The Blue Sky Alternatives Acess Fund (ASX: BAF) is not without its risks and is more complicated than most LICs in the market. However, we believe it also offers a very attractive risk versus return opportunity. The assets are generally ok, there are a few potential catalysts for a rerating, and our starting point is a very large discount.
How this opportunity came about
The opportunity we currently see in BAF is a direct result of well-publicised problems for the manager, Blue Sky Alternatives Limited (ASX: BLA). While a full explanation of these events would take up a book, we will keep it brief.
BLA was a listed alternative asset fund manager, which was somewhat of a market darling up to early 2018. However, in March 2018 the manager came into the crosshairs of short-seller Glaucus, who released a research report to the market detailing what they felt were serious shortcomings in BLA. The accusations included funds under management were much lower than reported, asset valuations had been inflated, historical returns had been falsified and a range of corporate governance issues.
BLA was trading at a very hefty valuation before this occurred. Once these accusations were made, the share price of BLA fell dramatically. Over the next 12 months, there were plenty of dramas as BLA restructured and fought to move forward. In late 2018, BLA made what has turned out to be a fatal decision to accept a loan from distressed debt provider Oaktree Capital. By May 2019, having breached the terms of the loan, BLA entered into administration/receivership. At this stage it is expected that the shareholders of BLA will receive no value for their shares.
What does all this have to do with the direct assets held by BAF? Actually, not much at all. Importantly, the assets of BAF are completely separate from those of BLA, and there is no danger of any action by Oaktree against BAF. Also, it is the parent of the manager that is in default, not the manager itself. Finally, the manager has a majority of independent Directors. To date, those Directors have acted commendably in looking after the interests of BAF shareholders.
Nonetheless, the change in perception and concerns about the value of BAF assets meant that BAF went from trading at a small premium in early 2018, to a 35% discount within months.
What the LIC does
The Blue Sky Alternatives Access Fund is an LIC that invests in alternative asset classes such as private equity, water rights, agricultural assets, student accommodation and other commercial property assets. The investment objective of the LIC is to provide investors with attractive absolute returns and to provide investors with the ability to access these types of assets. The assets themselves are generally illiquid (not actively traded). All of the investments are via unlisted Blue Sky managed funds, which are also mostly illiquid.
The following table summarises the asset allocation of the LIC at 31 July 2019:
While the precarious financial situation of BLA isn’t a great situation for BAF, arrangements are in place to ensure continuity of day to day management. There have also been several parties who have approached the BAF board with proposals to take over as manager of the LIC. The independent board members have recently announced that they are now undertaking a formal process to select a new manager for the vehicle. It is not clear how the existing management agreement would be dealt with under such a scenario. The fact that all of the current investments are managed by an associated entity also makes the situation a little more complicated. We do believe that these issues can be dealt with and that a change in manager would be very positive for BAF, and may be a catalyst to reduce the discount to NTA.
For the first four years of its existence, life was easy for BAF. It generally traded around NTA or at a small premium, and the manager undertook several capital raisings to increase the size of the vehicle. However, for the past 18 months, BAF has had an image problem caused by the plight of the manager. The share price plummeted.
As a result of the share price fall, the discount to NTA blew out past 30% and has stayed close to that level ever since.
Looking at the share price reaction, it would be reasonable to assume that the LIC had suffered some terrible loss of capital. But that has not been the case. Despite some ups and downs within the portfolio, the BAF portfolio in aggregate has performed adequately and has not shown any signs of significant distress. The following table summarises the portfolio performance for BAF up to 31 July 2019:
The issues surrounding the manager (BLA) did raise some questions for BAF:
- Were the asset valuations inflated?
- Was the manager propping up some of the underlying funds?
- Transparency from the manager had been poor, and could this be resolved?
As the majority of the assets are not exchange traded, there is an element of judgement involved in determining valuations. The current valuation process that is now in place is the most comprehensive it has ever been. There are new external consultants involved in the valuation process to improve the robustness of the reported NTAs. The manager has also sold a small number of assets (hedge funds and retirement living assets), at or close to NTA, which have increased cash levels. The Student Accommodation assets (which make up 13% of the assets) have been subject to a formal sales process. We expected they would sell for a good price and recently BAF announced a sale of the entire portfolio at a 17% premium to their carrying value.
We do still have some concerns about parts of the portfolio, particularly the private equity funds. This is the area of the portfolio we have the least confidence in, and by its nature, we would expect this sector to have the highest probability of loss. The Water Fund has also performed incredibly well over the past few years, which does raise concerns that these assets are more than fully valued. Notwithstanding, we believe the current share price of BAF more than compensates for this risk.
The previous level of transparency for BAF (and BLA) before the short seller attack was relatively poor. This has improved over the past 12 months, which has certainly aided us in understanding the portfolio. However, we feel that it is still far from ideal. For example, the manager does not report the valuation metrics for the different assets or sectors. Therefore it is not possible to perform a detailed assessment of the current carry values. This would be more of a concern if BAF were trading at NTA, but at a 30% discount we feel much more comfortable.
