If you are long the common shares of Oxford Lane Capital Corp (NASDAQ:OXLC) you have recently been granted non-transferable rights. Since a rights-offering is bit off the beaten path, there have questions about the purpose of these rights, their precise mechanics, and most importantly, what the proper course of action is. I am going to provide you with some considerations that will help you make an informed decision.
First let's review the facts as outlined in the Company's press release. All common shareholders on 18 January 2013 received a single right for each common share they held. Non-transferable means that there is no secondary market permitted for these rights-either the entity to which they were granted will exercise them, or they will expire unused. The holders of these rights have the option to exercise them no later than 15 February unless that deadline (known as the "subscription period") is extended by the issuer: Oxford Lane Capital Corp. Two rights will allow an investor to buy one common share of OXLC at a price of $14.50.
This may be a bit confusing, but a simple example will provide clarity. Suppose that on 18 Jan you owned 100 shares of OXLC. On that date in your brokerage account appeared 100 rights. You did not ask for them or take any proactive action to get them, they were simply there, granted to you by the company you own. If you did not previously own the common shares you did have an opportunity to get in on this deal, because the news of the upcoming rights offering was announced on 7 January. Now that you have the rights, you also have a decision/option/opportunity: to exercise or not to exercise? If you choose to exercise, then the question becomes when and how much? If you exercise all 100 of your rights, you could buy 50 shares of OXLC (2 rights per share) at $14.50, for a total cost of $725. By doing so you would increase the number of common shares in your position by 50%.
This example helps explain why a company, in this case a closed end fund, implements a rights offering. They are attempting to grow their assets under management. As stated in the press release, 2,522,077 additional shares would be created if all the rights were exercised, which translates to approximately $36.6MM of new cash for investing. If you compare that to the current market capitalization of $77MM, at a price of $15.26, you will see that this is about a 50% increase (as expected). The rights offering is a method of growing the asset base with investors that are currently long and bullish the investment-investors that do not need to be sold on the concept.
That explains the purpose of the rights, but the next question is "how do I use them?" This part is pretty straightforward. Contact your broker and order them to exercise a specific quantity of rights. Don't worry if you don't know the exact jargon of this type of trade: they are experienced and this and understand is not a typical event. They will be able to help you through it. Just be sure that you are clear about the quantity of rights and the corresponding quantity of common shares. For example: "I want to exercise 100 of my rights to purchase 50 shares of OXLC at $14.50." They have what is known as a "subscription certificate," and they will take it from there. Keep in mind that your account will need to have cash available to pay for your subscription at the time you exercise them.
So far this is pretty straightforward, but now is where investors have been a bit short on information. If you choose to exercise your rights, when will the actual shares of OXLC show up in your brokerage account? That information is not listed in the press release, but it is available in the company's filing of Form 497 with the SEC on 7 Jan 2013. According to the Form 497, the "Final Payment for Shares" is 25 February. It is on or about that date that you should expect the shares for which you subscribed to be available in your brokerage account. If they are late in arriving, which I have no reason to expect they would be, you do not have much recourse. I only mention this because I have personally witnessed subscription fulfillment taking longer than anticipated, so you should be aware that this could happen. There were no negative issues the last time OXLC performed a rights offering.
All these dates are important for a very critical reason. I have seen talk of this rights offering as a wonderful arbitrage opportunity. So the logic goes: buy today at $14.50 via the rights, and sell tomorrow on the secondary for a 5.25% profit. That will not work, because the soonest you will have your shares will be 25 Feb, and we have no idea where OXLC will be trading on that date. If you wait until the last minute, there are a full ten days between you committing your cash and when you will have the opportunity to sell the shares. During that period it is entirely possible that OXLC could sell-off on the secondary, e.g. you bought shares for $14.50 on 15 Feb and when they show up in your account the secondary is pricing them below $14.50. It is for that exact reason that this rights offering should not be viewed as an arbitrage opportunity-it is not.
But that drives another question: why don't I just wait and purchase them on the secondary, thereby eliminating the chance that I may pay a premium to market? This is a double-edge gamble. As we know, the trading price on 25 Feb is an unknown. Exercising the rights could as easily score you shares below trading price as above. Perhaps a better measure is to compare the $14.50 to NAV of the fund, which is currently $17.13. The trading price is currently an 11% discount to NAV, and the rights price is 15.3% below NAV. Think about it this way, if you own OXLC right now, and you are not selling, then that is tantamount to saying that you are a buyer at $15.26. That is opportunity cost. Now if it is a good opportunity at $15.26, is not it even a better opportunity at $14.50? This logic applies to a long-term investor versus a trader, but with the volume as low as it is with this issue, there are no traders.
It is also worthwhile to take a look at what happened the last time OXLC performed a rights offering. Last year common shareholders had the rights to subscribe for shares by 27 April 2012 for shares at $13.75. On the day the rights expired the secondary was pricing OXLC almost at par with the rights price at $13.80. Within 3 months the market had bid up the price over 4%, and the fund had issued a 3.96% coupon. Those that exercised their rights were rewarded nearly an 8% return in 3 months. Compare that to SPY which lost -3.8% during the same period, which is partially offset by a 0.51% dividend. There was a -3.3% loss for SPY with a +7.96% gain for OXLC: OXLC relative performance after issuing rights was +11.26% versus SPY. There is reason to believe that sort superior performance will repeat itself, but it should help assuage concerns about a rights-offering depressing market prices.
Despite the opportunity-cost reasoning there will be some investors that will still want to hedge the market risk associated with exercising the rights. For those investors there may be an option. If the shares are available at their broker, they could short an equal amount of OXLC as they are buying with their rights. This will provide a near neutral market position. For every penny that their short position moves, their incoming shares will move a penny in the opposite direction. It is near neutral, since shorting does not come without costs. There is a margin fee associated with shorting. Also, any dividends issued while shorting must be paid. While it does not look like the record date for dividends will occur during the projected period of this tactic, it is possible that management could deviate from their typical schedule or that the shares could arrive later than projected.
There are three final considerations that a rights holder needs to consider. The first is that any new shares issued through this offering will dilute current shareholders' percentage in the fund unless they exercise their rights or buy more on the secondary. Likely that is of no concern to any investor, but it is worth noting. Secondly, if not all rights are exercised by other investors, you are entitled to subscribe for unexercised additional shares. This could be an opportunity to take even a greater stake below NAV.
Finally, and this is the most important consideration, you are at a disadvantage if you exercise your rights any time before the expiration date. Those that exercise early have no priority over those that exercise at the final moment. Everyone will still get the same price: $14.50. This is similar to owning an in-the-money European call option. Anything negative could happen in the next couple of weeks that could push these rights out-of-the-money. Anything positive could push them further in-the-money. If you exercise early you will not get your shares sooner or at a better price, but it will forfeit the option to observe market conditions. Consider 15 Feb your exercise date, thereby minimizing your market uncertainty to 10 days.
DISCLOSURE: Belpointe currently has a long position in OXLC and the aforementioned rights. We may exercise the rights. Material within this article does not constitute investment advice and is meant for educational and discussion purposes only. Past performance does not guarantee future results.