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.

Third party effects occur when the self interest of two parties transacting has an un-intended effect on a third party. One such instance is within the arena of pollution where for example a plane flight can be more efficiently provided if the pollution effects are discounted. However, as anyone living under the flight path at Heathrow knows the resulting pollution does affect third parties.

One area where I am expecting third party effects to be generated is US sub-prime mortgages. Though these mortgages only represent 15% of the mortgage debt in the US, around a quarter of them are in default. So far these problems have only effected the sub-prime mortgage sector with both smaller mortgage firms imploding (for example, New Century Financial, see Yahoo! Finance Quote) and large multi-nationals such as HSBC taking a $10.6bn hit. Though I anticipated such problems back in September, see US ARM Mortgages, at present it is still unclear whether these problems will cause third party effects.

Within my hypothesis of this dynamic situation I see three key drivers:

• Highest mortgage sales commissions where paid on sub-prime mortgages.
• Recent record low credit spreads within BBB-rated asset based securities (i.e. packaged sub-prime mortgages).
• Ability of Wall Street firms to package BBB-rated asset backed securities and credit derivatives, which are then resold as AAA-rated securities.

The mortgage brokers on 2% front end sales commission, and the PhDs on Wall Street who where taking 9% yielding sub-prime mortgages and selling them on within 5% yielding AAA-rated packages had a clear motivation in entering into such arrangements. However, the un-intended consequence of such a set-up is that individuals where able to take on more mortgage debt than they could afford and institutions chasing yield where not adequately compensated for taking on sub-prime credit risk.

Since the US real estate market has stopped paying people to consume houses and the seeming Alchemy of the PhDs on Wall Street started failing apart went credit spreads on BBB-rated asset backed securities moved from 400bps in February to 800 bps now. There has been a rapid rise in the level of defaults on sub-prime mortgages and institutions have been scaling back there appetite for credit risk. The third party effect of such events (at least in time) will be additional supply of real estate (through repossessions), and the scaling back of mortgage credit availability which will limit the future demand for real estate.

Repossessed houses also tend to have a third party effect on the surrounding housing stock by reducing its value, which may result in effected local residents being less prepared to continue their mortgage repayments, leading to further repossessions. In a similar fashion, financial institutions will often use AAA-rated securities as collateral in order to back other outstanding contracts. If such collateral goes into default then the contract which they are used to back will also go onto default. Though it is rather unclear whether such events will take place in coming months, they are a very real possibility.

Direct Market Access (DMA) in short is about ‘making the spread’ and not ‘paying the spread’. By using a DMA platform you can sell at the offer price and buy at the bid price. Say for example say BT Group PLC is trading at a bid-offer spread of 300-300.5 pence. Through a traditional broker you will be able to buy BT shares at 300.5p, and sell shares at 300p each. However, if you are able to place orders directly onto the LSE SETS order book then you would most likely be able to buy at 300p per share and sell at 300.5p per share. In fact, this is exactly what the traditional broker does, after taking your order and pockets the spread along with the usual dealing charges.

For further explanation of the exact workings of the LSE electronic SETS, SETSmm and shortly SETSqx order books, I refer the interested reader to:

• iDealing Explanation of Direct Market Access
• The LSE web pages on the SETS/SETSmm/SETSqx platforms at:
1. SETS Homepage at LSE
2. SETSmm Homepage at LSE
3. SETSqx (mid-07) Homepage at LSE

By taking advantage of these direct access platforms allows the execution of LSE trades at the lowest possible cost. There is also the option to generate an income stream via these platforms by acting essentially as a market maker, and/or pairs trading strategies between products with a high and consistent correlation.

