Reaves Utility Income Fund (UTG) – Mean Reversion – 5% upside

Current Price – $31.5

Expected Payout – $33.4

Upside – 5%

Expiration Date – 4th of October 2017

UTG is closed-end fund investing in utility sector. The fund issued transferable rights to subscribe to new common shares. For every three rights held, a holder of rights may buy one new common share of the Fund at 5% discount to 5 day average closing prices preceding the expiration date (October 4th). This created an arbitrage play whereby the buyers/holders of rights were shorting UTG common stock to lock in the arbitrage profits (although this was never a sure thing, as arbitrage profits are dependent on the average trading price over the last 5 days). With a number of articles posted on SA the trade likely became quite popular and caused downward pressure on the UTG share price, which declined from $35 to $31 over the last couple of weeks.

The situation is well covered on Seeking Alpha and I direct you to articles by Left Banker (herehere and here) for further details on it. I have a slightly different trade on this – not the arbitrage with the rights, but rather expectation of NAV discount mean reversion.

 

Discount to NAV widens

In Aug 2017 (before rights distribution) discount to NAV was close to zero, and 52 week average discount stands at only 2% (check historical discounts here).

CEF Connect chart

Now the discount is at 9% – a clear outlier as can be seen in the graph. Part of the widening discount can be explained by expected NAV dilution due to new shares being issued at a discount to NAV. However, assuming the extreme scenario where 100% of rights get exercised (2015 offering only 53% were exercised) and where market price discount to NAV prevails at current levels through expiration, NAV declines by only 3.5% (calculated this using 33% increase in the number of shares at 14% discount to NAV). The remaining 5.5% widening of the discount was likely driven by the selling pressure from arbitrageurs.

 

Mean Reversion

There do not seem to be any reasons to suggest that this wide discount should persist and I would expect share price to revert close to new NAV (which will be 1%-3.5% lower than the existing NAV due to dilution). Similar rights offerings have already been done in 2012 and 2015. Both saw the exact same mean reversion that I am expecting for the current one (more detailed analysis of previous offerings here).

Thus by buying UTG now and assuming NAV remains unchanged, I stand to gain up to 5%.

Another option would be to buy rights and exercise them to acquire newly issued shares of UTG. However, taking into account the cost of rights, the additional gain using this method is only $0.5/share, but leaves one exposed to uncertainty regarding the exercise price.

 

Risks

- Exposure to NAV – although UTG NAV has remained relatively stable over the last year (in the range of $32-$35/ per share), any wider fluctuations might completely eliminate any gain and even cause losses. On the positive side, UTG invests in dividend yielding utilities, thus wide NAV fluctuations are quite unlikely, especially for short term trade.

- Mean reversion might not happen – I was very wrong about this in my trade on QQQX. However, this time the widening of the discount has been clearly driven by selling pressure resulting from the corporate action – and this pressure will be eliminated once the rights expire.

- Current case might be different than 2012 and 2015 rights issues - current rights offering seems to have gained far more popularity this time (at least judging by SA coverage) than the previous ones. Not yet sure whether this is a positive or a negative, but the situation might end up differently than before.

18 COMMENTS

  1. Makarid

    We can find a similar-like ETF and short selling it in order to hegde the exposure to NAV.Thanks for this idea!

  2. greg lia

    I have been trading the rights actively and done very well although sold at lower levels than where we are today. NAV dilution would be greater than the 3.5 percent calculation you mentioned if the company takes advantage of its 25% over allotment option would it not? (and deal is fully subscribed)

    1. dt

      If I understand this over-allotment correctly, then company would be using it only if demand for newly issued shares would be above the initial allocation. As I indicated above in 2015 rights offering only 53% of the rights were exercised, so I do not believe that it will be fully subscribed in this case. However, if it is and company fully utilized the additional 25% over allotment, then NAV would drop by 4.4% (instead of 3.5%) due to dilution – still far from explaining the current discount.

