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Special Opps Fund: A Downside-Protected Bet on an Elite Fund Manager

September 27, 2012 | About:
whopper investments

whopper investments

49 followers
Last week, I mentioned I had started a small position in Liberty Equity (USA). In it, I mentioned Special Opportunities Fund (SPE) and that I would be doing more research on it. Well, the research is done, and I’m reporting back that I really like what I see.

First, I want to again credit Brooklyn Investors as that’s where I first saw the idea, and he had a great write up on it.

Let’s start with a brief overview. SPE is run by Phil Goldstein, who made his fame running the Bulldog Fund. The basics of the Bulldog fund is this: Its an activist fund that specializes in closed-end funds trading at a discount to NAV. They invest in the funds trading at a discount, talk with management, and find a way to close the gap to NAV over a one- to two-year window.

Phil makes the process sound pretty simple: Buy a fund trading at a 10% to 15% discount and have them liquidate in the next two years. The fund will perform more or less in line with the market over that time period. Thus, over a two-year time frame, you’ll get (after fees) whatever the market returned plus 10%-ish. If the market is flat over that time frame, you’d expect about 5% per year of alpha. If the market runs up 15%, maybe you get 19% (only grabbing 3% to 4% alpha as the liquidation keeps you from fully participating in the upside). If the market is down 10%, you’ll return 0%, but still generate alpha. Basically, the only way this strategy has a down year is if the market has a crash. I think the theory is born out in the numbers: Bulldog’s only had one down year (2008), and I believe I read that it still outperformed that year.

So that’s the background. If you want more, I’d definitely recommend listening to these interviews with him (part 1 and part 2) or reading this profile.

SPE is run using the same strategy. So I think that’s the first positive here: you’re grabbing a manager with a proven strategy for delivering alpha that is somewhat market neutral.

The second positive, of course, is that SPE trades at a pretty large discount to NAV. They report NAV every Friday: Last Friday’s NAV was $17.69. Thus, at today’s price of approximately $15.60, you’re investing in a manager with a proven record for outperformance trading for almost a 12% discount. Pretty interesting, especially when you consider that Phil himself has said he likes to buy closed-end funds when they’re trading 10% to 15% below NAV!

Consider then what NAV consists of: 60% is closed-end funds trading at a discount. So, in a way, today’s price offers a double discount to that 60% of funds! The other 40% is mainly, but not completely, blank check SPACs, which Phil equates to a “heads I win, tails I win a little” situation with no real market correlation.

I’m content with letting the thing trade for a discount while they continue to invest in discounted closed end funds, etc. But if it continues to trade at a discount, or the places SPE could invest in dry up, I’m pretty confident Phil would do something to push the fund closer the NAV.

So most of the fund is in something with 1) relative market neutrality (SPACs) or 2) correlation to the market, but should deliver alpha no matter what (CEFs trading at a discount). I think that alone makes the fund interesting for people (like yours truly) who are worried about how high the market has run in the past year, mainly on the back of fiscal stimulus and despite on going fiscal woes and a somewhat softening economy.

But also consider this: The fund just completed a rather interesting rights offering to raise $37.5 million. Given the whole fund had net assets of just over $115 million at June 30, that’s a pretty significant amount of cash! The last time they had this much cash was at the beginning of 2010, when they had just taken over the fund. Here’s what they had to say then:

Since January 25, BCM has been methodically and opportunistically making investments in shares of closed-end funds that it believes are undervalued. As a rule, we are not interested in making an investment unless we think that we have an edge. Consequently, while we are not averse to seizing investment

opportunities of any kind, including, for instance, in the securities of operating companies or in risk arbitrage, if they present themselves, we are in no rush to become fully invested. In fact, that may not happen for six months or more. As of the date of this letter, less than 10% of the Fund’s assets have been invested in accordance with the new objective and policies.

So the fund currently has approximately 25% of its assets in cash, with the other 75% in SPACs and closed end funds at a discount, and will slowly deploy that cash over the next six months (or longer). To me, that makes it a pretty interesting market hedge. They should perform well if the market goes up or stays flat, given the alpha baked into their current holdings, but (over the long run) they’d perform really well if the market went down, as they’d get to employ that large cash balance at a discount.

Finally, there is one more thing I like: Bulldog has a great track record, and Phil seems (to some extent) to be putting his record on the line here. Listen to these quotes:

However, in practice most closed-end funds do not generate superior performance. In my opinion, that is because the managers are either mediocre or are not sufficiently motivated to outperform their peers. Hopefully, you will agree that our track record is one that merits your support. And, I can assure you that complacency has no place in our mindset. I am personally committed to making our Fund a long-term success for our stockholders. My goal and that of the Brooklyn Capital Management team is that in ten years stockholders of Special Opportunities Fund will be able to look back and say that this is one of the best investments they ever made.

and

To conclude on a personal note, I am grateful for the opportunity to show that our stockholders can benefit from the unique advantages of the closed-end fund structure. If Special Opportunities Fund becomes just another mediocre closed-end fund, then we – and I — will have failed. And I hate to fail. While no one can guarantee investment success, I can assure you that the Board, BCM and I are committed to making Special Opportunities Fund a truly special investment vehicle.

That said, there is one thing that I am a bit taken a back by. Phil has constantly mentioned that he plans to make a holding in SPE a meaningful position. But, to date, I don’t really see evidence of that. The most recent disclosure I can find shows him holding approximately $450,000 worth of shares. While that’s certainly nothing to sneeze at, it seems like a drop in the bucket compared to how much wealth a fund manager who had trounced the S&P for almost 20 years in a row must have accumulated.

Still, I think there’s meaningful opportunity here. Do I think that this will be the best performing stock in my portfolio over the next year? No, definitely not. But I don’t mind using it as almost a “placeholder” for some of my cash, and I do think investors looking for attractive “buy and hold and forget for ten years” investments should take a long look at the fund.

Disclosure: Long USA, SPE

Rating: 3.1/5 (11 votes)

Comments

AlbertaSunwapta
AlbertaSunwapta - 1 year ago
I've always been intrigued by this approach. It's not new. Layering discounted CEFs on CEFs is also interesting. Nonetheless, I think the ability of a diversified fund (of funds) to successfully and repeatedly close the discount on a portfolio of CEFs is wishful thinking. Maybe one at a time would work to generate alpha, but a portfolio, I doubt it.

However maybe there is opportunity. Mediocre return market, proliferation of ETFs, vintages go CEFs and their managers, etc. might make some CEFs willing participants in a runoff scenario.

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