Why we like it
Owning BAF right now is predicated on our expectation that the current level of discount is overdone and that there is a catalyst in place for this to change over the next 1-2 years. We never considered owning BAF when it was trading around NTA. While we can see the attractiveness for investors being able to access these type of alternative assets through a simple LIC structure, the lack of detail around valuation metrics and the illiquidity of the underlying assets meant we were always looking for a reasonable discount before we would be tempted.
To be fair to the manager, the result for those investments that have completed and wound up has been relatively strong and helped to verify their carrying values. Also, the fact that performance over the past 12 months has been positive, after all the rigour around asset valuations, to us shows that the valuations were pretty close to start with.
Discount capture is one of our key alpha strategies in the Affluence LIC Fund, and we believe at this level of discount, BAF presents a good opportunity for this. Of key Importance for any discount capture strategy is not only the level of “excess” discount but also how long it might take for the discount to close. With BAF, we see several potential catalysts. They include a change of manager, realisation of a significant portion of the assets at or close to the current carry values, or even a full wind-up. Also, global discount capture specialist Miles Staude, who manages ASX: GVF is now a major shareholder. More recently, Miles also joined the BAF Board, giving us additional comfort that significant steps are being taken to close the discount.
Additionally, we are likely to be paid to wait. The portfolio return history for BAF has demonstrated returns between 5-8% per annum. Returns over the past 12 months were just over 5%, excluding the profit on sale of the student accommodation portfolio. It is difficult to predict what returns might be going forward, but buying at a 30% discount means ongoing returns are magnified.
Here are our top three risks for this LIC:
1: Manager Risk
The parent of the manager is now controlled by the administrators in consultation with the largest creditor, Oaktree Capital Management. While an independent Board is calling the shots for BAF, it is still subject to a long-term management agreement with BLA. The board of BAF have made it clear that they would like to appoint a new manager for BAF and are currently running a process to determine the most appropriate party. While we believe the board of BAF are trying to do their best by shareholders, there is no requirement for BLA to agree to transfer the management rights or co-operate outside of the existing management agreement.
It is difficult to predict how this will play out. The existing manager does have a fiduciary responsibility to manage the existing assets in the best interest of BAF shareholders, so we have no doubts that the existing assets are being managed professionally. But it is likely that BLA/Oaktree will be seeking some form of compensation if they are asked to step aside for another manager.
2: Fall in Asset Values
Given we have no visibility of the valuation assumptions or metrics that underpin the NTA, there is a risk that they are aggressive and the portfolio at some point suffers a material fall in the NTA. With the rotating external parties reviewing the valuations and audit process, we don’t believe this is likely, but it can’t be discounted completely. In addition, if a quick realisation of the assets were required, for example through a sale of the investments in the Blue Sky funds, would likely need to occur at a reasonable discount.
While we believe the underlying assets will continue to produce reasonable returns, our investment thesis for this LIC includes a contribution from the discount to NTA reducing. With BLA in receivership and the new manager process uncertain, BAF will likely remain in limbo for a while. While the independent board has announced they have started the process for a new manager, there is no fixed timeline for agreeing on an arrangement with BLA. This process could take much longer than everybody expects.
This LIC is not without its risks and is more complicated than most in the market. However, we believe it also offers a very attractive risk versus return opportunity. The assets are generally ok, there are a few potential catalysts for a rerating, and our starting point is a very large discount.
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 updated 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.
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I notice you did not mention the cash flow account. It shows two thirds of their cash flow is from sales of assets. In previous years two thirds of the cash flow was from issue of shares, which they cannot do now. Their assets do not provide adequate cash.
I think you have made a well argued case there Daryl. I am biased though as I was tempted a few months ago around 72 for basically the same reasons. They have recently gone ex div but I’m still happy to own hopefully for more upside. Just a question regarding the first risk point you highlighted in terms of honouring the original IMA. Is it possible the events of BLA trigger some sort of clause whereby shareholders can vote to break from the IMA if it came to that? I thought maybe because they went into voluntary administration this IMA could be broken. Reading your words it appears that there is certainty around the fact that BLA could hang onto the management rights. Is this issue clear cut one way or the other do you think? Cheers Steve
Hi. I agree with Steve. You would think that the insolvency of BLA would trigger some sort of contractual right for BAF to terminate the existing management agreement.
Some good points here. Steve Wood, we assume there will be minimal cash coming from the assets and therefore low dividends in the near future. The upside mostly comes from the sale of investments and a re-rating of the NTA discount. Cash is now around 25% of assets after the sale of further investments recently announced. Steve Green and Trevor the responsible entity and investment manager is a subsidiary of Blue Sky and not in any financial difficulty. A change of manager without compensation is certainly possible but it’s never clear in these situations. That said we think the independent board members are doing an excellent job right now on behalf of shareholders.