180 Degree Capital: To Everything There Is A Season, TURN, TURN, TURN

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Investing 501
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Summary

  • Closed-end fund structure combined with a strong investment process has provided some unique opportunities in microcap stocks that generated outsized returns.
  • Even with 50% of investment portfolio in illiquid securities, a 30% discount to NAV seems too large.
  • Expenses have been cut in half as a percentage of NAV since the closed-end fund conversion.
  • Insiders continue to increase their holdings.

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In this article, we examine the merits of a former Business Development Company (BDC) that converted into a closed-end fund to invest in micro-cap companies using “constructive activism.”

We have always thought that the utilizing a closed-end fund structure to invest in small/illiquid stocks would provide a better chance for generating alpha than an open-end mutual fund. The closed-end fund structure eliminates the problem of investor money flows arriving/leaving at the wrong time. In essence, the closed-end fund structure provides a permanent capital base that can take advantage of the volatility that is commonly seen in sub $250M market cap stocks.

  • The investment process has provided some unique opportunities that generated outsized returns.
  • Even with 50% of investment portfolio in illiquid securities, a 30% discount to NAV seems too large.
  • Expenses have been cut in half since the closed-end fund conversion.
  • Insiders continue to increase their holdings.

Background

In March 2017, Harris and Harris (TINY) transformed from a BDC to a closed-end fund. At the same time, the corporate name was changed to 180 Degree Capital Corp. (NASDAQ:TURN), and Kevin Rendino formally joined the company as Chairman and CEO. His background can be seen in the press release announcing his hiring.

Included in the press release announcing his hire were Mr. Rendino’s thoughts on his investment philosophy:

“As many of you have read and seen over the last several years, the world of active investing has been under siege by the advent of exchange traded funds ((ETFs)) and index funds. Active funds have seen massive redemptions and fees have been compressed. We are taking 180 to a world that has not been thoroughly indexed and where we believe the potential return profile is much greater. Simply put, many micro-capitalization stocks are overlooked, orphaned, and, depending on the specific company, undervalued. With the appropriate investment process, discipline, and patience, we believe we can generate significant long-term capital appreciation for our shareholders.

“We are Graham and Dodd value investors centered on a belief that the price you pay for a business will ultimately determine investment success. As Seth Klarman said in the Margin of Safety, ‘Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process.’”

June 30th 2017 letter to shareholders provides more insights.

The June 30th 2017 letter to shareholders further laid out the new investment strategy of the fund:

Our new strategy is centered on making investments in micro-capitalization publicly traded companies with a constructive activist approach. We are bottoms-up, Graham and Dodd investors. Our overall investment philosophy is centered around the following theses:

The price we pay relative to the business we buy is the most important driver of investment returns.

The public markets continuously overreact to near-term or environmental challenges in certain stocks, thus creating attractive valuations and buying opportunities.

Out-of-favor companies and industries create opportunities to identify investments that offer asymmetric return to risk potential.

Companies with strong franchises, managements, and balance sheets are best positioned for turnarounds, increased market share, and improved profitability.

A portfolio of strong business franchises, purchased at the right price, outperforms over the market cycle.

Our ultimate goal is to constructively engage with existing management teams and boards to help unlock value. Some companies may need to realign their financial performance to achieve growth in cash flows, not just focusing on increasing revenues. Others need to improve their investor relations strategies and outreach. Others may need to evaluate strategic options including mergers, acquisitions, sales, and divestitures. Some may need to access to management talent. The constructive part is entering into a collegial dialogue with our investee companies to work together on what is required to increase the value of the company’s stock. To 180, activism means that when and if required, we will not be averse to pursuing change through other routes, including proxy solicitations.

We encourage investors to read the quarterly shareholder letters and conference call slides. They are candidly refreshing and provide significant insight into management’s investment process.

We have spoken with Mr. Rendino and Mr. Wolfe and think the fund is in good hands.

“Constructive Activism” has produced very good results so far.

As pundits debate the death of value investing, TURN has been putting up extremely strong performance number since its transformation. While two and a half years is far too short to evaluate the performance of the fund, a few of the investments to date have provided an insight into how the fund intends to apply its “constructive activist” approach. The fund’s objective is to run a concentrated portfolio (7-15 stocks), which is significantly less than many of the other microcap investment funds that are available to individual investors.

