No free lunch in listed funds' options

By Shoeshine

Friday 14th May 2004

New Zealand's smaller companies have long complained about the treatment meted out to them by the capital markets. Covered only sparsely by sharebroking analysts, and largely ignored by managed funds, some cracking little operations have struggled for oxygen even as they rack up double-digit growth rates.

So from their point of view, the sudden, almost simultaneous creation of three smaller-company-focused investment funds can only be good news.

Investors, however, should take a long, hard look before they part with their money.

The three listed investment companies are remarkable both in their similarities and in their differences.

Kingfish was first off the blocks, raising $58.5 million when it listed on March 31.

Kingfish's shares closed on Tuesday at 92c, against a $1.00 issue price, but the options that came with the shares traded at 16c, making the package worth $1.08.

The company will invest in small-to-medium sized companies using a market capitalisation ceiling of $450 million.

That means its universe is considerably larger than those of this week's crop, Colville Equities and Salvus Strategic Investment.

Colville is looking for $50 million and will accept up to $25 million in oversubscriptions.

Salvus has set its sights considerably lower, even though it has already placed shares to four British institutions and an undisclosed number of local funds. Its minimum is $25 million, with $25 million available for overs.

The first shots of the marketing battle were fired this week, with first blood going to Colville.

Even though its offer opens on Monday, a week after Salvus, it got in its media briefing a day earlier, allowing its manager and chief marketing weapon, high-profile columnist Brian Gaynor (pictured), to get in a few remarks Salvus would rather not have seen printed.

The fee structure the traditional managed funds industry charges New Zealand retail investors, Gaynor thundered, was a disgrace. Colville was therefore charging only a 1% management fee and no performance fee.

Gaynor, whose reputation among small investors has been gained in no small part by his campaigning against poor corporate governance, also made a virtue of his fund's intention to fully disclose its voting intentions at shareholders' meetings of the companies it invests in. It will also turn up to meetings, ask questions "if necessary" and publish its opinion of portfolio companies' "departures from appropriate standards of corporate governance."

By contrast, Salvus' approach offered nothing new, leaving it looking like one of those traditional fund managers about which Gaynor and others complain. It will charge a 1.25% management fee and performance fees.

Asked about its intention to participate publicly in the corporate governance of portfolio companies, principal Andrew Couch said he hadn't given it much thought.

"But I think we'd be prepared to disclose our voting where we have a significant shareholding," he said, a little cagily.

Kingfish also has a bit of an "old world" fund manager look compared to Colville. It charges a 1.25% management fee and will also extract a performance fee, albeit one that falls dramatically if shareholders don't get at least what they would have got on bank deposit.

In some aspects the three are singing from the same fund manager sheet. All have dividend reinvestment plans, the capacity to borrow to fund investments, management contracts much shorter than the average (five years for Kingfish and Salvus, three for Colville) and the ability to execute share buybacks that is, buy their own shares as the best investment they can make.

All three are also going to market with options or warrants attached to the shares. But as investment services firm Russell Investment Group points out, these are of dubious benefit to shareholders.

They give the shareholder the ability to subscribe for more shares, at various future dates, at today's issue price. If you take the view the funds' shares are likely to rise steadily over time, this might appear attractive.

But, Russell warns, when pricing the shares, the market takes account of the number of potential shares there are going to be in the future, when people exercise all those warrants and options into shares.

If the options are worth anything that is, if the shares are trading above their issue price the market will discount the shares to allow for the dilutionary effect options exercises will have on each shareholder's stake in the whole caboodle.

In other words, while these sorts of instruments look like a free lunch, they aren't.

Russell also points out that listed investment companies that have internal management that is, the fund owns its manager as well as its investments generally have far lower fees, with management expense ratios as low as 0.25%.

Another interesting wrinkle is the three funds' tax postures.

As you'd expect given Gaynor's straight-up profile, Colville is taking a line Joe Blow investor can easily understand.

His fund is investing for the purpose of making money for investors. When it sells shares at a profit, it will pay tax. And when it sells them at a loss, it will claim a tax credit.

Such naivety is not for Kingfish or Salvus. Both have interesting "tax-effective" structures.

Salvus will invest through seven subsidiaries. Six of these will invest long term and will therefore, in KPMG's opinion, not be liable for tax on realised gains. The seventh will trade actively and will pay tax.

"This [KPMG's] view of the income tax law may differ from the view ultimately adopted by the Inland Revenue Department and the courts," KPMG notes. Quite so.

Comments from our readers

No comments yet