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Are free LIC options too good to be true?

ETF Watch - Jan 31, 2018

Common practice for any new Listed Investment Companies (LICs) launching for many years now, is for investors in the IPO to be offered bonus options as an incentive to invest in the IPO. An incentive is generally required as investors in the IPO are required to stump up for the listing costs, including commissions to brokers. This means a LIC with a unit price of $1.00 will have a Net Asset Value of arounewd $0.97 on day 1 (with 3 cents in costs), so to incentivise investors to participate in the IPO they are offered a free option for every share they purchase.

How do these options work?

Options give investors the right but not the obligation to buy a share at a certain price by a certain date. Take an example where an investor purchases 10,000 shares in a LIC IPO at $1.00, therefore costing them $10,000. In most cases they will be issued 10,000 options with an exercise price of $1.00. The options will have an expiry date of anywhere from 1 – 4 years (set by the issuer). The options are tradeable on the ASX so can be sold at any time until the expiry date (sometimes with an initial vesting period). If the share price rises the investor makes a profit by only having to pay the option exercise price to gain access to the share. If the share price falls, the options simply expire worthless.

Here’s a an example:

LIC ABC Limited IPOs on 14 March 2016 at $1.00 per share. Investors in the IPO receive one option for every share they purchase. The options have an expiry of one year from listing, 14 March 2017.
Jimmy the investor invests $10,000 in the IPO, giving him 10,000 shares and 10,000 options.

Scenario 1:

ABC Limited performed pretty well in its first year and the LIC remains in high demand by investors. On 10 March 2017, shares in ABC limited are trading at $1.08, with the options trading on the ASX at $0.07. Jimmy has 3 options:

  1. Exercise the options before the 14th of March, receiving 10,000 more shares in ABC Limited, and costing him $10,000.
  2. Sell the options for $0.07 on the ASX, receiving $700 (less brokerage).
  3. Do nothing and let the options expire.

Options 1 and 2 will both return a higher profit to Jimmy. Assuming the share price remains the same after the option expiry date, Option 1 will give Jimmy a 16% return in the first year, compromising 8% from share price growth and 8% from the free options which until the last few days have not required any of Jimmy’s capital. Option 2 will give Jimmy a 15% return, with 8% share price growth and 7% from the sale of the options.  Option 2 has the benefit of Jimmy not having to stump up another $10,000 of capital to purchase the options.

Scenario 2:

ABC Limited didn’t have a great first year and is now trading at $0.92 on 10 March 2017. The options have no buyers in the market depth making them effectively worthless. In this scenario, options 1 will provide Jimmy with a greater loss, option 2 is not available to Jimmy and the only viable course of action to be let the options expire worthless.

The two examples above show the benefit that options provide. The share price rising beyond IPO prices effectively doubled Jimmy’s returns, with the share price falling having no additional negative effect on Jimmy’s portfolio performance.

IPO costs and dilution of capital

Whilst the above scenarios may make investors excited about the upside that the options bring, there’s two things working against them during this period, meaning the odds may not be in their favour. These are the costs of the IPO as well as dilution of capital that exercising of options brings.

IPO costs

As we discussed earlier, free options are generally provided by LIC issuers to entice investors into the IPO that without the option would not look so attractive. Historically a LIC passes the listing costs on to the investor. These listing costs can be anything from 2% to 5%. This means that the Net Asset Values of the LICs on day 1 of listing will be anywhere from 2% to 5% less than the initial investment. In Jimmy’s case, the $10,000 he initially invests will be worth anywhere from $9,500 to $9,800. From day 1 Jimmy is in a losing position.

Of course, depending on the popularity of the LIC, it may trade at a premium or discount to its NAV and Jimmy may not see this loss in his brokerage account (if trading at a premium), but if the manager fails to perform well from very early on, it will be difficult to recoup this initial loss by the time the options expire.

Dilution of Capital

Apart from helping to fund the IPO costs, fund managers love giving up free options in IPOs to help them growth the size of the fund. A fund that raises $100m in an IPO that does well in its first year can see its funds under management grow to $200m just through exercising of options. With largely fixed costs and percentage based management fees, this can greatly increase revenue to the fund manager.

However, from an investor’s point of view the exercising of options will dilute their initial gains. Let’s look at the previous example:

Assuming ABC Limited initially raised $100m, and on the 10th of March 2017, ABC Limited was trading at $1.08, with a Net Asset Value also of $1.08  and no Options had yet to be exercised, giving ABC Limited an 8% gain. This gives ABC Limited a market capitalisation of $108m. Over the next few days ALL options are exercised, for a total of $100m. This will give ABC limited a market cap post option expiry of $208m. With 200m shares now on issue, the Net Asset Value of ABC Limited now falls from $1.08 to $1.04.

It’s because of this that LICs with Options outstanding can trade at significant discounts to Net Asset Value, as the market prices in this possible dilution of capital. This means that even if a LIC performs well, its share price may be depressed, and may not rise to above IPO price before the options expire.

How has it worked in practice? 

We’ve taken a look at all the LICs that have launched since 2013. There’s 24 LICs that have launched during that period which have now seen their options expire.

NAV Discounts around option expiry

In the below chart we look at the average LIC Net Asset Value discount in the 12 months prior to Option Expiry and the 12 months post expiry. Of course there are other factors at play that influence premiums or discounts to Net Asset Value such as manager performance and general market sentiment, but we think the sample is large enough to smooth this out.

 

It can be seen that in the months leading to Option expiry, the LICs traded on average up to an 11% discount to Net Asset Value. Post expiry this discount narrowed to around 7%. We put this down to the dilution of capital discount that the market has applied during this period.

Share price at expiry date

Next we look at the share prices on the day of Option Expiry of the 24 funds available in the sample. Of course the LICs may have traded at higher share prices leading up to option expiry, but we assume investors can’t forecast when the shares will peak and will look to exercise their options around the expiry date.

 

13 of the LICs in the sample (54%) had a share price at option expiry date higher than the exercise price of the options. However, only two of these had a meaningful differences of 5% or more. 9 of the LICs reported share prices at or below the option expiry date, with the largest being almost 25% below the expiry price. As each of the LICs had different terms to Option expiry (with some as little as 6 months and others up to 4 years), the performance should not be compared side by side, however the data does show the chance of outsized gains utilising bonus options are slim.

Changing tides?

We hope the above analysis has provided some insights into the things investors should consider when investing in LIC IPOs with bonus options attached. The data shows in some cases it can be a profitable endeavour, however there are a number of headwinds that may make the options not look as valuable as they first may seem.

We may be coming to the end of the ‘bonus option’ era, with many of the LICs launching over the last 12 months not including bonus options, and having all listing costs borne by the fund manager, removing both the upside and the downside from investors. With most of these offers raising many hundreds of millions and making 2017 a record year for LIC IPOs, we think this may become the new norm.

 

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