This report was co-produced with acamus for Yield Hunting's Marketplace Service. It was released March 4th to members.
Special Opportunities Fund (SPE) is a unique animal - we call it a hedge fund in a closed-end fund. Our thesis is that the fund provides low correlation to equity returns while providing a strong risk-reward trade-off. We believe the fund will move towards a monthly distribution payout helping to increase visibility and demand for the shares, closing the discount substantially.
George Spritzer had a great report on it 18 months ago where he went through the history of the fund.
SPE has an interesting history. From 1993 through 2009, the Insured Municipal Income Fund invested exclusively in tax-free municipal securities. It was targeted by several CEF activist investors: Karpus, Western Investments (Art Lipson), RiverNorth Capital and Bulldog Investors (Phil Goldstein). After a proxy contest that ended in August 2009, a new Board of Directors was elected to manage the Fund.
SPE is an activist closed-end fund that is run by notable hedge fund manager Phillip Goldstein through their management company Bulldog Investors. The profile on the firm's welcome page describes them well, much better than I could do:
Bulldog Investors is a value oriented investment management firm for sophisticated and high net worth investors but with an important difference: Bulldog is not content to wait indefinitely for the intrinsic value of its investments to be unlocked. Like other value investment managers, Bulldog rigorously analyzes and focuses on undervalued investment opportunities, targeting only securities it understands and can appropriately value. However, unlike other value investment managers, Bulldog will often take activist measures to enhance the value of its investments through various time-tested and proprietary means. In other words, Bulldog actually adds value to its investments.
The result is a unique investment approach that, for nearly two decades, has produced above-average returns for Bulldog's investors with below-average risk.
Essentially, the fund invests mostly in other closed-end funds and then uses its clout to alter the target fund in order to close the discount to net asset value. Think of Phillip Goldstein as the Carl Icahn of the closed-end fund world. These are typically classified as special situation strategies and make up 78% of the portfolio, according to their semi-annual 2013 report. Common stocks, mostly SPACs, make up another 20%.
At the end of 2018, a breakdown of the Special Opportunity Fund portfolio looked like this.
Closed-end funds (CEFs)
Special purpose acquisition companies (SPACs)
Bonds and notes
Business development companies (BDCs)
Exchange traded funds (ETFs)
The total is greater than 100% because SPE is leveraged, discussed later.
With its substantial allocations to other funds, SPE looks like a fund of funds - and it is - but it's more than that. In addition to investing in funds that the adviser believes offer good value, SPE is unique in that it employs activism.
Unlike a lot of stock funds, where advisory fees might not offer good value, one definitely gets something unique and useful with SPE.
Having made investments, the adviser doesn't just hope those investments produce the returns they expect; they take action to increase the value of their investments.
The adviser does this in many ways, including proposing changes that will unlock value, pressuring target firms' boards to take action, nominating new board members, creating special situations, etc. In many cases, shareholders of targeted companies willingly elect activist nominees to replace existing board members, hoping they will instigate positive change.
SPE itself is a product of activism. It used to be a municipal bond fund. During the financial crisis, activists replaced the management and board, converting SPE into what it is today, a CEF that pursues strategies usually only employed by hedge funds.
Recently, through a combination of special dividends, tender offers, and liquidations, SPE was the primary activist involved in unlocking value at several closed-end funds, including Alliance California Municipal Income Fund (AKP), High Income Securities Fund (PCF) and Swiss Helvetia Fund (SWZ), among others. SPE also benefited from activism by City of London Group relating to several emerging market equity CEFs, including Aberdeen Emerging Markets Equity Income Fund (AEF) and China Fund (CHN).
SPE has a long history of activism in closed-end funds but is also involved in other opportunities, including Emergent Capital (OTCQX:EMGC), Hill International (NYSE:HIL), Brookfield DTLA Fund Office Trust Investor preferred stock, and others.
Activism is a source of alpha and returns with lower correlation to equity markets.
Special Purpose Acquisition Companies
After closed-end funds, the second largest group in the portfolio is Special Purpose Acquisition Companies (SPACs), which are another unique element of SPE.
