On the surface, it appears to be a straightforward exercise: an investor buys a unit in a closed-end fund and receives the annual distributions in the expectation of holding the stake until maturity, when he or she will receive its net asset value.

In reality, the situation is complicated by the tendency of closed- end funds to trade on the market at values lower than their NAVs, combined with unitholders’ ability to redeem their stakes once a year at NAV.

The resulting level of redemptions can be so high that questions arise concerning the funds’ long- term viability, given that the same costs to operate the funds now have to be spread over a smaller asset base.

To protect against the erosion of assets, some managers are offering investors rights or warrants to acquire more units of their funds. The options and/or warrants are generally priced attractively — at less than NAV — to entice investors.

But that strategy poses interesting questions for investors. Essentially, they have three options. And deciding the best course of action may not be an easy matter:

> investors can take up their pro rata shares, which means that they maintain their level of ownership, but only if they agree to commit more capital;

> they can sell their rights and receive some cash, a move that reduces their stake in the fund; or

> they can do nothing, which means that they will miss out on the cash that they would earn by selling the rights and also reduce their stake in the fund.

If a unitholder likes the fund manager and the way the fund has performed, then the easy approach would be to keep paying to play and stay in the game by taking up the rights.

But if the unitholder doesn’t like the manager or the asset class, some action is required. The easiest course, in this case, would be to sell the rights. But that may not be as lucrative as the unitholder might expect.

A policy of doing nothing is the worst option.

“The people who lose are those existing shareholders who don’t exercise their rights,” says Ron Mitchell, managing director of equity capital markets at CIBC World Markets Inc. , who is not a big fan of rights offerings. “If you don’t exercise your rights, you get diluted because investors are buying new units for cheaper prices than they are worth. An existing shareholder is paying for that. Rights are giving the new guys a good deal.”

Mitchell adds that it is often tough to sell the rights and get fair value. One reason is that the rights “don’t tend to trade that well,” he says. Also, brokerage costs can eat up a lot of the so-called “fair” value.

In his view, unitholders who exercise their rights “end up where they would be, but they have to put money in.”

Nonetheless, some recent offerings have found their mark.

For example, Toronto-based Mt. Auburn Capital Corp. ’s MACCs Sustainable Trust, which invests in a basket of income trusts, found itself with a declining asset base this summer that was caused by redemptions from investors who had exercised their right to exit the fund at NAV.

(MACCs went public in March 2005 with the sale of 3.5 million units at $10 a unit, creating a $35.3-million fund. It is one of a number of closed-end funds that have suffered large redemptions in recent months.)

In July, holders of 1.4 million units, or 40% of the float, indicated that they wanted out at NAV. At the time, NAV was about $9.57 a unit. As a result of those redemptions, the fund had to pay out $13.2 million, shrinking the fund’s market cap to about $21 million.

“We had two choices,” says Conor Bill, managing director at Mt. Auburn. “We could either wind up the fund — because the operating expenses would have been such a big part of the cash flow and we are trying to run it as a low-cost operation — or we could to increase the size of the fund.”

So the trust opted to award one warrant to each existing unitholder. Each warrant allowed the holder to purchase an additional trust unit at $8.64.

@page_break@At the time of the offering — which required unitholder approval at special unitholder meeting — the fund was trading at $9.05, while its NAV was $9.63.

“We had to price the warrants at a discount to trading price, otherwise no unitholder would exercise. There is just no incentive. But we didn’t price them so low that it was abusive or coercive,” Bill says, adding that the 10% discount to NAV is about right.

The warrants, which expire next February, are listed on the Toronto Stock Exchange. If all the warrants are exercised, MACCs will raise $17.6 million. So far, about 400,000 warrants have been exercised, raising about $3.5 million.

The MACCs warrants have meant an increase in the trust market capitalization, and has spread the fund’s operating costs over a large base.

“They enable us to keep going for another year,” Bill says.

One unexpected consequence has been that trading in the MACCs units has jumped about tenfold.

The MACCs warrants, which were allocated to existing unitholders, are also listed on the TSX, which means that other investors can buy them, pay $8.64 and receive a new unit. A warrant trades in the 30¢-40¢ range. If an investor buys a warrant for 30¢, for example, he or she can acquire a unit in the fund for a total of $8.94.

The decision to buy the warrants would be based primarily on the market price of the underlying MACCs units and an assessment of their potential for gain or loss. IE