From time to time, investment company shares may trade at significant discounts. When this happens, investment company boards may decide to buy back shares in the investment company in order to cancel them.
This can have two beneficial effects for shareholders:
- It helps to narrow the discount at which the shares trade, because it reduces the supply of the shares while demand remains constant. Demand may even increase if the market views the buy-back in a positive light.
- It increases the fund’s net asset value (NAV) per share. This is because, when shares are bought back, they are bought back at a significant discount. For this reason, the cash used to buy the shares is less than the value returned to shareholders when the shares are cancelled. Mathematically, this must increase the NAV per share.
An investment company may buy its own shares in the open market, in the same way as any other investor. It may also use tender offers, which is common if a large percentage of the investment company’s shares are being repurchased, or provide redemption options to investors.
Cancelling shares versus holding them in treasury
Instead of cancelling the shares it buys back, an investment company may ‘hold them in treasury’. All this means is that the shares can be reissued more easily in future if the discount moves to a premium.
Treasury shares have no rights to capital or income, nor any voting rights. They are not included when an investment company calculates its NAV per share. Generally, buying back shares to hold in treasury has the same effect as buying shares back for cancellation.
Typical discount control policies
A discount control policy may:
- Aim to buy back shares when the discount exceeds a certain level, say 10%, or whenever the board sees fit
- Offer investors regular opportunities to redeem their shares for cash at a set discount (common among VCTs)
- Offer continuation votes at regular intervals: for example, every five years. In these votes, shareholders determine whether the company should continue its life or be wound up and the cash proceeds distributed to shareholders
Discount control policies may become self-fulfilling. If market participants believe that an investment company will buy back shares at a discount of 10%, they may be prepared to buy shares themselves when the discount nears this level. In this way, a discount control policy can be effective with minimal intervention from the investment company.