"Misery acquaints a man with strange bedfellows." Shakespeare, The Tempest, Act II sc. ii
Investors in SRQ and SRO, two closed-end real estate funds run by Deutsche Bank's asset management arm, have soundly rejected the manager's attempt to liquidate the funds and bury a truly awful record. Last year the asset value per share for SRQ and SRO fell -81.5% and -91.2%, respectively. In the 4th quarter alone anyone owning SRQ endured a market price decline from $13.32 to $1.95 and holders of SRO were almost wiped out as the share price dropped from $8.09 to just 66 cents. But when wealthy closed-end investor Stewart Horejsi announced in February 2009 that he was interested in gaining control over the remains of the two funds, the folks at DWS RREEF reacted vigorously. They not only proposed that shareholders vote to liquidate the funds, but also engineered by-law amendments and a "poison pill" rights issue aimed at blocking Horejsi, who countered by soliciting proxy votes against the liquidation plan.
Earlier articles wondered what was going on: "Why is DWS so intent on having SRO and SRQ commit corporate hara-kiri that it feeds them poison pills to use in case anyone tries to rescue them?" Why are professional asset managers now 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?" Leading experts on closed-end funds are also baffled: "What puzzles us most is management's motivation to fight [the Trust] so hard. Management is devoting significant legal and proxy expense to fight [the Trust], but if they win, the ultimate outcome gives them no future benefit." The Herzfeld Closed-End Report, as quoted in Horejsi's DFAN14A for SRQ on 5/11/09
The voters have now spoken. A May 20th press release from DWS on Business Wire:
[A]nnounced today that the Funds’ Special Meetings of Stockholders were held on May 20, 2009. A quorum at each meeting was present, but each Fund’s proposal to liquidate and dissolve did not receive a sufficient number of votes for approval. Therefore, each Fund will continue to exist as a closed-end registered investment company in accordance with its stated investment objective and policies. Voting results will be posted to each Fund’s website once available....
The proposals needed to get a majority of the outstanding shares in order to be approved. Closed-end shareholders are notoriously inert when it comes to actively voting their proxies in contested elections. (Turnout is artificially pumped up in routine uncontested fund elections, where brokers are allowed to cast "trash votes" on behalf of silent beneficial owners.) Here, SRQ and SRO investors were prodded with four rounds of additional mailings and at least two rounds of telephone solicitation. It wasn't cheap paper. SRQ's DEF 14A filing on April 7th estimated total solicitation expenses at $198,000 plus another $25,000 - $50,000 if contested, which "will be incurred by the Fund [i.e. be at shareholder expense] regardless of the outcome of the stockholder vote on the Proposal." SRO's cost estimate was $290,000 plus $25K-$50K -- about 1.3% of the fund's net assets!
Although the actual count hasn't been posted yet, it probably wasn't even close. If it had been, the DWS folks could have adjourned the meeting (their recent by-law change gave the presiding officer the unilateral right to do this) to get additional time and scrounge up more votes. If it had been a near-run thing, DWS might have waited until the market closed before announcing defeat -- rather than hitting the wire at 2:52 PM. (SRO shares instantly dropped by five cents -- an 8.5% hit -- on heavy turnover with no change in net asset value. SRQ lost 4% on the day.)
"So, Professor Gwailo, does this mean that the DWS managers who wanted to sell the assets and give the money back to the shareholders can't do that? Does this mean that shareholders will still have their investments locked-up as captive assets under managers they despise? Does this mean that Horejsi spent a bundle of his own money on a counter-solicitation so that his 16% of SRQ would only be worth $4.8 million ($1.92 per share) instead of cashing out for $6.3 million (NAV $2.50 per share)? It looks like everyone is now stuck with the opposite of what they want? How peculiar!"
1) An explanation for the investors' apparently illogical rejection of DWS' plan to pay them net liquidation value can be found in some current research in behavioral economics and neuropsychology. As social animals, we seem to have a natural sense of justice: "dishing out punishment to people seen to be behaving unfairly - even if it is not in the punisher's own best interests." Those stockholders who twinged every time they looked at a price quote for SRQ or SRO last year may have felt a nice warm glow in the dorsolateral prefrontal cortex at the thought of just saying "no" when DWS wanted a "yes."
2A) It's hardly "back to normalcy" for DWS. According to the April 7th proxy filings, annual meetings are "typically held late in the second quarter or early in the third quarter each year ... and would likely be delayed until later in the year if the Proposal is not approved." Horejsi's SEC filing back on February 5 called for a vote on terminating the management contract with DWS, and with the liquidation plan now defeated, he might well put up opposing candidates for the available directorships. [Both fund Boards are classified, so only 1/3rd of the seats are open in any given year. The bylaws require a majority (*not* a plurality) of stockholder votes to elect a candidate. If, as appears likely, no candidate gets 50% +1, the current directors stay in office, but in case this happens two years running any stockholder can ask a judge to wind up the fund under court supervision. Maryland Corps & Assoc Code Sec. 3-413.]
