SRO, SRQ Update: Becoming More Curious

Includes: DB, SRO, SRQ
by: Gwailo

An earlier article wondered why the folks at DWS investments were trying so hard to get investor approval to liquidate two of last year's worst-performing closed-end funds. To review: common shares of DWS RREEF Real Estate Fund I (SRQ) fell more than 85%, from $13.32 to $1.95, during last year's brutal fourth quarter, while owners of its sibling fund (SRO) experienced a 91.8% decline, from $8.09 to only 66 cents. The losses, more than $500 million in total, were the result of leverage (the funds were geared with auction-rate preferred), delay in cutting back the leverage (a 6/10/08 press release anticipated redeeming the ARPS "sometime during the third quarter of 2008", but no shares were bought until late November), bad bets on interest rate swaps, illiquid holdings that had to be written down by 90% - 99% and the like. But that's not the mystery.

Earlier this year SRO and SRQ attracted the attention of Stewart Horejsi, a wealthy investor who has gained control over four other closed-end funds (BTF, BIF, DNY and FF) through heated proxy fights with their former managers. Soon after Horejsi announced his intention to buy a controlling interest in what remains of SRO and SRQ and replace DWS as investment advisor, DWS and the fund Directors responded by seeking shareholder approval for a plan to liquidate and dissolve the funds, at special meetings now set for May 20th. When Horejsi persisted, they countered by registering an anti-takeover "poison pill" rights issue and amending fund bylaws to add additional defenses.

Closed-end fund managers usually fight tooth and nail against activist proposals to buy back shares, to make shares redeemable at will, or to liquidate funds, because these disrupt the pleasant stream of perpetual fees that come from having captive, non-redeemable assets under management. When pressed by activists, funds tend to prefer share buybacks (which leave the remaining shares still captive) to open-ending, with liquidation as a last resort. Here, however, the fight isn't about protecting DWS' fee arrangements with SRO and SRQ; it's about terminating them in one way (liquidation) or another (takeover). Deutsche Bank's (NYSE:DB) asset management division is acting like some fanatical mother in a besieged city who would rather poison her children than allow them to be captured alive by the enemy. Why?

SRO's proxy statement says it's because they have the best interests of their investors at heart:

Deutsche Investment Management Americas Inc. (“DIMA”), the Fund’s investment adviser, has consequently determined that, based on the Fund’s current asset level, expense ratio and trading discount and on its belief that the credit market and real estate market are not likely to improve materially in the near future, the continued operation of the Fund as a stand-alone, leveraged closed-end fund is not in the best interests of stockholders.... Providing common stockholders with liquidity at net asset value would permit them to realize the value of the Fund’s current trading discount.

Let’s take these one at a time:

1) Expense ratio:

As a result of its reduced size, the Fund has experienced increasing expense ratios. For the fiscal years ending December 31, 2007 and 2008, the Fund’s expense ratio was 1.07% and 1.48%, respectively.... If the Fund’s net assets remain at their current level ($20,581,529 on March 27, 2009), DIMA, the Fund’s investment adviser, has estimated the Fund’s expense ratio going forward to be 4.07%.

4% of $20mm is about $800K. But this is a slippery estimate, because we don't know the underlying assumptions about overhead costs (lawyers, auditors etc.) or ongoing fee arrangements. DIM... fee, based on gross leveraged assets (including the preferred stock) is the biggest expense. In 2008 it was about 3/4ths of SRO's $6.1mm total expenses. (Fee = 0.85% of total common + preferred assets = $6.2mm less $1.75mm temporary reduction = $4.45mm). Next was a $735K "auction service” fee to a Deutsche Bank affiliate, to cover a 25 basis point payment to those brokers whose customers bought the preferred shares. Interest on terminated credit facilities -- an abortive plan to redeem the preferred with borrowed money -- accounted for $312K. Professional fees came to $194K, and "reports to shareholders" telling them how much money they were losing cost $163K. Finally, there were servicing fees paid to various DWS affiliates: the DWS transfer agent ($16K), the DWS fund accountant ($91K, with the actual work farmed out to State Street), the DWS auction administrator ($27K) and the DWS typesetter-filer ($14K).

What will it cost to liquidate? The proxy solicitation for the special meeting is "currently estimated to be $290,000" plus $25K to $50K more if it's contested, "and will be incurred by the Fund regardless of the outcome of the stockholder vote on the Proposal." Oops. There goes 1.7% of net asset value. The proxy also cautions that liquidation asset value may be less than the current reported NAV, due to such things as "transaction costs and expenses of liquidating the Fund’s securities and dissolving the Fund" and the

adverse effects on the sale price of particular securities currently held by the Fund due to sale by the Fund of a large percentage of the outstanding shares, or a large percentage of the trading volume, of such securities.

