Foresight Capital Partners

Classical Closed-end fund arbitrage on the LSE is getting near impossible due to the ever smaller discounts. As detailed within the post Is closed-end fund arbitrage viable, from October 2006 the classical approach starts to break down when discounts go sub-10%. However, modified technique will allow closed-end fund arbitrage to become viable at much lower discount levels, possibly even for trusts trading at a premium to NAV. Below we detail the main steps in this approach.

Steps involved in Mandate Transform Arbitrage

1. Arbitrage Fund buys large stakes and/or partners with other share holders in order to obtain control.
2. Changes the investment manager of the fund to Arbitrage Fund, changes the fund mandate to the Arbitrage Fund’s preferred investment approach (generally fund arbitrage) and (where possible) increases the management charges. The increase in charges will generally be by the introduction of a performance fee which will be charged in addition to the base management fee.
3. Continue to run the fund, in accordance with the new mandate.

The classical approach will similarly apply the first step and will then often appoint a third party manager which is assigned to wind up the trust in an orderly fashion and return proceeds to shareholder at (or near) NAV. The new approach however seeks to exact value but not only decreasing the discount at which assets trade, but also using such techniques as an asset gathering mechanism for the Arbitrage Fund Managers.

What this means for the future of Closed-end funds
This approach looks very promising because there are potentially two sources of value which can be extracted, namely:

1. Discount Arbitrage: By liquidate the assets with the acquired fund at a lower level of discount.
2. Increase AuM: Increase the Assets under Management (AuM) of the Arbitrage Manager since the capital within the Closed-end fund is fixed.

The nature of the discount uplift is clear and the benefits will be gained by the investors. However, the value created through the increase in the AuM (see * below for further explanation) will only be gained by the Arbitrage Fund, if such fund unit holders also have ownership rights over the Fund Management company.

(*Note, that a fund manager will generally be valued at 5% of AuM where long only type fees are charged (i.e. base fee only), and 10% of AuM where hedge fund type fees are charged (i.e. base fee plus x% of all profits where x% is generally 20%).)

Exactly how the benefits of this approach are assigned between the parties is really a matter for such parties to decide. Saying this, the total value which can be extracted allows such arbitrage of closed-end funds to take place at much lower levels of discount, than the traditional approach which starts to break down when discounts go sub-10%. If is even conceivable to benefits are assigned appropriately that this new approach is viable at just about any level of discount and possibly even when the trust is trading at a slight premium to NAV. Making just about any trust on the LSE a potential target.

Today the successful investment trust, at least in terms of performance, Edinburgh UK Smaller Companies has been forced into liquidation by arbitrageurs. In a similar way to how it is rather ironic that the founder and heart-beat of a technology company can be forced out by a Venture Capitalist (see Don’t Fear the Dragons Den, at Strive Notes) it is rather ironic that a financial manager that is adding value can be forced into liquidation just because his fund (through possibly no thought of his own) falls out of favor.

The New City Investment team which at present runs a Investment Trust which a mining stock mandate is to lauch a new fund which specifically looks to invest within the Uranium mining sub-sector. The lauch follows on from the lauch of Merrill Lynch Commodities Income Investment Trust a few months ago which is at present trading on a 3% premium.

Whether such activity can be construed as bearish or bullish I am not sure, but at least it shows to there is demand out there for more Investment Trusts within the mining sector.