Over view of LSE Electronic Order Books

The SETS platform offers users to place order directly onto the order book for all FTSE 100 constituents the most liquid FTSE 250 securities. The SETSmm service allows order to be place on the order book for:

1. FTSE Mid Cap index securities not traded on SETS
2. FTSE Small Cap index securities
3. Other liquid Main Market equity securities outside the FTSE All share
4. Liquid AIM securities including all of FTSE AIM UK 50 index constituents
5. Liquid dual listed Irish securities
6. Large London secondary listed securities eligible for central counter-party clearing
7. Exchange Traded Funds
8. Exchange Traded Commodities

The SETSqx system is due to become available by mid-2007 in accordance with the MiFID directive. The SETSqx platform will replace the SEATS Plus system and rather than offer an order book/market maker system will offer an uncrossing auction system at the open, close and 2 intra-day auctions at 11am and 3pm.

During recent currency moves the Yen has strengthen against just about all currencies. The strengthening of the Yen at some point was inevitable and in the intermediate, longer term with purchasing parity moving back into equilibrium the Yen should strengthen further.

This period also saw Sterling further weaken against the Euro and the dollar, and this weakening has occurred before clear signs of economic weakness have appeared in the UK. Moreover, the OECD have even recently upgraded the growth prospects in the UK, and the Bank of England latest inflation report suggests further interest rate rise(s) will be necessary to keep inflation I check over the banks two year horizon. Hence the sudden weakness now is something of a surprise.

It is possible that market participants are just reacting to the amount of leverage in the UK housing market which dwarf’s even the levels seen in the US on an equity-to-debt or average earnings-to-debt basis. The idea being that recent events in the US mortgage market must prompt market participants in the UK to reassess their over all credit risk exposure and the amount of compensation they are being paid for taking on such risk. An alternative hypothesis is that the Chinese (and/or other Asia) central banks are switching out of Sterling (3rd largest currency within Foreign exchange holdings) in favor of the Yen. The rationale being that for many Asian central banks the Yen is just about the only currency in the world which is more undervalued against a common basket of currencies than their own currency.

Though the recent movements where something of a surprise the longer term trend is likely to be further weakness of Sterling (and US Dollar) against the Yen. With the OECD estimating on a purchasing parity basis that Sterling is worth $1.62, i.e. more the 15% less than its present value against the US Dollar. And the dollar itself overvalue against the Yen, Sterling has much further the fall against the Yen in particular and a basket of Asia currencies in general.

By purchasing shares with a significant Asian currency cash flow and/or assets located within such domiciles and then waiting for currency movements to take their natural path. The GBP based investor should be able to take advantage of such mis-pricing over the coming years.

The Fund management industry gets paid an exorbitant amount of money for (on aggregate) adding zero value to the investment process. The sad reality is that 70% of managers will under performance the index and the simple reason for this is that the average manager is destined to generate: index – fees – costs.

Moreover, it is common practice to use the costs incurred by the fund to pay soft commission to third parties for marketing services, capital introductions and investment research. Though these arrangements are usually not formally acknowledged they are very much the norm across the fund management industry. For example, according to Dresdner Kleinwort analysts recently reported that the typical hedge fund manager pay fees of 4-5% of fund under management a year for borrowing stock, leverage and brokerage.

Which begs the question, what are fair and reasonable fees? Which leads one to consider how the fund management activity itself, should be organized to ensure transparency and fairness for all parties. Clearly the structure which ensures the maximum transparency would be a partnership where there are ordinary partners who invest capital in the partnership, and managing partnership who run the day-to-day investment activities of the partnership. Naturally within a pure partnership the managing partners would be paid in accordance with the amount of profit generated for the partnership. Hence a base fee should be discounted and profit sharing only fee used. Moreover a principle of shared risk with shared return amongst the partners should apply, with managing partners also investing monies within the partnership. The level of fee which I would suggest for such a partnership is:

“the managing partners receive a fee of 10% of profits over 1-year LIBOR”

Recall, that 1-year LIBOR is essential the rate available of 1 year term deposits which at present is around 5%. Hence, if the managing partners obtain a performance of 15%, then there management fee is 1%, for 25% performance the fee would be 2%.

