Opportunities and risks in the evolving LIC/LIT market

VGI Partners, founded in 2008, has been one of the successes of the local investment/hedge fund industry in recent years. Investment returns have been strong in their unlisted funds, they launched what is now almost a billion-dollar global LIC in 2017, VGI Global investments Limited (ASX: VG1), and in June this year they listed the management company VGI Partners (ASX: VGI), now with a market cap of $1 billion. They are currently seeking to raise up to $1b for an Asian LIC, VGI Partners Asian Investment Limited (ASX: VG8), targeting 10-15% p.a. and to be listed 13^th November. VGI already manages around $2.6 Billion.

While part of the success has derived from good risk adjusted performance, part has been the result of revamping the LIC IPO model by paying all up front and allowable ongoing costs thereby providing a more cost efficient and transparent vehicle. (Although management fees at 1.5% p.a. and performance fees of 15% with no hurdle are high in today’s market). However, a big contribution to current growth has come from the use of “alignment shares” in the listed manager, VGI, as a carrot to raise additional money in the LICs, firstly in a recent secondary issue for VG1 around the IPO of the manager, VGI, and currently as part of the VG8 Asian offering.

VGI Partners management have also backed themselves with significant personal and company investment in their own unlisted and listed funds and shown a willingness to buy more, including reinvesting the after tax value of performance fees paid out as dividends (and escrowing these shares). The manager is putting $20m into the VG8 cornerstone offer with additional amounts from key staff and family. Managers buying into their own listed funds has been a growing trend in the LIC space, although this may raise some issues in the future and is discussed further below.

The addition of alignment shares in VGI makes the VG8 offer at $2.50 seem very appealing, especially for existing VGI Partners fund investors. Following an odd spike of almost 10% in VGI share price to $15.50 on Friday 20^th September (the last business day before the offer opened) the alignment shares were worth 20.7 cents or 8.3% of the VG8 application price for existing VGI “family” investors buying into the priority offer (one VGI share for every 75 VG8 shares applied for - capped at a total $300m) and 12.4 cents or almost 5% for other investors participating in the broker or general offer (one VGI share for every 125 VG8 shares).

Certainly, this looks extremely attractive compared to the LIC IPOs of old where investors wore the upfront costs meaning they were effectively buying in at a 3-5% premium to NTA and relying on the “gimmick” of options at the IPO or a higher strike price to make the package look palatable.

New versus old opportunities

Still, there may be some nuances and risks that investors focusing on the positives features of this offer are missing. Further, perhaps this focus is leading investors to neglect other LIC/LIT opportunities that are available, some of which may be emerging partly as a result of market pressures created by VG8 and other large LIC/LIT offers currently being promoted.

Discounts on other Asian and global LIC vehicles particularly have widened significantly in recent weeks and months, and this may continue in the short term. This is likely partly driven by some brokers and advisers selling shares in existing LICs to make way in client portfolios for the new offering. Another innovator in the LIC/LIT space, Magellan, is raising money for their High Conviction Trust (ASX: MHH) with loyalty units for those still invested on 30 December 2019 equivalent to 7.5% for existing Magellan family investors (to a maximum of $50,000 per existing Magellan investment) and foundation units equivalent to 2.5% for non-Magellan investors, closing on 27 September, and listing on 11 October. (Although this offer may be less attractive to brokers and some advisers as no broker selling or stamping fees are being paid). Large LIT raisings in the private debt/credit space - Partners Group Global Income Fund (ASX: PGG) which raised $550 million and is to be listed this Thursday 26^th September and KKR Credit Income Fund, seeking up to $825million, closing 6 November, listing 21 November, are also drawing interest away from existing LICs and LITs.

For example, on Friday 20^th September, among Asian specialist LICs on the ASX, Platinum Asia (PAI) was trading at an estimated discount to pre-tax NTA of around a 15%, Ellerston Asia (EAI) around 17% % and PM Capital Asia (PAF) at around 19%. Global LICs have also generally seen discounts increase with some now at discounts of around 20% to pre-tax NTA. Given PAI, for example, has traditionally traded at a single digit discount, and occasionally at a premium, investors may be blindly throwing out good existing opportunities, although Asian markets poor showing recently has also been a factor. (Note I am a current holder of PAI).

An easy sell

The elephant in the room is the payment of lead manager, broker selling and stamping fees which has been subject to recent industry, government and regulator discussion. It is a subject for deeper discussion on another day but in the case of VG8, the combination of these fees being available, the manager paying for them, plus the significant manager alignment “bonus” shares discussed above, is seen as nirvana for some brokers and advisers.

