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ASX: PIC – And the Inside on Bonus Options from the Best Performing Value LIC

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On 2 June PIC announced a 1 for 1 Bonus Options issue combined with an up to $30K share purchase plan (SPP) per share holder. The former is all about market timing, and that timing is good for PIC currently based on: 1) strong performance over, in particular, the last 12-months; 2) a market environment that is providing further investment opportunities according to the manager; and, 3) given PIC currently trading at an 6% discount to NTA.

Additionally, more broadly, we believe the general investor view of the LIC/LIT sector has returned to a more sensibly balanced view after the stamping fees issue (as some rather negative, vested interest views expressed in the media), with a recognition of the potential benefits of a close-ended vehicle structure.

The key terms of the Bonus Options are: Options record date 23 June 2021; for those share holders that participate in the SPP, 1 for 1 bonus options eligibility will also include those additional SPP related shares; Options Exercise Price: $1.35/share; Options Expiry Date: 2 September 2022; and, Options ASX trading date commencement: 30 June 2021. Investors should bear in mind that all bonus option issues are American style options, that is an investor can choose to exercise the option and receive the shares any time up until the Options Expiry Date.

The PIC issue will certainly not be the last material capital raise offer over the shorter term. The timing for a number of investment managers is currently very strong based on some exceptionally strong 12-month performance numbers and, as a corollary, moves to near parity or share price premium to NTA. So, RRM thought it an opportune time to re-examine the pro’s, con’s and ramifications of the (1 for 1) bonus options structure.

This examination is comparative, with the comparison being that of the alternative means of rewarding existing shareholders – an entitlement offer (issued at a slight discount to NTA), which typically comes with a shortfall placement to the broader investment community. Both structures, assuming the share price exceeds the options strike price, are NTA dilutive, and most dilutive to share holders that do not participate. Additionally, with an entitlement offer to raise a comparable level of capital would require multiple offers over different time periods, so there are multiple dilutionary impacts over multiple time periods, and which is precisely the same impact the American style (exercisable at anytime prior to expiry date) bonus options.

Investor Benefits
From an investor perspective, the benefits of the 1 for 1 Bonus Options issued are potentially nine-fold in the view of RRM:

1) Bonus options reward existing investors (and by a greater degree than an entitlement offer) by providing a free ‘kicker’ and provides investors with a free look at the market/fund over the duration of the issue date to expiry date (15 months in the case of PIC). An entitlement offer is a here and now decision.

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

3) Bonus options provide an alignment between management and the shareholders as a result of the duration of the 1:1 options. In the PIC case, for example, the exercise price is 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) The NTA dilutionary effect overall for the LIC/LIT is based on the time weighted exercise dates of the options multiplied by the premium of the share price to the options strike price when the options were exercised. Through either good luck or a judicious decision, an investor’s exercise has the potential to be NTA accretive for that investor.

5) An increase in FUM scale leads to increased secondary market liquidity and market relevance (broader market interest). PIC currently has 349.381m shares outstanding and a FUM of $486M (based on a pre-tax NTA of $1.39/share). The bonus options issue has the potential to increase the PIC FUM to circa $973M, assuming a 100% exercise rate (the 12th largest LIC/LIT out of 98 in total and factoring in 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) Should compelling investment opportunities present, a manager has greater capacity to seek to capitalise on those opportunities based on the additional capital raised and given bonus options are American style, that capital is not raised all in one hit which may otherwise lead to digestion issues.

9) At a more esoteric level, a canny investor can potentially game options exercise investor behaviours and the consequent cyclical impact on discounts / premiums to NTA for an ‘arbitrage profit’ opportunity (see ‘Trading Bonus Options’ section below)

Investor Risks
Bonus Options do come with some downside risks. The key amongst these are:

1) At least 50% of share holders will ‘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 are 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 all things equal a drop in a premium / discount to (the publish non fully diluted) NTA.

4) Should some share holders exercise options then sell some / all delivered shares on market, the risk of more sellers than buyers than otherwise the case (greater adverse premium / discount to NTA risk).

5) The strong likelihood that the share holder 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. This is examined further below.

Trading Strategies around Bonus Options
1) If not a pre-existing investor (or wish to top up) and comfortable with the manager and outlook, buy in prior to the Options Record Date – it is a free option, and that has implicit value.

2) Exercise in-the-money options. You will be less diluted than otherwise.

3) To be entitled to an upcoming dividend in relation to option entitlements, a share holder must exercise prior to the dividend record date.

4) Remember that overall dilution risk is a function of when most investors exercise. And most options get exercised in the last three months prior to the expiry date. Other material exercise periods after a period of particularly strong performance or approaching an attractive fully franked dividend entitlement date.

5) All things equal, do not sell during the above periods. Real world examples, noting that RRM has only examined a limited number of examples, shows a distinct correlation between large exercise months and a deterioration in the premium / discount to NTA.

6) Game investor crowd behaviours – buy shares on market during peak exercise months as real world examples show an improvement in premium / discount to NTA in following months.

Bonus Options: RRM’s View
RRM was previously not overly predisposed to the bonus options structure but after speaking to Perpetual and hearing the feedback it has received from share holders (favourably predisposed to bonus options) our views have changed. At the end of the day, there are pro’s and con’s to both the bonus options and the entitlement structures, but in RRM’s view neither is necessarily better than the other.

Upon reflection, our prior negative view was probably that of a more focused analytical view, rather than seeing the benefits for at least some share holders. RRM did not like the adverse impact NTA dilution has on performance and how this led to superficial criticism of the sector as a whole. RRM also did not like that a 1.5 years after the options had expired no one remembers that there was ever NTA dilution, opening up a manager to criticism of poor relative performance.

From an analytical perspective, in an ideal world a manager would also be permitted to published undiluted performance numbers to provide an accurate indicator of manager skill.