SPACs are distant cousins of closed-end funds. Like closed-end funds, SPACs raise fixed capital from their Initial Public Offering (IPO) and seek to invest the proceeds.
Unlike closed-end funds, SPACs usually seek to invest in a single private company in order to bring that company public. From the point-of-view of the target private company, being acquired by a SPAC is an alternative to going public via a traditional IPO. From the point-of-view of SPAC investors, they become the first public investors in a newly public company.
The management team of a SPAC usually has 2 years from launch to negotiate a deal. In the interim, the cash IPO proceeds are placed in a trust account, where it is safe. If management fails to make a deal in the allotted time, management covers their own costs and SPAC investors get their money back. If management is successful in making a deal, SPAC investors usually still have the option to get their money back, for example, if they don't like the deal, or they can go ahead and become investors in the acquired company.
A forecast in the June 2018 semi-annual report read:
We expect our diversified portfolio of SPACs to generate an annualized rate of return in the high single digits, which is attractive considering that there is virtually no risk of loss on any one SPAC.
SPACs are another source of returns that are uncorrelated with equity markets.
In 2016, SPE issued its 3.50% Series B convertible preferred stock (SPE.PB). It's unusual for closed-end funds to leverage by issuing convertible securities. What makes convertible securities special is they may be converted, usually into common stock. In the case of SPE.PB, preferred shareholders may convert one share of SPE.PB preferred stock into 1.6223 shares of SPE common stock at any time (this conversion ratio is adjusted whenever SPE pays a dividend).
If preferred shareholders decided to convert all of their shares, they would forgo their claim on the $25 per preferred share principal value, which would mean that net assets would increase by the value of the preferred stock. However, counteracting this effect, preferred shareholders would become common shareholders, meaning the number of common shares outstanding would increase. This is called "dilution."
We can estimate when the market anticipating this potential dilution might cause SPE's discount to widen.
With SPE.PB priced at $25.00 and SPE priced at $13.23, converting doesn't make sense because 1.6223 shares of SPE common stock would only be worth $21.46 ($13.23 x 1.6223), i.e. less than $25.00, so preferred shareholders would lose value by converting.
For conversion to break even, 1.6223 shares of common stock would have to be worth $25, which would happen if SPE traded at about $15.41 ($25 ÷1.6223), which corresponds to about a 16% return from current price or about 6% annualized between now and when the preferred stock matures in August 2021.
In the future, there is certainly a realistic possibility that preferred shareholders might convert their shares. However, SPE would have to return about 16% before this became an issue. Also, since the preferred stock has been callable since August 2018, it seems likely that the preferred stock would be redeemed before dilution became a big issue.
By the way, this potential dilution is why SPE reports two distinct NAV numbers.
Source: Special Opportunities Fund website
The regular "Daily NAV" is what NAV currently is with none of the preferred stock converted. The "Diluted NAV" is what NAV would be if the preferred stock was converted.
SPE pays its adviser fees equal to 1% of total assets annually with no performance fee. This compares favorably to other funds that employ activist strategies - primarily hedge funds - where 2% of AUM and a 20% performance fee are typical.
The 3.50% Series B convertible preferred stock is not technically an operating expense but it is a leverage cost.
During the 6 months ending June 2018, the overall expense ratio, including everything except preferred stock dividends and acquired fund fees, came to 1.4% of total assets.
As this table shows, SPE has historically distributed a relatively large amount to shareholders, which makes sense given some of its relatively high turnover strategies.
Historically, SPE has paid one distribution per year, at year end, making it less appealing to income investors. That should soon change though.
For regulatory reasons, investment companies like SPE may only distribute capital gains once per year, which they usually do late in the year: the much anticipated "year-end special distributions." This can make things difficult for equity funds that seek to pay regular monthly or quarterly distributions throughout the year since much of their returns come from capital gains.
Some funds ask the Securities and Exchange Commission (SEC) for permission to distribute capital gains more than once per year. SPE recently applied for such permission and we expect the SEC to grant the necessary exemption on March 4, 2019, or soon after.