Sample of Microcap Funds

Symbol

Assets

$ Millions

Holdings

Top 10

Average

Market Cap

$ Millions

Expenses

Minimum

RMT

$373.00

336

15%

$456.00

1.07%

N/A

FRMCX

$196.00

74

26%

$284.00

1.17%

$1,000

NSMVX

$74.00

44

37%

$252.00

1.42%

$5,000

THBVX

$72.00

100

21%

$498.00

1.75%

$100

PREOX

$36.00

79

28%

$84.00

1.72%

$1,000

ANCIX

$18.00

81

22%

$128.00

1.60%

$5,000

RFIMX

$16.00

33

42%

$587.00

1.75%

$250,000

Source: Fund Documents

Source: Company Documents

Three investments over the last two years represent the types of investment opportunities available to TURN.

The fund was able to help improve the capital structure of both Turtle Beach and The Street by eliminating a preferred stock overhang when other investors were not. The investment in Quantum Corp. was done while the company was temporarily delisted for missing SEC document filing dates.

Turtle Beach (HEAR)

Source: Company Documents

Source: Company Documents

Turtle Beach (HEAR), continued

Source: Company Documents

Source: Company Documents

TheStreet, Inc. (TST)

Source: Company Documents

Source: Company Documents

TheStreet, Inc. (TST), continued...

Source: Company Documents

Quantum Corp. (OTCPK:QMCO)

Source: Company Documents

Quantum Corp. (OTCPK:QMCO), continued...

Source: Company Documents

Expenses have improved significantly, but still are a headwind for performance.

The fund expenses have been reduced by almost 50% since the conversion to a closed-end fund. We believe there is little room to reduce expenses on an absolute basis, but there will also be little growth in expenses. Expenses as a percentage of NAV are projected to be about 3.4%. This does not include a bonus pool accrual of $292,425. Including this accrual would raise the expense ratio to 4.2%.

Source: SEC Filings

There is a minimum amount of expenses that have to be incurred when running a closed-end fund. Management has done a reasonable job cutting those expenses. The increase in broker-dealer (BD) expenses is the result of opening a BD in order to raise money for their Special Purpose Vehicles. These SPVs raise money from private sources outside of the fund to increase investments in target companies. Approximately 50% of fund expenses are personnel related and include accruals for performance bonuses.

We believe management’s compensation is within industry standards and that their interests are aligned with shareholders. In fact, insiders own over 3.4% of the shares outstanding and are regular buyers of the stock at market prices.

Source: Company Documents

Source: Company Documents

However, one large variable cost is the bonus pool. Next, we take a closer look at this cost.

Is the bonus pool compensation reasonable?

We believe there is little room to reduce expenses on an absolute basis, but there will also be little growth in expenses in the future. However, the fund does have a compensation bonus pool for management. This could be a significant amount of money as shown in 2017.

Q3 2017 letter to shareholders:

Source: Company Documents

As of December 31, 2017 our NAV reflects a year end compensation pool for management of $1.2M with 67% paid now and remaining 33% paid out over the subsequent two years, but only if the individual and corporate performance in 2017 is persistent through 2018 and 2019.

Source: Company Documents

While the exact formula used to determine the annual bonus is not publically available, the fund has provided a rather detailed description of the framework the compensation committee utilizes.

We believe that the framework aligns the actions of the fund managers with shareholders, and that the compensation is reasonable.

Source: Company Documents

Source: Company Documents

Discount to NAV has narrowed, but remains extremely large.

Closed-end funds trading at discounts is not unusual. Neither is assigning a discount to illiquid investments. However, with the current discount of approximately 30%, we believe there is room for the discount to narrow if the fund can convert its private investments into cash and its performance since inception can continue.

Over the last ten quarters, public investments and cash has steadily increased as a percentage of NAV. At the time of announcement of the conversion the discount to NAV was approximately 50%.

As the following tables illustrate, as the ratio of public-to-private investments has increased, the discount has narrowed (albeit not in a straight line).

We believe that as the fund sells its private investments, the discount will narrow further.

Q1 2017

Q2 2017

Q3 2017

Q4 2017

NAV

$2.43

$2.44

$2.68

$2.60

Share Price

$1.45

$1.62

$1.74

$1.97

Discount

40%

34%

35%

24%

Public + Cash

$20.80

$22.60

$28.10

$25.90

Private

$57.20

$54.90

$55.30

$55.20

Private

73%

71%

66%

67%

Public

27%

29%

34%

33%

Source: Company Documents and Author’s calculations

Q1 2018

Q2 2018

Q3 2018

Q4 2018

NAV

$2.64

$2.91

$2.81

$2.64

Share Price

$1.86

$2.31

$2.17

$1.75

Discount

30%

21%

23%

34%

Public

$28.10

$43.80

$39.60

$32.70

Private

$55.10

$50.00

$49.70

$50.10

Private

66%

53%

56%

61%

Public

34%

47%

44%

39%

Source: Company Documents and Author’s calculations

Q1 2019

Q2 2019

NAV

$2.76

$2.82

Share Price

$1.86

$1.97

Discount

33%

30%

Public

$36.40

$38.50

Private

$50.10

$50.80

Private

58%

57%

Public

42%

43%

Source: Company Documents and Author’s calculations

Closed-end funds with discounts over 20% tend to have governance issues, performance issues or highly illiquid or hard to value investments. We do not believe that TURN has governance, nor performance issues, so conversion of the private investments to public investments will be a major factor in narrowing the discount.

