CRE Skeptic's  Instablog

Closed-end funds pay distributions from three sources:  Investment income, realized gains, and from the fund’s paid-in capital. GUT has paid a 6c per month distribution for many years. In the first half of 2009, GUT funded 90% of this dividend by returning paid-in capital to shareholders, 10% from investment income, and zero came from realized gains.  Why was this?  Well, there were no realized gains to be distributed! 

H1 2009 was, perhaps, a tough period for stocks, but this pattern is not new.  In 2007, for instance, utilities rallied by 19%, but only 68% of GUT’s distribution could be funded from income and realized gains.  The balance came from raiding the fund’s paid-in capital.

The long-run problem for the shareholders, and for Gabelli Funds, LLC (the investment adviser), is that paying out GUT’s capital in monthly distributions dissipates the assets of the fund.  In GUT’s case, the NAV per share has fallen, fitfully, over the decade since the fund was spun off, even though the utilities index has risen:

                

On November 20^th, 2009, GUT’s board authorized the fund's investment adviser to “explore the benefits to shareholders of a rights offering”. However, the current arithmetic makes it hard for shareholders to benefit.  As mentioned in Eqcome’s January 17th article, GUT is trading at a premium to NAV of more than 70%, among the highest in the closed-end funds universe.  Even though rights issues are invariably sold at a discount to the market price (and GUT’s three rights offerings in 2002, 2003, and 2004 sold shares at an average discount of 22%), the current stock price implies that the new rights would be offered at a huge premium to the fund’s NAV. The fund would be selling new shares for far more than their share of the value of the fund’s assets. 

However, selling new shares at a premium to NAV has one, optical, benefit to the fund: It raises the net assets of the fund by more than it increases the share count, thereby increasing the NAV per share.  Two of GUT’s three prior rights issues were sold at premiums, and the 2003 annual report shows the impact (in “Financial Highlights”):

Who does this increase in the NAV really benefit?  The shareholders?  Not really – after all, they are paying for it.  But maintaining the NAV is essential if the manager is going to be paid its management fee and keep the fund in operation.  Therefore, in the absence of strong realized gains or a sustainable distribution policy, the manager has a strong incentive to “top up” the NAV from time to time, even if it means taking money from shareholders today, at a premium, to later put it back in the pockets of future shareholders at par. 

This is a movie that we may have already seen in the financial markets.  Unfortunately, it’s a movie that always ends badly …

The debate about General Growth Properties’ (GGWPQ.PK) equity value had focused on the prospects for its NOI and the cap. rate at which the company should be valued.

However, if you are purchasing shares (rather than buying the company outright) the critical factor may be the number of shares outstanding after the bankruptcy plan is confirmed. Citigroup (C) may still have an equity market capitalization of $83bn, as it did in July 2008, but five-fold dilution means that’s no comfort to anyone who bought Citi’s shares at that time. 

Writers seem confused about the potential impact for dilution on GGP.  To sample just one, Whitney Tilson wrote on December 30^th:

“Hovde doesn’t appear to understand bankruptcy law and what will likely happen to the unsecured debt. There is almost no chance that it will remain outstanding: it will either be refinanced or, more likely, be converted into equity …. But here’s the key: it will NOT BE DILUTIVE because it will convert AT FAIR VALUE, as determined by the bankruptcy judge. Of course, if the judge determines that fair value is $1/share, then it would be massively dilutive, but that’s not going to happen. The judge has a great deal of discretion in determining fair value, but will certainly take into consideration the current stock price, comps and the price of any equity offering(s) GGP might do.”

By this reasoning, no corporate finance transaction would be accretive or dilutive, since the assets or liabilities changing hands are presumably traded at fair value.  However, accretion and dilution are caused by the impact of a transaction on the company’s earnings versus its share count, which has nothing to do with fair value.

Pershing Square make a more subtle error, expecting dilution when it’s helpful and ignoring it when inconvenient.  In their “A Detailed Response to Hovde’s Short Thesis” on December 22^nd, Pershing Square conclude that GGP’s interest coverage will be adequate by “Assum[ing] unsecured debt converts to equity in bankruptcy for illustrative purposes” (page 10, footnote 2). Pershing Square later makes exactly the same assumption in showing that the Debt / LTM Cash NOI ratio is little higher than Simon Property’s (page 26, footnote 2).  However, just one page later, they get to the punchline:  GGP’s equity value is between $24.20 and $42.56 per share - but the share count they use is 319.6 million shares, almost the same as the 312.3 mm share count at Q3 2009.  The only way this can happen is if there is no conversion of unsecured debt to equity!

How can GGP emerge from bankruptcy with a credible financing structure?  GGP can’t touch most of the 74% of its Q3 2009 debt that is secured, since GGP’s agreement with its secured creditors reinstates the secured debt, at the existing principal amounts and coupon rates, but with an extension of the debt maturities.  But Pershing Square’s powerpoint deck points out that GGP must lower leverage and improve interest cover to approach a sustainable capital structure.  And now it has only the 26% of unsecured debt to negotiate with to craft the solution. Much of the Rouse Company unsecured debt is in the hands of a few large holders, who will resist ferociously any capital structure proposal that does not give them fair value for their debt.

Any conceivable Chapter 11 exit plan for GGP will greatly dilute the current shareholders. While the emerging company can probably support some unsecured debt, the rest must be eliminated, most likely by buying it out (with new capital) or by exchanging it for a substantial proportion of the common shares: the market value of the unsecured debt is around $6.5bn, whereas the market value of the equity is currently around $4.1bn.  One way or another, 319 million shares is not going to be the share count on the day GGP emerges from bankruptcy.

For example, assume that GGP undertakes an equity offering to repay the $6.5bn of debt at par plus accrued (let’s say 106%).  The equity offering will need to price at a discount to current market price to attract investors (just refer to recent BAC or C equity offerings).  To pick a number, let’s say the new shares are priced at $10 per share.  The resulting dilution would be nearly two-thirds (i.e., GGP would issue nearly 2x the currently outstanding shares).

In that case, where would GGP stock trade?