding & Alliances at Colonial First State. Nothing in this article constitutes personal financial advice. Graham holds investments in the companies mentioned above.
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