It creates a very easy sell. A new investment vehicle of a reputable manager at an effective discount to NTA (given the alignment shares) and with brokers receiving a considerably higher fee compared to the standard transaction fee for trading an existing LIC. Some extra work is clearly involved in a new vehicle but how much? Will those currently supporting this offer be the ones selling VG8 at a discount in the future, perhaps with the next attractive and exciting deal in mind?

These arrangements are thanks to the “generosity” of VGI, and that generosity is forthcoming because VGI hold the view they are locking in permanent capital and the cost of raising that equity capital in the listed manager is attractive given the current manager valuation. With a 10-year management agreement and a 5-year automatic extension, if they do a good job both in terms of performance and managing the discount, they can expect to earn large management and performance fees on the listed pool of capital for many years.

Risks and opportunities being ignored

However, things have a habit of sometimes going wrong in the listed investment fund space and that is when the dynamics can turn on the manager and investors. The reality is market conditions can be treacherous at times, investment performance is not guaranteed, fund managers come into and out of favour and many LICs/LITs will trade at discounts to underlying NTA, sometimes at deep levels.

One theory of why LICs typically trade at a modest discount on average (i.e. mid-single digits) is they are pricing in the “noise trader risk” that irrational investors become more pessimistic and discounts might increase compared to the discount level one buys into. This is an additional risk that one doesn’t have in an unlisted fund or an ETF. However, this “sentiment” theory (see Investor Sentiment and the Closed-End Fund Puzzle, Lee, Shleifer and Thaler 1991) also suggests that patient LIC investors can achieve a higher return for taking that risk, all other things equal. That higher return can come from a higher dividend yield compared to the underlying portfolio (e.g. a 4% dividend yield on a portfolio of an unlisted fund becomes a 4.4% yield at a 10% discount to NTA) or it can also come simply because of the mean reversion in the discount back to normal or lower levels and the ability for patient, rational investors to wait until such lower discount levels are available to sell.

If you buy a fund at a much larger than normal discount (say 15-30%), assuming there is nothing fundamentally wrong with the manager, the strategy, or the assets, the potential uplift in yield and mean reversion return can be significantly higher, especially if there are near term catalysts for that discount to narrow. Of course, mean reversion of discounts is far from guaranteed which is why it’s a risk you are expecting to be paid for. Investors are also still taking on the market risk of the underlying portfolio (unless they are partially or fully hedged by short selling the underlying equivalent portfolio or using futures).

VGI Partners have had a smooth ride in the short history of their listed entities to date. Certainly, the optimists point to the trading of VG1 (at a premium since listing until recently) and argue that a substantial discount is not likely. However, increased supply of VGI listed product following the secondary issue for VG1 and now the VG8 raising is likely to change the dynamics and the recent move of VG1 to a small discount may be indicating this.

Certainly, the enthusiasm that I have seen some brokers and advisers talking about the VG8 offer suggests there may be a lot of “weak handed” holders once the IPO is done and preventing it from trading at a meaningful discount at some point is likely to be an increasingly challenging task. And while high management/performance fee structures are generally ignored when performance is good and optimism high, they can quickly become a factor contributing to a larger discount when initial support subsides and in a period of poorer performance.

This highlights risks with even the best LICs and that buying funds at NTA or premiums is riskier than many perceive. This doesn’t mean some funds can’t trade at NTA or premiums for extended periods of time. Clearly, some funds have expertise and the ability to add significant value which may justify them trading at NTA or a (small) premium. But in practice all managers have periods where performance struggles, and all have periods of being in and out of favour, which typically reflects in the discount level.

In the case of VG8 and MHH one might argue that investors are being paid extra (by the manager alignment shares in VG8 and loyalty/foundation units in the case of MHH) to buy at NTA exactly because investors are taking on these “sentiment” risks peculiar to listed closed end vehicles such that when they sell they might have to do so at a discount to NTA, perhaps a substantial one. Still, that’s much better for investors than having to pay to invest at NTA under the old LIC IPO model, and still having those risks.

Further, given the concentrated investment strategy of both vehicles (VG8 is 15-30 stocks long, 5-25 short, MHH is 8-12 long) the risk of periods of poor performance is arguably greater. VG8’s long/short strategy may lower risk although this is partly offset by the focus on Asia, despite their current exclusion of some of the “riskier” markets such as China, Indonesia and India. There is also some risk that their investment flexibility is constrained as funds under management grow, given their willingness to hold some positions of lower market capitalisation and liquidity in the past.

A closer look at manager/investor alignment

At first glance, a manager’s significant investment in their own listed fund vehicles is seen as positive by all concerned. They are aligning themselves with investors and the monetary success or failure of that vehicle. There is some evidence more generally that managers investing in their own funds do have better returns. In addition, to the extent this manager investment involves buying the LIC/LIT on-market, it can sometimes help narrow a discount. However, in some circumstances a large manager stake can become problematic.

