Some investors eschew all CEF investing because of how CEFs raise their initial capital. While we do not believe this is wise, there are some unique risks involved with purchasing a CEF at its IPO. This article details how a CEF raises its initial capital and why a CEF always trades at a premium immediately following the IPO.
Birth of a closed-end fund
An idea for a proposed CEF takes shape.
- Executives at a fund family with other CEFs may come up with an idea for a new CEF.
- Sometimes, managers with no ability to launch a CEF come up with an idea, and then solicit a CEF family for sponsorship.
- A manager can sponsor its own, initial CEF.
- Ultimately, the CEF needs to find a fund family to be the sponsor.
Meetings with underwriters ensue.
- Underwriters determine which proposed CEFs they will bring to market.
- Underwriters not only have the leading role in setting the pricing and fees for the IPO, they also can recommend certain characteristics for the proposed CEF.
- For instance, they may not give their support to a CEF that does not plan to have a certain minimum distribution rate.
- Without the backing of sufficient underwriters, the proposed CEF will not be launched.
As all of this is going on, the proposed CEF begins the process of meeting regulatory requirements.
- This involves legal costs and regulatory filing fees.
- Later, the costs of mailing prospectuses and other documents ensue.
Once the proposed CEF begins to be actively managed, the IPO process is not dissimilar from a corporate IPO.
Special risks of investing in a CEF IPO
IPOs of any sort carry special risks. CEF IPOs carry a few larger risks, just given their nature.
- No track record: With corporate IPOs, the entity has an operating history, complete with financial statements, experienced managers, and a business strategy.
- With CEF IPOs, the fund doesn't even exist until after the IPO. There is no capital that has been invested. There is no track record. Even if the manager has track records with other funds, that is no guarantee of either future performance or the new fund's execution.
- Investment Risk: The successful IPO will bring in cash that must be invested according to the fund's strategy. Even if the strategy is sound, the timing of purchases with nearly 100% of the fund's capital could be inopportune, harming the fund's long-term prospects.
- Investors who purchase the CEF IPO will always be purchasing the shares at a premium.
Why does a CEF IPO always price at a premium to the CEF's net asset value?
- Accounting conventions and simple math: Fees and expenses related to the IPO are typically charged against the capital assets raised in the IPO. After all, the money to pay the bills has to come from somewhere.
- In rare cases, a fund family may pay some of the fees.
By far the largest portion of the fees comes from money paid to the IPO underwriters.
- Typically, this represents 4.5% of the capital raised in the IPO, which by extension means that 4.5% of the price paid per IPO share goes to the underwriter and its brokers rather than to the fund.
- This sales load pays for advice related to the structure and organization of the fund, as well as for sales/distribution of the shares. The underwriters' own brokers often get paid commissions to buy CEF IPOs for their clients' accounts.
The second, aggregated fee is typically referred to as "offering expenses."
- This usually represents 0.10% to 0.25% of the capital raised in the IPO.
- These expenses are related to filing fees, legal fees, and the like.
These fees cause the shares to immediately trade at a premium to net asset value. For example:
- IPO share price = $20.00
- 4.5% Sales Load = -$0.90 per share
- 0.25% "Offering Expenses" = -$0.05 per share
- Net Asset Value immediately after IPO = $19.05
- Absolute Premium = ($20.00 ÷ $19.05) - 1 = 1.0499 – 1 = +4.99%
Another way to look at it:
- A CEF sells 50 million shares at $20 per share in its IPO.
- Total Capital proceeds are $1 billion (50 million shares * $20 per share)
- "Sales Load" paid to underwriters = $45 million ($1 billion * 4.5%)
- "Offering expenses" of $2.5 million ($1 billion * 0.25%)
- Net assets of $952.5 million ($1 billion - $45 million - $2.5 million)
- Net assets per share of $19.05 (Net assets ÷ shares outstanding = $952.5 mil ÷ 50 mil shares = $19.05)
What happens to the premium over time? Because of market conventions and regulations, the underwriters can support the share price for months after the IPO. This means that the IPO premium will tend to persist. Eventually, the free market is allowed to dictate the share price. When this happens, the premium tends to disappear in one of two ways:
- The NAV rises toward the share price. This would be ideal for IPO investors.
- The share price declines toward the NAV.
As with any other investment and as we outlined in CEF Discounts and Premiums (See Related Lessons) there is no way to know before the fact how the premium will go away.
It is unwise, however, to exclude all CEFs trading at absolute single-digit premiums from investment consideration. A study we conducted of all CEF IPOs from Jan. 1, 2001, through Oct. 31, 2011, found that 73.7% of the IPOs had positive share price total returns since inception.
However, many investors prefer to wait to invest in the secondary market in the hope that the share price will decline below the IPO's net asset value price. Although we don't blame these investors for waiting, we also do not believe--based on our limited study--that investing in CEF IPOs, in general, is a fool's game.
- Purchasing a CEF IPO entails paying a premium for an unproven investment asset.
- Brokers have a large financial incentive to invest client assets in a CEF IPO. There is a saying that CEF IPOs are sold, not bought.
- Just because a CEF is suitable for your portfolio doesn't mean it's in your best interests. There's a large difference between the suitability and fiduciary-duty standards.
- If the CEF's investment strategy is appealing, there may be already-existing CEFs offering a similar strategy and trading at discounts.
- If you do purchase a CEF on its IPO, the premium does not mean that you won't be able to make money over the long term. It just means that you initially overpaid for the assets in the fund.