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CEF Mergers Abound in 2013, but Boulder's Potential Deal Sticks Out

Four Boulder funds take action on persistent discounts by proposing a merger.

Cara Esser, 12/03/2013

Despite a healthy year for closed-end fund initial public offerings, a rash of fund mergers shrank the overall CEF universe from 616 at the start of 2013 to 600 as of mid-November. Although merger transactions slowed this year compared with those in 2012, the trend hasn't ended: Eight mergers have been proposed or approved this year to be completed in 2014.

Generally speaking, firms with numerous municipal offerings, especially Invesco and Nuveen, focused on merging smaller, often single-state, funds in years past. In 2013, however, there was an uptick in non-muni-fund combinations, including the recently proposed merger of four equity funds from Boulder Investment Advisors. If approved by shareholders through a proxy vote in the first quarter of next year, this will be the first equity fund merger since early 2012.

On Nov. 4, the funds’ boards of directors approved the acquisition of Boulder Total Return BTF, Denali Fund DNY, and First Opportunity Fund FOFI by Boulder Growth & Income BIF. Each of these funds is managed by the same team, using a similar bottom-up, value-driven stock selection strategy with resulting holdings that are similar, though FOFI’s holdings differ somewhat. The management team took over that fund in 2010 with the intention of transitioning it to a large-value equity portfolio from its prior focus on small financial-services stocks. Management has taken its time winding down certain holdings due to the illiquidity of some positions and has kept stakes in firms it believes remained attractive investments.

Double-Digit Discount Woes
Another similar component of these funds is the persistently wide discounts at which they all have historically sold. (Each fund’s discount was more than 20% as of Nov. 20.) Portfolio manager Brendon Fischer came on board in February 2012 and, in combination with the funds’ boards, has played an integral role in the proposed merger. He believes that by combining the funds, many of the issues contributing to the persistent discounts will be addressed.

While there are many reasons for the wide discounts (a previous article discusses BTF’s struggles in particular) the funds’ low distribution rates have arguably been the most significant contributor because investors look to CEFs for regular distribution payouts. As of Nov. 20, BIF had the largest distribution rate of the four funds (4% at share price) which was still much lower than its CEF peer average distribution rate of 6%.

Although Fischer cannot change the distribution policy to a managed or level policy that generally appeals to investors--a CEF’s board of directors must approve that type of change--he believes the best long-term policy for investors is to pay only what a fund has earned without overpromising steady payments throughout the year. This means the funds make year-end distributions payments based on income earned and realized capital gains after offsetting any capital loss carryforwards. FOFI and BTF haven’t made distributions for a number of years due to large capital loss carryforwards that have offset realized gains. DNY and BIF have made small, but uneven, distribution payments over the years because they do not have capital loss carryforwards.

The newly merged fund will take on BTF’s and FOFI’s $80 million in capital loss carryforwards and future distributions of realized capital gains will be paid only after the loss carryforwards have been fully used. Current investors in these four funds should also note that each fund intends to distribute undistributed net investment income and realized capital gains prior to the merger.

Though it’s too early to know for sure, the distribution policy is likely to remain a headwind for the combined fund’s discount. Distributions and discounts go hand in hand and, unless the board of directors makes a move towards a managed distribution policy, all signs point to a lower-than-average distribution rate in the future.

Cara Esser is a closed-end fund analyst at Morningstar.

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