Australia | Sep 11 2020
Download related file: Monthly_LIC_Report_September_2020_FINAL
The malaise that is the Australian Listed Managed Investment sector needs a clean up, and Independent Investment Research analyst Rodney Lay is here to provide some guidance.
[A Listed Investment Company (LIC) is a listed investment vehicle that offers investors access to a diversified portfolio of shares in other companies also listed on the stock market. These are variously also known as Listed Investment Trusts or Listed Managed Investments. They differ to Exchange Traded Funds in that they are close-ended, whereas ETFs are open-ended vehicles that are created and destroyed by the ETF sponsor based on demand/supply, akin to a futures contract.]
Note: For comprehensive comparative data tables for LICs and ETFs please see attached. The story below is part of IIR's monthly update on Listed Managed Investments (LIMs), which in its entirety is attached to this story.
3 Ways to Clean Up this Munted Shitshow (And I am not talking about the US / Covid-19 / D Trump)
By Rodney Lay, analyst Independent Investment Research (IIR)
Despite the attention grabbing headline above, this article has the express purpose of making a range of suggestions to ultimately improve the health and prospects of the Australian LMI sector.
If the UK market provides an indication, the sector can not only recover from its current malaise, but prosper (commissions were banned by the Retail Distribution Review commission in 2013 yet FUM doubled from £95bn in 2012 to £197bn today, with tight NTA discounts after a 10-year sector re-rating and innovative new asset classes focused on income).
To do so, the boards and managers in the sector need to start acting in a way that overcomes a range of issues in the sector, and which serve to firmly act in the interests of both versus investors. These issues include: appallingly long date Investment Management Agreements (IMA) with respect to the most egregious examples; Boards that are not acting in the best interests of investors (lack of true independence); vested interests of both managers and boards not to convert or wind-up; poor investment management styles that do not capitalise on the single biggest advantage of close-ended investment vehicles – captive capital; and, poor discount control management.
Unlike open-end funds, for which there exists a convex flow-performance relationship as investors react to past fund performance, in the closed-end fund industry management companies expand their assets under management when investor demand is strong, but fail to reduce them when investor demand is weak. Investors in open ended funds have a greater balance of power versus close ended funds – they can redeem in the context of poor performance.
What riles this analyst regarding the LIC sector is the sense of entitlement certain managers have, essentially exploiting the privilege of captive capital for their own economic advantage and at the expense of long suffering investors on account of persistent and deep discounts to NTA. To address this, IIR suggests boards action one or a combination of the following:
-Propose a conversion to an exchange traded managed fund (ETMF) or a wind-up;
-Introduce annual continuation votes for vehicles with a life of five years and greater (which allows sufficient time to recoup IPO costs), as per the bulk of UK listed closed ended vehicles. This is likely to increase the prospect of seasoned capital raisings (secondaries, tertiaries, etc). On the other hand, managers that generate a large discount may become entrenched;
-Engage in more effective discount control mechanisms (DCMs) , such as setting discount to NTA floors to guide buy-backs. These need to be telegraphed to the market – the messaging is important.
Discount control mechanisms typically include discretionary share repurchases and, in the UK, mandatory continuation votes that are triggered by the fund discount falling below a pre-specified level. Since repurchasing shares or liquidating the fund can greatly reduce assets under management and the resulting compensation for the management company, it is costly to managers if these mechanisms are implemented and these costs would fall disproportionately on managers with poor performance.
For instance, highly skilled managers with ability to generate positive abnormal performance would have a lower probability of losing a mandatory continuation vote than managers with inferior performance. Thus, skilled managers who commit to this DCM find it less costly to do so than their counterparts with potentially inferior future performance.
Discount Control Mechanisms
We sort DCMs in two categories depending on whether or not the fund’s directors can exercise discretion in putting the mechanism in place. A mandatory voting category comprises funds with periodic continuation votes and discount floor provisions.
A buyback discretion category is represented by share buybacks, redemption facilities and tender offers that are exercised at the directors’ discretion without a pre-specified NAV discount trigger or that the board may adopt at its discretion if the fund’s discount to NAV passes a certain level.
