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.

Last week, Matthew Richards who writes for the FT on closed-end funds contacted me with regard to closed-end funds in general and an article he was preparing that week in particular. The article in question was on the activities of hedge funds who apply the strategy of closed-end fund arbitrage. This weekend Matthew’s article appeared in the FT, and for those who have access to the FT the article was entitled “City prey fight back against the big beasts”, published: November 18 2006, within the FTMoney section. As a direct follow up on this article I wish to make the following additional points:

1) The idea that such arbitrage activity only effect’s weak or failing trusts is just not true. There was the case of Edinburgh Investment Trust which obtain good relative performance in the small cap sector, however the sector as a whole fell out of favor and hence the discount widened to 20%. Recently there has been the case of Resource Investment Trust (REI.L) where the trust has not only obtained good performance but also offers essentially a unique product where existing investors in REI.L will find it difficult to find a suitable replacement. Moreover, in this case the fund management team is in the process of taking legal action against the trust for essentially deformation of reputation. The idea being that if you are running a trust which is wound up then it implies you are not any good. I cannot see this legal action succeeding since the contract between the fund and fund management team is very clear with get out clauses on both sides. However, the activities of arbitrage funds is increasing the risk associated with starting an investment trust (particularly outside of the latest hot sector), and this effect is just not in the interest of retail investors.

2) Matthew also mentioned the use of CFDs which arbs use to hide positions. In addition to this strategy there is also the tactic of obtaining huge amounts of loaned stock just before a vote on a special resolution (usually proposed by the arbitrage outfit) in order to push the resolution through. The point here is that the stock will typically only been loaned for 1-day (over the voting period) where the “real” shareholders are just retail investors which hold the stock in nominee accounts which (1) are not able to vote (due to being held in a nominee account) and (2) have no idea there stock is being loaned. Moreover, the special resolution may not even been in the investors long term interests. However this practice continues because the investment bank which is the agent in loaning the stock can obtain up to 10% over LIBOR, on an asset which it does not even own.

3) Essentially in symmetry to (2) above there is also the issue that within some closed-end funds there are differing classes of investors with differing voting rights. This has been a particular problem for equity warrant holders in Investment Trusts since if the trust is wound up the warrant holders get a particularly bad deal since the LSE uses a arcane formulae which greatly under-values the time value of the warrant. In particular, the arcane formula used by the LSE is not equivalent in any way with the widely used and accepted Black-Scholes option pricing model. What this has meant in practice is that an arbitrary outfit can buy a large amount of the ordinary stock, force a wind up (against the wishes of the non-voting warrant holders) and then not only obtain value from the narrowing discount but also get value from being able to give the warrant holders a bad deal. A good example of this was Bearings Emerging Europe Investment Trust which was restructured in 2002, see:

http://www.trustnet.com/general/news/display-story.asp?id=36978&db=it&txtS=y

There are some other points I would like to make but will not due to the risk of annoying the wrong people. However, if you know me in meat world then I am happy to let you know the gory details in confidence and in person.

As reported by Trustnet, see:

http://www.trustnet.com/general/news/display-story.asp?db=it&id=82081

the JPMorgan Income & Growth split capital trust is going to be rolled over into another split-cap structure. If you are not familiar with split-caps investment trust structures then there is a brief guide on the BBC site at:

http://news.bbc.co.uk/2/hi/business/1613719.stm

Now the significance of this event is that since the split-cap mis-selling scandal there has been no launches of split-caps. Moreover, all split-cap have a fixed redemption date and until now the funds reaching redemption have only offered investors to options of either cash/loan note or to roll the investment into an investment trust vehicle with a “vanilla” capital structure (i.e. only ordinary shares with possibly some gearing).

Anyway, I am glad to see split-caps of an asset class continue since for the more quantitative investor who makes the effort to do the analysis, opportunities do occur from time to time. For example, after the mis-selling scandal the zeros went to extremely low levels and back in the 90s (i.e. pre-internet days) for those who had the patience to get the annual reports and the time to unwind the various cross holdings and debt structures there was great opportunities.