Looking at other closed end funds that either take an activist approach like the Special Opportunities Fund (SPE) or other microcap-focused funds like Royce Micro Cap Trust (RMT), a discount of 10% or less would seem to be a reasonable target.

Private investments are the biggest risk/opportunity.

Private investments still make up approximately 50-55% of net assets. Since December of 2016, the private portfolio has only contributed 6% of the increase in NAV. On every conference call, the monetization of the investments in the private portfolio is discussed at length. So far, only modest progress has been made on converting these assets into liquid investments.

As we mentioned, the discount should continue to be extremely wide until more of these investments are liquidated at or above their current estimated values.

Source: Company Documents

There is little public information available about the investments and analyzing them is well beyond the scope of this article. However, management on several occasions has stated that AgBiome, D-Wave, Nanosys and ORIG3N are the most mature companies and the most likely to have their value realized. These investments are valued at approximately $29.4M or 60% of the private portfolio.

Q1 2019 Conference Call: Daniel Wolfe

I should note that 18 of these 24 positions that are collectively valued at $47.5 million are in actively operating businesses. The remaining positions that are collectively valued at $2.7 million are primarily ones that represent rights to potential future payments. The remaining are basically companies that are in the process of shutting down.

Source: Company Documents

While perhaps overly simplistic, the following table illustrates the substantial discount (almost 75% on August 14th) that investors seem to be assigning to the private portfolio.

Reasonable investors can disagree significantly on the valuation of these private companies and a substantial discount is warranted. However, a 75% discount seems extreme to us.

Source: Company Documents

Mr. Wolfe and Mr. Rendino have every incentive to realize the value of these investments in order to provide a larger pool of capital to invest utilizing their strategy. However, since TURN is a minority investor in the most mature investments (i.e 2.5% of D-Wave and less than 10% of AgBiome), they have no ability to determine the timing of a liquidity event. In conversations wth management, we are confident that they are looking at every possible way to maximize the value of these investments for shareholders.

In the last two years, TURN has been able to sell its investment in HZO and participate in an IPO of Mersana Therapeutics. A liquidity event on one of the major holdings should cause a quick narrowing of the discount as well. For example, if the AgBiome investment were sold for the $14.6M it was valued at as of June 30th, the fund would immediately own $14.6M in cash (there are ample tax losses to shield the gain) that was valued in the market at about $4M. Re-rating that valuation could add up to $0.30 per share to the stock price.

Since the timing of any transactions is highly uncertain, we believe that a narrowing of the discount to NAV will be lumpy and unpredictable. In the last two years, TURN has been able to sell its investment in HZO and participate in an IPO of Mersana Therapeutics.

The largest investments AgBiome and D-Wave (Wikipage) have an impressive list of co-investors, but they represent a significantly smaller as a percentage of their assets and therefore may not be a high priority in terms of realizing their value.

Examples of investors in AgBiome include:

  • The University of Texas Investment Management Company
  • Fidelity Investment Management Company
  • Bill & Melina Gates Foundation
  • Monsanto Growth Ventures

Investors of D-Wave include:

  • Bezos Expeditions
  • DFJ (Tim Draper and Steve Jurvetson)
  • Goldman Sachs
  • PSP (a large Canadian Public Sector Pension Fund)

Judging by investor questions on the conference calls, the lack of a liquidity event at D-Wave has been somewhat disappointing. We were able to find a couple of articles on the company here, and here.

The following table provides a summary of the valuation of the four most mature investments in the portfolio.

$ Millions

Value 9/30/17

Value 6/30/18

Change

Value 6/20/19

Change

AgBiome

$10.80

$12.92

20%

$14.67

14%

D-Wave Systems

$10.00

$9.82

-2%

$8.64

-12%

Nanosys

$3.40

$3.50

3%

$3.35

-4%

ORIG3N

$3.02

$2.81

-7%

Total

$24.20

$29.26

$29.47

1%

Source: Company Documents

Consistent Insider Purchases

Management has been a consistent buyer of the fund’s stock since the conversion to a closed-end fund. The following chart shows the insider purchases since December 30th, 2016.

