Essays on Closed-end Funds

Transcription

1 Essays on Closed-end Funds A thesis submitted to The University of Manchester for the degree of Doctor of Philosophy (PhD) in the Faculty of Humanities 2012 Tianna Yang Manchester Business School

2 Table of Contents Abstract... 6 Declaration... 7 Copyright Statement... 8 Dedication... 9 Acknowledgements Chapter Introduction Motivation Research Focus and Contributions Market Reaction to the Expiration of the Required Holding Period: Evidence from Venture Capital Trusts The Effect of Share Repurchase Transactions on the Liquidity of Closed-end Funds Risk-taking Behavior and Pay-Performance Sensitivity: Insights from US Closed-end Funds Organization of Thesis References Chapter Closed-end Fund Industry: Institutional Details Introduction Closed-end Funds vs. Open-end Funds Institutional Framework for Closed-end Funds Overview of the UK and US Closed-end Fund Market The Discounts or Premiums of Closed-end Funds Gearing of Closed-end Funds The Corporate Structure of Closed-end Funds

3 2.4. Institutional Background for Venture Capital Trusts Differences in Repurchase Regulations between the UK and US Institutional Background for Management Compensation of Closed-end Funds Conclusion References Chapter Literature Review Introduction Literature Review relating to VCTs Literature Review relating to Repurchases Literature Review relating to Management Compensation in Financial Industry and Risk Effect on Pay-Performance Sensitivity Compensation Literature on the Financial Industry Literature of Risk Effect on Pay-Performance Sensitivity on non-financial firms Conclusions References Chapter Market Reaction to the Expiration of the Required Holding Period: Evidence from Venture Capital Trusts Introduction Institutional background Development of Hypotheses

4 4.4 Data and Methodology Calculations of abnormal returns and abnormal trading volumes around the expiry date Analysis of the cross-sectional determinants of abnormal returns and abnormal trading volumes Empirical Findings Abnormal returns and abnormal trading volume around the expiry date Results for the Cross-sectional Determinants of Abnormal Returns and Abnormal Trading Volumes around the Expiry Date Conclusion References Chapter The Effect of Open Market Share Repurchase Transactions on the Liquidity of Closed-end Funds Introduction Repurchase Regulations for UK Closed-end Funds Literature Review and Development of Hypotheses Data and Methodology Empirical Findings of the Liquidity Effect An Examination of the Features of the Liquidity Effect Comparison of the Liquidity around Repurchase Transactions The Impact of the Repurchase Frequency on the Liquidity Effect The Impact of a Change in Repurchase Regulations on the Liquidity Effect Conclusions References Chapter

5 Risk-taking Behavior and Pay-Performance Sensitivity: Insights from US Closed-end Funds Introduction Literature Review and Hypotheses Effect of Risk on Fund Pay-Performance Sensitivity The Effect of Pay-Performance Sensitivity on Fund Risk The Endogenous Relationship between Fund Risk and Pay-Performance Sensitivity, and Risk Measurement Data and Methodology Analysis of the Effect of Risk on Fund Pay-Performance Sensitivity Analysis of the Effect of Pay-Performance Sensitivity on Fund Risk Simultaneous Analysis of the Relationship between Fund Pay-Performance Sensitivity and Fund Risk Empirical Findings Descriptive Statistics and Univariate Analysis Empirical Results for the Effect of Risk on Fund Pay-Performance Sensitivity Empirical Results for the Effect of Pay-Performance Sensitivity on Fund Risk Empirical Results for the Simultaneous Analysis on the Relationship between Fund Pay-Performance Sensitivity and Fund Risk Conclusions References Chapter Conclusions Summary of Findings and Suggestions for Future Research References Main Text Word Count: 50,727 5

6 Abstract The University of Manchester Tianna Yang Doctor of Philosophy (PhD) November 2012 Essays on Closed-end Funds This thesis is comprised of three separate empirical chapters on the closed-end fund industry. The first chapter examines the performance and trading volume of UK Venture Capital Trusts (VCTs) focusing on the expiry of the minimum holding period required for investors to gain income tax relief on VCT shares bought at flotation. The second explores the effect of repurchase transactions on the stock liquidity of UK closed-end funds. The third chapter investigates the relationship between pay-performance sensitivity (PPS) and fund risk of US closed-end funds. The first empirical chapter finds negative abnormal returns and permanent increases in trading volumes at and around the expiry of the required holding periods of VCTs. VCTs investing in companies listed on the Alternative Investment Market experience higher abnormal returns and lower abnormal trading volumes than VCTs investing in unquoted companies. VCTs with better asset performance during the required holding period have lower abnormal returns and higher abnormal trading volumes. Income tax relief becomes more generous (increases from 20 to 40 percent) and holding periods shorter (from five to three years) over the sample period. The more generous (to the investors) the income tax relief, the higher the abnormal returns and the lower the abnormal trading volumes. The second empirical chapter reports that repurchase transactions improve the stock liquidity of closed-end funds suggesting that funds act as competing market makers. However, the positive liquidity effect of repurchase transactions is short-lived and positively affected by the frequency of repurchase transactions. The positive effect seems to have been increased by the change in repurchase regulations on 1 st December 2003 that allowed funds to re-issue repurchased shares and appears to have increased the ability of funds to manage their stock liquidity. The third empirical chapter finds that fund risk has a positive impact on fund PPS, suggesting that shareholders need to provide greater compensation incentives to managers of riskier firms to reduce the adverse selection problem. PPS has a positive effect on fund risk, which suggests that, in the closed-end fund industry, the increase in the value of the fund manager s wealth due to a higher PPS outweighs the negative effect of increased pay volatility on the manager s expected utility. 6

