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Does a distribution reinvestment plan (DRIP) dilute fund investors?

How a DRIP prices new shares in an evergreen fund, the dilution when it reinvests below NAV, who pays it, and why the real benefit is the sales load it avoids.

Julian R. Sterling · from The Evergreen Fund Handbook

Not if the reinvestment price is the ex-distribution NAV: new shares issued at NAV leave every holder's NAV per share exactly where it was. A plan that reinvests at a discount does dilute. At a 5 per cent discount, with 60 per cent of an illustrative fund enrolled and a 6 per cent distribution rate, the investors who take cash lose 18.5 basis points a year, and that value goes to the investors who reinvest.

Worked in full in The Evergreen Fund Handbook by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

How a distribution reinvestment plan works

An evergreen fund declares a distribution per share. Investors enrolled in the distribution reinvestment plan (DRIP) receive new shares instead of cash, usually at the NAV struck after the distribution, and usually without the upfront sales charge their share class carries on new subscriptions. The cash never leaves the fund. The question is what price the new shares are issued at, because every share issued below NAV transfers value from all the existing holders to the buyer.

The assumptions

Illustrative evergreen fund, one quarter

Input	Value
NAV per share before the distribution	25.00
Shares in issue	40,000,000
Fund NAV	1,000m
Annualised distribution rate, paid quarterly	6.0% (1.5% a quarter)
Shares enrolled in the DRIP	60%
Discount on the reinvestment price, case B	5.0%

Step 1: reinvestment at NAV

Exactly the ex-distribution NAV. The reinvesting investor bought shares at what they are worth, so nobody gained and nobody lost. A cash taker holds 24.625 of NAV and 0.375 of cash per share; a reinvestor holds 25.00 of NAV in more shares. Same wealth.

Step 2: reinvestment at a 5 per cent discount

Who gains and who pays, one quarter

Group	Shares before	Effect
Reinvestors: value gained on the new shares		+0.469m
Reinvestors: dilution of their existing shares	24m	−0.282m
Reinvestors, net		+0.188m
Cash takers, dilution of their 394m holding	16m	−0.188m

The fund's total NAV is unchanged by the pricing. Only its division moves: the cash takers' loss is precisely the reinvestors' net gain. Across four quarters the cash takers lose 0.74m, or 18.5 basis points of their holding.

What if more investors enrol, or the discount is smaller?

Annual cost to cash takers, basis points of their holding

Reinvestment discount	30% enrolled	60% enrolled	90% enrolled
0.0%	0.0	0.0	0.0
2.5%	4.6	9.0	13.4
5.0%	9.4	18.5	27.4

The cost to a cash taker rises with enrolment, because more money is reinvested at the discount and fewer holders are left to bear none of it. In a fund where 90 per cent reinvest, the minority taking cash for income pays 27.4 basis points a year for the privilege. That is a fairness question, not a performance one, and it belongs in the same review as dilution from a stale NAV: reinvesting at a NAV that lags a rising fair value transfers value in exactly the same way, with no discount written anywhere.

The real benefit of a DRIP: no sales load

For the investor, the plan's value is usually not the price but the absence of the upfront charge. Take a holding of 100,000 in a share class with a 3.5 per cent sales load, NAV growing 2.0 per cent a year and distributions at 6.0 per cent, so roughly 8.0 per cent in total, over ten years:

• Enrolled in the DRIP, distributions reinvested at NAV: 220,804.
• Taking cash and subscribing again each quarter through the class with the load: 216,303. The load costs 4,501, 2.0 per cent of the end value.
• Taking cash and spending it: 122,079 of NAV plus 66,238 of distributions received over the decade.

The common mistakes

• Calling the DRIP discount a reward. It is paid by the other shareholders, not the manager. A fund that wants to reward reinvestment can waive fees on DRIP shares, which costs the manager, instead of discounting the price, which costs the cash takers.
• Treating reinvested distributions as new money. DRIP shares bring in no new cash: the distribution simply stays in the fund. A fund that reports gross inflows including reinvestment overstates demand, and the same investors can submit those shares for repurchase the next quarter.
• Reading the distribution rate as income. Part of a distribution can be a return of capital, as worked in distribution yield versus total return. Reinvesting it changes nothing about that.

Takeaway

• Reinvestment at the ex-distribution NAV is neutral: 994m over 40,365,482 shares is still 24.625.
• A discount transfers about reinvested × d / (1 − d) a period from all holders to the reinvestors: 18.5 basis points a year from the cash takers in this case.
• Check the reinvestment price in the prospectus before checking the distribution rate.

The fair-treatment numbers, class by class, are laid out in the free companion files for this book.

Questions readers ask

What price are DRIP shares issued at in an evergreen fund?

Usually the NAV per share struck after the distribution. In an illustrative fund at 25.00 paying 0.375 a share, reinvestors receive shares at 24.625 and the NAV per share after the reinvestment is still 24.625, so no one is diluted. Some plans have priced at a discount to NAV; that discount is paid by the shareholders who take cash.

How do you calculate DRIP dilution?

Value transferred per period is approximately the amount reinvested times d / (1 - d), where d is the discount, shared across all shares. With 9.0m reinvested at a 5 per cent discount that is 0.474m, which takes NAV per share from 24.625 to 24.6133. The cash takers, holding 40 per cent of the shares, bear 0.188m a quarter.

Is it worth enrolling in a DRIP?

When the alternative is reinvesting through a share class with an upfront load, usually yes. On 100,000 earning about 8.0 per cent a year for ten years, reinvesting at NAV ends at 220,804, against 216,303 if each quarterly distribution is resubscribed with a 3.5 per cent load. Investors who need the income should take cash and check that the plan prices at NAV.

Also on this site

• How does a stale NAV dilute investors in a semi-liquid fund?Subscriber gain = flow x (fair NAV - stale NAV) / (stale NAV + flow). 100 dealt at a NAV 5.1% stale gains 4.64 and dilutes existing holders 44 bp.
• Is an evergreen fund's distribution yield its return?No. Total return is distributions plus the NAV change. An illustrative 5.5 per cent yield is 58.2 per cent covered by income, with 27.3 per cent paid from capital.
• How do you calculate NAV per share with multiple share classes?Share the result on opening class NAV, deduct each class's fees, divide by its shares. A 0.90% month: class I 102.50 to 103.303, class S 96.25 to 96.916.
• How much does a day-one secondary gain inflate evergreen returns?Discount times deployment. Buying 20% of NAV a year at 85 and marking it to 100 adds 3.0 points: a 7.5 per cent portfolio reports 10.5, 28.6% of it from marks.
• How is an evergreen fund's performance fee calculated?12.5 per cent of NAV gains above the high-water mark, capped so investors keep a 5 per cent hurdle. Four illustrative years: 3.67 of fees, 4.48 without the mark.
• Are evergreen fund fees lower than closed-end fund fees?Per year invested, at 12.40% gross: evergreen 1.25/12.5 costs 2.64 points, closed-end 1.5/20 costs 3.57. At 10% gross, the closed-end fund is cheaper.

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