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8 ways LIC bonus options can benefit investors

The general investor opinion of the Listed Investment Company (LIC) and Listed Investment Trust (LIT) sector has returned to a more sensibly-balanced view after the criticisms around stamping fees, with a recognition of the potential benefits of a close-ended vehicle structure.

One benefit is the ability to issue bonus options to existing investors, and we will use the example of Perpetual Equity Investment Company (ASX:PIC) to explain how these issues work. Many other LICs have used a similar technique.

We were previously not overly keen on the bonus options structure but after speaking to Perpetual and hearing the positive feedback it has received from shareholders, our views have changed.

There are pros and cons to bonus options but our prior negative view was mainly due to the adverse impact of Net Tangible Asset (NTA) dilution on performance. In some cases, a year or two after the options had expired, no one remembers that there was a known NTA dilution which opens up a manager to criticism of poor relative performance.

Inside a bonus options issue for a LIC

The key terms of the PIC bonus options are an exercise price of $1.35 per share (share price at the time of issue was around $1.30) and an options expiry date of 2 September 2022. Investors can choose to exercise the option and receive the shares any time up until the expiry date.

This examination compares an options issue with alternative means of rewarding existing shareholders, such as an entitlement offer (issued at a slight discount to NTA), which typically comes with a shortfall placement to the broader investment community.

Potential investor benefits

From an investor perspective, the benefits of bonus options are potentially eight-fold:

1) Bonus options reward existing investors (and by a greater degree than an entitlement offer) by providing a free ‘kicker’. Investors gain a free look at the market and LIC over the duration of the issue date to expiry date. An entitlement offer is a here-and-now decision.

2) Investors have perfect choice – a time window before which to exercise, hold or sell the options on-market to raise cash (if the share price exceeds the exercise price or the options have a market value due to the time value).

3) Bonus options provide an alignment between management and the shareholders as a result of the duration of the options. In the PIC case, for example, the exercise price was at a premium to the share price/NTA and the goal posts change as distributions are paid. This provides management with a clear mandate to perform in order to raise capital.

4) An investor’s exercise has the potential to be NTA accretive for that investor. However, there may be an NTA dilutionary effect overall for the LIC/LIT based on the relation between the share price and the options' strike price when the options are exercised. Dilution for some investors occurs when other investors buy shares at prices below NTA.

5) An increase in FUM scale leads to increased secondary market liquidity and market relevance with broader market interest. PIC has a FUM of about $486 million (based on a pre-tax NTA of $1.39/share). The bonus options issue has the potential to increase the PIC FUM to circa $973 million, assuming a 100% exercise rate, making it the 12th largest LIC/LIT out of 98 in total following the disappearance of MLT.

6) In the LIC/LIT sector, larger FUM scale is strongly correlated historically to superior premium/discount to NTA performance (read, potential share price upside over and above NTA growth, assuming a recalibration occurs).

7) The greater FUM scale leads to lower fixed costs per share incurred by investors, improving net post-costs returns, all things equal.

8) A manager has greater capacity to capitalise on compelling investment opportunities using the additional capital raised. Given bonus options are American style, that capital is not raised all in one hit which may otherwise lead to digestation issues.

Investor risks

Bonus options come with some downside risks, including:

1) Some shareholders may ‘suffer’ NTA dilution. NTA dilutionary risk is, in turn, driven by:

a) the degree to which the strike price is below the NTA over the full time period in which options can be exercised, and

b) the percentage of options that are exercised.

2) The degree of NTA dilutionary risk is an unknown and a function of investor behaviours (when they exercise) and moves in the share price relative to the options strike price. With an entitlement offer, the dilution risk is a known and limited to the offer discount to NTA at the time.

3) An options ‘overhang’, namely the market share price often will factor in some degree of NTA/share dilution risk, leading to a drop in a premium or discount to the published (non fully diluted) NTA.

4) Should some shareholders exercise options then sell shares on market, there is a risk of more sellers than buyers than otherwise the case (greater adverse premium/discount to NTA risk).

5) The strong likelihood that the shareholder register will go through an unsettled period, with more marginal sellers than buyers than would otherwise be the case (adverse share price to NTA dynamic).

6) Have a lasting adverse impact on the investment vehicles performance metrics over time assuming NTA dilution risks transpired. 

A comment on peer relativity analysis with ETFs

Bonus options are just one of several reasons why a direct comparison of LIC/LIT performance to an industry benchmark or the unlisted trust or ETF universe lacks validity. Other reasons are Share Purchase Plans and Dividend Reinvestment Plans issued at a discount (dilutionary), share/unit buybacks (accretive) and most importantly, LICs/ LITs report a pre-tax NTA figure which is after all operating expenses. 

The term ‘pre-tax NTA’ is a misnomer. The measurement of a LIC/LIT’s performance is calculated after all operating expenses and the provision for realised capital gains tax (and the reinvestment of dividends, but does not incorporate franking). LIC/LIT returns will consequently be understated relative to an index return given benchmarks do not factor in operating costs or provisioned capital gains taxation while unlisted unit trusts are not measured on an after-tax basis (provisioned capital gains taxation) and therefore do not provide a like-for-like comparison.

 

Rodney Lay is an Analyst at Risk Return Metrics. This article is general information and does not consider the circumstances of any individual.

 

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