I haven’t written about closed-end funds in a while, so when I was skimming through the possible teaser pitches I might cover today this one caught my eye. It’s for Sovereign Man’s 4th Pillar newsletter, helmed by Tim Staermose (it’s pricey at $1,995/year but does, at least, offer a 30-day money-back refund, something most of the high-end letters that are heavily promoted have stopped doing).
And the ad is all about what most closed-end investors dream of: closing the discount.
If you’re not familiar with closed-end funds, they’re basically like mutual funds or ETFs — but unlike those fund structures, there’s no mechanism for immediately smoothing out a huge premium or discount valuation. Closed-end funds generally own the same kinds of publicly-traded stocks as any other mutual funds, and they report their net asset value every day (usually), but they don’t promise to redeem shares at NAV every day(like a mutual fund) or offer to let institutions redeem shares (like an ETF), so the shares can trade in the public market at a price that’s much higher or much lower than the value of their actual portfolio holdings.
The general tendency is for most close-end funds to trade at a discount to their NAV, whether because of the performance of the fund manager or the worries about their cost of leverage (many closed-end funds borrow money to improve their returns), but some of them are particularly adored by investors, particularly if they generate consistent dividend income, and do trade at frightening premiums. And they also tend to be levered to the market even if they don’t use a lot of debt — that’s because when there are mass selloffs in the market it’s not unusual for CEFs to get sold off in the same proportion as everything else, while the NAV is also falling, and therefore they may tend to fall more harshly… and, on the flip side, when there’s ebullience in the market and prices are soaring and CEFs are performing well, people pile into them and the shares begin to trade at a smaller discount to the NAV (or even at a premium), helping the shares outperform.
Asset managers like closed-end funds because they are “captive” funds — once you raise the money to form a closed-end fund, there’s no simple mechanism for “cashing in” the shares like you can with a regular mutual fund, the way that investors get out of the fund is by selling their shares on the public market. That doesn’t impact the portfolio or the manager’s management fee — they continue to have the same assets under management, so they collect the same fee, and they don’t have to sell stuff they don’t want to sell just because investors are redeeming shares at the absolute worst time (which is the fear of most mutual fund managers, and one reason why they tend to keep a fairly substantial cash cushion on hand to manage redemptions).
Closed-end funds are companies, really, so they can make changes that benefit shareholders — it’s just not a particularly sexy form of shareholder activism. They are mostly too small to attract big hedge funds, but there have been activist investors focused on the closed-end space for a while as they try to shake up sleepy boards or get fund managers to make more effort to close the discount, often by offering redemptions at NAV or buying back shares of the fund. The most prominent and largest firm involved in closed-end funds recently has probably been Saba Capital, though Bulldog Investors gets a fair amount of attention too (perhaps partly because both Saba’s Boaz Weinstein and Philip Goldstein of Bulldog are both fairly high-profile and regularly speak at investment conferences).
Interestingly enough, both Saba and Bulldog also offer their own exchange-traded funds that give exposure to their investment strategy… which is, in part, to narrow the discount at which closed-end funds trade and profit from that narrowing (by buying at a big discount and selling at a much smaller discount or at NAV). And, yes, one of those funds also trades at a discount (Bulldog’s is the Special Opportunities Fund, ticker SPE, trades at about a 12% discount right now… Saba’s Closed-End Funds ETF is actually an active ETF, not a closed-end fund, so trades near NAV).
But while that might be interesting, I’ve gotten pretty far afield — neither of those is the Closed-End Fund being teased by Sovereign Man… so what is this secret investment?
Clues from the ad:
“… after you learn the full story about this investment, you’ll see there aren’t many ways this can go wrong.
“Even better, there’s a catalyst at work, right now, that could send shares ripping higher any day now….”
And we get a few hints about the holdings in this fund:
“I’ve found a way to buy a basket of some of the biggest and safest blue-chip stocks out there at a massive discount to where they trade on the open market.
“You’d know the names of these companies…
* One of them is a well-known consumer brand ($90 billion)
* Another is a leading services provider to businesses ($60 billion)
* And there’s a global food giant whose products are probably in your kitchen cabinet ($70 billion)….
“Through this publicly traded fund, you can buy the exact same shares of these high-quality blue chips for 26% less than everyone else is paying on the market.”
OK… what else?
We’re told that this fund is managed by one of the best in the world… and that with this fund, you get his expertise for a lower fee.
So why is it down? We’re told that “shareholders are incredibly bearish” and have lost faith in the fund manager, so they’re selling even at a 20%+ discount to NAV.
More from the ad:
“A monkey could be managing this portfolio… when you’re buying blue-chip stocks at 26% below their market value, there’s not a lot that can go wrong.”