Continuation votes are the sole discount control mechanism that is not applied at the directors’ discretion but is instead mandatory. They provide shareholders with the possibility to vote on the future of the fund (e.g., to liquidate or open-end the fund). If a continuation vote is not passed, the fund’s directors are obliged to put forward proposals to reconstruct or liquidate the fund.
Continuation votes are either periodic (annual or occurring at pre-determined periods, usually following a longer initial period post-IPO before the first continuation vote is held), or they may be triggered by the level of the NAV discount (i.e., a discount floor provision).
Share buybacks are the most common tool to correct imbalances between the demand and supply of shares and thus control the level of the discount to NAV that fund’s shares may trade at. Share repurchases in the secondary market are typically realized up to a certain percentage of the shares in issue (usually 14.99%). Typically, the directors seek authority from shareholders to repurchase shares at each annual general meeting of the company.
Prospectuses offer varying degrees of specifics on the use of share buybacks as a mechanism to narrow the NAV discount. They range from the announcement of the existence of an authority to repurchase shares indicating the instances when it will be exercised to stipulating a trigger point, i.e., the NAV discount raising above a certain threshold that the Board will use as guidance on when to intervene with repurchases in the secondary market. The making and timing of buybacks however is predominantly at the discretion of the Board.
A redemption facility is an alternative mechanism used by some funds to narrow the NAV discount. Such facility enables shareholders to periodically redeem some of their shares (usually up to about 25% of the shares in issue) at net asset value less costs. Similarly to share buybacks, funds may implement a redemption offer if a pre-specified NAV discount threshold is reached. Although redemption facilities allow shareholders to redeem shares on a periodic basis, the directors typically exercise their discretion to operate the facility.
Tender offers are also offered usually at the Board’s discretion and there may or may not be an NAV discount trigger attached to them. They are made available to all shareholders for a predetermined number of shares at a pre-specified price (below NAV).
IIR is aware that DCMs alone are not a silver bullet for the sector with respect to discounts to NTA. Indeed, while the UK sector as a whole has recovered well from sustained discounts, there are a number of sub-sectors that have continued to perform poorly. A key aspect to the improvement in the UK industry has been the growth of alternative strategies. That said, DCMs are an important part of the equation and one that is directly pertinent to existing LICs in Australia.
IIR understands that circa 50-60% of UK closed ended vehicles have continuation votes. The chart overleaf details the scale and type of capital returns over time while table summarises the return of capital events over the 1H20 period. We would make a few points:
-Note how active the UK market is versus the Australian market;
-Note how boards actually to do advise not passing a continuation vote (liquidating) in some cases. You would not see that in Australia;
-Note how some buybacks are based on protecting a clearly telegraphed defined maximum discount to NTA;
-Note also the sheer scale of FUM some managers have returned capital to investors. For example, NB Global Floating Rate Income has been consistently buying back shares with the aim of protecting a 3% discount in the face of negative sentiment towards the US senior loan market and lower interest rate expectations. Over the last three years, it has returned c.£557m, representing 61% of share capital, but the discount remains at 8%. In the face of this unsustainable shrinkage, the board is consulting with shareholders on a potential shift in strategy, whilst the fund remains a meaningful size at c.£315m market cap.
However, some policies of discount control do not require a commitment on the part of the fund managers. While continuation votes are mandatory, the typical language regarding share repurchases indicates that the management team can utilize its discretion to decide the timing and the amount of any share repurchases. Thus, the announcement of discretionary repurchase programs as a mechanism to control the discount is not necessarily a costly information signal:
Managers can costlessly announce their intention to consider share repurchases under certain circumstances in an attempt to control the discount the fund but not carry out any actual repurchases when the fund discount increases substantially. On the other hand, the firm commitment to hold continuation votes and thus give shareholders the opportunity to decide whether to liquidate or convert to an open-end structure could more clearly serve as a costly signal of managerial skill. This costly signal would reduce the information asymmetry between fund managers and fund shareholders.
If managers do not have a stake in the fund, they would not benefit from a reduction in the discount. Since management company compensation is typically proportional to the assets under management, managers would have an incentive to resist liquidation or engage in share repurchases. In addition, the presence of substantial managerial stock ownership or blockholders affiliated with the fund manager, such large shareholders tend to use their voting power to secure private benefits that do not accrue to other shareholders and thus veto liquidation proposals. As a result, discounts would persist, even in the presence of mandatory continuation votes.
