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

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.

ASX: RF1 – Distribution, the Screamingly Obvious DRP Opt-in and ASIC No Action Announcements

0

It was implicitly foreshadowed in the AFR article dated 7 June quoting RRM, but RF1 announced the obvious – a ‘monster’ estimated distribution of of $0.75 cents per unit. It was obvious because: 1) RF1 is a LIT not a LIC and therefore is required to announce / distribute any realised gains in the same financial year; 2) RF1 NAV returns of 86% over the 12-month period to 31 May 2021; 3) as a long / short strategy that reduced gross leverage in peak Covid, then increased leverage, then decreased again, this process implicitly means on the surface of it a higher degree of realised gains (and potentially very large ones); and, 4) the close-ended underlying Emerging Companies Fund III, which recorded a very large +130% gain for the 12-month period to 31 May 2021, was also going to make a large distribution to RF1.

The share price premium to NAV has increased markedly over the last few weeks. In part RRM suspects because some canny investors were aware that under RF1’s DRP, new units are issued at NAV when the share price is trading at a premium. So, an arbitrage opportunity may play out.

In fact, RF1 was trading at $5.20/unit on Friday 25 June and the NTA was $4.39/unit. That is new units under the DRP would be issued at an 18.5% discount to the share price. Money for jam! The record date is 1 July 2021 while the DRP Election Cut Off date is 2 July 2021. To put it another way, if an investor does not take up the DRP option that investor runs the risk of material NTA dilution. There has probably never been a DRP in the LIC/LIT segment where the incentive to opt into the DRP is so obviously to do so. And that is great news for Regal, otherwise it could be a sizable loss of capital.

The ASIC No Action announcement means that ASIC will take no enforcement action following an investigation in relation to three (never disclosed) stocks. No details were ever released to the market regarding the investigation which Regal first became aware of and announced to the market on 27 November 2019. In RRM’s view, when tied with the sheer length of time for this resolution to be arrived at and announced – surely the process can be improved moving forward given the detrimental impact to FUM net flows.

The significance of the investigation is that some research houses and some WRAP platforms as a matter of due course place all Regal investment vehicles, including RF1, on-hold during that period. That is, such vehicles are not able to be invested in. This matters less for RF1, being a listed entity, but it would have still restricted financial advisors from investing in RF1 that solely invested via such platforms.

It is difficult to know what impact this will have on RF1 but at the very least one would say to will serve as an incremental positive in relation to marginal buying interest.

More significantly, it clears what may have been a barrier to coming back to the market to raise additional capital for RF1. And in that regard, the timing could not be better. RF1 recently passed its two year anniversary, which matters regarding any potential additional raise. Any such development would have to be post the DRP election cut-off date (as that will determine the NAV drop post distribution payment).

PGG Report Summary

0

RRM ascribes a “CONVICTION” rating to the Trust. Partners Group is a solid investment manager that plays to its relative abilities, which translate to income stability and capital preservation, rather than stretching for yield and capital upside by moving up the private debt risk-return spectrum. In this regard, RRM has a high degree of conviction in the manager’s ability to continue to at least achieve the stated income objectives over the foreseeable future. To date, PGG has not missed a annualised monthly amount and, subject to a deterioration in credit assessment leading to a material degree of LGD events (which we view as highly unlikely), we do not expect it to. But as RRM pointed out earlier, that does necessarily mean that there can be gyrations in the mark-to-market NAV, which are further augmented by the Fund’s leverage at a whole of portfolio level. Over and above this, like any close-ended vehicle, investors must also bear in mind the additional risk associated with premium / discounts to NAV. However, subsequent to the peak Covid material (which presented excellent buying opportunities in the ASX-listed debt LIT sector), we have seen the discounts contract materially and we would expect this to persist short of another extreme (black swan) market event.

Click here to download PGG Report Summary

RF1 Report Summary

0

RRM ascribes a “EXCEPTIONAL” rating to RF1. What’s not to like? The investment team is deep, well structured, accountable, and invested (literally and heavily with respect to Philip King). It is overseen by a PM that is probably the most experienced long/short manager in the country and Regal is one of three investment houses that excel in the pre-IPO space. While the strategies may differ, there is a commonality of investment process and portfolio and risk management guidance by Philip King across all the underlying strategies. The fundamental investment process is repeatable and style agnostic (through market cycle). The strong track record of RF1 is based on broad attribution by underlying strategy and by PMs. Want’s not to like? Oh, the performance fee structure – 20% over the RBA Cash Rate. The hurdle is (not that its not uncommon for absolute returns strategies) is inconsistent with the risk profile of the strategy and the long-only beta creep over the last year. And given RF1’s performance over the last 12-month period the performance fee has been material.

Click Here to download RF1 Report Summary

LIC/LIT Monthly Report Summary

0

Welcome to the inaugural Risk Return Metrics (RRM) LIC/LIT Monthly Report. This is the first of three investment vehicle specific monthly publications that will be issued by RRM, the other two being ETFs (200 strategies) and a select Unlisted Managed Fund monthly (250 strategies). This monthly publication provides rated and non-rated coverage on 90 LICs/LITs. The rated coverage, which includes PGG and RF1 in this publication, will grow over the following months. The two Rated profiles were inadvertently excluded (the Non-Rated profiles were inadvertently added – please ignore), so we have attached separately. This publication is differentiated from existing research PDF-only publications in five key ways, most notably: 1) two HTML embedded ‘buttons’ in each investment product profile labelled ‘Click here for Performance Analysis’ and ‘Click here for Peer Index Comparison’; 2) the use of a Peer Group Index as the Primary Index for comparative purposes rather than the standard use of assessing performance relative to an industry benchmark, 3) a Heat Map analysis of key return, risk, performance path and efficiency metrics; 4) the underlying technological platform; and, 5) the ability to isolate each investment strategy report as a separate PDF by clicking on the PDF icon at the bottom and end of each profile.

Click here to download LIC/LIT Monthly Report Summary