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Managing The Discount

 Managing The Discount

Click here to go forward to the Analysing Past Performance section
Click here to go back to the What Is A Discount Section
Click here to return to Investment Companies – Part Two
Click here to return to Investment Companies – Part One

Investment companies can influence both the supply and demand sides of the equation to reduce the absolute level of the discount or premium and control discount volatility.

 Boosting demand

An investment company can try to reduce the size of a NAV discount by stimulating demand for the shares. It could spend more on marketing, adapt its objectives, change its strategy or replace an underperforming fund manager. In recent times, many investment companies have decided to increase dividends as a way of attracting new investors and narrowing the discount.

 Buying back shares

Investment companies can manage their discounts by buying back shares. This reduces supply.

Buying back shares requires shareholder approval. Commonly, the investment company will put forward a resolution at its annual general meeting (AGM) seeking approval to buy back up to 15% of its shares. The resolution will usually stipulate the conditions for this trade – along the lines of “the price paid for the shares will be no more than 5% higher than the market price”.

These repurchased shares can be cancelled immediately or put into treasury – a kind of parking place. Treasury shares still exist legally but have no dividends or votes and are not usually recorded as an asset on the company’s balance sheet. The company should declare its policy for reissuing the shares. Most say that the shares will not be reissued at a discount to asset value, or that they will be reissued at a discount which is to be a higher price than the company paid in the buy back.

If the authority to buy back shares expires before an AGM, the company may call an extraordinary general meeting (EGM) part way through the year to renew the authority.

If a company wants to buy back a lot of shares, one of the best ways is through a tender offer. The tender offer is an offer made to every shareholder to buy back shares, usually at a fixed price (often set relative to the NAV less the costs of doing the tender – also known as formula net asset value). The company decides what percentage of shares it wants to buy back and shareholders have the option to accept or not. They can choose to sell none, some or all of their shares. Where shareholders decide not to tender their shares, those wanting to sell can dispose of a correspondingly higher amount.

In wind-up mode, an investment company may shrink itself through compulsory repurchases of shares. These redemptions are often accompanied by a consolidation of the remaining shares where the rights attached to the remaining shares remain the same but the nominal value is re-calibrated.

 Discount control mechanisms

Discount control mechanisms come in different forms. Many are promises to buy back shares if the discount exceeds a certain level in normal market conditions. Some companies have adopted a zero discount policy which means they will issue or buy back as many shares as necessary to keep the share price trading close to asset value. This makes them a lot more like an open-ended fund. To follow suit, investment companies would need assets that could quickly be turned into cash. Some investment companies measure the NAV discount over a period and if the average discount exceeds a certain level it may trigger a tender offer, a continuation vote or a liquidation vote.

Regular continuation votes are a feature of many investment companies. Shareholders are asked if they want to keep the fund going and, if more than 50% of those voting say yes, it does. Liquidation votes are a vote to wind up the company. Over three quarters of shareholders that vote need to say they want to liquidate the company for the vote to be passed.

 Issuing shares

The resolutions that govern issuing shares tend to come in two parts. One will ask shareholders to approve the issue of a certain percentage of the issued share capital. The other will seek shareholder approval to dis-apply pre-emption rights when they do this.

Pre-emption rights are very important. The rules say that, unless you agree otherwise, companies can’t issue stock to new investors without offering it to existing shareholders first (pro-rata in proportion to the size of your investment). This wouldn’t matter if the new shares were being issued at a premium to asset value as the excess paid over asset value benefits the whole fund (although really big shareholders might worry about a reduction in voting rights). However, issuing new shares at a discount transfers part of the value of your investment to the new investor – not something an existing shareholder would be happy about.

When the company is expanding, you should be wary about the impact of a significant expansion of the company on the portfolio. If it took a while to invest a big influx of cash, this could drag down the returns on the fund (cash drag).

This is the reason why many investment companies issue C shares when they want to expand. C shares are a separate class of share with their own portfolio. When the board judges that the C share portfolio is sufficiently invested, the C share portfolio will be merged with the normal portfolio and the C shares converted into ordinary shares (using a formula based on their respective net asset values). Another plus point here is that the new investors bear the costs of issuing the C shares and getting the money invested.

Click here to go forward to the Analysing Past Performance section
Click here to go back to the What Is A Discount Section
Click here to return to Investment Companies – Part Two
Click here to return to Investment Companies – Part One

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