Highlights from this year's Investment Company Institute conference.
Depending on an investor's level of interest in closed-end funds, this week's Investment Company Institute's conference on CEFs can be pinned anywhere along the spectrum from boring to wonky. The conference isn't geared toward individual investors and advisors as much as it is toward CEF industry personnel. This means that speakers generally focus less on market updates and selling their specific funds, and more on discussing CEF mechanics, new regulatory concerns, and challenges of sponsorship. The agenda certainly had its less exciting parts--the new, expanded definition of commodity pools under Dodd-Frank, for example, wasn't as enthralling a discussion as one might expect--but still offered some information that investors may find useful. In particular, discussions on the new-issue market and secondary market support offer insight into the direction the industry is heading.
CEF initial public offerings are a contentious issue. When a new fund is brought to market, underwriters take a sizable fee out of net assets (typically around 5%) for providing preissue services and secondary market support for a short time post launch. This causes CEFs to trade at premiums on day one. Investors are often skeptical of taking this deal (for good reason), making it difficult for firms to launch new funds. For CEF sponsors, this poses an obvious dilemma: Management fee revenues are tied directly to assets under management; fewer assets equal less revenue.
Panelists offered a few perspectives on this dilemma. One panelist of particular note represented a prominent CEF underwriting firm. The key takeaway from the panel was that bringing new CEFs to market is incredibly competitive--the underwriting firm received roughly 800 new fund pitches over the past four years with only 16 slots for launches in each calendar year. That's a 4% acceptance rate. Underwriters can afford to be picky.
With such a small number of accepted pitches, investors may wonder how underwriters narrow the field. One of the primary selection criteria is that the fund sponsors be well-established. Underwriters need an extensive distribution network to help sell the new product. Large CEF families such as Nuveen and BlackRock have an easier time raising assets than do smaller firms such as Bancroft or Foxby. In addition, larger fund sponsors typically have management teams with longer track records and are more likely to support the funds in the secondary market over the long term after their launch.
Secondary market dynamics also play a key role in selecting a new fund pitch to launch. Unsurprisingly, new CEFs need to pay competitive distributions. If a sponsor's lineup is filled with low-distribution funds trading at discounts, a new fund can be a difficult sell. While one panel member rightfully pointed out the importance of total return, income sells. Unfortunately, the question of whether income is overemphasized in new offerings is still open for discussion.
A new fund's strategy also needs to make sense in the current market environment. Municipal ETFs and open-end funds, for example, experienced sharp outflows this year, and many CEFs saw discounts widen and premiums narrow in the second half of the year. Now is not an opportune time to launch a muni CEF--good luck convincing investors to pay a 5% premium when a plethora of discounted options already exist. Alternatively, master limited partnerships and bank-loan funds are now incredibly trendy, making it significantly easier to launch these strategies. In other words, income with low interest-rate risk is what's selling in the current market. The rub here is that timing is difficult. Fund firms often start the process months in advance, which means that by the time an IPO is ready to launch, the market environment may no longer be favorable.
The panel also discussed the growing popularity of liquid alternatives. Many investors want to diversify their portfolios, and alternative strategies offer returns with potentially low correlation to other asset classes. Meanwhile, many less-liquid alternative strategies are well-suited for the closed-end capital structure. But, a big concern for some panelists from a sales standpoint was complexity. It's already difficult to explain CEFs to many financial advisors, so new funds should ideally have strategies that can be easily summed up in one or two sentences.
One audience member (yours truly) suggested that new CEFs can be brought to market, almost by definition, only if the strategy is overvalued. After an awkward pause, the panel members admittedly took the blame. In all, it certainly brings to mind the industry adage: "Closed-end fund IPOs aren't bought; they're sold."