Closing The Gap At MCN And MSP

| About: Madison Covered (MCN)


MCN and MSP both generate income through a covered call strategy. Both funds have a history of trading at a discount to NAV and underperforming their benchmark.

Three different investor groups have put pressure on management over the past year. In July shareholders will vote on a proposal to eliminate the external advisor.

Removing the external advisor may reduce costs, and or lead investors unlocking the full net asset value of each fund.

Investors can collect a relatively high yield while awaiting the likely eventual closing of the remaining discounts.

The Madison Covered Call & Equity Strategy Fund (NYSE:MCN) generates income by investing in large and mid-cap stocks, and writing covered calls. The Madison Covered Call Sector Premium Fund (NYSE:MSP) follows a similar strategy, with a slight tilt toward growth at a reasonable price stocks, and sector concentrations. Both MCN and MSP are externally advised by Madison Asset Management LLC The top ten holdings in each fund are mostly the same. A covered call strategy is a sensible way to generate income and total return. However MCN and MSP has underperformed the similar strategies, and the overall market.

Performance, Discount and Insider Ownership

CBOE previously published a study entitled "Performance Analysis of Options- Based Equity Mutual Funds, CEFS and ETFS." Madison's management pointed out that MSP and MCN has paid a higher yield than most other closed end funds with similar strategies discussed in the CBOE study. MCN and MSP both have retail heavy, yield focused investor bases. However, activists have pointed out that this higher yield comes with lower total return for shareholders:

(Source: Merlin Partners letter to shareholders, as of August 2016)

Stock price performance since inception of the funds has lagged behind the broader market, and the CBOE S&P 500 Monthly Buy-Write Index

MCN hand MSP have both consistently traded at steep discounts to net asset value. Although this is endemic in the CEF space, MCN and MSP have traded at steeper discounts compared to other similar funds.

(Source: Merlin Partners letter to shareholders, as of August 2016)

As of the most recent proxy, all of the trustees and management of combined owned only 1% of stock in MSP, and less than 1% of the stock in MCN. The three independent trustees each serve on the boards of 40 funds in the Madison Asset Management complex. Overall incentives are not aligned with outside MSP and MCN shareholders.

Madison charges MCN 1.06%(0.80% as investment advisor plus 0.26% under the services agreement), and MSP charges 0.98% (0.80% under the advisory agreement, 0.18% under the services agreement), in addition to various other expenses of running the fund and paying trustees. For comparison purposes, The PowerShares S&P 500 BuyWrite Portfolio ETF (NYSEARCA:PBP) has an expense ratio of 0.75%.

Given the performance and discount, its surprising there wasn't more activist activity earlier. Bulldog Investors filed a 13D on MSP back in 2014, but then trimmed its position own below 5% a month later, never having submitted a specific proposal In May 2016, the Fund attempted to merge MCN and MSP together, causing shareholders to protest. The funds postponed the original merger plan is continuing to reevaluate other options.

Activists Try To Close the Discount

Merlin /Ancora (MSP only)

Merlin Partners, an MSP shareholder, submitted a non-binding proposal at the annual meeting in September 2016 requesting that MSP conduct a self tender offer for all outstanding shares at or close to NAV, and to convert the fund to an open end fund if over 50% of shares were tendered. Management of course disagreed. Merlin Partners followed up with a letter to shareholders. Ultimately, the proposal was rejected: 44.6% of investors voted on the proposal, and of those 53.2% voted in favor (23.8% of the total).

Merlin Partners is a very active fund, having frequently filing 13Ds and proxy proposals on operating companies and investment companies.

Punch & Associates (MCN only)

Punch & Associates filed a 13D in May 2016 opposing the merger between MCN and MSP, and also suggested that MCN's board either conduct a large tender offer or convert MCN to an open end fund. They followed up in June praising management 's decision to cancel the proposed merger, and reiterating their suggestion for a large tender offer or conversion to an open end fund. That letter included this gem:

We believe that we are in the midst of a sea change in the closed-end fund market. Fund companies and their advisors are waking up to the idea that shareholders deserve better terms and structures than what has been the norm for a very long time. The days of perpetual life funds with broad mandates and no shareholder- friendly provisions are gone. The increasing issuance of funds with termination dates, liquidation options, and shareholder rights plans embedded into their bylaws is a powerful signal that funds and their advisors respect the capital entrusted to them. The idea is simple: funds need to produce value or else return capital to its rightful owners.
Over time, we firmly believe that enhanced corporate governance will lead to a healthier, more robust, and larger asset class, benefiting investors and advisors alike.

Whatever happen with MCN, and MSP, this is an excellent insight into the closed end fund space.

Punch & Associates invests in a wide variety of sectors, but rarely goes public with opposition to management. It still holds 7.21% of MCN as of the most recent filings.

Karpus (MCN and MSP)

In February Karpus Management filed 13Ds on both MCN and MSP, and put forth proposals for each fund to terminate its advisory agreement with Madison.

Karpus appears to have followed all the procedures to get a binding proposal on the ballot for both funds under rule Rule 14a-8 (its a record holder for each fund, and has held over the required number of shares for over, etc). Although its possible that management will find a way to block it. Based on the advisory agreements for MCN and MSP, a majority of the shareholders in each fund must vote for the respective proposal (theoretically a majority of trustees could also vote to terminate the agreements, but given the conflicts, that seems unlikely).

If the campaign to terminate the advisory agreement is successful, this would pave the way to close the remaining discount to NAV, and potentially improve long term performance. The buy-write strategy could probably be continued at much lower cost by a different manager. Alternatively, converting to an open ended structure or liquidating the funds would generally require affirmative votes from 75% of shareholders for each respective fund.

However, it might be difficult to get the required number of votes. Less than half of the shareholders even bothered to vote for the MSP shareholder proposal in 2016 . Nonetheless, the threat of these proposals should get management to improve their behavior. This proposal may spur management to go forward with a Dutch tender offer. Shrinking the size of the fund (and therefore fees), is better than losing the management contract completely. Although open-ending the fund would cause management to lose the "permanency" of the capital, if its shareholder base is truly satisfied with the income and performance, management shouldn't have anything to fear.

Karpus has a history of activist investing in closed end funds. As of the most recent filings, Karpus owns 7.21% of MCN, and 23.66% of MSP. Therefore, its more likely that the proposal will succeed at MSP than at MCN.

What Next?

MCN currently trades at approximately 8% discount to net asset value, and MSP currently trades at a 5% discount to NAV. If the shareholder proposals succeed, investors should be closer to getting full value for their shares. In the meantime, investors receive annualized distributions of almost 9.0% for MCN and 8.4% for MSP.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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