March 1, 2017
Authored by: Matthew D'Amico
It’s clear to anyone paying attention that the market for initial public offerings of closed‑end funds has fallen off dramatically over the last few years. Undoubtedly, the primary cause of this fall off has been the gaping average trading discount of existing closed‑end funds (i.e., on average these funds have been trading at steep discounts to net asset values). That made it difficult, if not a practical impossibility, for asset managers to sell shares of a new closed-end fund when investors could simply purchase shares of a similar, existing closed-end fund at a significant discount.
Also contributing somewhat to this fall off has been the relative increase in the cost of leverage as a result of the phasing in of new capital rules for banks. Many closed-end funds employ leverage to deliver additional returns to investors; these increased costs (which correspondingly reduce returns to investors) have made it incrementally more difficult for asset managers looking to launch new closed-end funds to make their case to investors.
On top of all of this, according to many industry observers the so-called “fiduciary rule” (finalized on April 6, 2016) would make it nearly impossible for financial advisors to recommend to investors that they purchase shares of a closed‑end fund at the IPO stage. The key problem for closed-end fund IPOs under the fiduciary rule is not necessarily inherent; it arises out of the fact that, at times, while many closed-end funds trade at a premium at and shortly after the initial offering, thereafter they begin to trade at a discount. This can have the effect of creating at best a short-term paper loss, and at worst a short-term actual loss, for investors.
But within the last three months a lot has changed. The Trump administration has indicated that it may not support parts of the new capital rules for banks; it is considering a loosening of capital standards to encourage more lending which the administration believes would result in a boost to the economy’s rate of expansion. Such a loosening should help bring the cost of leverage down helping to increase returns to investors. And the new administration and Congress have both taken steps to delay and/or abandon the fiduciary rule. While all that is generally good news for asset managers looking to sell new funds to investors, even with the loosening of capital standards and a complete abandonment of the fiduciary rule, as long as existing closed-end funds are trading at significant discounts to net asset value it will be challenging at best to market them effectively. However, recent reports by both Barron’s and Hilliard Lyons indicate that average discounts of closed-end funds have narrowed significantly since November, and are now approaching levels not seen in several years. One asset manager I spoke with is readying several potential offerings that had been mothballed.
My Take: We are likely to see a significant uptick in the IPOs of closed-end funds, perhaps not to prior levels, but certainly above current levels. And if average discounts continue to narrow, the market could make a resurgence. That would be welcome news to both asset managers marketing funds and to the banks that look to provide leverage to these funds.