Turning on the tap

This month’s successful £80m ‘tap issue’ by Woodford Patient Capital Investment Trust made the headlines – that’s no surprise given the high profile of the investment company, which is managed by the widely followed Neil Woodford. But Patient Capital is not the only closed-end fund to have raised funds in this way of late – a string of investment companies have also chosen to conduct tap issues over the past six months or so.

These funds include P2P Global Investments, New City High Yield, Ruffer, Premier Energy & Water and Starwood Real Estate, all of which have managed successful tap issues during 2015. But despite the increasing popularity of this fund-raising mechanism, many financial advisers may not be familiar with the basics of a tap issue.

In practice, closed-end funds run tap issues for a variety of reasons. They may feel that the fund would benefit from economies of scale: sharing fixed costs across a bigger pool of assets under management. They may have identified interesting investment opportunities that require fresh capital. Or they may believe that becoming larger would increase their appeal to investors, particularly large institutions, which often refuse to consider small investment companies for liquidity reasons.

Recently, however, another factor has started to eclipse these in importance. As investment company discounts have narrowed to record levels, several popular companies have started to trade at premiums. Sometimes this is because of a well known manager at the helm (as with Patient Capital of course). But more commonly, it’s in sectors with an income focus. For example, Property Direct – UK and Infrastructure and are trading at average premiums of 6 and 9 per cent respectively.

At one level, trading at a premium makes tap issues easier for investment companies. They can issue shares at a small premium to net asset value that allows them to cover the costs of the issue, so that existing shareholders don’t bear those expenses (companies must, of course, gain shareholder approval to do tap issues). But the new shares are still attractive to prospective investors, because they are cheaper than those available to buy in the open market.

But the premium may itself be a driver for the tap issue. Boards may feel that very high premiums are unsustainable, and may cause unnecessary volatility for shareholders if they suddenly reduce or move to discounts. To mitigate this risk, they may issue shares with the express intention of bringing down the premium. This kind of ‘premium control’ is the polar opposite of the much more familiar ‘discount control mechanism’, where investment companies buy back their own shares to cancel them in an attempt to narrow discounts.

Tap issues are not the only way boards can create new shares in an investment company. There’s also the C-share issue, typically much larger than a tap, where a new pool of shares is created. This avoids a situation where existing shareholders have to suffer the impact of a large quantity of cash suddenly being injected into the company, diluting a portfolio of assets that may have been carefully built up over time. But it’s also more of a palaver, with the necessity of issuing a prospectus and so on. In comparison, tap issues are quick, cheap and particularly suitable for smaller and more frequent injections of capital.

Corporate actions such as tap issues, C-share issues and buy-backs are entirely at the discretion of the board. Investment company directors aren’t under any imperative to use such tactics – though some funds have formal triggers that require them to take action if discounts or premiums hit a certain level – but in recent years they have proved increasingly willing to do so.

It is likely there will be more tap issues in the months and years ahead, as managers respond to prevailing market conditions – just as share buy-backs and other corporate actions have become more common. Advisers should welcome them all as evidence of the investment company sector’s determination to manage valuations and liquidity carefully.