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Watch those unexercised options in LICs

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.

13 Comments
malcolm mawson
January 30, 2015

Hi Graham

Good article but the subject of dividends declared/paid on shares issued following exercise of options pre expiry( but immediately qualifying for divs), not addressed.

As an example WAM lic,s allow options to be exercised immediately before
declared dividends paid .This results in a higher quantum dividend payout & lower future eps /nta based on a higher no of shares on issue.

The value of options are therefore always chasing reduced nta after dividends paid .

Mal

Steve Martin
September 05, 2014

Thanks Graham. It is important for investors to understand the effects of options, and your article canvasses the issues very well. While options are on issue, they tend to flatten the share price, in line with the NTA as new capital is invested over the period, so the investment strategy has to be carefully considered at the outset.

On a new listing of a quality LIC, my preference is to buy the options on market rather than with shares in the IPO. A stag profit as you refer to in your article, is going to be usually small and carries some level of risk (market and liquidity being the main risks to my mind). The options will generally pick up the growth in the underlying shares with a smaller outlay. I always anticipate that earnings and dividends will be low in the first year as funds are invested when opportunities arise, so I figure I am better off holding aside the funds I want to ultimately invest (perhaps at interest) and then consider whether to exercise the options before each ex-div date.

While I agree that disclosures about the effect of options on the NTA is helpful, it is hard for simple punters like me to make any tangible use of the disclosures as you set out and the bigger investors are on top of it anyway. But, more open disclosure is better than less. Just on that, I do wish LICs would more uniformly disclose in their headline reports, performance AFTER fees. Before fees performance is good information for the manager but useless to a punter who is trying to work out whether to be in a LIC or just invest in the banks and Telstra. ( I really couldn't care less about how high the fees are as long as I am doing well out of the investment AFTER fees and other expenses). I also wish funds that boast doubling of profits and more would footnote that the increase is due (often substantially) to increased capital from an options issue that closed.

George Nassios
September 04, 2014

Graham good article and well put - pity is Strike Risk needs to be managed

Peter Rusbourne
September 01, 2014

Thanks Graham. Investors are often not aware of the underlying value. Great to see comments and disclosures being made.

Graham Hand
August 31, 2014

Hi Graham, if I buy a share for $1.26 when the reported NAV is $1.26, and the next time I check the NAV, it is $1.13 when the market has not moved, I'm unlikely to ever recover from this loss compared to other investments I may have made. A group of shareholders has been able to buy new shares at $1 and disclosure should ensure I know about it before I buy.

Graham Wright
August 31, 2014

You are correct about the dilution effect of a sudden mass of options being exercised. However, I cannot see that we can consider it in isolation from the after-effects. like a stone dropped into water, the effect is maximum it time of impact (when the options are exercised) but then it diminishes with time, often quickly, as the force of the impact spreads out. For the LIC, the new options become part of the one big pool and quickly start earning their own income.

One substantial impact the new shares can have is their entitlement to receive a dividend at the same time and rate as earlier issued shares. If the new shares come into existence just in time to be entitled to the dividend, they will receive income without having earned any income themselves. This will certainly dilute the fund earnings and gains in a most positive way. The LICs I have been involved with accommodate this by preserving some of previous years' gains in "Profits Reserve" and "Franking Credits" Accounts to provide a moderated FF dividend flow each year regardless of market instability. These preservations can accommodate the additional dividends for the new shares as they become accretive.

Thus, I believe the significance of the dilution diminishes with time, often quickly.

Graham

Graham Hand
August 30, 2014

Hi Ramani, provocative questions. My answers are:

1. Yes, LIC managers do advise investors of coming expiry, but it's in their interests to do so. It's a wonderful way to raise new money. Investor inertia might prevent some of the dilution effect, but it's great to have 100 million exercised options and $100 million of new FUM at fees of 1% a year, or $1 million pa to the bottom line.

2. LICs do create additional options, usually issued pro rata to existing shareholders. So these people are probably happy with the process. The investors who 'suffer' are those in the secondary market who do not factor in the coming dilution, or those who sell the options immediately thinking they are making a few cents without realising they will be diluted later.