  3. Doug Mohn

    A couple thoughts…

    If I were a closed-end fund manager, I would sell the complete over allotment as increasing AUM would increase my paycheck. (I would note, this is also why I don’t usually buy closed end funds). That they didn’t sell them in the past seems more like poor salesmanship to me than market efficiency, so I expect max dilution. Along with max dilution, some of the new buyers are arbs who will be quick sellers, so I expect the discount to take a month or two to revert.

    The ability to buy at 95% of the market as opposed to 95% of the NAV drives a very interesting cycle where a lower stock prices increases the value of the rights. Perversely the more the stock drops the more valuable become the rights to buy them.

    I have low expectations for a large gain on this one, but barring a quick rise in interest rates, I don’t see much loss potential either, so I bought a small position in the common this morning mostly to see how this plays out and learn more about closed end behaviors. If I can net 2% in two months, that’s significantly better than my cash account pays.

  4. over2u

    Why do you prefer to buy UTG share rather than rights without hedging? If I understand it correctly UTG rights will give you additional potential ~1-2% gain to 9% NAV discount.

    1. dt

      At the time of writing the article it was still not clear what the exercise price for the rights will be and therefore additional 1% gain did not seem worth this risk. If the price of UTG had increased in the meantime (which did not happen), then the exercise price of rights would have been higher and the pay-off lower.

      Now the exercise price should be set – 5 day average closing prices average of preceding the 4th of Oct. My calculations indicate it should be $31.5 *0.95 = $29.92. Thus by buying the rights one effectively purchases UTG at $30.97 vs. current market price of $31.51. If the rights are still trade-able and exercisable today and today is also the expiration date (press release is quite vague regarding the final cut-off date), then now it is obviously better to acquire UTG through rights.

      I am trying to confirm the exact situation with IB and will post if I hear something back.

      1. dt

        Just got clarification from IB, that rights are still exercisable today, but submission must be made before 11am New York time (might be different for other brokers).

        Thus those acquiring the rights will effectively be buying UTG at $31 – an incremental 1.7% upside.

  5. greg lia

    33 percent more float. (Assumes full subscription but not overallotmnet issuance) 33 percent new issuance will represent 25% of fund. 25% percent times 14 percent discount to NAV equals equals 3.5 percent dilution

  6. greg lia

    Fidelity cut off for submitting rights was yesterday but will accept today on a best effort basis. Will be interesting to follow the rights today. One would think possibly some upward pressure now that pricing is known and arb opportunity more certain. Although you are still at market risk until you receive your shares. On the other hand if many are concerned they won’t be able to submit the rights because cut off is ended could perhaps dampen demand. I have been in and out of the rights twice exiting again yesterday morning. I’m now watching closely for the company’s announcement on Subscription percentage and possible overallottment. If undersubscribed I will look to buy aggressively as the discount to NAV could settle in at possibly the 7 to 8 range, As opposed to possibly around 5% discount to NAV if company were to issue full over allotment

  7. dt

    Company announced that it will issue the up to 25% of additional shares to those who exercised the rights and indicated that they want to participate in over subscription. I take is a s sign that majority of the rights will be exercised and then including the additionally issued shares total NAV dilution will be around 4%.

    http://www.businesswire.com/news/home/20171005006370/en/Reaves-Utility-Income-Fund-Announces-Rights-Offering%E2%80%99s

    Final results of the rights offering will be announced on the 12th of Oct. I assume the newly issued shares will also be distributed around this date.

    1. dt

      I think this is just a broad market sell-off – this is a fund, so if underlying securities are dropping, the fund stock is also declining.

  8. greg lia

    UTG down over 1.5% several of its top holdings actually up today, CMCSA and CHTR. I would guess a NAV hit of .7 percent or so…….could be looking at a discount to NAV at 6.75 or so the way things are going and based on 5.99 last night.

  9. dt

    This has not played out as expected and the discount to NAV remains stubbornly stuck at 6.5%.
    I am closing out UTG position at a tiny loss (including dividend).

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