LICs under pressure to close discounts

In the past year, LIC discounts have increased, and the IPO market has become more difficult. We've seen a handful of LICs commence windup or restructuring transactions designed to close the NTA discount gap. 

We think there's more to come, as investors put pressure on poor performers. Holding selected small to medium size LICs trading at 15% plus discounts could pay dividends.

The discount opportunity

Right now, the average level of LIC discounts is very high. In fact, it's much higher than usual. What is also unusual is that these elevated discounts have appeared at a time when the ASX has been going very well. History would suggest that LICs are more likely to trade at a discount when times are tough. The situation is presenting a good opportunity to reallocate some equities exposure away from areas that have done very well and towards LICs.

Our current LIC portfolio has an average NTA discount of 15% and is predominantly comprised of underlying LIC managers we rate very highly. We believe for various reasons that the current high level of discounts will be much lower in 12 months. 

One of those reasons is that LIC managers are coming under increasing pressure from shareholders to deal with the expanding discounts. Another is that the IPO market is also coming under pressure (who wants to subscribe to a new LIC when the existing ones are so cheap)!

The result of these pressures may well be a shrinking of the LIC market, but an improvement in the average NTA discount. Below we talk more about each of those areas.

The LIC IPO market is changing

An announcement earlier this month from Magellan may represent a step-change in how LICs are marketed. Magellan has plans to list a new LIC, which is a high conviction version of their Global LIC (MGG). 

Magellan has announced as part of this transaction that they are proceeding with the offer without appointing a broker syndicate and are not paying any fees or commissions to brokers or advisers to handle the raising. Instead, they will issue additional units to investors. Shareholders in Magellan itself and some Magellan funds will receive even more units through a loyalty bonus. In doing this, Magellan acknowledges that the funds being committed are of value to them and are sharing that value with investors.

The practice of paying upfront fees to intermediaries has been a hot topic of late. Some commentators are suggesting it should be outlawed, as it already is for unlisted funds. Upfront payments are a part of the listed market, as they are for listed markets worldwide. Should we stop differentiating between listed and unlisted funds and ban all conflicted payments for listed vehicles? There are now many who think we should. But it's not an easy decision to make. For example, REITs are listed property funds. Should we ban capital raising payments for REITs as well? What about stapled structures, which combine both a passive investment vehicle with an operating business? What about hybrids and listed debt instruments?

The issue is now on the radar of politicians, and there might well be some changes in this area. Perhaps a capping of the amount payable might be on the cards. This could take the form of either a maximum percentage of capital subscribed or a maximum dollar amount per applicant.

The effect of any change will likely be that less money will be raised for LICs and LITs in the future. That may well turn out to be good for the LIC sector, helping to ensure the investor base is there for the right reasons, rather than crowded with transient capital looking to move on to the next opportunity.

Some LIC restructures have already been announced

Since late 2018, we've seen a small but steady stream of LICs undertaking windups or otherwise restructuring to close the NTA gap.

Watermark was the first to kick it off, with proposals in December 2018 to delist two of their three LICs and convert them to unlisted funds. The transaction also offered investors the chance to exit at NTA. These transactions were completed earlier this year. Prior to the announcement of the transactions, both LICs had consistently traded at 15-20% discounts to NTA for some time. Investors who bought within a short period prior to the restructure announcement would have done very well. However, longer-term investors didn't fare so well, with the performance of both vehicles very subdued since listing.

Early in 2019, 8EC Emerging Companies (8EC) announced a wind-up proposal, with all investments to be liquidated and funds returned to shareholders. The transaction announcement came after sustained pressure from a major shareholder, following a reasonably long period of poor performance. The windup was approved by shareholders recently and will be substantially completed over the next two months.

More recently, the Monash Absolute Return LIC (MA1) announced a proposal to restructure to an exchange-traded managed fund. This is still to be voted on by shareholders, and some of the transaction details are still being worked on, but we expect that it will proceed in time. The proposal is similar to the Watermark restructure. The key difference is that the resulting investment vehicle is expected to trade on ASX, rather than be an unlisted managed fund as in the Watermark example.

We applaud each of these managers for (eventually) taking decisive action to fix the discounts.

On other cases, we're seeing LICs merge to gain the benefits of larger scale, without diluting existing holders of either vehicle. 

In the last few months, we've seen friendly merger proposals from both CBC/Clime and from Mercantile/Sandon Capital. While we also think this is positive, there is unlikely to be as much short term benefit in terms of price appreciation.

Many more LICs are coming under pressure

In our current LIC research universe, almost 50 LICs are trading at 10% or greater discounts. 

Of these, more than 25 are trading on at least a 15% discount. Examples include Acorn Capital, two PM Capital LICs, Pengana International Equities, Australian Leaders Fund, L1 Capital, two Ellerston Capital LICs, two NAOS LICs, and two Thorney LICs. 

Around a dozen are trading at discounts of 20% or more. These include Bailador Technology, Morphic Ethical Equities, two Fat Prophets LICs and Blue Sky Alternatives Access. 

Many of these LICs have reasonably open registers. In other words, they do not have one or more major shareholders that would be supportive of the status quo.

Within these discounted LICs, we are aware of quite a few that now have activist investors on the register. The Blue Sky LIC is one example where multiple investors are encouraging management and the Board to take decisive action to solve the discount problem. Another example is URB Investments, which now has 360 Capital on the register. 

We expect activist investors to play an increasing role in the sector in the near term. The result will be an increase in the number of wind-ups, restructure and merger transactions over the next year or so.

Summing up

It seems the LIC market is running out of patience with discounts. As restructure or wind-up transactions occur, this will increase the spotlight on remaining LICs. They will have to either perform well and/or close the discount gap. If they don't, they will face increasing pressure to return capital back to shareholders through wind-ups or restructures. An investor holding a portfolio of small to medium size discounted LICs may do very well out of it over the next year or two.

We encourage you to do your own research before making any investment. A great LIC, investment fund or manager is only part of the story. We also like to make sure they’re trading at the right price and that the assets they are investing in are not themselves overvalued. We explain how we do this in our LIC Guide, but in the end, it’s up to you to make the investment decision that’s right for you in conjunction with your financial advisor if you have one. Take care and all the best with your investing.

Hear Daryl speak at the 2019 Listed Investment Company Showcase

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