Four Boulder funds take action on persistent discounts by proposing a merger.
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.
Can Small Changes Lead to a Big Transformation?
Concentrated portfolios, small fund size, lack of transparency from the fund’s advisor, and high fees have also played a role in the funds’ persistently wide discounts. Aside from FOFI, each holds a 30% or greater allocation to Berkshire Hathaway BRK.A A shares, and BTF has an additional 15% allocated to Berkshire Hathaway’s B shares BRK.B. Overall holdings tend to be concentrated in 25 to 30 large-capitalization equity names--FOFI again is the exception with closer to 60 equity names plus direct investments in financial services companies and hedge funds.
Fischer argues that some advisors are restricted from investing in the funds because of high concentration in certain names. If this is true, the combination should reduce the concentration of some holdings, though Berkshire Hathaway will remain a large allocation in the surviving fund. Unless some of Berkshire Hathaway stake is sold, those advisors may still face investment restrictions.
For smaller, thinly traded CEFs bid-ask spreads tend to wider which makes buying and selling shares more expensive. As of Nov. 20, these funds’ net assets ranged from $100 million to $350 million, relatively small even in the CEF universe. The combined fund would be more than $1 billion in assets, a line which only 53 CEFs crossed as of Nov. 20. Not only should bid ask spreads narrow following the merger (and shares should become more liquid), but the larger fund is likely to attract more attention simply due to its size.
On the transparency front, the firm has updated its website to include more information about portfolio holdings, provide easier access to regulatory documents, and a detailed discussion of the firm’s investment philosophy. Whether this can impact the future fund’s discount is unclear, but investors always benefit from increased transparency and the effort should not go unnoticed.
Finally, there are reasons to believe that fees should improve post-merger. All four funds currently charge an advisor fee of 1.25% with a 10 basis point waiver for BIF, BTR, and DNY. Because FOFI invests in hedge funds, the advisor waives a larger portion of the fees, though its overall expense ratio is higher than its average peer.
Once completed, the newly merged fund intends to reduce advisory fees and add a sliding fee schedule. The new fund will charge a fee of 1.10% on total assets under management up to $1 billion and 1.05% for total assets between $1 and $1.5 billion. Though shareholders will benefit from the lower absolute fees and a sliding scale that reduces fees as assets increase, the advisory fee is still quite high. The average advisor fee charged by a large-cap value CEF is 0.95%.
On the whole, the proposed merger and resulting changes appear positive for investors, especially on the fee front, though questions remain. The large Berkshire Hathaway position may continue to deter some investors as might the new fund’s likely lower-than-average distribution rate. Fischer believes that perception is reality and hopes that changing investors’ views of the funds will benefit long-term shareholders. While it remains to be seen whether investors will react positively to the changes, each is a step in the right direction for the funds.