There have been numerous investment companies launched onto the AIM exchange over the past few years. Since these firm are under researched (in comparison to there Investment Trust counterparts) mis-pricings may appear leading to opportunities for out-performance over time. One area which has particularly interested myself (and an area which other have drawn my attension to) is that of clean energy. As the FT pointed out today, onshore wind farms are getting very close to being viable without state aid and hence this sector may very soon offer an realistic alternatives to hydrocarbon energy sources. Below I list two firms which allow one to gain exposure to clean energy technologies with the assistance of specialist fund management:

Imperial Innovations

Commercialization of Imperial College London Universities IP. The University spends a fortune development intellectual property which general is just published in academic journals, the Imperial Innovations offers an alternative where the University and individual can get a kick back to IP developments which are commercialized. After looking at there site it just looks like is very cost effective means by which the buy up IP assets in the biotechnology and re-newable energy fields.

http://www.imperialinnovations.co.uk
http://www.investegate.co.uk/Index.aspx?searchtype=3&words=IVO&Go=search

Low Carbon Accelerator

Guernsey-domiciled Closed-end private equity AIM fund specializing in green energy sector. Fund run by Mark Shorrock, former CEO and founder of Wind Energy, a UK-based independent wind farm developer.

http://www.lowcarbonaccelerator.com

Investment Trust (or Closed-end fund) arbitrage has become sufficiently popular that parties who apply this strategy such as QVT Fund of New York, and Laxey Partners of the Isle of Man, are just running out of potential targets in which pure arbitration is a viable approach. By ‘viable’ I am referring not to the profitability of such strategies but the fact that in order for such hedge funds to justify their high fees the strategies are (at present) not sufficiently profitable.

What is Closed-end fund Arbitration?

Now before I continue let me just detail in broad terms what the essence of closed-end arbitrage is. The activity known as closed-end fund arbitration is essentially a sophisticated version of the ‘building society carpet bangers’ approach of the 1990’s. Naturally the prospectus of such funds will tell you all sorts of tales concerning sophisticated hedging techniques and high level maneuvering within business moguls. But the simple reality is that the core of the strategy comes down to essentially the same approach as what is referred to in the popular press as ‘carpet bangers’. In particular, in a similar fashion to how parties trying to de-mutualise building societies will form collectives of members, the modern day arbitragers will build up a large stake within closed-end funds and then use these large blocks of stock via voting (or just the threat of voting) to force the board to effect changes which allow the arbitrager to exit the closed-end fund at a lower level of discount than was previously prevailing. Typically mechanisms which are enacted to achieve this end result are tender offers of shares or a formal buy-back program to manage the discount level. The arbitrager may or may not hedge the market risk (i.e. ‘beta’) of the underlying assets of the closed-end fund but the discount (i.e. the ‘alpha’) can in most cases be captured.

Narrowing Discounts

The arbitrager is nearly always structured as a hedge fund and in order to make such strategies justify the high fees charged by such parties they really need to be able to enter there large positions at an average discount on the closed-end fund of over 10%. Now at present according to Trustnet the average discount on the 277 funds covered is 4.8%, moreover out of these funds there is only 58 funds with a discount over the required 10% level. Moreover, even some of these funds have either legal challenges or powerful existing share-holders which would and/or has frustrated the activities of the arbitragers. Hence, at present there is rather limited scope for the application of arbitrage to the UK funds sector. Moreover, over the past several years the discounts have been narrowing and the main driver for this narrowing has been precisely the activities of arbitragers.

Recent Activity

Naturally the parties active within this field have been aware of the narrowing of discounts across the UK closed-end sector and this fact has been commented on a number of times within the annual reports of funds active within this area (for example the annual reports of Laxey’s Value Catalyst Fund). Moreover, it appears to be the case from viewing the performance figures that such parties have been limiting the amount of hedging of the underlying exposure in order to capture both the market return (’beta’) and the anticipated return from the narrowing discounts (’alpha’). One could imagine the driver here is to increase to over-all performance, then sell this performance to the investors as ‘pure alpha’ and pick up the hedge fund fees for the generation of ‘alpha’. In the most extreme of cases it would appear that investors have been paying hedge fund fees for what looks like a closet index tracking fund.

China offers Arbs fresh opportunities

Though the application of closed-end fund arbitrage is rather limited in the UK, there are markets particularly suited to these techniques. For example, the dynamics of the Chinese market and Chinese retail investor has resulted in some domestic closed-end funds aimed at the local retail market trading on 40-50% discounts to NAV. However, obtaining direct access to Chinese markets is only really possibly for parties with primary brokerage relationships with the few major investment banks which have been granted access because of a significant investment within the Chinese banking sector. However, there is one particular fund just launched on the AIM which may allow access to an arbitrage strategy applied to Chinese Closed-end funds, the fund in know as:

Pacific Alliance Asia Opportunity Fund Limited, more info, quote

Interestingly, the fund have been backed by a number of parties including QVT Fund would have been active within closed-end fund arbitrage. Though I am not aware of any investments or even if any investments have been made, the mandate and approach of the fund is a good fit for closed-end fund arbitration activities within the Chinese market. Personally, I will be watching this fund to see how things develop. At present, it would appear there is scope for closed-end fund arbitration in China but as is the situation now in the UK there may quickly become too many active players which will quickly render to approach obsolete for everyone even in China.

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.