7 Declaration I Tianna Yang declare that no portion of the work referred to in the thesis has been submitted in support of an application for another degree or qualification of this or any other university or other institute of learning. 7

8 Copyright Statement i. The author of this thesis (including any appendices and/or schedules to this thesis) owns any copyright in it (the Copyright ) and s/he has given The University of Manchester the right to use such Copyright for any administrative, promotional, educational and/or teaching purposes. ii. Copies of this thesis, either in full or in extracts, may be made only in accordance with the regulations of the John Rylands University Library of Manchester. Details of these regulations may be obtained from the Librarian. This page must form part of any such copies made. iii. The ownership of any patents, designs, trademarks and any and all other intellectual property rights except for the Copyright (the Intellectual Property Rights ) and any reproductions of copyright works, for example graphs and tables ( Reproductions ), which may be described in this thesis, may not be owned by the author and may be owned by third parties. Such Intellectual Property Rights and Reproductions cannot and must not be made available for use without the prior written permission of the owner(s) of the relevant Intellectual Property Rights and/or Reproductions. iv. Further information on the conditions under which disclosure, publication and exploitation of this thesis, the Copyright and any Intellectual Property Rights and/or Reproductions described in it may take place is available from the Head of School of Manchester Business School (or the Vice-President) and the Dean of the Faculty of Humanities. 8

9 Dedication I dedicate this thesis to my wonderful mother Junying Li and father Junbo Yang. 9

10 Acknowledgements I would like to express sincere gratitude and appreciation to my supervisors, Dr. Susanne Espenlaub and Dr. Arif Khurshed, for their constant inspiration, guidance and support. Their individual qualities, enthusiasm and invaluable advice provided me with the direction and motivation necessary to complete this thesis, particularly in difficult times. I would like to extend my thanks to the other members of the internal PhD committees at which I presented my research for their comments at various stages in the progress of this thesis. Working paper versions of chapter 4 and 5 have been presented at several international conferences. I would like to acknowledge my gratitude to the organizers and participants at the following conferences for the opportunity to present the results of the work, and for the constructive feedback received: British Accounting Association Annual Conference in 2008; Mini Finance Conference at Manchester Business School in 2010; 23 rd Australasian Banking and Finance Conference (Australia) in 2010; European Financial Management Symposium on Alternative Investments (Canada) in 2011; London School of Economics Alternative Investments Research Conference in 2011; Financial Management Association European Conference in Finally, I would like to thank all my friends and my family for the continuous support they have shown me throughout this PhD program. 10

11 Chapter 1 Introduction 1.1 Motivation Closed-end funds are collective investment schemes, investing the money raised from fund investors into diversified portfolios which include the shares of both quoted and unquoted companies. Closed-end funds are listed on the major stock exchanges around the world and considered an important class of financial instruments. However, there is to date little research on many aspects of closed-end funds besides the relationship between a fund s net asset value (NAV) and its share price which is typically at a discount to NAV per share (this is known as the discount puzzle; see e.g. Gemmill and Thomas 2002; Berk and Stanton 2007). This thesis aims to contribute to our understanding of three different aspects of closed-end funds. In the first empirical chapter (Chapter 4), I examine a particular category of UK closed-end funds known as venture capital trusts (VCTs) that were designed to fill the financing gap faced by small and medium enterprises in the UK and provide certain tax incentives to investors who buy VCT shares on flotation and hold them for a minimum period. This thesis examines the performance of VCT shares focusing on the abnormal returns and trading volume around the expiry of the required 11

12 holding period due to conditional income tax relief. The second empirical chapter (Chapter 5) explores the effect of repurchase transactions by closed-end funds on their stock liquidity. The third empirical chapter (Chapter 6) examines the relationship between fund risk and the performance-sensitivity of fund management compensation specified in the management contract. The venture capital trust (VCT) program was a practical policy response to a perceived market failure to provide sufficient amounts of risk capital to smaller and younger UK companies with high growth potential. The program was introduced through the UK 1995 Finance Act and encourages individual UK investors to invest in young, unquoted enterprises indirectly, through a managed fund structure, by providing substantial tax benefits. VCTs are considered to be a special type of closed-end fund. Of all the tax benefits to VCT investors, the most substantial is the income tax relief granted to investors who buy newly-issued shares at the time of the initial public offering (IPO) of a VCT and hold these shares for a minimum required holding period. This income tax relief is not available to investors who buy VCT shares in the post-ipo secondary market. As a consequence, little trading activity is expected within the required holding period of a VCT. Therefore, the conditional income tax relief may lock-in VCT shares on the secondary market during the required holding period. Shares sold prior to the expiry date of this required holding period forego the income tax relief. The expiration of the required holding period is an important event because it is likely to have a significant impact on the price and 12

