Templeton Emerging Markets may need to sell up to 25% of its assets if it fails to perform well. Do such conditional tender offers best serve private investors or institutional activists?
When is a closed-ended fund not a closed-ended fund? That’s not meant to be the set-up line for an esoteric joke aimed at investment trust enthusiasts; rather it is a question to provoke some thought in the wake of the Woodford furore.
One of the lessons of Neil Woodford’s decision to suspend his Woodford Equity Income fund amid a steady stream of large redemption requests is supposed to be that open-ended funds such as this trouble-hit vehicle are ill-suited to investing in illiquid assets. If too many investors want their money back too quickly, the fund has to start selling assets in a hurry to pay up, which can prove disastrous if it holds illiquid assets such as unquoted companies. A closed-ended fund, by contrast, faces no such problem: its share price may take a battering, but the underlying asset pool remains intact.
So far so good, but sometimes investment trusts aren’t as closed-ended as you might think. Take the case of Templeton Emerging Markets (TEM), the £2 billion investment trust. It has just announced what is known in the jargon as a ‘conditional tender offer’ – a promise it will offer to buy back investors’ shares in the fund in certain specified circumstances.
In this case, Templeton Emerging Markets has pledged to launch an offer for up to 25% of its shares in the spring of 2024 if performance disappoints. It will pay a price that is no lower than 2% below the prevailing net asset value, irrespective of what discount the shares are trading at when the time comes. The offer will be triggered if the total return it generates on its net assets fails to beat the total return from the MSCI Emerging Markets index over a five-year period to 31 March 2024.
Now, you might regard such an offer as a useful means for holding the fund’s managers to account. If they don’t beat their benchmark, they’ll lose up to 25% of the fund – and the valuable fee income they earn on this money.
Equally, however, the danger here is that the trust will find itself forced to sell assets at a time not of its choosing – in exactly the same way as Woodford Equity Income currently finds itself under pressure to offload investments it would rather keep.
In other words, Templeton Emerging Markets’ conditional tender offer has the potential to turn it into an open-ended fund in certain circumstances.
Simon Elliott, head of investment trust research at Winterflood Securities, thinks this is potentially awkward – partly because these offers can cause problems, but also because they don’t seem to work very well.
“While it seems reasonable to provide liquidity periodically, particularly in the event of disappointing performance, we have misgivings as to the benefits of conditional tenders,” Elliott says. “We do not believe they have a positive impact on a fund’s performance or on its rating; four of the seven funds that already have a conditional tender offer in place are currently failing the required conditions.”
One difficulty with this arrangement is that it potentially pits different groups of shareholders against one another. Some investors may relish the opportunity to sell their shares back to the trust at a price likely to be above the market price, given the 2% guarantee; it’s noticeable that Templeton Emerging Markets’ shareholder register includes a number of large institutions known for their activist approach to investment. Others – including many retail investors – may be committed to the trust for the longer term. These investors lose out at the hands of activists exiting the fund with a quick windfall.
Templeton Emerging Markets is not alone in having a conditional tender offer in place as a fall-back plan. The detail of the offer varies from trust to trust, but in each case, investors are potentially exposed to one of the downside characteristics of open-ended fund investment that an investment trust is traditionally meant to negate.
“[This is] a mechanism that may not be appropriate in five years’ time,” adds Elliott. “Over that period, a fund could have seen a change of manager, investment strategy or the opportunity set in the asset class – it is hard to say with any certainty what might be the appropriate course of action at that stage.”
For its part, Templeton Emerging Markets says the tender offer reflects “shareholder feedback” received during a consultation process ahead of a continuation vote scheduled for the trust’s annual general meeting in July. It thinks the outlook for the trust is favourable, in which case the offer may never be triggered.
Nevertheless, its proposals are a reminder that the concept of an investment company as a closed-ended fund isn’t straightforward. And while there may be upsides to having a bit more flexibility, there are potential disadvantages to ponder too.
In reality it has always been misleading to describe investment trusts as entirely closed-ended, with managers expected to run a fixed pool of capital ad infinitum. Investment trust boards can and very regularly do engage in share buyback programmes – of which conditional tender offers are just one variety – that shrink the size of the trust’s share capital. They also have the option of issuing new shares – most commonly through ‘tap’ issues and C share sales – which has the opposite effect.
“Investment trusts are listed closed-ended funds and are therefore not subject to the vagaries of in and outflows as is the case with their open-ended cousins,” adds Elliott. “However, the reality is that a large number do see capital flows both in and out in any given period.”
There is an important difference with the open-ended sector, however. “Investment trusts are, in general, in control of their flows – they are not compelled to issue shares or buy back,” Elliott points out. Even so, when these corporate events do take place, there may be winners and losers.
Take buybacks. The arguments in favour of such programmes are well-established. First, assuming an investment trust buys its shares back at a discount to the current net asset value, net asset value per share will be enhanced for continuing shareholders, because there will be fewer shares in issue offering exposure to the same pool of assets. In addition, buybacks provide demand for the shares, which can help reduce the volatility in the discount at which they trade relative to the underlying assets – and reduce a wide discount. Also, buybacks give investors who want out an opportunity to exit without affecting the demand and supply dynamic.
But what about the downside? Well, one potential problem is increased risk: assuming the fund maintains its gearing levels, this borrowing is now spread across a smaller pool of share capital, amplifying its effects, including in a down period. Another issue is finance: buybacks are generally financed from balance sheet cash, which reduces liquidity; in some cases, asset sales may be required.
C share distractions
It’s a similar story with share issues. The most common type of investment trust new issue is a C share offer, where existing shareholders are specifically protected. Importantly, since the funds raised are held separately to the existing portfolio until they are fully invested, there’s no drag on performance or costs for investors to worry about, and no question of dilution.
On the other hand, an investment trust raising money through C shares has to worry about managing two separate pools of assets, which may be distracting. In certain asset classes, funds may become so large they become unwieldy, with performance suffering as a result. Again, the benefits of expanding the size of an investment trust aren’t always straightforward.
It is important not to exaggerate these arguments. There’s no doubt the structure of an investment trust does have certain advantages . Still, closed-ended funds aren’t completely what they seem. Much of the time, the nuances don’t matter – but there will be occasions when investors should be more concerned.
Share buyback jargon explained
In a share buyback programme, the investment trust’s board buys its own shares on the open market and then cancels them. This reduces the number of shares in issue, supporting demand for the fund and enhancing the net asset value per share for shareholders who stay invested.
Tap issues allow for small increases in the size of an investment trust – typically no more than a 10% expansion – with shares typically issued at a premium without a full-scale sale process. The fund has to seek permission annually to issue stock in this way.
In a conversion or C share issue, an investment trust sells new stock to increase the size of the company. The new shares and the money raised are held separately to the main fund and invested in a portfolio of assets. Once the money is fully invested, the portfolio is merged into the main fund and the C shares are exchanged for ordinary shares.
In a subscription or S share issue, investors are offered new shares that, much like warrants, can be converted into new ordinary shares at a fixed price on a set future date.