So… what could close this discount or change sentiment? We’re told that the manager has already taken “several steps” to help close that discount, but that there’s more coming.
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Changes were approved last year at the annual meeting, which was held “on a small island off the coast of France,” which probably means its one of the many investment funds sheltered from taxes in the Channel Islands (Jersey and Guernsey).
And at that meeting, the shareholders also apparently voted to let the fund manager buy back 20% of the shares, which he has apparently already begun.
More from the ad:
“There’s also another catalyst the fund announced in early February… and I think it’s the biggest of them all. It should attract a MASSIVE wave of investors into the stock to close the gap (I share the details of this catalyst inside my new report).”
Any other clues? We’re told this is a large fund, with liquid holdings, and he thinks it’s a possible double as the investments appreciate and the discount closes. And that’s about it.
So what’s the fund? This is our old friend Pershing Square Holdings (PSH in Amsterdam or London, PSHZF OTC in the US), the closed-end investment fund launched by Bill Ackman’s Pershing Square just as he was at his peak of performance a few years ago, before the Valeant debacle. Those three holdings cited are presumably Starbucks (SBUX), Automatic Data Processing (ADP) and Mondelez International (MDLZ) — SBUX and ADP are still major holdings, but Pershing actually sold out of Mondelez in the third quarter last year.
And yes, I held shares in this one for a while when it first went public. I found the idea compelling that you could buy into Ackman’s investment strategy at a small discount, with a substantially lower fee than his hedge fund investors had to pay (it’s still a meaningful fee, but at 1.6%/16% was less than the 2% annual fee plus 20% of returns that was charged by most hedge funds). After all, he is a smart guy (just ask him), and has had some extraordinary returns in the past, particularly with activism and real estate (General Growth Properties and Howard Hughes especially).
But boy, Valeant was a HUGE mistake, exacerbated, I assume, by Ackman’s hubris as he built a huge position very quickly and got way too levered as a major owner of a house of cards that collapsed and put a huge dent in his reputation. Pershing Square hasn’t traded at discount of much less than 20% in a couple years now, and their decision to begin more actively trying to shrink the discount by buying back shares hasn’t helped yet.
What might help is the restructuring of Pershing Square, which seems somewhat like it might be Bill Ackman’s “come to Jesus” moment, admitting his sins and washing the slate clean and starting over with a much smaller and more focused team, without as much of a public presence for him personally, and with a focus on strong companies and on taking advantage of Pershing’s long holding period and activist muscle.
Which sounds good. Yes, they said they were buying the best companies back when they poured billions willy-nilly into Valeant, too, and Bill Ackman even tried to convince Charlie Munger to back down on his statements about Valeant being a “sewer” (he failed, of course)… but despite the fact that it feels really, really good to puff up your chest and guffaw at the foolish billionaires who got sucked into dumb investments, it does seem that Ackman is at least restructuring the investment strategy (and importantly, the process of vetting investments) to try to avoid such mistakes in the future.
And yes, we can point similar fun at Warren and Charlie’s massive investment in Kraft Heinz that’s currently coming back to bite them… though the scale is very different. That was not nearly as controversial a company as Valeant, of course, and Warren hasn’t accepted that as a mistake other than to say that he overpaid, unlike Ackman, who had to apologize to investors for the Valeant screwup a couple years ago. Also unlike Ackman, importantly, the exposure was never at risk of destroying Berkshire — Berkshire invested about $10 billion of its $200 billion book value in Kraft Heinz and is probably losing a little on that now (though the loss feels larger because Berkshire’s Kraft Heinz stake was valued at $15-20 billion for a little while), and that’s a lot of money… but Pershing Square had only about $20 billion in assets under management at its peak in the early Valeant days and lost $4 billion on just that one Valeant investment.
That’s really what caused the lack of trust in Ackman for me, not just that he stood by Valeant almost to the end, despite all the obvious problems (the last chunk he sold was at something like a 94% loss), but that he let it become a huge 30% of his portfolio and somehow, despite his vaunted analytical skills and powerful stable of analysts, wasn’t able to see the possibility of it collapsing in on itself. If it had been a 3-5% position, Ackman could have remained a king of the world after a few embarrassed CNBC interviews, instead of having to spend years trying to rebuild his reputation.
That’s all water under the bridge now, though, the question is whether it’s possible to trust Pershing Square again. The portfolio has almost completely rotated through from when I held shares during the ugly days a few years ago, Pershing has tried to add more discipline to avoid these kinds of mistakes, and gone through layoffs and lost a lot of its outside capital as institutions pulled out, and now the publicly traded Pershing Square Holdings is actually the majority of the money Bill Ackman’s group is managing (the closed end fund is about $5 billion in NAV now, out of Pershing Square’s total AUM of about $8 billion). Now Ackman’s investors are mostly the public investors through Pershing Square Holdings, and his fellow Pershing Square employees and himself.