13 trading activity of VCT shares. Abnormal returns and trading volume around expiry may convey private information about VCTs, such as the quality of their corporate governance and the confidence of the shareholders about the underlying investments. Chapter 4 of this thesis fills a gap in the literature by exploring the determinants of the abnormal returns and trading volume of VCT shares around the expiration of the required holding period. Chapter 5 examines the effect of repurchase transactions by closed-end funds on their stock liquidity. Closed-end funds are public funds that incur substantial listing costs to ensure that their shares can be traded on the secondary market among existing shareholders and new investors. While there is an established body of research on the repurchases in non-financial companies, there is to date no study mainly focusing on the actual repurchase transactions of closed-end funds, as opposed to the announcements by funds that they intend to conduct a repurchase program ( repurchase intention announcements ). Share liquidity is important because it is positively related with the market value of shares and shareholder wealth (see Amihud and Mendelson 1986; O'Hara 2003). Cherkes, Sagi and Stanton (2009) highlight the importance of liquidity in closed-end funds, and argue that closed-end funds exist to provide diversification and liquidity to small investors. Compared to conventional firms, closed-end funds are simpler and more transparent, and it is therefore easier to analyze the effects of repurchases in funds than in conventional firms (see An, Gemmill and Thomas 2012). The effect of repurchase transactions on 13

14 the stock liquidity of closed-end funds is clearly of interest. Incentive compensation in terms of performance-related pay is generally considered the best way of alleviating the agency problem caused by delegated management rights. The management compensation of a closed-end fund is specified in the management contract, and disclosed to investors, as a single fixed percentage of the underlying NAV, or as a schedule of percentages of NAV that vary depending on the size of the NAV. The closed-end fund industry provides a useful experimental environment to examine the relation between firm (i.e., fund) risk and the sensitivity of fund managers pay to performance. To measure a fund s pay-performance sensitivity (PPS), I use the applicable marginal compensation rate in the management contract. I argue that this is a more accurate measure of PPS than either that estimated in the existing literature for conventional firms or the marginal rates used for open-ended mutual funds. To my best knowledge, Chapter 6 is the first study to examine whether and how a closed-end fund s PPS and its risk-taking behavior determine one another. The absence of previous studies on this aspect of closed-end funds is surprising, especially given the ability to measure closed-end funds PPS directly from the data in the management contracts, and given the obvious importance of fund manager s investment risk-taking decisions for fund value and shareholder wealth. In conclusion, the three main empirical chapters of this thesis focus on a range of 14

15 previously unexplored research questions relating to closed-end funds. To facilitate the analyses, I extract relevant information on closed-end funds, including repurchase transactions and management compensation, from the Factiva database, the Investegate website, Morningstar s fund database and the Association of Investment Companies (AIC). The research focus and contributions of each of the three empirical chapters are elaborated in greater detail in the following section. 1.2 Research Focus and Contributions The research presented in this thesis focuses on three different issues related to the closed-end fund industry: (i) the market reaction to the expiry of the required holding period of a UK VCT and the determinants of the reactions, (ii) the effect of repurchase transactions on the liquidity of UK closed-end funds and (iii) the relationship between fund risk-taking behavior and fund PPS for US closed-end funds. The content and the contribution of the three empirical chapters are outlined below. 15

16 Market Reaction to the Expiration of the Required Holding Period: Evidence from Venture Capital Trusts The first empirical chapter focuses on the effects of the expiration of the required holding period on the secondary market for UK VCTs. The research question addressed in this chapter is: what is the information content of market reactions (price and trading volume patterns) around the expiration of the VCT required holding period? The detailed institutional background of VCTs is outlined in Chapter 4. Essentially, there is a high rate of income tax relief on the purchase of newly-issued VCT shares, subject to a long, required holding period. Moreover, this tax relief is not available to investors from the secondary market. As a result, existing shareholders will only sell their shares at a higher price that includes the value of their income tax relief, while investors from the secondary market will be reluctant to purchase shares at such a high price. Thus, as discussed in Holland and Jackson (2011), the trading volume of the VCT secondary market within the required holding period is extremely low, and newly-issued VCT shares seem to be locked-in during the required holding period. Therefore, the expiration of the required holding period is an important event because it is likely to have a significant impact on the price and trading activity of VCT shares. The abnormal returns and trading volume on expiry may convey private information about VCTs, and may depend on fund characteristics such as fund 16