How much might the managed distribution be?
It seems that a managed distribution could be as much as 7.5% of NAV annually, that being around the historical average annual distribution rate. Another possibility is SPE aims for a lower regular distribution of maybe 5-6% and continues to pay a larger year-end distribution, if necessary.
Will it be monthly or quarterly?
A quarterly managed distribution might make sense since the Series B preferred stock dividend is already on a quarterly schedule. However, since SPE's adviser is an expert in closed-end funds, they are well aware that a monthly distribution is more likely to narrow the discount than a quarterly one would. Monthly seems more likely.
When might SPE start paying a regular distribution?
Once the SEC grants an exemption, we expect SPE to announce a new managed distribution policy. A date that makes sense would be simultaneous with the declaration of the convertible preferred stock March dividend, which might happen around March 8, 2019. We would be surprised if a managed distribution is not announced sometime in the next three months.
SPE's returns have been good compared to funds that invest primarily in other CEFs. Shown below, SPE leads two other such funds: Exchange-Traded Funds PCEF and YYY, both of which have lower expenses than SPE. SPE was leveraged during some parts of this period, while PCEF and YYY were not. For a meaningful comparison, these are NAV total returns.
A fair criticism of fund of funds is they layer fees on top of fees, reducing returns. Shown below, between 2005 and present, risk-adjusted returns were unremarkable compared to low-cost mutual funds investing in the S&P 500 stock index (VFINX) and US bonds (VBMFX). This period was typical.
However, this does not account for SPE's relatively low correlation with other asset classes, owing to unique elements of its investment strategy, such as activism and SPAC investing. The "tangent portfolio" below shows that, as part of a diversified whole, SPE can contribute positively to risk-adjusted returns.
What makes SPE valuable is its relatively low correlation to other asset classes. As such, it might make sense for some investors at perhaps 0-5% of the portfolio. Another reason to size SPE small is because it is somewhat illiquid, with perhaps $300,000 worth of shares changing hands on an average day.
While it might benefit a diversified portfolio, SPE is by no means essential. Waiting for a good entry point makes sense. At the time of writing, SPE had negative discount z-scores for all but the 3-month time period.
The discount is currently more than -12%: historically, wide for this fund, suggesting a reasonable entry point.
As with other CEFs that invest in CEFs, there can sometimes be a double opportunity where not only is SPE heavily discounted but also so are the CEFs it invests in. A good strategy can be to wait until such an opportunity arises. Although we think SPE is reasonably priced at this time, it is not such a "double opportunity."
When evaluating the discount, be wary of the timeliness of NAV, which SPE only reports on Fridays rather than daily, as with most CEFs.
Earlier, we compared SPE's performance to fund of funds PCEF and YYY. Neither of these funds employs activism nor invests in SPACs. Two funds that do are Rivernorth Opportunities Fund (RIV) - which invests in SPACs and special situations - and Saba Closed-End Funds ETF (NYSE:CEFS) - which invests in special situations and benefits from activism. We chose not to compare performance to RIV or CEFS because they are relatively new funds without a lot of history. Both are interesting funds though.
We think SPE is a diversifier and source of uncorrelated returns because of its unique investment strategies.
We think SPE will adopt a managed distribution in the near future, putting it on the map for income investors. We can only make educated guesses as to when and how much.
We think the managed distribution has the potential to narrow the discount. However, if the distribution rate is relatively low or if it is quarterly rather than monthly, we would not be surprised if it had little or no effect on the discount. We think potential discount narrowing should be treated as a "nice to have" since it might not happen.
We think it is worth waiting for a good entry point and now seems like a reasonable one, though not of the "double opportunity" type discussed earlier.
We think the convertible preferred stock is not a cause for concern since SPE would have to perform quite well before the option to convert was "in-the-money" and because the fund may redeem the preferred stock at any time.
SPE is somewhat thinly traded, around $300,000 per day, so use limit orders even for modestly sized trades.
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Disclosure: I am/we are long SPE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.