Alternatively, it is suggested that the announcement of discount control mechanisms at IPO allows managers to subsequently extract rents by increasing assets under management. Skilled managers can capitalize on fund’s past performance and the investor expectations of future performance increase the size of the fund by engaging in seasoned equity offerings or rights offerings. On the other hand, managers that generate a large discount may become entrenched.
While it has been found in the UK that it is less likely for large funds to delist and that large discounts over the previous year contribute to increasing the probability of liquidation or open-ending a fund, the explicit device that allows shareholders to vote on the future of the fund has no impact on the probability of delisting / conversion.
Moreover, research shows that funds with mandatory voting are even less likely to delist when faced with large fund discounts. The same holds for funds in which the management company has a stake: the commitment to hold continuation votes for such funds when interacted with the management company stake contributes to even lower the likelihood to delist. It appears that the benefit of reducing the discount that would accrue to the management company in case it has a stake in the fund is far outweighed by the rents it would capture if the fund continues to operate.
Second, UK research shows that closed-end funds that have explicit discretion to repurchase shares when discount is large are neither more or less likely to repurchase their own shares, regardless of the level of the discount.
To the contrary, all funds appear to engage in an increased level of repurchase activity when discounts widen. Having announced the potential to repurchase shares at IPO leads to even lower likelihood to implement this action if the management company has a stake in the fund. So, while there is evidence of a reduction in the outstanding shares of a fund following a large discount episode, this reduction is unrelated or in some cases negatively related to the announcement of a policy of discount control that is supposed to implement share repurchases.
This suggests that the announcement of a discount control mechanism at IPO does not constitute a costly information signal for the fund. Rather, it provides support for the alternative hypothesis that these policies are essentially a marketing tool used by fund managers to expand compensation by increasing assets under management.
The UK evidence indicates that both funds with that explicitly discuss share repurchases or have mandatory voting provisions are more likely to issue a large percentage of new shares in subsequent periods. That finding also holds for funds with substantial management ownership.
DCMs actually Decrease De-listing / Conversion Risks
In relation to the headlined topic, a comprehensive UK study drew the following conclusions:
-The size of the fund measured as the log of fund’s market value at the end of the previous year is inversely related to the probability of liquidation: large funds are less likely to delist.
-Interestingly, by itself, the level of the discount at which the fund has traded over the previous year does not seem to have any effect on the probability of delisting.
-When in addition we consider the presence of a mandatory voting provision at IPO, this mechanism of discount control does not seem to affect fund liquidations either.
-The strongest predictors of the probability to delist remain the size of the fund and the prevailing market return in the year prior to delisting.
-However, a striking pattern emerges once we consider the interaction of the mandatory voting provision with the past fund discount. While funds that have traded at a discount over the past year face a higher probability to delist over the following year, funds that have adopted mandatory voting are significantly less likely to delist if their discount widens.
-It is more likely for large funds to repurchase shares. As well, funds whose return has dropped in the previous year are significantly more likely to offer their shareholders the possibility to buy back shares in the subsequent year.
-There is evidence that funds that announce buybacks as buybacks are more likely to increase in size since they do not repurchase shares more often than their peers but at the same time they are involved in significantly more share issuances.
-Measures of discount control are launched with a bigger market capitalization than the rest of the closed-end funds. This in line with the marketing hypothesis that argues that closed-end funds IPOs are sold to investors that face relatively large information processing costs and thus become more prone to the influence of marketing devices.
The discount control mechanism that allows shareholders to vote on open-ending or liquidating funds that have been trading at a discount works precisely in the opposite direction: such funds are even less likely to delist than funds with no mandatory voting in place.
Looks like a win-win for both shareholders and investment managers/boards. For the latter, you can’t raise additional capital when trading at a discount to NTA!!!!!
IIR would encourage shareholders/unitholders in vehicles with persistent deep discounts and relative underperformance to get active. Pressure boards – apparently they are there to act in your interest.
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