17 managers ability and objectives, the quality of the fund s corporate governance, the true value of the underlying assets and the confidence of the shareholders about the underlying investments. Using the event study method, in Chapter 4 I examine cumulative average abnormal returns and average abnormal trading volumes over five different time windows covering 41 trading days around the expiration date of the VCT required holding period. The cumulative average abnormal returns and average abnormal trading volumes are calculated for both the whole VCT sample and for different subsamples. I examine the subsamples to explore the (univariate) determinants of the market reactions (abnormal return and volume) to the expiration of the required holding period. I explore the impact of the fund s investment policy, open-market repurchasing and investment performance during the required holding period, and the impact of the tax regime (considering three successive regimes with varying rules on income tax relief over my sample period). Finally, using ordinary least squares regressions, I examine the (multiple) determinants of cross-sectional variations in the abnormal returns and abnormal trading volumes around the expiry date. The cumulative average abnormal returns are statistically negative, and the trading volumes are permanently increased at and around the expiry of the VCT required holding period. This finding challenges the efficient market hypothesis (EMH) but is consistent with downward-sloping demand curves and costly arbitrage. I find that 17

18 VCTs investing in companies listed on the Alternative Investment Market have higher abnormal returns and lower abnormal trading volumes than VCTs that invest in the shares of unquoted companies. A fund s open-market repurchasing during the required holding period has no significant effect on either the abnormal returns or the abnormal trading volumes at expiry. The higher is the fund s investment performance during the required holding period, the lower the abnormal returns and the larger the abnormal trading volume at expiry. Tax relief to VCT investors varies during the course of my sample period becoming successively more generous in terms of a rising percentage of income tax relief and a reduction in the minimum holding period. Under the Type 2 tax regime (requiring a three-year holding for 20% income tax relief) VCTs have higher abnormal returns and lower abnormal trading volumes than in the prior Type 1 regime (requiring a five-year holding for 20% income tax relief). However, VCTs in the Type 2 regime have lower abnormal returns and higher abnormal trading volumes than those in the later Type 3 regime (requiring a three-year holding for 40% income tax relief). Consistent with the hypothesis that the abnormal return is caused by downward-sloping demand curves, I find that the abnormal return is more negative when trading volume is abnormally high. Chapter 4 fills the gap in our knowledge regarding the tax-induced lock-in effect in VCTs and the determinants of the market reaction around the expiration of the required holding period. It contributes to our understanding of tax-advantaged investment schemes and the literature studying the lock-in effect. The findings 18

19 summarized above are the original contributions of this chapter. My research on VCTs may provide lessons for other comparable schemes around the world, such as the Canadian Labor-sponsored venture capital corporations The Effect of Share Repurchase Transactions on the Liquidity of Closed-end Funds The second empirical chapter (Chapter 5) investigates the effect of repurchase transactions on the liquidity of UK closed-end funds. As will be discussed in Chapter 5, I use UK data (as opposed to US data) for two main reasons. First, the UK has a large, diversified and actively-traded closed-end fund industry in the world, with the longest history (see Levis and Thomas 1995). Second, and most importantly, UK closed-end funds are required to disclose the details of every repurchase transaction within one day. By contrast, there is no timely disclosure of repurchase transactions in the US. Research on UK funds repurchase transactions can take advantage of complete and reliable repurchase data. I study on 117 UK closed-end funds that went public on the London Stock Exchange during April 1998 to May Out of 117 funds, 76 make at least one repurchase transaction in the sample period. For these 76 repurchasing funds, I manually collect 3,221 repurchase execution announcements starting from each 19

20 fund s respective IPO date until the end of year I classify these 3,221 repurchase fund-days into a repurchasing subsample and control a non-repurchasing subsample of fund-days without repurchase transactions. 1 I compare the differences in fund spread and trading volume between the two subsamples and find that average trading volume is higher and average spread is lower in the repurchasing subsample. Next, I use a series of univariate and multivariate analyses to test my hypotheses on the liquidity effect. I also conduct two-stage least square (2SLS) regressions to address the endogeneity problem that can occur in OLS specifications. My findings show that repurchase transactions have a significantly negative effect on fund spread and a significantly positive impact on fund trading volume. This confirms the prediction by Barclay and Smith (1988) that funds act as competing market makers in an effort to manage their stock liquidity. These results do not alter after using an alternate definition of the non-repurchase subsample following the method of Ginglinger and Hamon (2007). Furthermore, I examine several conjectures of An et al. (2012) to investigate the nature of the positive liquidity effect of repurchase transactions. I find that the positive liquidity effect of repurchase transactions is short-lived and is affected by 1 I use two different methods to define the non-repurchasing subsample. The first method follows Brockman and Chung (2001) and defines it as five trading days before and five trading days after a given repurchase transaction. The second method follows Ginglinger and Hamon (2007) and defines it as all non-repurchase days in the entire sample period from a fund s IPO to the end of 2009 for the 76 repurchasing closed-end funds. For further details see Sections 5.4 and 5.5 in Chapter 5. 20

