The discount opportunity
Right now, LICs are under pressure as the average level of discounts is much higher than usual. What is also unusual is that these elevated discounts have appeared when the ASX has been going very well. History would suggest that LICs are more likely to trade at a discount when times are tough. The situation is presenting an excellent opportunity. It may be time to reallocate some equities exposure away from areas that have done very well and towards LICs.
Our current LIC portfolio has an average NTA discount of 15%. It is predominantly comprised of underlying LIC managers we rate very highly. We believe for various reasons that the current high level of discounts will be much lower in 12 months. One of those reasons is that LIC managers are coming under increasing pressure from shareholders to deal with the expanding discounts. Another is that the IPO market is also coming under pressure. Who wants to subscribe to a new LIC when the existing ones are so cheap!
The result of these pressures may well be a shrinking of the LIC market, but an improvement in the average NTA discount, which is well above long term averages. Below we talk more about each of those areas.
The LIC IPO market is changing
An announcement made earlier this month may represent a step-change in how LICs are marketed. Fund manager Magellan has plans to list a new LIC. Magellan has announced that they are proceeding with the offer without appointing a broker syndicate. They are also not paying any fees or commissions to brokers or advisers to handle the raising. Instead, they will issue additional units to existing investors in Magellan itself and existing investors in some funds. In doing this, Magellan acknowledges that the funds being committed are of value to them and are sharing that value with existing investors who elect to take up units.
The practice of paying up front fees to intermediaries has been a hot topic of late. Some commentators are suggesting it should be outlawed, as it already is for unlisted funds. Up front payments are a part of the listed market, as they are for listed markets worldwide. Should we stop differentiating between listed and unlisted funds and ban all conflicted payments for listed vehicles? There are now many who think we should. But it’s not an easy decision to make. For example, should we ban capital raising payments for REITs as well? What about stapled structures, which combine both a passive investment vehicle with an operating business? What about hybrids and listed debt instruments?
The issue is now on the radar of politicians, and there might well be some changes in this area. Perhaps a capping of the amount payable might be on the cards. This could take the form of either a maximum percentage of capital subscribed or a maximum dollar amount per applicant. Less money is likely to be raised for LICs in the future if any changes occur. That may well turn out to be good for the LIC sector. It will help to ensure the investor base is there for the right reasons, rather than crowded with transient capital looking to move on given any opportunity.
Some LIC restructures have already been announced
LICs have been under increasing pressure since late 2018. So far, we’ve seen a small but steady stream of LICs undertaking windups or otherwise restructuring to close the NTA gap.
Watermark was the first to kick it off, with proposals in December 2018 to delist two of their three LICs and convert them to unlisted funds. The transaction also offered investors the chance to exit at NTA. These transactions were completed earlier this year. Before the announcement of the transactions, both LICs had consistently traded at 15-20% discounts to NTA for some time. Investors who bought within a short period before the restructuring announcement would have done very well. However, longer term investors didn’t fare so well, with the performance of both vehicles subdued since listing.
Early in 2019, 8EC Emerging Companies (8EC) announced a wind-up proposal, with all investments to be liquidated and funds returned to shareholders. The transaction announcement came after sustained pressure from a major shareholder, following a reasonably long period of poor performance. The windup was approved by shareholders recently and will be substantially completed over the next two months.
More recently, the Monash Absolute Return LIC (MA1) announced a proposal to restructure to an exchange traded managed fund. This is still to be voted on by shareholders, and some of the transaction details are still being finalised. We expect that it will proceed in time. The proposal is similar to the Watermark restructure. The major difference is that the resulting investment vehicle will to trade on ASX, rather than be an unlisted managed fund as in the Watermark example.
We applaud each of these managers for (eventually) taking decisive action to fix the discounts.
On other cases, we’re seeing LICs merge to gain the benefits of larger scale, without diluting existing holders of either vehicle. In the last few months, we’ve witnessed friendly merger proposals from both CBC/Clime and from Mercantile/Sandon Capital. While we also think this is positive, there is unlikely to be as much short term benefit in terms of price appreciation.
Many more LICs under pressure
In our current LIC research universe, almost 50 LICs are trading at 10% or higher discounts. Of these, more than 25 are trading on at least a 15% discount. Examples include Acorn Capital, two PM Capital LICs, Pengana International Equities, Australian Leaders Fund, L1 Capital, two Ellerston Capital LICs, two NAOS LICs and two Thorney LICs. Around a dozen are trading at discounts of 20% or more. These include Bailador Technology, Morphic Ethical Equities, two Fat Prophets LICs and Blue Sky Alternatives Access. Many of these LICs have reasonably open registers. In other words, they do not have one or more major shareholders that would be supportive of the status quo.
Within these discounted LICs, we are aware of a range of LICs that now have activist investors on the register. The Blue Sky LIC is one example. Multiple investors are encouraging management and the Board to take decisive action to solve the discount problem. Another example is URB Investments, which now has 360 Capital on the register.
We expect the number of these types of transactions to increase over the next year or so as more LICs come under pressure to make decisive changes.
Summing up
It seems the LIC market is running out of patience with discounts. LICs are coming under increasing pressure to fix it. As restructure or wind up transactions occur, this will increase the spotlight on remaining LICs. They will have to perform well and close the discount gap. If they don’t, they will face increasing pressure to return capital to shareholders through wind ups or restructures. An investor holding a portfolio of small to medium size discounted LICs may do very well over the next year or two.
Take care and all the best with your investing.
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