Love them or hate them, we should all accept the self interest of investment banks, and China. Once fleeting access to China A-shares is no longer so. Van Eck Market Vector China A Shares ETF (PEK) was the bankers latest product launched on the back of a what is assumed to be a valuable privilege. Qualified Foreign Institutional Investors are presumed fortunate to be able to buy China A shares. Would my sarcasm be too evident if I exclaimed: “what a fortunate privilege!”.
Chinese investors have always been able to own A-shares and the Chinese culture stands to benefit from capital flowing into China. Who is the real beneficiary of purportedly privileged access? Beyond Chinese Culture, and Chinese investors, it’s our domestic Investment Bankers who are selling the purported privilege. The problem assuming a privilege is valuable is that it fails to consider which demand is intrinsic, and which demand is buying the perception of scarcity. In the 80s and 90s kids assumed baseball cards would be valuable collectables because cards surviving their fathers’ generation had been truly scarce. But the baseball card companies, much like today’s investment bankers, maximized profits by marketing into that assumption and the bubble popped when the scarcity value that everybody assumed was actually proven absent.
Sadly, some investors are less market savvy than teenage collectors. Lack of rationality was exhibited in PEKs debut. Sure, it was goofy. Still an ETF’s theoretical ability to adjust to capital flows could be a less hazardous alternative than a Closed-End Fund willing to bonfire shareholder wealth to pay bankers.
Morgan Stanley China A Share Fund (CAF) attempts to justify its existence on the back of the same perceived investing privilege. Recently CAF issued transferable rights to its stockholders of record August 18th, which enabled the issuance of 5,440,904 shares at a price as low as 90% of NAV. Transactions that issue shares below NAV are factually destructive of per share NAV, even before bankers get their fee. When a fund sells $1 for 90 cents, it loses 10 cents plus the bankers take each time. If a fund sells $1 for 90 cents less a 2% commission paid to a banker, it loses 12 cents each time. In such situations, whether any particular shareholder chooses to take part in the bankers’ payday or not, they share the cost burden equally as shareholders.
CAF’s offering’s “Distribution Arrangements”, are disclosed in its prospectus:
Morgan Stanley & Co. Incorporated will act as Dealer Manager for the Offer. Under the terms and subject to the conditions contained in a Dealer Manager Agreement between the Fund and the Dealer Manager, the Dealer Manager will provide financial structuring, marketing and soliciting services in connection with the Offer and will solicit the exercise of Rights and participation in the over-subscription privilege by Record Date Stockholders. The Offer is not contingent upon any number of Rights being exercised. The Fund has agreed to pay the Dealer Manager a fee for its financial structuring, marketing and soliciting services equal to 3.50% of the Subscription Price per Share for each Share issued pursuant to the exercise of Rights and the Over-Subscription Privilege. The Dealer Manager will reallow to broker-dealers included in the selling group, if any, formed and managed by the Dealer Manager selling fees equal to 2.50% of the Subscription Price per Share for each Share issued pursuant to the Offer as a result of their selling efforts. In addition, the Dealer Manager will reallow to other broker-dealers that have executed and delivered a soliciting dealer agreement and have solicited the exercise of rights solicitation fees equal to 0.50% of the Subscription Price per Share for each Share issued pursuant to the exercise of Rights as a result of their soliciting efforts, subject to a maximum fee based on the number of Shares held by each broker-dealer through DTC on the Record Date. The Fund has also agreed to reimburse the Dealer Manager up to an aggregate of $100,000 for a portion of its reasonable out-of-pocket expenses incurred in connection with the Offer. These fees and expenses of the Offer, including the dealer manager fee and reimbursable expenses, will be borne by all of the Fund's stockholders, including those stockholders who do not exercise their Rights. The Fund and its investment advisers have agreed to indemnify the Dealer Manager or contribute to losses arising out of certain liabilities, including liabilities under the Securities Act of 1933, as amended (the "1933 Act"). The Dealer Manager will benefit from this Offer as a result of this fee arrangement. See "Distribution Arrangements."
Prior to the expiration of the Offer, the Dealer Manager and its affiliates may independently offer for sale Shares, including Shares acquired through purchasing and exercising the Rights, at prices it sets. Although the Dealer Manager may realize gains and losses in connection with such purchases and sales, such offering of Shares is intended by the Dealer Manager to facilitate the Offer. The Dealer Manager's fee for its financial structuring, marketing and soliciting services is independent of any gains or losses that may be realized by the Dealer Manager through the purchase and exercise of Rights.
An issuance has an effect on the Advisor. Assets under management (“AUM”) increase, which may be of interest to the Advisor who is compensated for managing Assets. Based on assumptions provided in “Certain Effects of the Offer”, from the prospectus, “the Adviser would receive additional management fees of $2,017,832 for the twelve months following the completion of the Offer and would continue to receive additional management fees as a result of the Offer”.
Speaking generally, I often observe that the market price of a Closed-End Fund relative to its NAV may reflect concern in the marketplace as to the Closed-End Fund’s purpose. I would never contemplate buying a long term position in a Closed-End Fund at a price near NAV, should that Closed-End Fund appear subject to governance decisions that favor the Advisor.
In fairness, CAF’s Board would argue that the rights offering is intended to serve shareholders. The prospectus language states the following under “Purpose of the Offer”:
The Board of the Fund has determined that it is in the best interests of the Fund and its stockholders to increase the assets of the Fund available for investment so that the Fund will be in a better position to take advantage of investment opportunities. Without an infusion of additional capital, the Fund is limited in its ability to take advantage of new investment opportunities.
I put everything I read through a filter. Over time, I expect that the market price of CAF relative to its NAV will reflect whose interest capital infusions below NAV serves. I have my opinion, but my opinion means nothing. “Mr. Market” will demonstrate his opinion over time and I will surely be observing. I don’t own PEK, but might consider it to hedge a short in CAF. I love Closed End Funds and my long positions are far more substantial in size than my short positions. I believe that details are very important in the Closed-End Fund marketplace, and that lack of appreciation for the nuances creates market inefficiencies.
Some will observe that the direct cost of any rights offering is absorbed, then passes. Such is factually accurate and making such a statement is a free privilege. The broader issue is the business model in my view. CAF already had a prior pattern of rights offerings, and I believe they recently demonstrated the pattern would be unaffected by what were per share NAV destructive circumstances.
Disclosure: My short position in CAF along with my other portfolio and trading activities are licensed as data to Covestor Ltd. (“Covestor”). Covestor is a Registered Investment Advisor that uses my trading data in effort to replicate my actions for its retail investing clients. This short position in CAF is among portfolio data licensed to Covestor's Long Short Opportunistic model. Inquiries relating to Covestor, or originating from Covestor clients and prospective clients must be directed to Covestor Client Services at (877) 873-8830.