Defending Against Arbitrage Attacks on Closed-End Funds

Meyrick PayneMutual FundsLeave a Comment

Closed-end funds are often formed because they offer investors an opportunity to invest in a focused portfolio which meets their specific needs, usually with built-in leverage, potentially higher returns, and tax advantages. Often the investment focus of the fund is fashionable at the time it is launched. Theoretically the investor can get their money out by selling shares to another investor through one of the established stock exchanges.

The sponsor likes the idea of a closed-end fund because it does not have to worry about open-ended redemptions, advisory fees are predictable, and the financial advisers, who initially sell the product, do not have to focus on continued marketing and distribution efforts. For a fund sponsor, a predictable product like a closed-end fund is a key factor for success.

However, things do not always work out. The focus of the fund can go out of favor, the leverage becomes dilutive, the tax rules change, the market suffers downturns,or the fund does not perform well. The measure of the opinion of and demand for a closed-end fund is the premium or discount at which it trades relative to net asset value(NAV). For example,some of the PIMCO closed-end fixed income funds trade at a premium partially because many investors have been drawn to them during the continued gloomy economic environment.

When a closed-end fund perpetually trades at a discount, or the discount from NAV becomes large, arbitrageurs(arbs) may become involved-especially if the fund is sponsored by a well-healed management company and the positions held in the closed-end fund are readily marketable. Sometimes a closed-end fund starts out holding relatively illiquid positions which overtime become readily marketable securities.

The arbs buy in at the discounted market price and then seek to earn a premium by shrinking or eliminating the discount from NAV. They often do this by trying to force the sponsor to convert the fund to an open-end format. They describe this as “unlocking value”. Opening a closed-end fund is technically the decision of the independent directors. Over the years the arbs have become effective at investor activism and they often influence proxy votes.

The arbs attack in one or more of several ways: (a) seeking to elect their own slate of directors, (b) winning a resolution to open the fund or (c) liquidating the fund (which necessitates bringing the value back to NAV). Any one of these strategies involves persuading the board of directors and then winning a proxy vote of stockholders.

A proxy vote requires a quorum of shareholders registered at a specified date, either in person or by proxy, and winning a majority of the votes cast. Since a combative arb will usually buy at least 5% of the fund’s shares (requiring a 13D filing with the SEC) and is accomplished at persuading the shareholders that they are not being served well by the current board, the arbs may win the requisite proxy. However that in itself does not mandate the board to act. The board has to take into account the interests of all of the shareholders, some of whom might not have voted.

The strange aspect of the battle between the sponsors and the arbs is that the discount is often reduced purely due to the involvement of the arb. Investors may believe that the arbs are going to increase the value by forcing the sponsor into better governance or implementing a defense that improves liquidity that typically reduces the discount. The anticipation reduces the discount. If however, the environment changes again, the discount may well reappear. As a result of this phenomenon, arbs are sometimes content just to cause a commotion, watch the discount diminish and then sell out –making a hefty profit for themselves.

So now we come to the point of this bulletin:what should fund directors do when arbs get involved?

The first and foremost point is for the fund directors to be confident that the arbs are not correct in their statements and accusations. It is conceivable that shareholders would be well served by the arbs’ proposed action, in which case the fund board might want to adopt their plan. What is clear is that fighting the arbs just because they have brought a hostile action,or because they are not particularly likeable, serves no one’s interest.

The second consideration is to use the proxy process to advance your own logical argument. This might detail how the current board has done a good job representing the interests of all the shareholders, that closed-end funds have inherent advantages (such as leverage, favorable tax treatment and a greater proportion of invested assets), and that the current directors are knowledgeable and well attuned to the long term needs of the shareholders. In order for this defense to be effective, directors must be effective with their 15(c) oversight. Unfortunately,the logical defense may not prevail. The arbs would not have started their attacks if performance had been splendid and the fund was not trading at a discount from NAV. The best hope in a proxy battle may well be that the arbs have not mustered a quorum for their proposition.

A third option is to allow the periodic redemption of fund shares. The most common time frame is quarterly. This will almost certainly reduce, but not totally eliminate, the discount. This is effectively the same as offering to buy back shares from any of the shareholders in a tender offer. In some cases it may be possible to reach a “standstill” agreement with the attacking arbs. Another defense, actually more of a capitulation, is to merge the fund into an open-end fund or even to liquidate the fund. One shouldn’t be surprised if the arbs just go away after creating astir. Frequently the discount from NAV inclosed-end funds will be diminished just because the arbs have attacked. Once they have made their gain, they may become passive and avoid any further expense in the battle.

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