21 the frequency of repurchase transactions. This confirms the argument of An et al. that the liquidity effect of repurchases will not last, unless repurchases are repeated over a long time. An et al. also argue that the liquidity effect is more likely in an environment where funds can re-issue repurchased shares. It implies that the change in the UK regulation repurchases allowing UK companies and funds to hold shares repurchased after 1 st December 2003 as treasury shares which can be re-issued may have an impact on the liquidity effect. Colson (2002) implies that selling treasury shares from repurchases can help UK funds to add liquidity. Dhanani and Roberts (2009) suggest that the regulation change in 2003 has improved the ability of UK funds to continue influencing liquidity after repurchases by re-selling treasury shares as part of their management of demand and supply for their shares. I find that the liquidity effect is indeed increased after the regulation change. The analysis conducted in Chapter 5 not only contributes to the literature on open-market repurchase activity, but also provides insights into the benefits of repurchase transactions on stock liquidity that are of interest to market participants, policy makers and academics. 21

22 Risk-taking Behavior and Pay-Performance Sensitivity: Insights from US Closed-end Funds The third empirical chapter of this dissertation focuses on incentive compensation in closed-end funds and examines whether and how the pay-performance sensitivity (PPS) specified in the management contract of a fund and the risk-taking behavior by the fund management determine one another. In this chapter, I investigate a comprehensive sample of 2,351 fund-year observations for US closed-end funds traded on the New York Stock Exchange, the American Stock Exchange and the NASDAQ Stock Exchange at any time between 2006 and As discussed in detail in Chapter 6, the compensation paid to the fund manager of a closed-end fund is explicitly specified in the management contract which is renewed each year at the annual general meeting. The applicable marginal compensation rate defined in the management contract is the most appropriate proxy of the fund manager s PPS for a closed-end fund (see Coles, Suay and Woodbury 2000; Deli 2002). A fund s investment risk is measured by its NAV return volatility. I control for a series of variables relating to fund characteristics in my regression analysis. The analysis is divided into three parts. First, I examine how the fund return volatility affects fund PPS using OLS regression. As Hausman tests show that the fund return volatility is endogenously determined, I use 2SLS regression. I find that fund return volatility has a significantly positive effect on fund PPS. Second, I 22

23 investigate how the fund PPS affects fund risk, using OLS regression. Again I use 2SLS regression to account for the endogeneity issues of fund PPS (as indicated by Hausman endogeneity tests). I find that fund PPS has a positive impact on fund return volatility. Since an endogenous relationship between fund PPS and fund risk was found in the first two parts of the analysis, the final part of my analysis uses simultaneous equation models to examine how the two variables are jointly determined. Consistent with the first two parts of the analysis, I find them to be positively influenced by each other. Previous literature on conventional firms typically estimates PPS using linear regressions that contain potential biases. Taking advantage of the transparent and accurate PPS information in management contracts for closed-end funds, this is the first study focusing on how the fund risk-taking behavior and fund PPS are interrelated. This study contributes to the literature on management incentives, decisions on risk-taking behavior and on corporate governance in general. The positive effect of fund risk on fund PPS supports the predictions of the managerial ownership model in Demsetz and Lehn (1985) but is contrary to the implications of the standard principal-agent model in Holmstrom and Milgrom (1987). Fund risk-taking behavior is positively affected by fund PPS, which indicates that, of the two managerial incentives due to higher PPS, the increase in the value of the closed-end fund manager s compensation outweighs the negative effect on her expected utility caused by increased volatility in compensation. 23

24 1.3 Organization of Thesis This thesis is structured around three essays containing original researches in Chapters 4, 5, and 6. The chapters are self-contained as separate and complete papers i.e., each chapter has a separate introduction, original research question, literature review and hypotheses, distinct analysis with different datasets, discussion of empirical analysis, conclusion and reference list. The equations are independent and are numbered from the beginning of each chapter. But footnotes, tables, figures, page numbers, titles, and subtitles have a sequential order throughout the thesis. The remainder of the thesis is structured as follows. Chapter 2 demonstrates the institutional framework for the whole closed-end fund industry and gives background for each of the three empirical chapters. A review of literature relevant to three empirical chapters is outlined in Chapter 3. Chapter 4 elaborates the first empirical chapter, which investigates the information content of market reactions to the expiration of the required holding period for VCTs. The second empirical paper, which investigates the effect of repurchase transactions on the stock liquidity of UK closed-end funds, is presented in Chapter 5. Chapter 6 contains the third empirical paper, which explores the relationship between risk-taking behavior and the fund PPS for the US closed-end funds. Chapter 7 provides a brief conclusion of the major findings of the thesis and also highlights future research. 24

