The below text is licensed to Covestor Ltd. (“Covestor”), by Dan Plettner. Such text may be disseminated only by Covestor. Dan Plettner invests and receives income for securities research, including “buy-side” research. Dan licenses his own real time trading data to Covestor Ltd. (“Covestor”). Covestor is a Registered Investment Advisor that uses Dan Plettner’s data to create the Core, Long Short Opportunistic, Tax Advantaged Income, and Taxable Income models for its clients. Dan’s words should not be misconstrued as investment advice.
Dan Plettner is short CAF in his Covestor Long Short Opportunistic model.
September 15, 2010: I recently shorted Morgan Stanley China A Share Fund (CAF) which trades near parity with its Net Asset Value (“NAV”). CAF issued transferable rights to its stockholders of record August 18th, which enable the issuance of 5,440,904 shares at a price as low as 90% of NAV. The offering will expire on September 14, unless extended. Such rights have arbitrage value and are likely to be exercised even by those shareholders intending to sell their existing positions. Not exercising the rights, at minimum against a similarly sized sale, would presently appear to constitute an economic waste. And, the offering would likely be unaffected anyway because of an Over-Subscription Priviledge.
The problem is that new issuance of Closed-End Fund shares at a discount to NAV has a factual and adverse effect on per share NAV. The financial effect on NAV from the offering is not limited to the valuation gap, which may be as large as 10% of NAV for each newly issued shares. Such may be the most significant cost which adversely affects NAV, but there are also distribution costs. The offering’s “Distribution Arrangements”, are disclosed in the August 12, 2010 prospectus titled: MORGAN STANLEY CHINA A SHARE FUND, INC:
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. (https://www.sec.gov/Archives/edgar/data/1368493/000110465910045062/a10-13409_1497.htm, August 12, 2010).
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”.
The offering’s “Distribution Arrangements”, are disclosed in the 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. (https://www.sec.gov/Archives/edgar/data/1368493/000110465910045062/a10-13409_1497.htm, August 12, 2010)
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, if I that Closed-End Fund appears 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. (https://www.sec.gov/Archives/edgar/data/1368493/000110465910045062/a10-13409_1497.htm, August 12, 2010)
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 a CAF capital infusion below NAV can serve. I have my opinion, but my opinion means nothing. “Mr. Market” will demonstrate his opinion over time and I will surely be observing. 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.