2B) Even if Horejsi does not press the attack, fund Directors will be in an awkward position when the DWS management contracts come up for renewal in September. Boards made up of friendly (though technically independent or "non-interested") Directors usually rubber-stamp such renewals, while counsel crank out boilerplate lists of "reasons and factors" for the back pages in the annual reports. This year, however, things may be different: "To lose 50% of your investors' money is a misfortune. To lose 91% seems like carelessness." [Note: Gwailo does not agree with the comments some have made calling the DWS managers crooked or even criminal. One should never attribute to malevolence that which can be sufficiently explained by incompetence.] The warning signs were clearly visible the last time the Directors reviewed the contracts, back in September 2008 just before the funds imploded. According to SRO's most recent Annual Report:
...The Board also noted that it has put a process into place of identifying "Focus Funds" (e.g., funds performing poorly relative to their benchmark or a peer group compiled by Lipper), and receives more frequent reporting and information from DIMA regarding such funds, along with DIMA's remedial plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for each of the one- and three-year periods ended December 31, 2007, the Fund's performance was in the 4th quartile of the applicable Lipper universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has underperformed its benchmark in the one- and three-year periods ended December 31, 2007. The Board also noted the disappointing investment performance of the Fund in recent periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance....
On the basis of this evaluation and the ongoing review of investment results by the Board, the Board concluded that the nature, quality and extent of services provided by DIMA and RREEF historically have been and continue to be satisfactory.
Since that time the funds have nearly been annihilated. Any Director who still thinks that the services have been "satisfactory" when the contract comes up for renewal this September will face significant liability exposure -- legal liability in this world and moral liability in the next one.
2C) And then there's the question of fees. SRQ's proxy argued that liquidation was desirable because a shrunken asset base meant excessive operating costs: "If the Fund’s net assets remain at their current level ($28,241,173 on March 27, 2009), DIMA, the Fund’s investment adviser, has estimated the Fund’s expense ratio going forward to be 3.13%." For SRO, the adviser projected an even higher ratio of 4.07%. But since most of the expenses involve fees paid to DWS/DIMA and affiliates, and since the asset base was lost under DWS management (in particular, it looks like they bungled risk and leverage control), wouldn't the logical next step be for the Board to insist on trimming expenses by cutting fees?
3) In recent years Horejsi has acquired control of four closed-end funds (BIF, BTF, FF and DNY) by purchasing large blocks of stock, besting incumbent managers in proxy fights and litigation, and installing affiliates as new managers under fee arrangements that tend towards the high side. Another Seeking Alpha contributor has portrayed Horejsi in infernal terms as "The Devil You Don't Know". However, that commentator holds a sizeable position in BIF and could realize a quick and tasty profit if that fund were pushed to pay out its cash hoard or use it for a tender offer, rather than holding on to it in hopes of timing the market. Each SRO and SRQ shareholder should make up their own mind about Horejsi's investment skills, and decide whether his self-interest will coincide with theirs. He did, after all, go from managing a family welding supply business to being a multi-centimillionaire as a result of discovering Warren Buffett and BRK-a back in 1980, while DNY and BIF have recently received Lipper performance awards and sport 5 MorningStars. Horejsi might be a genius, or he could just be lucky -- when it comes to investing, it's often difficult to tell the two apart (until it's too late...).
4) Meanwhile, back at the portfolios, April saw SRO turning over about 1/3rd of its holdings and drawing cash down from $5.9 mm to $900K in order to add 11 new positions in large liquid REITS -- even as DWS was telling shareholders to vote for liquidation because "the credit market and real estate market are not likely to improve materially in the near future." SRQ acted similarly, turning over about 25% in April and opening 8 new positions. This contrasts with the total turnover figures for all of year 2008 -- just 37% at SRO and 31% at SRQ. (Though the method they used tends to understate because it compares average assets to the lesser of purchases or sales.)
Trading continued at this frantic pace during the first half of May. Both funds managed to unload their not-very liquid blocks of Sunstone preferred stock (SHO-PrA), and SRO also sold all 46,600 shares of CLI that it had bought just the month before. On May 1, SRO had positions in 32 REITs, and by the 15th it had added two new holdings, increased seven, decreased six and eliminated two. Overall, SRO sold about $6.7mm of the $41mm worth of REIT shares that it held on 4/30 -- which works out to an annual turnover rate of 398%.
SRQ joined its sibling in clearing out $1.9mm worth of CLI shares that it had bought in April, along with a $1.9mm VTR position from that same month. Starting with 34 positions, two weeks later SRQ had added four, increased six, decreased six and eliminated three. The fund sold about 13.6% ($8.6mm out of $63mm) of what it owned at the start of the month, for an annual turnover rate of about 327%.
And the result? SRO's net asset value (after adjusting for the remaining preferred shares) fell from $0.71 to $0.64, a 9.9% loss in two weeks, while SRQ was down 11.4%, from $2.63 to $2.33. By comparison, VNQ (Vanguard's REIT ETF) was down just 6.7%. All those buys and sells, all that hopping into and out of positions, all those transaction costs and bid-asked spreads don't seem to have produced particularly good results for the shareholders. So why do this, especially when a liquidation vote is pending? "Cui bono?" Who benefits?
According to SRO's annual report for year 2007:
The Board considered that a portion of the Fund's brokerage may be allocated to affiliates of DIMA or RREEF, subject to compliance with applicable SEC rules. The Board also considered that, subject to ongoing review by the Board, a limited portion of the Fund's brokerage may be allocated to brokers who acquire (and provide to DIMA and its affiliates) research services from third parties that are generally useful to DIMA and its affiliates in managing client portfolios. The Board indicated that it would continue to monitor the allocation of the Fund's brokerage to ensure that the principle of "best price and execution" remains paramount in the portfolio trading process.
As they say on Wall Street, "2 out of 3 ain't bad."
Disclosure: I still own the 500 shares of SRQ purchased in better times, as well as VNQ. .