Closed-End Funds Open Doors
To Worrisome Rights Offerings
By TOM LAURICELLA
Staff Reporter of THE WALL STREET JOURNAL
An old practice that long has drawn the ire of shareholders is getting renewed attention in the world of closed-end funds.
The practice is known as a rights offering, a way for a fund to raise money from investors. For a while, it looked as if such offerings were going the way of the dinosaur, but recently more funds have revived the practice.
Closed-end funds differ from the more-popular open-end funds in that they issue a fixed number of shares that trade on stock exchanges. However, through rights offerings, closed-end funds can increase the number of shares by giving existing investors the right to buy new shares at a less-expensive price than they could in the market.
When a fund issues shares, the stake of existing shareholders is reduced -- what is known as dilution. "For the investor that can mean having to buy more [shares] just to stay even," says Eric Jacobson, an analyst at Morningstar Inc. "You have to hope that whoever is managing the process is doing it with the shareholders' best interest, but in the history of closed-end funds, there have been very few such situations."
The dilutive effect of a rights offering doesn't automatically hurt a fund's share price, although news of a such an offering frequently sends fund prices tumbling. Those invested in funds making offerings are stuck with the choices of buying more shares, selling their holdings or suffering dilution. (Another option sometimes allows investors to sell the rights to the shares and avoid substantial dilution.)
Critics of the offerings for years have said there is one true reason offerings occur: "The only thing that's guaranteed about these is that the managers will make more money," says Phillip Goldstein, a hedge-fund operator in Pleasantville, N.Y., who invests in closed-end funds.
How much money do fund managers stand to gain? A study published this summer by the "Journal of Financial and Quantative Analysis" estimated that during a 10-year period ending in 1998, rights offerings increased the advisory fees for the funds in question by an average of nearly 24%. "The advisers are clearly the primary beneficiary," says Ajay Khorana, one of the study's authors and a professor at the University of Virginia's Darden Graduate School of Business Administration in Charlottesville, Va.
Although the chance that a particular closed-end fund will conduct a rights offering is relatively small, such offerings can be made at any time. From a peak of more than 35 offerings raising $1.9 billion in 1993, the number of offerings dwindled to two in 2000, drawing $114 million, according to fund tracker Lipper Inc.
The offerings are making a comeback, however: Last year there were six offerings and this year four deals have been completed and five more are under way, according to Thomas J. Herzfeld Advisors Inc. in Miami, which specializes in closed-end funds.
"We're seeing a little bit more activity here," says founder Thomas J. Herzfeld. He sees the activity as stemming in part from a need to boost assets in a bear market and because some managers see investment opportunities in the market.
The issue recently received attention when a pair of funds run by Aberdeen Asset Managers, a United Kingdom fund firm, decided in October to launch rights offerings. However, some shareholders fought back, taking their case to the media and ultimately filing a lawsuit to try to stop the offerings.
This week, Aberdeen announced it will delay the sale for an unspecified period because of "market conditions." An Aberdeen spokesman said the fund's directors were aware of the shareholder complaints. But the spokesman declined to comment on whether they played a role in the delay of the offering.
Because rights offerings aren't predictable, there is no foolproof way to avoid them. But one option is to not invest in funds or fund companies that have a history of such offerings, such as Alliance Capital Management in New York. Alliance declined to comment.
Then there is Nuveen Investments in Chicago, which swore off the offerings after a fight with shareholders that included a lawsuit nine years ago. "We got a pretty clear signal that this is not what the market wanted," says Ted Neild, a managing director at Nuveen.
The extent of the dilution from a rights offering depends on investors' response. The gravest dilution occurs when investors don't participate at all in the offering. It isn't uncommon for investors to find the value of their stake cut by 5% or 10%.
If an investor exercises the rights or is able to sell the rights, there can be dilution. That is because shareholders bear the cost of running the offering -- not the manager. Worse, even investors who decide to take part in the offering need to be wary: If the funds are held in certain tax-deferred accounts, purchasing more shares could bring about a taxable event.
This isn't to say that rights offerings are necessarily a negative. If a fund's exchange-traded shares are changing hands at a substantial premium to the net asset value of the portfolio's holdings, a rights offering can give existing investors a chance to buy the fund on sale. Or if the fund is small -- say, less than $50 million -- then the additional money raised can help lower a fund's expense ratio by spreading the costs of managing the portfolio across a broader investor base.
Fund managers list other reasons behind their boards' decisions to approve offerings. For example, managers sometimes say they see investment opportunities for their funds but need additional capital to avoid selling holdings. Some managers say liquidity in the fund's shares will be boosted through an offering, thus helping the market price of the fund.
But a chunk of the cash investors hand over sometimes never makes it to the investments. Although the funds' managers are asking for more money, the cost of making an offering is actually borne by the investors. In the case of an offering in November 2001 by the ACM Income Fund, run by Alliance Capital Management, 3.75% of the money raised went to pay brokers to solicit shares and to the underwriters that put together the deal. That amounted to about $16 million of the total $415 million raised.
What about the other benefits touted by the fund companies? Expense ratios do, in fact, sometimes fall following rights offerings, but only in roughly one out of every four offerings among 106 instances during the past 10 years tracked by Lipper.
Since a fund's directors must approve a share offering, the responsibility falls on their shoulders to determine whether the move is in shareholders' interest. But too often fund directors "are not looking out for the interests of the shareholders," says Peter Schiff, president of Euro Pacific Capital, an advisory firm in Newport Beach, Calif.
Money-Fund Assets Rose
Money-market mutual-fund assets rose $38.38 billion to $2.378 trillion for the week ended Wednesday, from a revised $2.34 trillion for the previous week, the Investment Company Institute said.
Assets of the 1,013 retail-class shares rose $3.91 billion to $1.045 trillion, the institute said. Among retail-class shares, assets of the 663 taxable shares rose $2.84 billion to $851.47 billion, while assets of the 350 tax-exempt shares rose $1.07 billion to $193.92 billion.
Assets of the 1,071 institutional-class shares rose $34.47 billion to $1.333 trillion. Among institutional-class shares, assets of the 845 taxable shares rose $34.71 billion to $1.246 trillion, while assets of the 226 tax-exempt shares fell $239.3 million to $86.66 billion. |