And yes, they’ve been trying like heck to shrink the discount that the fund trades at — after a big wave of investor redemptions in other Pershing Square partnerships in 2017 and early 2018 they seemed to get more serious about shaking things up. Last year Pershing Square shrunk the free float of Pershing Square Holdings shares by almost 25% by both doing a tender offer for $300 million and having Pershing Square affiliates buy $520 million worth of shares, and the news from February that the ad references is the initiation of a dividend this quarter (10 cents/quarter) that’s intended both to help compete with the S&P 500 (the dividend level is similar to the broad market average) and to slowly shrink the discount through dividend reinvestment.
Will it work? Well, that probably depends on how the portfolio does — so far, it’s looking pretty good. They had a very good 2018, only partly because of the buybacks, and had a blistering start to 2019 that got a lot of attention for Ackman as a reborn star… and he got rid of the assets that were unexciting (Mondelez) or seemed like persistent hubris (the Herbalife short), which made room for him to enjoy strong returns on ADP, Chipotle, Lowe’s and Starbucks.
Chipotle has been the best performer of late, finally showing some good returns after a rough start in 2016, and the other holdings that have gotten a fair amount of attention are Hilton Worldwide (HLT), which Pershing built a large stake in last year; United Technologies (UTX), which Pershing helped to push into their announced breakup; and Starbucks (SBUX), which Ackman presented to acclaim at the Grant’s Conference in October. Ackman has also long fought for the rights of Fannie Mae (FNMA) shareholders and holds a major stake, which helped the fund in the early part of this year when those shares recovered to 2017 levels. The largest holding is still Restaurant Holdings (QSR), the parent of Burger King and Tim Horton’s and not really a stock I find interesting, but Pershing has done pretty well with it and has been selling it down recently.
Pershing still runs a very concentrated portfolio, though not quite as concentrated as it was when Valeant was at the top of the holdings list, and that’s another challenge for investors: It’s hard to pay 1.6/16 fees for a hedge fund that is essentially just buying 8-10 large cap US companies who are S&P 500 components, a portfolio that most of us could pretty easily emulate for ourselves, and that isn’t really even hedging at this point (they closed their major short position, though I suppose there will be others eventually). And, like many closed-end funds, Pershing Square Holdings also carries some debt, so it’s not just a riskless pass-through portfolio of equities (I think it’s only about $1 billion in debt, but would have to check — with a $4-5 billion portfolio that would make the leverage similar to many other levered closed-end funds, so that aspect probably isn’t super-risky).
The fees are actually going to be lower than that 1.6%, too, at least for the near future — the management fee will be about 1.3% for another year or so, since Pershing is using some settlement money to cover part of it… and the stock will have to get back above the high water mark and start showing some performance before Pershing can start to earn its 16% performance fee (also likely to be reduced, though it’s complicated), so Pershing will at least be motivated to get to that point (Barron’s reported last year that the high water mark is $26.37 per share… that’s NAV, not share price). Do also note that these offshore hedge funds are usually classified as passive foreign investment companies (PFICs), which makes taxes a bit more complicated (and perhaps less favorable than regular mutual funds, since you’ll owe taxes on the fund’s income but probably won’t actually have that income distributed to you).
The appeal, then, is just that you get to buy into Bill Ackman’s management… and you get to do so at a huge discount to net asset value, and enjoy a reasonable dividend. Whether or not you want Ackman’s management is up to you, of course, but the huge discount does, at least, help to ameliorate the impact of the high management fees, and Pershing is enjoying its first spurt of good relative performance in years without narrowing that discount and getting some press coverage as a result, so that might attract more investors. You can see where Pershing considers itself to be by checking out their annual investor meeting presentation here.
I was burned enough by my investment with Ackman years ago that I haven’t jumped back in, but a 25% discount to NAV is pretty compelling even if it doesn’t close down to 10% over the next year or two and come closer to other closed-end funds (The NAV on February 19th was $22.37, they publish NAV once a week, so at $16.79 that’s almost exactly trading at 75% of NAV… NAV will probably drop 1% or so when they next report tomorrow)… so if you want to get involved, I won’t try to talk you out of it. Whether I can get that Valeant taste out of my mouth, however, is another matter.
Disclosure: I own shares of Starbucks and Berkshire Hathaway, both of which are mentioned above. I am not invested in any of the other stocks covered, and will not trade in any covered stock for at least three days, per Stock Gumshoe’s trading rules.