Insight

The closed-end funds H&Q Healthcare Investors (HQH) and H&Q Lift Sciences Investors (HQL) recently announced non-transferable rights offerings to each respective fund. HQH invests in public and private companies in the healthcare industry while HQL invests in public and private companies in the life sciences industry.

Many may have heard the term “rights offering” tossed around without fully understanding its meaning and may simply bypass this opportunity. Though these offerings typically dilute the value of stocks after, these offers, when used strategically, can be a profitable strategy for investors by allowing current shareholders to buy additional shares of a fund at a discount to its current trading price. The number of allotted purchases from the offering is determined by the quantity of shareholders, but investors may purchase additional shares, or “oversubscribe,” if other shareholders choose not to exercise their rights. Although funds conducting rights offerings will typically decrease in value after the offering period ends, investors can make profit by over subscribing and buying the discounted shares below the market value.

The market price of HQH and HQL or any closed-end fund that is conducting a rights offering will likely decrease in value after the ex-rights date because the discount is likely to widen in anticipation of NAV dilution. Unlike mutual funds or hedge funds, closed-end funds are limited to a fixed amount of shares available for direct purchase at the initial public offering. After that period, shares may only be purchased in the market from current shareholders. Additionally, CEFs usually sell at discounts to their net asset value (NAV). The rights offering will dilute existing shareholders as new shares are created and sold at a discount to market price, therefore holding a substantial position in a closed-end fund conducting a rights offering is not recommended. Typically, merely exercising one’s rights will only counteract the effect of the diluted holdings.

However, if managed properly, it is possible for an informed investor to benefit from a rights offering. How? By owning a small amount of the closed-end fund simply to receive the rights, anticipating this initial investment will likely decrease in value. After the initial investment, holders of these rights are given the opportunity to buy additional shares of the closed-end fund at a discount from the actual market price, not net asset value. Opportunity is created by exercising your rights properly and oversubscribing, or agreeing to purchase additional shares which other rights holders failed to exercise. The potential for real value in a rights offering is dependent upon the ability to purchase these additional shares. Once the shares are received, and as long as the CEF remains at the same net asset value, there is an unrealized profit on those additional shares equal to the market price discount.

Investors should exercise their rights and oversubscribe, as these offerings typically only occur within a specified time frame. Afterwards, the discount to market price will no longer be available. In the case of HQH and HQL, the final subscription price of the rights offering will be 95% of the share price in the New York Stock Exchange, effective June 24, 2014 and June 25, 2014, respectively, as well as the three preceding business days following.

Investors seeking to profit from a rights offering should make a small initial purchase on those funds before they trade ex-rights. Though the purchases will most likely decrease in value as the CEF discount widens, the initial purchase will entitle the investor to rights to buy additional shares below the market price (5% in the case of HQH and HQL). During the rights offering period, in addition to exercising the rights on current holdings, holders should oversubscribe, or agree to purchase extra shares that were reserved for shareholders who ignored the offer. Owning additional shares 5% below the actual market price provides an attractive risk-return proposition.