In what has been reported as a market first, the independent directors and shareholders of an open-end fund (mutual fund) agreed to convert an approximately $1 billion open-end fund to an exchange-listed, closed-end fund.
While open-end funds issue shares continuously, closed-end funds typically raise money through issuing a fixed amount of shares in an initial public offering. In a more common type of conversion, closed-end fund shareholders pressure the fund (for example, if its share price is trading at a substantial discount to its asset value) to convert to an open-end fund to increase the net asset value (NAV) of its shares and reduce the market discount to NAV.
The impetus for this transaction was the uncertainty surrounding a 2015 court case currently on appeal. The lower court decision ordered a large financial institution to pay $287.5 million (minus attorney fees) to the fund for certain allegations—a large gain for the fund (approximately 30 percent). However, since the appeals process has not yet been exhausted, the fund may not include the payment in the fund’s calculation of its NAV since the payment is still contingent. As a result, speculative investors could buy shares of the fund, in anticipation of the fund’s receipt of payment, diluting existing shareholders realization of gains from the proceeds. In addition, significant inflows between the time of a final judgment confirming the payment order and the time the fund actually collects the money could create a potential liquidity mismatch.
By converting the fund to a closed-end fund, open-end sales of the shares of the fund were immediately stopped, preventing shareholder dilution in the event the judgment is upheld. Instead of issuing additional, dilutive shares on purchase demand, which is what an open-end fund would be required to do, the closed-end fund’s price per share would simply rise with more demand. Moreover, the liquidity mismatch could be managed better since closed-end funds do not have the same redemption requirements as open-end funds.
The facts underlying the decision to convert the fund, and the underlying lawsuit itself, are unusual, but not altogether impossible to repeat. This transaction creates another tool for funds to better protect shareholder interests.