FMO: Proposed Merger Looks Like A Bad Deal For Shareholders

Aaron Morris profile picture
Aaron Morris
24 Followers

Summary

  • Guggenheim oversaw FMO's loss of over $200 million in early 2020 (~80% of the fund) with another $20 million following a botched tax accrual.
  • Management now proposes to merge FMO into KYN, a higher fee fund, with no additional consideration to FMO shareholders.
  • The merger is unusual and appears to be intended, at least in part, to interrupt litigation over the fund's losses.
  • The alternative to the merger, a fund liquidation, would deliver the value of the fund's trading discount, roughly 14% or $12 million, which would outweigh any potential tax implications.

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Guggenheim Museum New York

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Shareholders of the Fiduciary/Claymore Energy Infrastructure Fund (FMO) have a decision to make that will affect the value they realize from the fund. As of today, the fund has about $90 million in net assets, down from $270 million following a liquidity crisis in the first quarter of 2020. It's sitting at a roughly 14% trading discount.

Guggenheim appears to have concluded that the Fund is now too small to manage (as noted by others), and the trustees have been considering "whether other alternatives may better serve the interests of FMO and its shareholders." (Source: Proxy Statement) Of those alternatives, liquidation is the most obvious, and other MLP funds have gone that route. For FMO, shareholders would capture the 14% discount, roughly $12 million, in the process. But management appears to be avoiding that option, at least in part because it may entail SEC involvement and could require them to address claims arising from the fund's liquidity crisis.

Instead, Guggenheim has orchestrated a highly unusual merger to effectively give away (at Guggenheim's expense) FMO's assets under management to Kayne Anderson and its MLP fund, Kayne Anderson Energy Infrastructure Fund, Inc. (NYSE:KYN). The deal will not only deprive investors of the value of the fund's full NAV, but will interrupt the fund's case against management for negligence, which has already been filed (there are other avenues for the shareholders to pursue claims directly, but the fund's case is already ongoing). Given the magnitude of the fund's losses, the value of its "litigation asset" potentially exceeds two-fold the fund's current net assets.

The various arguments in favor of the deal boil down, ironically, to a belief that KYN is simply a better fund than FMO, and current FMO shareholders should switch over. But even if that is true, it's irrelevant. The fund's trustees could have hired Kayne Anderson years ago and still can today. Shareholders, for their part, can buy KYN if they want to. Management makes noise about the potential tax consequences of a liquidation, but as discussed below, the fund-level taxes are more than offset by the value of realizing the fund's trading discount, and few if any shareholders have taxable gains at the personal level. The real question is how can FMO shareholders maximize the fund's current assets, and management does not attempt to argue that the value of the proposed merger outweighs the value of capturing the fund's trading discount through a liquidation.

This article addresses below the events leading up to the fund's collapse, the proposed merger, and considerations before the shareholder vote on February 4, 2022.

The Liquidity Crisis

FMO is a closed-end fund that invests primarily in master limited partnerships ("MLPs"). It is managed by Guggenheim, which took big risks with the fund's use of leverage that did not pay off in recent years (i.e., investors did not see increased returns) and ultimately contributed to a liquidity crisis in the first quarter of 2020 that destroyed over 80% of the fund's net assets.

Going into 2020, FMO was relying aggressively on leverage, maximized by so-called reverse repurchase agreements, which few if any other funds in the peer group were using. Relative to net assets, the fund was levered 65%, which exceeded both its normal range and the leverage utilized by the vast majority of other MLP funds. When volatility increased in early 2020, the fund began to receive margin calls as early as February after only modest declines in its benchmark. The fund had no contingency plan, and instead the managers paid down debt by selling into a declining market. By the end of the quarter, the fund had lost 81.7% of its net assets while its benchmark had declined by only 24.26%.

Following the investment losses, Guggenheim then botched the tax implications of the sell off. It took them until the fourth quarter to realize that (because of IRS "recapture" rules) the fund-despite being obliterated in the spring-would have to pay an additional $20 million in tax expenses out of its remaining assets. FMO announced this in November 2020 and restated its NAV 42% lower than reported the day before.

By the end of 2020, FMO's net assets had declined by $220 million. Its returns since inception are now negative. Year to date, the underlying MLP investments have actually fared well, but basic mathematics dictates that it would take investors years (likely decades) of above-market returns only to break even (i.e. an 80% loss on $10 leaves you with $2; a 100% gain on $2 leaves you with $4).

The Compensation Plan And Lawsuit

In the aftermath, Guggenheim effectively admitted fault for the tax mistakes, but refused to compensate investors for the fund's tax expenses or the investment losses caused by the liquidity crisis. Rather, it created a shareholder compensation plan that, at best, pays compensation to some investors who purchased at an inflated NAV (i.e., relatively recent purchasers) for the amount they overpaid for FMO shares before the tax expenses were disclosed. But, in exchange, these investors are required to provide a full waiver and release of claims, including with respect to their other losses. The latter appears to have been a motivating feature of the compensation plan.

