Financial Engineering and Firm Value: Split-Capital Closed-End Funds in the UK
30 Pages Posted: 4 Mar 2002
Date Written: February 2002
Ever since Modigliani and Miller made their irrelevance proposition, a key theme in finance has been to explain the conditions under which engineering of liabilities does affect firm value. Split-capital closed-end funds have conventional portfolios of assets, but are financed by a mixture of zero-coupon bonds, dividend shares, capital shares and bank debt. This engineering of the liabilities results in their market values being 11% higher than for conventional closed-end funds. Cross-section and time-series analyses reveal that the extra value comes from two approximately equal sources. First, the limited life of the funds increases value by 4.7%, because it forces any discount to net-asset value to converge to zero at maturity. Second, being fifty-percent levered raises the dividend yield, for which there is a clientele effect worth an extra 5.6% in fund value. An option-pricing approach shows that it is the capital shares, rather than the other classes of liability, which capture most of the extra value. The main contribution of the paper is to show that engineering of liabilities can add value to financial companies. If companies have a pre-determined wind-up date, this enhances value by placing a constraint on the freedom of the managers and thus limits the agency problem. If companies have more debt, there is an increase in value because small investors would have to pay more if they borrowed directly. An intriguing question is whether similar conclusions would apply to non-financial companies, for which having fixed lives and high leverage would be strongly resisted by incumbent management.
Keywords: Financial engineering, capital structure, closed-end fund, disount, option, leverage, prime, score
JEL Classification: G20, G14, G32
Suggested Citation: Suggested Citation