Closed-End Funds: A Legalized Ponzi Scheme?

Dec.16.09 | About: Cornerstone Progressive (CFP)

Conclusion: Cornerstone Progressive Return Fund's (NYSEMKT:CFP) current share price ($9.10) has been vastly inflated by rookie investors chasing an ephemeral yield composed almost entirely of return-of-capital. It is estimated the correct price for the shares to be around $5.75. This would represent an 8.4% discount from its current NAV and a 37% decline from its current price.

Difference between a Ponzi scheme and Certain Closed-End Funds:

A Ponzi scheme is a fraudulent investment operation(s) that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned.[1]

A managed distribution policy is a distribution policy approved by the SEC whereby a closed-end fund (CEF) can effectively make systematic distributions of a return-of-capital to its shareholders.[2]

It’s all about Disclosure: The key difference between Madoff’s Ponzi scheme and Cornerstone Progressive Return Fund is one of disclosure. CFP, by disclosing it is paying its shareholders back its own money through the establishment of a managed distribution program (Rule 19a-1), is essentially separating itself from the criminal aspect of a Ponzi scheme, i.e., fraud. CFP is telling its shareholders with the blessing of the SEC that “this is your capital and you’re getting it back in the form of a distribution”. Madoff’s crime was essentially one of non-disclosure.

The Value of Good Advice: If Madoff was properly advised, he could have—early in the process of the Ponzi scheme, “rolled up” his accounts into a closed-end fund, Madoff Progressive Return Fund (MAD), received approval by the SEC to institute a managed distribution program, and continue to distribute back to the shareholders’ their own money with impunity.

Instead of languishing in prison for the rest of his life, Madoff could have instead continued his lavish life-style and possibly enjoy a 45% premium (the same as CFP) on MAD stock relative to its NAV. Moreover, he could have sold his stock holdings in MAD at premium—all nice and legal. He could have been even richer.

(Click for an excellent article by George Spritzer entitled, “Cornerstone Progressive Return Fund: Clever IPO Distribution Strategyfor additional insight on CFP.)

Faux Pearls: The reason people buy “faux pearls” advertised on late-night TV is that they don’t know “faux” is an old French word (“fals”) meaning false. If such merchandise had been advertised as “fake pearls” instead, I wonder if sales would have been negatively impacted?

Faux Dividends: The reason investors are chasing CFP’s perceived high nominal distribution is that they are unaware that the distribution is essentially a return-of-capital. The net impact of chasing non return-on-investment distributions yields is to artificially inflate the stock price relative to its NAV with the potential of creating a stock price bubble.

Nothing for Nothing: A return-of-capital distribution should have zero investment value. Investors should pay nothing for it as essentially they’re getting their own money back. In this case, NAV would be a good metric for valuation.

However, since CFP is trading at a 45% premium of NAV, new investors are essentially paying $1.45 for $1.00 worth of future periodic distributions. If an investor really understood the concept, they wouldn’t hand over $1.45 for a dollar.

So, one must conclude that investors are either not well-informed regarding the composition of the distributions (see chart below) or that they have unrealistic expectations regarding the future performance of CFP’s management (see “3” below).

Let’s Do the Numbers: CFP has continuously paid a monthly distribution of $.2050 per share since its inception in 2007. When annualized ($2.46), the distribution generates an incredible nominal distribution yield of 27% on a stock price of $9.10. An impressive yield. But here’s the fine print: approximately 93.5% of these distributions are in the form of a return-of-capital distribution. This means that your true distributed return-on-net investment income is a paltry 1.75%.

To add insult to injury:

1. CFP stock is trading at 45% premium to its NAV;

2. two-thirds of CFP’s portfolio is other CEFs—which you could buy at a discount and not have to pay a premium owning them through CFP;

3. CFP has generated a cumulative net unrealized loss in managing the portfolio, i.e., they haven’t made any money;

4. You’re paying an investment management fee of 1.23% for this privilege.

Valuation Models: CFP’s NAV is currently $6.28 per share. This is currently what the stock is worth if it were to be liquidated today without any transaction costs. You should not pay any more than this.

However, since an investor would be receiving their return-of-capital distribution on a monthly basis, the time value of the cash flow, at a 5% imputed discount rate, would be approximately $5.77 per share.

The CEF stock price valuation method which I prefer the most is a multiple of net investment income. This method produces the least desirable valuation for CFP. Based upon an annualized net investment income of $.16 per share and a market multiple of 17 times, the valuation would be $2.72 per share.

The stock should currently be selling at a discount to its current NAV. If I had to pick a point, I’d guesstimate $5.75 per share, an 8.4% discount.

Caveats: What CFP is doing is not illegal. At the very worst CFP is manipulating the share price by arbitraging the distribution information gap. Given that investors lack this knowledge, they are unwittingly cannibalizing their investment.

While there is no law against investors committing financial suicide with investments of this nature, it is still not a pretty sight.Click to enlarge

Disclosure: Short CFP