Specifically, there is a possibility the manager becomes conflicted down the track if investment performance is suffering and/or the fund has drifted to a large discount to NTA and other shareholders are lobbying for changes (e.g. buybacks, higher dividend, other capital management etc.). The risk is the manager may use their ownership as a blocking stake to help prevent the approval of measures that may be in most shareholders, but not necessarily the manager’s, best interest. Historic studies of manager stakes in closed end funds in the US and UK have showed that not only did managers use those stakes to prevent actions to remedy a large discount or poor performance, but that such funds had larger discounts on average. See “Private benefits from block ownership and discounts on closed end funds’ Barclay, Holderness and Pontiff (1991).

I am not aware of more recent studies although I suspect greater transparency and responsiveness of boards and managers and more active and knowledgeable shareholders today may have improved this situation. Indeed, these days, when it is clear that a manager has a stake and is using that to help pursue their own interests, it is very obvious to shareholders and may even strengthen their willingness to be active in such situations, including generating more publicity that can negatively impact the manager’s reputation. (There is a small subset of fund managers with little integrity who don’t care about their reputation – these should be avoided at all costs, especially in a LIC structure).

In practice, it seems smaller manager holdings are positive (say around 5%) but holdings of over 10% can become more problematic in some circumstances. Clearly, the so called “alignment” with shareholders from a manager holding large stakes in the vehicle can be a two-edged sword.

I am not suggesting this will necessarily be an issue with recent LIC/LIT floats. However, as we have noted, some managers are paying significant value away to lock in funds under management. This may increase their incentive to fight to retain funds in the future irrespective of what is in investors best interest. Note this is separate from any other costs embedded in investment management agreements regarding terminations. For example, the VG8 prospectus has a clause that the manager will receive the equivalent of the previous year’s base and performance fee if they are terminated.

At the very least this needs to be recognised as a potential risk when talking about the “benefits” of manager and shareholder alignment. At the very time shareholders may want something done about a large discount or the investment strategy after poor performance that would help restore value to shareholders, the manager may be focused on retaining maximum assets under management, particularly when the manager has paid a lot up front to build those funds under management.

Lack of Diversification

The VGI and Magellan incentive structures also encourage existing investors to put more into the one manager’s vehicles which may not necessarily lead to sensible diversification and portfolio construction. To the extent investors end up building a holding in both the manager and the (two) VGI LICs there is a risk that a period of poor performance would hit both badly, with VGI suffering a de-rating and lower fees and VG8 (and VG1) seeing disappointing NTA growth (or losses) and a growing discount to NTA. Magellan face a similar risk especially since, without the payment of stamping fees, their current raising is narrowly targeted at exiting investors. Of course, some investors will no doubt be taking up such offers with the intention of quickly selling part or all their holding once listed to prevent such manager overconcentration. However, to the extent that such thinking is widespread it can be the very factor that helps generate a growing discount to NTA in coming months and years.

Conclusions

The trend for managers to pay for LIC/LIT IPO costs is clearly positive for investors although this is not something easily done by small managers. The use of listed management entities to facilitate the payment of such costs and attract assets though additional alignment shares or bonus loyalty units is clearly impossible for smaller and privately-owned managers. Further, only large, well known branded managers like Magellan can raise substantial money for a listed vehicle without the payment of broker/stamping fees. Obviously, some large managers in the credit space have also used their size and prominence to raise substantial funds (although still reliant on broker/stamping fees). Clearly, whichever way the stamping fee issue goes, the hurdles for smaller/boutique mangers to get a LIC/LIT off the ground with a viable sum of assets has increased significantly. Yet selected smaller managers with integrity, and who have an investment edge, clearly have something to offer in the listed fund space. Its dominance by large, branded managers only, would not be healthy.

While the latest offers from VGI Partners and Magellan look particularly attractive to existing clients in those groups, investors need to carefully consider how much exposure they end up with the one manager/strategy and consider what the market dynamics of those vehicles will be in the future. It is also sensible for those managers to use their currently highly rated equity in the listed management entities to pay to attract such funds, although again with an eye to future dynamics and challenges. Sometimes opportunities that look very attractive at first glance and in the short term have some hidden issues and future risks that shouldn’t be ignored. In addition, the narrow pursuit of such opportunities may be helping to generate even more interesting investment opportunities in other vehicles which are being blindly sold to finance these new offers. The VG8 and MHH offers seem to be excellent examples of these dynamics at play. Still, it will take some time to demonstrate whether either the highlighted risks, or the other interesting opportunities, are real.