(Your mileage may vary, but I'll still love you in the morning.)

2) Trading discount: Cashing in on the discount -- the spread between asset value and market value for a closed-end fund -- is what motivates fund activists. It's wonderful to see that DWS is now concerned about the deadweight loss to shareholders due to discounts, because in the past other DWS managers had vehemently opposed open-ending or discount reduction proposals for funds such as GF and GCS. As of May 1, several other DWS funds were also trading at large discounts: -24.6% (DRP), -23.4% (NYSE:GF), -19.6% (NYSE:DHG), -17.7% (NYSE:KST), -17% (NYSE:EEA) and -15.5% (NYSE:KMM). Shareholders in these funds will be very interested to learn what DWS now plans to do in order to further their best interests and to help them realize the value of their current discounts.

3) "Belief that the credit market and real estate market are not likely to improve materially in the near future." How depressing. Shouldn't we shareholders conclude from this that the managers at SRO and SRQ are just sitting tight, pending the vote on winding-up? That any proceeds from selling the illiquid REIT preferreds stuck in the portfolios after the market turmoil will just be plunked into T-bills?

Er... no. What actually happened this April was very different. SRO turned over about a third of its portfolio in just one month, and made good progress on whittling down its oversize holdings in SHO-PrA and AEC-PrB. Yet instead of hoarding the proceeds, SRO's cash position fell from $5.9 mm in March to only $927K in April. During the month, SRO eliminated three of its 24 positions, but added eleven new ones, generally in common shares of large, liquid REITS such as PLD, TCO, EQR, AVB, etc. Such new positions accounted for roughly $13mm of SRO's $41mm securities holdings at 4/30/09. REIT shares staged a major rally in April (Vanguard's VNQ REIT index fund was up 30.7%), and SRO's NAV/share rose from $0.54 to $0.71 -- up 31.5%. (This was actually a weak result, considering the leverage provided by the preferred -- it looks as though gross assets were only up at 20% or so.) The good news is that SRO's portfolio was managed so as to catch the April rebound, but aggressive buying doesn't seem consistent with DWS' gloomy belief that the market "is not likely to improve materially in the near future". Yet DWS says this is the reason shareholders should vote to liquidate: "Do what I say, not what I do".

Mercy-killing the funds was not the only alternative DWS might have chosen. The managers could have recommended instead that SRO merge with SRQ, resulting in a larger base over which to spread any fixed costs, as well as increasing the amount any outsider would have to spend to buy control. The two funds combined had a total portfolio value of about $100mm as of 4/30/09. This is a manageable size: about 170 funds of the 642 in Nuveen's ETF database report assets of $100 mm or less, including DRP (the DWS World Real Estate fund), EEA (the DWS Europe Equity fund) and 2 DWS closed-end bond funds. Even GCS at $117mm is in this size range.

DWS might also have let shareholders choose between exiting at NAV or staying invested in a diversified REIT fund, if it had proposed merging SRO/SRQ into its $1 billion size three-star real estate mutual fund, RRRAX. The same individuals manage all three funds, and the similarity even extends to the stationary design for the annual reports. The portfolios have much in common, tho RRRAX isn't weighted down with failed auction rate preferreds, illiquid preference shares from obscure REITs, underwater interest rate swaps or private equities of doubtful value. The expense ratio for the institutional class shares (RRRRX) is just 0.63%. Compared to liquidation, a merger would reduce the time pressure for selling off securities, and would retain some part of whatever tax shield value there may be in the large capital loss carryovers now on the books at SRO and SRQ. (Tax Code Secs. 382 and 384 limit the use of acquired loss carryovers, and the benefit to fund shareholders is quite indirect in any case: a fund with capital loss carryovers can retain an equal amount of future capital gains before being compelled to distribute any further gains as taxable dividends to shareholders. Buy-and-hold shareholders get a timing benefit from tax deferral.) It's unlikely that Horejsi would want to take over a mutual fund like RRRAX that redeems its shares on request: it's too big and it's too easy for investors to leave if they don't like the new management.

And so the mystery remains. Why liquidate? "When you have excluded the impossible, whatever remains, however improbable, must be the truth." Sherlock Holmes in The Beryl Coronet (1892).

Disclosure: I own 500 shares of SRQ, as well as positions in GF, GCS and DHG.