Source: Company Documents

After the quarter, management continued to acquire stock at prices near the current price. Insiders currently own approximately 3.6% of outstanding shares.

Rendino - CEO

Shares

Price

Total Shares

16-Aug

2,800

$2.08

625,907

19-Aug

6,019

$2.14

631,926

23-Aug

5,093

$2.08

637,019

Source: SEC filings

Wolfe -Pres

Shares

Price

Total Shares

20-Aug

500

$2.22

263,000

20-Aug

500

$2.14

263,500

20-Aug

1,000

$2.22

264,500

21-Aug

670

$2.19

265,170

23-Aug

1,330

$2.15

266,500

29-Aug

2,000

$2.12

268,500

25-Sep

1,500

$2.14

270,000

25-Sep

1,000

$2.15

271,000

Source: SEC filings

Bigelow-VP

Shares

Price

Total Shares

19-Aug

1,000

$2.15

104,150

28-Aug

5,000

$2.12

109,150

3-Sep

17,226

$2.13

126,376

4-Sep

42,774

$2.15

169,150

19-Sep

1,300

$2.18

170,450

Source: SEC filings

Gift-Treas

Shares

Price

Total Shares

20-Aug

2,300

$2.17

41,449

23-Aug

700

$2.08

42,149

Source: SEC filings

Risks

Of course, there are several significant risks associated with an investment in TURN. Even though the current discount is very wide, as with every closed-end fund, the share price can be influenced by investor sentiment and the discount can increase. However, this is an investment risk with any closed-end fund.

While the company has been reasonably successful in monetizing its private portfolio at prices near their current valuations, there is no guarantee that will happen in the future. The company has no ability to force its private portfolio companies to realize their value. The lack of publicly available financial information makes it difficult to assess the actual value.

Even when the fund is able to IPO one if its companies, there is no guarantee that the investment will continue to be successful. For example, one of the company’s private portfolio companies, Mersana Therapeutics (MRSN) came public via an IPO in 2018. The stock dropped 75% in the last year and cost the fund over $3.5M in asset value.

The fund plans to invest in less than 15 holdings most of the time. While this strategy will magnify the successes, it will also magnify the losses. Microcap stock investing does carry significantly more risk of loss than larger capitalization investing. While the potential lack of liquidity of the Fund’s public investments should not be a problem due to the closed-end fund structure, it could cause significant, albeit, temporary market-to-market losses.

Finally, while the expenses of the fund are about 50% lower than at the time of conversion, 3-4% of total assets and 6-8% of liquid assets are a significant drag on performance. Unless the discount to NAV disappears, the company will not be able to increase investable assets to reduce expenses as a percentage of assets. The company has used Special Investment Vehicles (SPVs) to raise approximately $6M in investable assets outside of the fund for specific stock acquisitions (TST, SYNC) to overcome the discount. But the only benefits to TURN shareholders are fees and carried interest these SPVs earn. The proceeds cannot be redeployed into subsequent investments and TURN does not benefit from the increase in the investments directly.

Summary

TURN has many of the characteristics of an investment vehicle that we believe can provide uncorrelated returns for investors. The closed-end fund structure gives the fund a permanent capital that can be used to implement its “constructive activism.” The modest amount of capital ($80-90M when private investments are liquidated) allows the fund to avoid many of the liquidity and market cap restrictions of most microcap mutual funds. Management’s interests are aligned with outside shareholders in terms of both ownership and compensation.

We are more interested in evaluating the investment process rather than the investment performance since the conversion. We believe that the process has been able to uncover opportunities that are not typically available to other institutional-quality microcap investors, to the benefit of TURN shareholders.

This article was written by

Investing 501 profile picture
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We have over 80 years of investment analysis experience. We have published investment research from the perspective of the buy side and the sell side. Our work has been used by institutions managing over $1 trillion in aggregate. We have published reports from both the long and short perspective and have worked with the largest short selling mutual fund in the world. We are long term value investors. It is our belief that, contrary to popular opinion, most individual investors and patient professional investors have the best opportunity since the beginning of our investment career to beat institutional and mutual fund managers in terms of risk adjusted performance. The "Information Arbitrage" advantage institutional investors have had is mostly eliminated, while the individual investor still can maintain an edge with "Time Arbitrage". Our goal is to provide institutional quality buy side articles that educate and stimulate investors in the hope of improving their returns. We also are willing to mentor young analysis who wish to improve their analytical skills.
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Disclosure: I am/we are long TURN. 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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