Since the fund management is organized around a partnership various conflicts of interest would just not exit since all partners who vote of the material issues affecting the service provider relationships. In such a model the partners will adhere to ensuring the maximum efficiency of the operation ensuring the best over-all outcome for the partners.

Though most investment businesses are not run in accordance which such a model and principles there are some, with the most prominent being Warren Buffet’s Berkshire Hathaway. In addition, I wish to bring your attention to a less well known investment partnership set-up Walter Schloss who just turned 90. Walter ran his investment partnership between 1956-2002, building up an exceptional track record on the way. When asked by Outstanding Investors Digest in 1989, “How would you summarize your approach?”, he replied, “We try to buy stocks cheap”. For more details about Walter, see page 22 of the Berkshire Hathaway’s 2006 Chairman’s Letter available at:

http://www.berkshirehathaway.com/letters/2006ltr.pdf

The Isle of Man government has recently published a report produced by Aquatera Limited on the viability of various forms on renewable energy for the Island. The report available at:

http://www.gov.im/dti/Energy/

broadly concludes that Wind Power is the only viable resource in the near term using existing technologies. Moreover, analysis of the economics of an offshore resource details that the resulting revenue from such a project would repay the initial set-up and running cost after 13.73 years. Hence, such a project would only provide an internal rate of return of 5.1756% over 13.73 years. With the 10 year Gilt yield being around 4.82%, such a project (in my view) is not financially justifiable since its return over gilts is not enough to justify the inherent risk of such a project.

What about Onshore Wind Farms?

The report unfortunately makes no real attempt to explain why the much more obvious options of an onshore wind farm were not considered. In fact, the option of an onshore wind farm seems to have been discounted from the start, with the rationale given on page 47:

Due to the structure of the Manx planning process, the possibility for commercial scale onshore wind turbines has already been discounted.

Moreover, within the 143 page report the only other reference’s on commercial scale onshore wind farms is on page 18, which reads:

Onshore wind was specifically excluded from this report at the request of the DTI, as previous studies have already looked at the opportunities for this technology.

and on page 15, I found:

In the case of the Isle of Man there are some specific legal protection mechanisms that make onshore development of renewables particularly challenging.

Financial case for Onshore Wind Farms

Though the figures where not worked out for an onshore wind farm, after doing I little digging I found within the article ‘Land- vs. Sea-based Wind Farms’, at:

http://www.pbs.org/newshour/science/wind/landvssea.html

the following guidelines:

Cape Wind itself has an expected energy output of 38 percent of capacity over the course of a year, compared to the mid-to-high 20s or low-30s for onshore wind farms, noted Cape Wind’s communications director Mark Rodgers…

But one of the main challenges to building offshore is cost. The price tag of installing offshore sites can reach 50 percent to twice that of land-based wind technology, Calvert said

Hence, as an estimate I would suggest the drop in power of an onshore vs offshore site would be around 18%, but the reduced cost on an onshore vs offshore farm would be between a 1/3–1/2. Therefore, the cost per KWH would be reduced by 21% - 41% over 13.73 years. Implying an internal rate of return of 6.26%-7.30%, which would provide a return over gilt yield’s in proportion to the level of risk taken by the investor.

I was rather pleased the other week when my journal (along with five others) was picked out within an article by Ellen Kelleher at the FT on 17th Feb 07, for special attention see:

http://search.ft.com/search?queryText=webcab&x=0&y=0&aje=true&dse=&dsz=
(login required to read full article)

The only other UK finance journal out of the five picked out was Interactive Investors, which wrote up a review of the article entitled: The best possible time to be alive. Anyway, without further ado here is a quote from the original FT article:

On the hunt for nitty-gritty technical information on the markets? Try WebCab Services Investment Journal (www.webcabcomponents.com/finance/blog). This is an interesting site if you are keen to know more about investment trusts and other closed-end funds. Run by an active private investor with a Phd in mathematics, it offers links to news that might have some influence on the market for closed-end funds. He also offers some astute ideas on investment strategies, strong stocks for income and the mechanics of investing.