For investment trusts with large discounts, this is a slippery slope

Tenders and buybacks can be used by investment trusts with large discounts to bridge the gap

However, these don't yield the best results for investors and aren't a sustainable solution.

The threat posed by activist investors has alarmed many investment trusts, and they are worried about lowering their discount to net asset value (NAV). For the most part, this is good: more focus on structural discounts was long overdue, and some boards had gotten too comfortable prioritizing the interests of their investors.

However, it's also evident that a lot of investment trust boards are persuading themselves that the best way to maintain low discounts is through frequent share buybacks and tender offers, which are offers to purchase shareholders' shares. As a shareholder in several investment trusts, I am not at all persuaded that this consistently yields the greatest results for investors such as myself.

The regulations governing investment trusts with significant discounts.

Wide discounts can be caused by a number of things, such as subpar performance, questions about the reported NAV, being in an unpopular industry, or an investment trust that is too small and/or illiquid. For the first three, tenders and buybacks are ineffective. If the issue continues, you might need to switch managers, alter your approach, find ways to demonstrate the NAV, or simply wait for your market to gain traction once more.

Problems with BFIA today. In the meantime, the fourth scenario explains why an excessive number of tenders and buybacks may even be detrimental. They reduce the fund's size, which will deter many investors. If an investment trust becomes dependent on buybacks and tenders in an ineffective effort to manage a discount caused by other factors, even one that begins at a healthy size may shrink to irrelevance. In 2021, Bellevue Healthcare (now CT Healthcare) reached a peak of approximately 1 billion, but by 2025, it had dropped to less than 300 million without significantly lowering the discount.

Trust for CT Healthcare.

Who gains the most from tenders and buybacks?

The other question is who gains the most from tenders and buybacks. If the price is actually lower than the net asset value, buybacks are at least accretive to the remaining shareholders. However, I am wary of trusts that choose to sell illiquid assets to finance buybacks in weak markets since they might be selling the best assets and leaving the fund with junk that is unlikely to be worth its carrying value.

Tenders are not directly accretive since they usually take place close to NAV. It's true that long-term investors have the option to accept every tender offer up to the maximum amount permitted, keep the money, and use it to purchase shares at a lower price on the open market once more, but many won't. Therefore, powerful shareholders, activists, or organizations that desire an opportunity to leave at a favorable price are frequently the beneficiaries in this situation. Long-term holders have been negatively impacted by the entire process if the discount does not subsequently decrease and the trust grows smaller and less viable.

This does not imply that buybacks and tenders are always bad; rather, they must be designed to minimize these drawbacks. It is more equitable for all investorsnot just those who wish to cash outto have a sizable exit opportunity every five years, possibly only if the fund underperforms, as opposed to continuously reducing the assets.