With yield compression running apace, many investors are turning to alpha generation strategies to keep returns of their portfolios at healthy levels without having to take on additional risk. In a previous article we covered some of these strategies. In this article we discuss CEF tender offers; in particular, we look at a case study using the recently completed transaction for the BrandywineGLOBAL – Global Income Opportunities Fund (BWG).
Our main takeaway is that tender offers can generate alpha for investors in two ways. First, tender offers have in the recent past generated about 1% in PL over the two-week period covering the expiration of the tender offer. And secondly, a tender offer can generate alpha even without having to participate in the offer by providing a measure of discount control for the given fund since the tender offer will tend to anchor the discount at a certain level based on the specific characteristics of the individual offer.
That said, because tender offers can feature very different characteristics, investors have to approach them on an individual basis. Specifically, they should have a plan for dealing with the sell-down of the residual shares, which can be difficult for less liquid and high-beta funds, especially when the share acceptance rate is low.
Tender Offer Dynamics
Tender offers are typically a result of CEF activist engagement with the fund sponsor. This often happens when the fund’s discount is trading at particularly wide levels, typically double-digit levels. Activist investors try to make life difficult for fund sponsors by trying to get their representatives elected to the board. The fund sponsor, in turn, will often try to reach a standstill agreement with the activist by agreeing to a number of shareholder-friendly actions, particularly, if the sponsor does not have a strong hand to play.
Which funds may go through a tender offer is not always easy to gauge. Holdings of individual activists can be telling, however. For example, it is not a coincidence that the large ownership stakes in the two funds highlighted below have ended up in a tender offer recently.
Source: Systematic Income
In a tender offer, the fund will buy back up to a set percentage of outstanding shares at a fixed discount to NAV. For instance, in the recent BWG tender the fund offered to buy up to 20% of outstanding shares at a price equal to 99.5% of the fund’s NAV on September 23.
How should we think about the potential profit of participating in a tender? From a pure alpha generation perspective – that is, of someone acquiring shares for the purpose of monetizing the tender offer we can split the total profit & loss or P&L into the P&L on tendered shares (shares that are accepted by the fund in the tender) and the P&L on the residual shares (shares that are not accepted in the tender).
Conceptually, the total P&L looks like the following.
Source: Systematic Income
Let’s use an example of someone who acquired 1,000 shares of BWG on September 15 – a week prior to expiration date – at $12.50 and submitted all 1,000 into the tender. On the date of the purchase the NAV of the fund was $13.87. The actual P&L on the tendered shares will depend on the percentage of shares accepted into the tender (which will be a function of the total shares submitted and the fund’s acceptance rate cap of 20% of total outstanding shares). It will also depend on the NAV on September 23. At the point of purchasing the shares neither figure is known.
The best estimate of the fund’s NAV is its NAV on the purchase date less any ex-dividend changes, in this case $0.07. This gets us to $13.87 (NAV on the share purchase date of September 15) less $0.07 resulting in $13.80. We then need to multiply this by the fund’s publicized buyback NAV percentage of 99.50% which gets us to $13.73. Hence, our expectation is for a profit of $1.23 per share plus the $0.07 distribution or 10.4% on the tendered shares. As it happened the actual NAV on September 23 was $13.60, which resulted in a buy-back price of $13.53 and a return on tendered shares of 8.8%, with the distribution included.
As far as the return on residual shares, this P&L is simply a function of the purchase price and the sale price, also accounting for the distribution. The slight complication here is that all of the shares submitted into the tender are locked for several days so they are not available to be sold on expiration date. In the case of BWG the residual shares were unlocked around September 28 at which point they were trading at $11.61. This makes the resulting return on residual shares to be -6.6%. It goes without saying that this is based on closing prices, so the individual mileage will vary.
The final step is to figure out the proportion of shares that were actually tendered. In the case of BWG 67% of outstanding shares were tendered, which means that about 30% of the tendered shares were accepted. This makes the total P&L of 30% x 8.8% + 70% x -6.6% = -2%.
A loss of 2% on the tender offer is clearly not a great result. This example illustrates the potential risk in the tender offer transaction. In particular, the total P&L is driven in large part by what happens to the price of the residual shares, which in this case fell over 7% between the purchase date and the date when they were unlocked and were able to be sold in the market. The example also shows that the residual shares have a wider price risk window – the price risk window on the tendered shares is at most a week while the price risk window on the residual shares can stretch up to two weeks.
