Shareholders and Investors may be interested in understanding the impact that issuing Convertible Notes has on a company’s NTA value and other metrics important to investors in LICs. The primary reason is to be able to amortise the expenses over a larger shareholder base, thereby increasing the earnings per share.

Entrusted with additional funds the investment manager has the capacity to make additional and new investments that it may previously have wanted to make but either did not have the funds available, or the parameters (fund rules) did not permit the investment to be made.

An example of this might be a rights issue or new IPO or simply that the investment manager may have that ability and thus more funds to invest into a larger universe.

Larger portfolio size but NTA stays the same

So does that larger investment portfolio increase the Net Tangible Asset (NTA) value also? The answer is no – the NTA is not specifically impacted by additional money as the first instance the dollar amount of new assets is basically offset by the same amount recognised as a debt of the company…assets equalling liabilities. However, should the funds invested from the Convertible Note increase in value and exceed the dollar amount of the Convertible Note then the NTA would see an increase in its overall and per-share value.

One important feature of the Portfolio size being now larger is that potential exists to generate even higher returns for shareholders. While we are told that past performance is no predictor of future performance, it is fair to say that if an investment continually underperformed for the previous 20 years it would give an indication of a manager’s likelihood of outperforming going forward.

Likewise, the corollary of that should be acknowledged that where a manager has continually outperformed since inception then it is reasonable to anticipate that they may continue to deliver similar performance.
As such, giving strongly-performing investment managers more money to invest would be recognised as a responsible strategy.

Consider allocating additional funds to successful investment managers who have a proven track record of outperforming, increasing the likelihood of continued success.

Accounting for interest payments

With regards to the Interest payment made they are an expense to the company. The amount of interest paid reduces the company NTA value when the payment is made or when any accrued amount is calculated and deducted from the declared NTA value.

Impact on Dividends

Once the funds received from the Convertible Note are invested into the market then they are able to generate dividends in addition to potential for capital growth.

That said when any (new) dividends are received they do not affect the NTA because that investment simply went Ex-Dividend usually to the amount of the dividend and the holding value of the portfolio and NTA, therefore, does not change.

However, what we do now have is potential for the portfolio to obtain Franking Credits from those Dividends received on the additional invested capital and to distribute these to the same number of shares and shareholders. It is important to note that a LIC is not like a unit trust and franking credits can be extremely valuable to it.

A Listed Investment Trust must distribute all its realised gains and its income and dividends received. If it has a bad year it may not have anything to distribute to unitholders.

A Listed Investment Company on the other hand distributes a dividend from its NTA. Provided the company is solvent and it has retained earnings it can declare a dividend at any time. It doesn’t matter how the portfolio performed during the period it can still declare whatever dividend it wants.

However, the Franking that it passes through in those dividends payments can only come from franking received in any dividends and its franking reserve. Convertible Notes can enhance the franking a LIC is able to pass through to its shareholders when it declares a dividend and this, in turn, can impact the desirability of the shares and its share price.

When Noteholders convert

Over time Noteholders can convert their holdings into shares in the company. When this happens the liability is extinguished in exchange for equity.

In this instance, while the Company NTA will rise the NTA value per share will generally remain similar because the company is issuing new shares in exchange for the conversion to equity. The company would then stop making interest payments to the Noteholder and – where declared – would be paying dividends instead.

The above summary is general and hopefully serves as a helpful insight into how a convertible note is reflected in the monthly NTA value.
The most important consideration for a LIC Board in determining whether it is suitable to issue a Convertible Note is whether they have confidence that the investment manager will generate a higher return than the interest payments that would be required to be paid to Noteholders. If the performance is greater than the cost of funds then it would positively impact the NTA per share value.