Sometimes referred to as a sinking fund, a purchase fund is a type of financial fund that is created specifically as a resource for purchasing securities that are currently below the par value, or the value originally assigned to those shares. A fund of this type is maintained by the issuer of the securities, and is used to buy back a predetermined number of shares in the event that the stock is trading below the identified price per share. This strategy is not uncommon with offerings of preferred stock, and helps to reduce the degree of risk carried by investors, since those shares must be repurchased at the par value, and not the currently lower market value.
It is important to note that the establishment of a purchase fund does not mean that the issuer must repurchase all issued shares if the market value falls below the price per share that applied at the time of issue. When this type of financial model is utilized, it is typical to identify a specific number of shares that must be repurchased. In some cases, there are governmental regulations imposed by a national regulatory agency that require that the issuer attempt to buy shares currently offered in the marketplace first, then turn to investors not currently trading shares, if that is necessary to comply with the provisions of the purchase fund.
There are also situations in which a purchase fund strategy can be used in other investment settings. For example, this type of investor protection is sometimes included in bond indentures. Should the underlying assets associated with the bond fall below a certain market value, issuers are required to repurchase a fixed number of those shares and thus protect the interests of the bond holders. Just as with stock offerings, the purchase fund in this setting helps to ensure investors at least recoup their initial investment, even if they ultimately do not earn any type of return.
While a purchase fund arrangement does protect the interests of investors, the strategy does have the potential to create serious financial problems for the corporation that issues the securities involved. The potential for problems increases as the market value of the shares continues to decrease. While placing a limit on the number of shares that must be repurchased at par value does help to limit the issuer’s hardship to a point, severe drops in market value are sometimes difficult to offset, and could undermine the financial stability of the corporation. When this happens, the potential that investors may incur losses over the long term becomes more likely.
