Virtus Total Return Fund's Tender Offer: An Opportunity For Small Investors?

| About: Virtus Total (ZF)

Summary

Virtus Total Return Fund is offering shareholders a tender offer to exchange shares of DCA for cash in the amount of DCA's Net Asset Value.

If the exchange happened today, tendered shares would make a premium of over 5%.

Small investors particularly should consider buying DCA, either now or later, and participating in the tender offer.

Virtus Total Return Fund ("Virtus,") (NYSE:DCA) recently registered a tender offer in which shareholders can exchange their DCA for a cash payment in the amount of 99% of Virtus' Net Asset Value per share (NAV). It aims to repurchase 40% of its 27.5 million shares outstanding. Right now, its NAV is at 4.86, and DCA trades at 4.57-a 6.28% premium. I believe this could be a good opportunity for a small investor to buy and tender shares of DCA.

What is Virtus, and what is NAV?

Virtus is an asset manager of a single close ended fund and its NAV is simply its assets minus its liabilities. In other words, NAV is the value of its portfolio, which has consistently trailed its market capitalization. Daily NAV updates can be found on Virtus' website in the link provided at the end of the article.

Why is Virtus giving shareholders a 6% premium on this exchange?

Virtus lists three reasons - to give shareholders liquidity, to move its stock price towards its NAV, and to stop Bulldog Investors from taking over the company. If the third sounds like the biggest reason, that's because it probably is -DCA is relatively liquid, with tens or hundreds of thousands of shares traded each day. Last year, investment firm Bulldog Investors was about to take over the company and liquidate its holdings, due to the consistent gap between NAV and market capitalization.

The reason for this gap, in my view, is probably the risk involved - people don't want to own a $4/share stock, because of the volatility that comes with changes in NAV. Instead of forcing them to liquidate their portfolio, though, Bulldog agreed to let Virtus retain control if they bought back 40% of their stock at NAV, in a bid to achieve Bulldog's goal of pushing the stock price toward parity with NAV.

The wrinkle

Another company under the Virtus umbrella (although a separate legal entity), The Zweig Fund (NYSE:ZF) is in negotiations to acquire Virtus . A shareholder vote is scheduled for March, and it seems likely that Bulldog and other major shareholders plan to use this tender offer to drive up the stock price and therefore get a better deal from The Zweig Fund. In my opinion, Virtus is willing to pay a premium in order to gain control of more shares and drive up their price prior to the possible merger.

What are the risks?

There are three main risks - the price of DCA could go down, the NAV could go down, and the offer could be oversubscribed. In my opinion, the first is the least. If the price of DCA goes down, then the premium paid in the tender offer goes up, and more people will buy and tender DCA. Furthermore, you don't have to take this risk if you don't want to - you can just wait until the last day of the tender offer before deciding whether or not to buy DCA.

This mitigates the second risk as well - if you wait to see what the ratio is, there's no uncertainty over what the price of DCA and its NAV are. However, by waiting you take out some of the upside. If you buy now, there is a risk of the NAV decreasing, as Virtus will have to sell some of its portfolio in order to raise the cash needed to buy back $400-500 million worth of stock (as of its 10-K filing, it had just over 200 million in cash).

This risk, though stressed in detail in the offer letter, seems relatively low - Virtus trades mostly liquid equities and fixed income securities, and so would have to sell off a huge block of the same security to impact its market price, and thereby Virtus' NAV. But assuming the NAV:Price premium stays around current or historical levels, it will pay a 4-12% premium.

The third risk is of proration - if the offer is oversubscribed, you won't be able to tender all your shares. As a relatively experienced tender offer investor, I usually avoid proration - it exposes you to uncomfortable downside risk. But in this case, there just isn't that much opportunity to oversubscribe the offer because such a large percentage of the company is available to be tendered.

It's hard to imagine substantially more than 40% of all shareholders, especially the board members party to merger negotiations, tendering their shares. Further, the downside of oversubscribing by a little isn't that high; the point of the buyback is to raise the market price anyway, so there's a good chance you'll be able to sell your untendered shares for a good price.

Please note the other possible risks and benefits - I have provided a link to the full prospectus for anyone interested.

Past results

One factor that makes me think the downside risks I mention are relatively small is the very similar buybacks performed by other Virtus companies (like ZF). Recently, ZF ended up exchanging cash for shares at a premium of about 8% - a fund with almost all the same risks, upsides, as well as similarities in management. More on this can be found on their EDGAR page.

Why small investors and not big money managers?

The stock is just too small for a hedge fund or institution to deal with. If a hedge fund wanted to drop millions on shares of DCA, it would significantly increase its stock price, and wouldn't be able to acquire those shares early. This means it would take on millions in volatile investments while holding such a low-price stock. Further, it wouldn't be able to wait and see what the final premium of NAV to market price will be. It's a trade suited to those of us with thousands to invest, not millions.

Conclusions and what to do

There are two possible plays that I see. One, wait and see the final exchange ratio (which I think will be reasonably favorable), and buy in and tender shares at the last minute. This is the low-risk, lower-reward option. Two, buy now, and wait for the stock price to go up as others buy DCA and push the NAV:stock price ratio toward parity. This also gives you the option to tender the shares if it ends up being a good ratio at the end. The danger is it opens you up to a bit more risk - chiefly, the NAV going down when Virtus liquidates some of its portfolio. I see good rationale for both options, and which you choose should come down to risk tolerance.

The tender offer expires on March 15.

Offer letter to shareholders (prospectus)

Where to track daily NAV

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DCA over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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