Subscription shares: who exactly do they benefit?

The investment trust sector has seen many different trends over the years, and one of the more obvious of recent years was the significant issuance of subscription shares from 2008 to 2010. Subscription shares, like warrants, give the holder the right but not the obligation, to convert into ordinary shares at a fixed conversion price in the future. The key difference is that subscription shares can be held within an ISA.

There are a several reasons for issuing subscription shares, but the key benefit is it gives a fund the possibility of growing its assets, regardless of whether its shares are trading at a premium. Besides the obvious benefit to the managers of a greater pool of assets on which to charge fees, boards have espoused benefits of increased liquidity, and lower total expense ratios (TERs) as a result of the larger asset base.

Most investment trusts trade at a discount to net asset value (NAV) and to issue shares at a discount to NAV would be dilutive to existing shareholders. As a result, most closed-ended funds have struggled to grow their assets through issuance.

Subscription shares issued in recent years had maturity dates ranging from one year to five or six, some with stepped exercise prices. We estimate £160 million was raised in 2010 as a result of conversion of subscription shares into ordinary shares. This included £25 million for Utilico Emerging Markets and £23 million for JPM Asian .

The potential for further fund raising in the next few years is considerable. If all outstanding subscription shares were to be exercised at their highest exercise prices, we estimate that over £1 billion of new capital would be raised. We accept it is unlikely that all subscription shares will be exercised, and that all with stepped subscription prices will convert at their highest prices. However, based on the number that are already in the money, further issuance is likely to be significant in 2011 and 2012.

The issue with subscription shares is that once they are in the money, they become dilutive to the fund’s NAV per ordinary share. For subscription shares well in the money, the dilution can be significant. For shareholders who own both ordinary and subscription shares this is not a problem, as the dilution on the ordinary shares will be made up through the subscription shares.

However, investors who bought only the ordinary shares since the subscription share issue will have been diluted. Industry practice is to consider funds in this situation on the basis of the diluted NAV, so current discounts are considered on the basis of a diluted NAV. What is less clear is whether future potential dilution has been taken into account.  

In addition to the future effect on ordinary share classes, subscription shares are separately tradable securities in their own right. While liquidity can be patchy and spreads wide, they can provide geared exposure to a fund’s underlying portfolio.

Given the inefficiency of the subscription share market, this can provide some interesting opportunities. At present, the short-dated and highly geared subscription shares on Eastern European Trust*, and the longer dated subscription shares on JPMorgan Chinese * which expire in 2013, look attractive on a Black-Scholes valuation basis. But investors should note subscription shares are highly geared instruments, and if they expire out of the money, will be rendered worthless.

Subscription shares have broadly been a success, raising significant new capital for the sector. However they are not without their downside, not least the potential dilution to potential new investors in ordinary shares.