NAOS Ex-50 Opportunities Fund Ltd has recently announced the launch of a new income offer: NAC Notes. Access is available through the shareholder offer and a Wholesale Investor Broker Firm Offer before listing in November.

The Notes will pay a semi annual coupon at 5.50%pa rising to 7.50%pa and are due to mature 30^th September 2027. The Notes will be traded on the ASX.

This issue will be used invest in securities listed on the ASX.

NAOS

NAOS Ex-50 Opportunities Fund is a Listed Investment Company that listed in 2014 and manage $56 Million (30/09/20) and one of three Listed Investment Companies run by NAOS. The Ex-50 fund invests in undervalued listed small and mid-cap companies with an industrial focus (management fees of 1.75%pa + 20% performance fee over benchmark).

Closest Comparables

We have previously written about the AFIC Convertible Notes (AFIG) and Clime Convertible Notes (CAMG), having used them extensively within our client portfolios.

Both issues offered investors a fixed term bond of just over 5 years at 6.25%pa, plus a conversion option should the share price rise above the strike price.

AFIG has since matured allowing investors to benefit from 6.25%pa plus a further 10% at maturity for those that elected to convert. CAMG matures next year now trading at a yield to maturity of 3.11%pa.

A bond with equity upside

• Investors looking for the security of a bond like investment are able to benefit from 5.5%pa (stepping up to 6.5%pa in 5 years and 7.5%pa in 6 years, finally maturing at 7 years.
• Investors further benefit by being able to convert to ordinary shares at a fixed price of $1.15 per share, approximately 16% above the share price on date of announcement.

Smaller companies such as NAOS are caught between a rock and a hard place. They typically trade a discount relative to the larger LICs, and need to grow the company in order to dilute the ongoing costs associated with being listed and eventually narrow the discount.

Since the company is currently trading at a large discount to Net Tangible Assets (NTA), any capital raised would further dilute the existing NTA. Therein lies the conundrum;

How do you grow the company when trading at a discount without diluting shareholders?

The Convertible Note allows NAOS to attract new funds, leveraging their investment returns with the benefit of increasing the shareholder base should Noteholders convert.

With NAOS’s share price sitting at 19% below Net Asset Value (NAV) and LICs typically sitting at larger than their historical discounts, we can easily anticipate a 16% move in the share price providing investors with the opportunity to convert their Notes for a premium.

In effect, investors are receiving a fixed income return (bond) with a free option over an equity portfolio.

Attractive Pricing

In our opinion, the Notes look reasonably attractive on a number of measures;

 

1. 5 year term deposits are typically below 1.00% pa. Term Deposit rates are fixed for the period with financial penalties should you wish to exit early.
   NAOS Convertible Notes allow you to access a greater 5 year return at 5.5%pa, rising to 7.5%pa over 7 years with market liquidity should you wish to exit early (subject to market pricing).
2. The conversion option is not dissimilar to having a (American Style) call option over ASX 300 for 5 years with a 16% hurdle. We would expect retail investors to pay close to 10% for this type of exposure (8% if you feel NAOS’s discount may widen), rounding the equivalent return to just under 7%pa (5 years).
   
3. There is almost no debt and the company holds over $56 Million dollars in assets. An estimated $73.5 Mill after this raising. NAOS pledge that the total indebtedness will not exceed $17.5 Million.

 

Impact of dilution to ordinary shareholders

There are naturally concerns over dilution in the NTA when options or a convertible note are issued. There are a significant number of variables that come into play. Primarily;

• the share price relative to NTA at time of exercise
• the timing of exercising conversion
• investment performance

The majority of Noteholders are unlikely to exercise if the share price remains below the exercise price, and if the share price rises relatively quickly, investors may look to exercise sooner rather than later, reducing the impact of potential dilution.

We’ve modelled some of the scenarios below. Notably, assuming 100% of Notes convert, the effect of dilution is relatively minor and is arguably offset by the savings to shareholders due to proportionally lower fixed costs.

Assumptions: NAC dividends of 5.3c pa do not increase over the period shown, all Notes are converted at 5 years and excludes the impact of existing listed options (this chart was updated 29/10/20)

Our view

NAOS Convertible Notes offers an excellent risk return profile.

NAOS would need to lose approximately 75% in the value of their portfolio for Noteholders’ security to be impacted. As unlikely as this seems, investors should take note that the portfolio is relatively concentrated and invests in small and mid-cap stocks.

Aside from investment risk, we see the key risk as the likely lack of liquidity in the secondary market, albeit that we wouldn’t anticipate many sellers for this issue.

Clime Capital Notes are the closest comparable trading at 3.11%pa Yield to Maturity in 2021 and illustrate how attractive a yield of 5.5%pa is in this market.

We anticipate the Notes are likely to be redeemed at the end of year 5, with the additional two years to maturity a feature to provide flexibility in capital repayment.

With only $17.5 Million available via the broker firm and priority offer, investors who are not invested in the NAOS stable of companies will have to wait until it lists before being able to buy.

Note: NAOS Convertible Notes will be listed on the ASX and as such the price of the Note’s will be subject to market movements. Investor’s selling on market may receive a price lower (or higher) than the issue price.

Key features

• Fixed return of 5.5%pa – Paid half yearly in arrears
• Maturity in 7 years –Expected repayment in 5 years
• Negative Covenant – The issuer must not without approval of an Ordinary Resolution, increase total debt above 40% of total assets
• Option to convert –NACGA Notes to Ordinary NAC shares at a fixed price of $1.15 per share at any time during the 5 year term (conversion not applicable in years 6 and 7)
• Semi-annual unfranked interest – Often overlooked by investors, hybrid returns are typically quoted inclusive of franking credits. Un-franked payments are more attractive as you avoid the need to wait until the end of the tax year to claim back the franking.