What explains this large drop in the fund’s price? In part, the timing of the expiration of the BWG tender offer was simply unlucky. The global income sector returned about -3.5% over the same time frame. With this perspective BWG actually did okay – outperforming its sector over the same time frame by 1.5%.
So how should investors approach tender offers? The key figure in our view is what we call the tender offer breakeven, which is the amount that the residual shares can fall in price for the overall P&L to be zero. This is just the – estimated P&L on tendered shares x (accepted share %) / (1 – accepted share %). The higher this number is the greater amount of wiggle room there is for investors, all else equal. Of course coming into the tender we don’t know any of the components of that equation with any certainty. The key figure here is the accepted share percentage. This figure is going to be a function of the amount of institutional holders of the fund, the buyback percentage of NAV and the percentage cap of total outstanding shares accepted. The higher each of these numbers is the greater amount of shares are likely to be submitted into the tender and hence the lower the percentage of submitted shares accepted. Over the last year or so, the total amount of shares submitted was about 50% and the average number accepted was about 30%.
So how unlucky was BWG? Fairly unlucky by our count – we looked at 6 previous tender offers and all of them had positive P&L – ranging from 0.5% to 3.1% – far from spectacular but worth doing for a couple of weeks of work.
Apart from this analysis, there are a few additional questions worth thinking about for investors looking to pursue tender offers. The first question is when to acquire the shares? The key date here is the expiration date of the tender, which in the case of BWG was September 22. You have to be a holder of record of the shares with the instructions sent to your broker in order to participate in the tender on that date. The practical reality, however, is more complicated. Brokerages typically require a few additional days to guarantee the processing of the corporate action, though a phone call on the expiration date will likely be sufficient. It is also important to have bought the shares a sufficient number of days ahead of the record date since funds don’t settle the same or even next day.
The second key question is if tender offers provide interesting alpha opportunities, why don’t these opportunities close instantaneously? The answer here is that sometimes they do. For instance, when the Pioneer Floating Rate Trust (PHD) announced its intention to carry out a tender offer on August 31. The combination of a price equal to 98.5% of NAV, a 50% cap on tendered shares combined with a double-digit discount made the tender offer quite attractive. The discount rallied on the following day from above 10% to below 5%. This does not always happen but it can happen for funds with attractive attributes. At current pricing, the tender offer remains attractive at an estimated breakeven of about 8% on the residual shares.
Another question is what to do with the residual shares after they are unlocked. It is fairly likely that there will be some technical selling pressure for a couple of days after the shares are unlocked. There is no right answer here. Ultimately, investors have to balance the value of holding the fund at the then current discount valuation as well as their P&L so far on the tender offer.
As a pure alpha strategy, investors entering into the tender offer would be increasing the overall risk of their portfolio, so they should consider replacing one of their current allocations with the fund undergoing the tender.
Finally, in taxable accounts there may be tax consequences – the tendered shares will likely be taxed as a sale and if there is a gain it will likely be taxed as a short-term capital gain which would reduce the total return.
Keeping Track of Tender Offers
There are (at least) three different ways to track tender offers with different levels of effectiveness.
First if you are already a holder of the fund you might get an email either from the fund or your brokerage notifying you of the upcoming corporate action and a request for a decision. The obvious issue here is that if you are not already a shareholder you will miss the notification.
Secondly, various fund news aggregators and wire services such as Business Wire publish fund press releases. Rather than setting up funds on individual wire services, the best bet might be to use an aggregator such as Yahoo that will let investors view releases for funds in a given portfolio.
The third, most direct, though technically the hardest, is to plug directly into the SEC filings service and load all relevant filings for a set of tickers. This does require some technical know-how; however, the advantage of this approach is that it allows investors to get a quick sense of what the funds are doing based on the filing type rather than having to go into the individual press release. The filings themselves also contain additional relevant information and investors would have to read them anyway if they are to act on them.
Source: Systematic Income
Tender offers are attractive for a couple of reasons. First, they can generate additional alpha in CEF portfolios. The average recent tender offer has delivered a total return of about 1% over a 2-week period. Secondly, they can provide a measure of discount control through the holding period into the tender offer which can last several months. We saw this with BWG where the fund’s discount tightened slightly over the month leading into the expiration, while the average discount of the sector widened about 1.5%. With CEF yields moving steadily lower and discount volatility likely to increase, tender offers can offer an attractive way to generate additional returns for income portfolios.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.