3. I wouldn't call for a 'class action' against LICs (let's not lose even more value through legal bills), but I do think disclosure about the impact of unexercised options should be mandatory. This is especially so since LICs are growing significantly, and are especially popular with SMSFs who deal directly on the ASX and don't want managed funds on platforms.

Ramani
August 30, 2014

Thanks for the instructive article and exchanges. Oh for our Oscar Wilde, to pen 'The importance of being Graham'!

Some issue arise:
1) Do the option-issuing LICs alert the investor cum option-holder about their expiry closer to time, as brokers do with ETOs? Or do they expect to benefit from investor inertia?
2) In corporate finance, issuing additional shares or options to acquire shares on a selective basis resulting in stake dilution would be a concern. Are LICs able to issue additional options and jettison this wholesome principle with impunity?
3) ASIC is mandated to ensure that investors receive adequate, proportionate and intelligible disclosure so they could operate on an informed basis. This article strikes at the heart of robust disclosure, treating it as discretionary. Why is there no class action against the LICs, with ASIC being impleaded as well for regulatory malfeasance?

Chris Humphrey
August 30, 2014

Most LIC options are American style. They should not be valued using Black-Scholes.

Graham Hand
August 29, 2014

Thanks, Graeme. Interesting strategy. As you know, even if the potential dilution is ignored in the market and shares trade at stated NAV or above, the dilution will eventually feed into the NAV as options are exercised. There is no hiding from the dilution unless the options expire worthless or the holder forgets to exercise.

Graeme
August 29, 2014

I generally don’t have a problem with the 1 for 1 options at listing. If my long term strategy is to have x number of shares in that LIC, I will buy x divided by 2 shares and exercise the options near expiry. If the share price at that time is below the exercise (list) price, I will let the option lapse and buy the shares cheaper on market.

I do, however, have problems with options issued after listing. I don’t want to increase my investment, so it becomes a problem of how to get rid of them. I am not unduly disturbed if the share price immediately drops just sufficiently for the period of the option to discourage anybody from exercising. Ignoring the hopefully small costs involved with the issue, it will then be business as usual. If the share price had risen, it is usually not desirable to sell in the first 12 month, as, due to the cost being zero, all the proceeds are taxable. Selling after 12 months means only half the proceeds are taxable. However after that period, unless the options are long dated, you will invariably have lost all of the time premium. And of course the share price may have varied widely in the interim. All very good if one has experience as an option trader, but I suspect LIC investors are more likely to be of the buy and forget variety.

Guess one shouldn’t complain too much. I have recently been able to sell unwanted options held for over 12 months at a time when the share price is both at a large premium to NTA and I suspect also ignoring the dilution affect. A deductible contribution to my super fund reduces the tax even further.

I find the comments on disclosure interesting. Over time I have contacted four LIC managers requesting they disclose NTA adjusted for options. MFF started publishing the quoted disclosure the very next week - impressive. Wilson explained why they did what they did - that’s good too. The third didn’t respond and the fourth didn’t seem to understand the meaning of the word dilution!

Graham Hand
August 29, 2014

Hi Graham, not sure I understand the question, but this article is about unexercised options, not exercised options. The main point is that unexercised options may have the right to buy more shares at $1, even if the share price is $2. If an investor in the LIC does not hold such options, they will be diluted (their shares will be worth less) when the options are exercised. I'm suggesting people should check for such unexercised options before they buy a LIC. I'm not making any statement about what happens to the cash after the option is exercised.

Graham Wright
August 29, 2014

I am a little confused.

I can understand the validity of this argument if the funds from the exercised options sit idle in a cupboard, but surely they would be at least invested into term deposit or fixed interest if not wanted in the equities market. Thus they contribute to the annual profit/loss report. When some LICs are strategically holding as much as 70% cash, the exercised options would add to that investment and increase that proportion of the fund capital thus return bank interest or better.

Across a year, the fund capital would be regularly varying so that a shareholder cannot see the daily or weekly capital to be able to calculate the return on capital accurately. Thus it would be hard to accurately know how many times each dollar is turned over in investments for the year.

Graham

 

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