A charitable foundation that owns FMO has filed a lawsuit on behalf of the fund asserting claims against Guggenheim, the fund's trustees, and the fund's subadviser. (See the disclosures below regarding the author's involvement in that case.) The suit seeks to recover the fund's investment losses and tax expenses caused by the liquidity crisis, but the fund must continue to exist in order for it to continue to assert the claims.

The Merger

In September 2021, Guggenheim and the trustees announced a proposal to merge FMO into KYN in a transaction that will net shareholders only KYN shares equivalent to their current FMO shares. It was proposed months after learning that the shareholder above was preparing to file a lawsuit on the fund's behalf for negligence.

The merger has all of the appearances of an escape hatch for Guggenheim. While many investors have lost their principal, the merger will interrupt the fund's ability to pursue legal claims (although shareholders have other ways to assert the claims directly). Further, shareholders will be deprived of the value currently locked up in the fund's discount, and will end up paying exponentially greater fees for the same services under Kayne Anderson.

Not surprisingly, management has crafted a number of arguments in support of the merger, but none carry water. The key arguments are addressed below:

Guggenheim's recommendation. The trustees state that Guggenheim "recommended that the [trustees] approve the Merger based on [Guggenheim's] belief that the Merger will benefit FMO shareholders." This is ironic, given that Guggenheim is the largest beneficiary of the Merger: it is attempting to escape liability and avoid continued management of an unprofitable fund with an atrocious track record. Its "recommendation" doesn't suggest that the merger is a good deal.

Avoiding the adverse tax consequences of a liquidation. The trustees state that a liquidation would cause "$6 million in federal and state corporate income taxes" at the fund-level as well as shareholder-level taxes if anyone has unrealized gains in the fund. But the trustees neglect to mention that the value created by a liquidation would be twice the fund-level taxes, and few if any shareholders are sitting on unrealized gains, given the fund's enormous losses.

The increased expenses are worth it. The trustees state that the "potential benefits of the merger outweigh the expected higher fees and expenses that will be borne by FMO shareholders as a result." But it provides no quantification for that assertion (nor could it). Expenses will more than triple, and FMO shareholders will pay millions over the coming years for the same management services. At best, the trustees reference a vague potential for improved investment performance, but even if that were true, shareholders- after deriving the value of a liquidation-could simply buy KYN.

Hypothetical Expense Savings. The trustees originally contended that "[t]he increase in management fees is substantially offset by the reduction of other operating expenses (excluding leverage expenses)." They later retracted that statement, given that the savings, if any, are expected to be only $400k per year, and thus won't matter in comparison to the millions of dollars in additional expenses shareholders will pay under KYN. Nonetheless, trustees still tout the $400k in savings as a value for shareholders. It isn't.

Hypothetical investment performance. The trustees make various arguments about the improved investment potential under KYN, including that shareholders will benefit from a larger asset base, broader investment opportunities, and improved use of leverage. But this is an odd argument, as an initial matter, because KYN is available today to any shareholder. The current question is how to maximize FMO's current assets, and the trustees have little basis to argue that vague future performance promises under KYN outweigh the value of liquidation today, especially given that shareholders could then buy KYN post-liquidation whenever they want. Moreover, even with "moonshot" future returns, pre-crisis shareholders have little chance of recovering their principal. The best shot of that, at this point, is the fund's litigation, which the merger seeks to interrupt.

Guggenheim isn't being paid. The trustees state that "[Guggenheim] will not receive any payment in connection with the Merger." But the motive of the deal isn't a cash payment; it's to avoid litigation over the fund's collapse. The fact that Guggenheim is willing to give away this fee-producing asset for free tells you everything you need to know about the purpose of the deal (as noted elsewhere on Seeking Alpha).

No Merger Costs Or Taxes. The trustees tout that the merger will be tax-free and FMO shareholders will not incur expenses. But that's cold comfort for investors, who would be losing the value of a liquidation, assuming exponentially higher expenses under KYN, and interrupting the fund's pursuit of its negligence claims. As above, the fact that Guggenheim is willing to pay for the merger is telling.

Conclusion

Guggenheim has announced a February 4, 2022, special meeting at which votes will be tallied for and against the proposed merger. The proposal requires a majority vote of outstanding shares to pass. If it does not pass, the trustees will have to try something else-likely a liquidation. In that scenario, the fund would continue to pursue its negligence claims, and any recovery would add to the net assets to be distributed.

Shareholders will ultimately decide whether an exit at NAV is preferable to a back-door investment in KYN. In either case, litigation avenues remain for shareholders to seek a negligence recovery, but the liquidation value will be lost unless and until another opportunity presents through KYN (which is currently equally discounted).

This article was written by

Aaron Morris profile picture
24 Followers
I am a lawyer who represents investors in stocks, mutual funds and ETFs with respect to investment losses, voting rights, and corporate governance. I write about developments, typically in the fund management space, regarding compensation, control disputes, oversight failures, and investor proposals.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Additional disclosure: My law firm is one of the firms representing the shareholder in the lawsuit mentioned in this article. The opinions expressed herein are my own and not necessarily those of my firm or its clients. This article relies only on publicly available information. Nothing above is intended to be legal or financial advice.

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