25 References Amihud, Y. and H. Mendelson (1986). "Asset pricing and the bid ask spread". Journal of Financial Economics 17: An, J., G. Gemmill and D.C. Thomas (2012). "The Agency Effect of Repurchases on Closed-End Funds". European Financial Management 18: Barclay, M. J. and C. W. Smith (1988). "Corporate payout policy. Cash dividends versus open-market repurchases". Journal of Financial Economics 22: Berk, J. B. and R. Stanton (2007). "Managerial Ability, Compensation, and the Closed-End Fund Discount". The Journal of Finance 62(2): Brockman, P. and D. Y. Chung (2001). "Managerial timing and corporate liquidity: evidence from actual share repurchases". Journal of Financial Economics 61: Cherkes, M., J. Sagi and R. Stanton (2009). "A Liquidity-Based Theory of Closed-End Funds". Review of Financial Studies 22: Coles, J. L., J. Suay and D. Woodbury (2000). "Fund Advisor Compensation in Closed-End Funds". The Journal of Finance 55(3): Colson, S. (2002). "Secondary Liquidity in the Investment Trust Sector". Association of Investment Trust Companies, London: Dhanani, A. and R. Roberts (2009). Corporate Share Repurchases: The Perceptions and Practices of UK Financial Managers and Corporate Investors. Edinburgh, The Institute of Chartered Accountants of Scotland. Deli, D. N. (2002). "Mutual Fund Advisory Contracts: An Empirical Investigation". The Journal of Finance 57(1): Demsetz, H. and K. Lehn (1985). "The Structure of Corporate Ownership: Causes and Consequences". The Journal of Political Economy 93(6): Gemmill, G. and D. C. Thomas (2002). "Noise Trading, Costly Arbitrage, and Asset Prices: Evidence from Closed-end Funds". The Journal of Finance 57(6): Ginglinger, E. and J. Hamon (2007). "Actual share repurchases, timing and liquidity". Journal of Banking & Finance 31: Holland, K. and R. H. G. Jackson (2011). "Taxation influences upon the Market in Venture Captial Trust Stocks: Theory and Practice". Accounting and Business Research 41(1): Holmstrom, B. and P. Milgrom (1987). "Aggregation and Linearity in the Provision of Intertemporal Incentives". Econometrica 55: Levis, M. and D. C. Thomas (1995). Investment trust IPOs: Issuing behavior and price performance Evidence from the London Stock Exchange. Journal of Banking & Finance 19(8): O'Hara, M. (2003). "Presidential address: liquidity and price discovery". Journal of Finance 58:

26 Chapter 2 Closed-end Fund Industry: Institutional Details 2.1 Introduction The empirical studies presented in Chapters 4, 5 and 6 of this thesis focus on the closed-end fund industry. This chapter provides an overview of the institutional framework of the closed-end fund industry and argues the importance of closed-end funds as an asset class that has been under-researched to date. To provide a clear understanding of the closed-end structure, I compare the definition, trading procedure and pricing features of closed-end funds with those of open-end funds. In view of the fact that this thesis focuses entirely on the former, more emphasis is placed on the special characteristics of the closed-end fund industry, including an overview of the UK and US closed-end fund market, the relationship between market and fundamental values of closed-end funds (in terms of the discount or premium of share price to net asset value), the gearing structure and the corporate structure. For the first empirical chapter on venture capital trusts in the UK, I describe the changes during my sample period in the income tax relief available to investors in VCT initial public offerings (IPOs) and the minimum holding period 26

27 required for such tax relief. In addition, I present the distribution of VCT IPOs over time and by sector, as categorized by the Association of Investment Companies (AIC). Next, I compare the repurchase regulations in the UK and US. Finally, I provide a description of the typical management contracts of US closed-end funds. The remainder of this chapter is organized as follows: section 2.2 compares closed-end funds with open-end funds. The institutional framework of the closed-end fund industry is described in section 2.3. Sections 2.4, 2.5 and 2.6 analyze the institutional background in relation to the VCT, repurchase and compensation empirical chapters, respectively. Section 2.7 provides concluding remarks. 2.2 Closed-end Funds vs. Open-end Funds Closed-end funds sell a fixed number of shares through initial public offerings (IPOs), and the number of outstanding shares does not change unless there is a capital reorganization through a share repurchase or an issue of C share 2. In other words, the shares of closed-end funds are traded among existing shareholders and new investors on the secondary market. In contrast, open-end funds have to 2 AIC (2010) suggests that a C share issue is the preferred alternative for investment companies to the conventional rights issue. A rights issue is an offer made by a quoted company to its shareholders to enable them to buy new shares in the company at a discount to the market price. Unlike a rights issue, a C share issue ensures that existing shareholders do not suffer any dilution. 27

28 continually create new units to meet demand and redeem shares from shareholders who want to sell. So, open-end funds trade shares directly, between the shareholders and the fund, and the fund capital varies over the life of the fund. The trading of shares in closed-end funds does not affect their underlying investment portfolios. By contrast, open-end funds may be forced to sell underlying securities to redeem shares when fund shareholders want to sell their shares. Consequently, open-end funds may find it difficult to invest in securities of unquoted firms whose liquidity is difficult to be realized in the short term. The Association of Investment Companies (AIC 2010) indicates that faced with a wave of sell orders and needing to raise money for redemptions, the manager of an open-end fund may be forced to sell securities he would rather keep and keep securities he would rather sell. Consequently, the underlying portfolio of an open-end fund may end up being too heavily weighted towards lower-quality shares. In contrast, a closed-end fund can avoid this, meeting supply and demand for shares automatically through the market, without any change in the underlying investments. Since a closed-end fund is a listed company, it must obey listing rules such as filing annual reports and holding annual general meetings with shareholders. As a result, shareholders can easily engage in shareholder activism, such as protesting against poor fund management. This implies that the corporate governance of a closed-end 28

