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Forum List » Value Ideas and Strategies Share and discuss value investing ideas and investing strategies. Special Opportunities Fund (SPE): Not Truly at 10% Discount
Posted by:
AlphaVulture
(IP Logged) Date: October 3, 2012 09:08AM
The Brooklyn Investor published an interesting write-up on the Special Opportunities Fund (SPE) that caught my attention, and also Whopper Investments attention. SPE is run by a hedge fund manager that specializes in investing in closed-end funds, and applying activism were necessary to unlock value. This is also how SPE was formed: Bulldog Investors won a proxy contest in 2009, and gave shareholders the option to cash out at a price close to NAV. At the same time the objective of the fund was changed. From the 2009 semi-annual report: Quote:So we get a manager that has a good track record, and they are applying a strategy that makes a lot of sense. From the 2012 semi-annual report: Quote:Besides the example above the same semi-annual report provides plenty of other examples of investments the company is making, the rationale for making them, and what they are doing to unlock value. So unlike most closed-end funds I think there is a good probability that they are indeed creating value. Having a track record is good: doing something that logically makes sense is even better. ## Capital structureThe capital structure of the SPE fund is what really got my attention. The fund completed a rights offering this summer for a new class of convertible preferred stock:Quote:To be honest: I don’t understand why the convertible preferred stock was created. It seems to be unnecessary complex without significant upside for the common. While all the downside remains with the common the upside is shared almost completely with the preferreds. The flip side of this story is that the preferreds are already callable if NAV grows with just 10%, so it could easily be that they will be called within a year. So why increase the size of the funds assets in such a temporary and volatile way? The latest reported NAV/share of SPE is $17.68/share while the common shares are trading at $15.81 and the preferreds at $52.00. This means that the common is trading at a bit more than a 10% discount, and it is possible to buy the common without almost no downside risk at $17.33/share. You don’t know how long you don’t have no downside risk since the preferreds are callable at a $20 NAV/share, but unless SPE starts trading at a huge discount this is always a favorable outcome. And while waiting for this positive scenario you will be paid $1.5 in interest a year and you know that no-matter what: you will be repaid at par in 5 years time. To properly evaluate the value the preferreds you need to create a Monte Carlo simulation. The reason for this is that the path that the asset value takes is very important for the value of the preferreds. You could have two scenario’s where after five years the total growth in NAV is zero, but if in one case NAV briefly hit $20/share in the first year the preferreds will be (or should be) called early while in the other case the preferred owner is going to enjoy five years of interest. Since I hadn’t programmed anything in a long time this seemed like a fun exercise. I have modelled the growth of the asset value using geometric Brownian motion. This basically means that the value takes a random walk with a certain drift (the expected growth rate) and a certain variance (I used the historical variance of SPE for the past year). The key part of the simulation, written in Python, is listed below and should be fairly straight forward to understand even if you aren’t a programmer. The full source code of the program can be found here if you want to play around with different assumptions. Simulation results are written to a .csv file that you can open in Excel.
Technically geometric Brownian motion is not completely correct to describe asset prices because it assumes constant variance and uses a normal distribution, but it’s a reasonable approximation to get an idea of the range of outcomes. Besides the variance a key input of the simulation is what you think the expected growth rate of the asset base is. The lower it is the higher the probability that the preferreds will not be called, and the higher the relative attractiveness of the preferreds. The three graphs below show after how many days you can roughly expect that the preferreds will be called assuming a 5% growth rate, a 7.5% growth rate and a 10% growth rate. Number of simulation trials was 10.000: As you can see the higher the growth rate the shorter the average number of days the preferreds remain outstanding. If the preferreds remain outstanding longer than 773 days (a bit more than three years, using 252 days/year) they will always outperform the common. The reason is that you can buy three shares using the preferreds at $52 or three normal shares at $15.80 each. The $4.60 price difference is roughly equal to three years in interest payments. On average the preferreds are expected to underperform the common because even with just a 5% growth rate the preferreds will be called within three years ~78% of the time and with a 10% rate the probability goes up to 90%. This is obviously not the complete picture: it also matters how much the preferreds underperform or outperform in the various scenario’s and how much risk they have. The following graph should provide some insight into this question. What you see here are average annualized returns weighted by the number of days before the preferreds are called. ## The preferredsWhile the preferreds are extremely low risk you are also not getting a great return. The reasons for this are: 1. the preferreds are trading above par, 2. when the preferreds are called NAV/share is diluted and 3. I’m assuming that after the conversion the common is still trading at a 10% discount. You do get an option on the discount of SPE shrinking with the preferreds because how valuable the conversion is depends on the discount of the common while the callable date depends on the underlying NAV.I do think that relatively speaking the preferreds are a good deal. There is a huge amount of excess collateral, and if this would be rated it probably deserves an AAA-rating. And a return of >2% a year for debt with a maturity below five year, and most likely around one year is a good deal. And you do get an option on the discount shrinking as well. I just don’t find it attractive from an absolute return perspective. ## The commonOne thing about the returns of the common in the above graph that should catch your attention is that the weighted average IRR is lower than the underlying growth rate. For returns below 3% this is logical: here the assets don’t return enough to service the dividends for the preferreds, so you do have leverage to the downside.The real problem is that the conversion of the preferreds dilutes common shares. If NAV grows with 10% from 158M to 174M the preferreds are callable because (174M – 37M) / 6.809.867 > $20. But if this happens you have 174M in NAV and 6.809.867 + 749.086 * 3 = 9.057.125 shares. This would result in a NAV of ~$19.20/share, and with a 10% discount you have a value of $17.30 remaining. With the stock at $15.80 today the 10% growth in NAV would result in a return of ‘just’ 9.4% for common shares (this is ignoring any dividends that are paid in the time it took to generate this return). ## DiscountAt first sight it’s a weird result: but I think the discount is the key to understanding what is happening. The current discount should already account for the highly likely future dilution, and when the preferreds are converted the discount should shrink. By assuming that the discount remains constant – at first sight a reasonable assumption – you are effectively assuming that it is growing. This should boost the expected returns of both the preferreds and the common stock.If the stock is trading at a 10% discount before the conversion NAV/share is diluted by 3.84%. The probability of this dilution happening is, depending on the growth rate, between 80% and 90% if I can trust my simulation results. So it’s probably fair to say that after the dilution the discount should shrink from the current 10% to ~7%. If we generate a new average return graph based on this assumption we get this: In this case both the returns of the common and the preferreds are higher. The common does have leverage to both the upside and the downside, and the preferreds are a bit more sensitive to the underlying growth rate. The expected return of the preferreds is no longer an almost flat line. ## ConclusionIf there is one thing to take away from all my ramblings:. Part of this discount (my guess: ~3%) is simply representing the possible future dilution from the preferreds, and because these are trading above par they don’t offer an easy way to profit.at today’s prices you are not truly buying SPE at a 10% discountSPE or SPE-P might still be an attractive investment: in the grand scheme of things a discount that is a few percentage points bigger or smaller is no big deal. And while I have talked little about my perspective on the cost structure of SPE or their strategy in this post (it is already long enough as it is), I do mostly agree with The Brooklyn Investor and Whopper Investments about the attractiveness of the fund. I haven’t yet made up my mind if I should buy SPE, or maybe SPE-P. Another option is to piggyback some of the funds holdings. Their latest semi-annual report is a goldmine filled with cheapish funds that do have a potential catalyst. To be continued… ## DisclosureNo position in SPE or SPE-P, might initiate one in the futureStocks Discussed: SPE,
ASG,
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