29 fund is more transparent for an open-end fund than for a closed-end fund. The shares of a closed-end fund can be traded whenever required throughout the trading day, while an open-end fund can trade its shares only at the end of a trading day. Finally, closed-end and open-end funds differ in terms of the determinants of market values of the funds and the resulting gap between the net asset value and the market value of a fund. Net asset value (NAV) is defined as the value of the fund s assets deducting all debts of the fund. NAV per share is total NAV divided by the number of shares in the fund. The share price of a closed-end fund is determined not only by the value of the investment portfolio but also by the supply and demand for fund shares in the secondary market. Generally, closed-end funds trade at a discount to their NAV; funds that trade at a premium are rare. In comparison, investors in an open-end fund trade shares directly with the fund itself, so the share price equals the NAV per share (possibly including charges for the sale and redemption of shares) and there is no discount (or premium). Open-end funds are available in most developed countries, though terminology and operating rules vary. Closed-end funds are formally known as closed-end companies in the US and investment trusts in the UK. US mutual funds, UK unit trusts and open-ended investment companies (OEICs), European investment companies with variable capital (SICAVs), and hedge funds are all examples of open-end funds. 29

30 2.3. Institutional Framework for Closed-end Funds Closed-end funds are structured as public companies, so they have to obey the relevant company laws, listing rules and tax regimes of the countries in which they are domiciled. As discussed above, one of the significant advantages of the closed-ended structure for investment companies is that investors trading shares have no effect on the underlying investment portfolio. The greater long-term certainty that a fixed capital base provides can allow closed-end funds to maintain lower cash balances and to hold more illiquid assets, such as smaller companies or illiquid securities. However, one disadvantage of the closed-ended structure is that the fund share dealings are always subject to the availability of matched buyers and sellers, and shares are sometimes tightly held and/or thinly traded. In the following subsections, I discuss the overview of the UK and US closed-end fund market, discounts or premiums of closed-end funds, gearing and corporate structure of closed-end funds respectively Overview of the UK and US Closed-end Fund Market Most of the closed-end funds globally, more than 70 percent, were established in the UK or the US. UK closed-end funds can be categorized into conventional funds, split capital funds and VCTs. Conventional funds issue only one class of ordinary share, 30

31 while split capital funds have more than one class of share capital, offering different rights to income and capital. VCTs were introduced under the 1995 Finance Act to help provide finance to the sector of small unquoted companies in the UK, from individual UK investors. VCTs have a similar corporate structure to conventional funds but with substantial additional tax benefits. In contrast, US closed-end funds comprise two types: equity funds and bond funds. Equity funds invest principally in stocks, while bond funds invest in bonds and other debt securities. Also, both equity funds and bond funds can be divided geographically, into domestic funds and international funds. Domestic funds mainly invest in the local market that is the country in which the fund is domiciled, while international funds spread their investments abroad. I study VCTs in the UK for empirical chapter 4, closed-end funds in the UK for empirical chapter 5 and closed-end funds in the US for empirical chapter 6. At the end of June 2010, Morningstar s fund database provides data on 1,252 UK-domiciled and 696 US-domiciled closed-end funds that had been listed on the major stock exchanges around the world (including both dead and active funds), raising around $211 billion and $200 billion, respectively. More specifically, of 1,252 UK funds, 236 are domestic conventional funds, 345 are domestic split funds, 315 are international conventional funds, 132 are international split funds and 224 are VCTs, raising approximately $37 billion, $53 billion, $96 billion, $20 billion and $5 billion at IPO, respectively. The 696 US closed-end funds include 225 equity funds 31

32 (with market capitalization of $65 billion) and 471 bond funds ($135 billion). Of the 225 equity funds, 113 are domestic ($32 billion) and 112 international ($33 billion), while among the bond funds there are 429 domestic ($123 billion) and 42 international funds ($12 billion). The distribution of the UK and US closed-end fund markets is shown in Table 2.1. [Insert Table 2.1 about here] The Discounts or Premiums of Closed-end Funds The shares of a closed-end fund may be traded at a discount to the underlying NAV, which is a well-known feature of the closed-end fund industry. According to the AIC (2010), the discount is the difference between the NAV per share and the share price, as a percentage of the NAV per share. The discount puzzle has raised intense debate in the academic literature and there is still no generally accepted explanation for it (see e.g., Gemmill and Thomas 2002; Berk and Stanton 2007). Widening discounts are generally considered to be bad for existing shareholders. A number of techniques aimed at reducing supply and/or increasing demand for the fund s shares can be considered by the fund s board of directors as a way of reducing or controlling discount levels: share repurchases, selling treasury shares and a change 32

33 of manager or investment policy Gearing of Closed-end Funds Closed-end funds are able to engage in gearing. There are three types of gearing: financial, structural and investment. Financial gearing is the process of borrowing money for investment purposes in the expectation that the returns on the investment purchased using the money borrowed will exceed the cost of borrowing. Some commonly-used financial gearing methods include bank loans, long-term debentures and floating rate notes. Structural gearing is where gearing is provided through the capital structure, as is the case with split capital closed-end funds. The gearing effect arises from the predetermined entitlements and order of priority of the payment of dividends. Investment gearing is where a closed-end fund invests in other investments which are themselves geared, for instance, shares in geared closed-end funds or in certain share classes of closed-end funds that are structurally geared. Gearing can magnify a closed-end fund s NAV performance. Closed-end fund gearing is carried out so as to generate a greater level of return from investments than the cost of financing the debt. The higher the level of gearing, the higher the potential returns. Gearing is calculated as the ratio of total assets (value of all the assets in the fund including debts) to net assets (total assets deducting the debts), or the difference 33

34 between total assets and net assets as a percentage of the net assets of the fund. Increasing gearing can help to reduce the costs per share and is also a strategy used by fund managers to increase their management fees, which are charged on gross assets. Gearing levels can be increased by borrowing more money, repurchasing ordinary shares, issuing a new class of shares (i.e. structured gearing) or investing in geared investments. Conversely, repaying debentures, selling treasury shares and selling geared investments can be used to decrease the gearing level The Corporate Structure of Closed-end Funds The boards of most closed-end funds delegate the day-to-day management and administration to one or more external investment management companies. There should be a formal investment management contract or agreement between the board and the investment management company, which would typically include items such as a list of delegated functions, reporting requirements, the basis for calculating the management fee and any performance fee, and the notice period required to be given by each party in the event that either the board or the management company decides to terminate the relationship. The board has a responsibility to represent and protect the interests of the 34

35 shareholders as a whole. Generally, the boards of conventional firms comprise both executive and non-executive directors. In comparison, closed-end funds (with the exception of self-managed ones) do not fit the standard model of corporate structure; their boards are entirely comprised of non-executive directors. Some directors of closed-end funds consider their role to be purely supervisory, while other directors view their function as providing leadership and strategic direction, and have greater involvement in both the business and the investment strategies. Due to the unique structure of the closed-end fund, a significant part of the board s work involves dealing with third-party service providers, in particular with the investment manager, on tasks such as reviewing the contractual arrangements with the manager so as to align his/her interests with those of the shareholders. Unlike in conventional firms, the customers and the shareholders are the same people in closed-end funds. This simplifies the board s role with respect to its different stakeholders but at the same time increases the importance of the board s relationship with its shareholders Institutional Background for Venture Capital Trusts VCTs are a class of special UK closed-end funds, providing a series of tax exemptions to individual shareholders. VCTs were introduced by the legislation of the UK Finance Act in April 1995, and were designed to mitigate the financing gap for young entrepreneurial firms, by encouraging wealthy individuals to invest 35

36 indirectly in small, unquoted firms. The substantial tax relief on VCTs includes a high rate of income tax relief for individual investors when they purchase VCT shares through an IPO subject to a required holding period, while dividends and capital gains on the disposal of VCT shares are both free of tax. This prominent characteristic of VCTs differentiates them from other standard closed-end funds and may create a lock-in effect on VCT shares issued by an IPO. The income tax relief is only available on subscriptions of VCT shares through an IPO and not on purchases from existing shareholders through the secondary market. Additionally, if investors sell the new shares within the required holding period, they have to repay the tax relief from the sales. For VCTs that did an IPO between the 6 th of April 1995 and the 5 th of April 2000, investors were given a 20 percent income tax relief on their investments in these IPOs on the condition that the investors held their investments for a period of 5 years. For the VCT IPOs that came to the market from the 6 th of April 2000 to the 5 th of April 2006, the minimum required holding period was reduced from 5 to 3 years. This holding period was again increased to 5 years from the 6 th of April The income tax relief rate increased from 20 to 40 percent for VCTs launched between the 6 th of April 2004 and the 5 th of April Since the 6 th of April 2006, VCT IPO investors qualify for a 30 percent income tax relief if they hold their investments for a minimum period of 5 years. 36

37 By the end of June 2010, 224 VCTs (including both active and dead VCTs) had been listed on the Main Market of the London Stock Exchange, raising approximately 3 billion. Table 2.2 displays the distribution of VCT IPOs by AIC sector over the periods of varying income tax regime. The AIC divides VCTs into sectors according to their investment policy. AIM VCTs are VCTs investing in a range of qualifying companies that are listed, or about to be listed, on the UK lower-tier stock market, the Alternative Investment Market (AIM), or on any other exchange where the securities are treated as unquoted. Generalist VCTs always invest in a range of qualifying investments in different sectors. By contrast, specialist VCTs invest in certain specific sectors; examples include media, leisure & events VCTs, environmental VCTs (with investments in environmental and alternative energy companies), healthcare & biotechnology VCTs and technology VCTs. [Insert Table 2.2 about here] Out of the total of 224 VCTs, generalist VCTs account for the largest proportion (50 percent), specialist VCTs investing in technology firms and AIM VCTs each make up almost 18 percent, while only two of the VCTs invest in healthcare & biotechnology companies. In the period , there are 39 VCT IPOs, in which 18 VCTs invest in technology firms, 15 VCTs belong to the Generalist sector and only 6 VCTs belong 37