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Incentives, edges, and closed end funds

October 18, 2013 | About:
whopper investments

whopper investments

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I’ve made no secret of my theory of having an “edge” when investing and that incentives matter. I’ve also previously discussed my love of the Special Opportunity fund (SPE).

Earlier today I was reading this press release on share buybacks at ETJ, one of Special Opportunity’s largest positions, and this table really jumped out at me.

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Specifically, the third column (% shares repurchased). Just about every fund repurchased ~1-2% of their shares… except for ETJ, which repurchased almost 6%. ETJ literally repurchased more than 3x the second closest fund as a % of share outstanding.

Is it any coincidence that ETJ, which is facing activist pressure to narrow their discount or face liquidation, is buying back shares much faster than all of the other funds, which (as far as I can tell) are not? I don’t think so.

Consider the fund manager’s incentives for a second. His main incentive is to increase his management fee. The only way to do that is to grow assets under management, and buying back shares actually reduces assets under management, even if it can be a huge boost to shareholder returns if done at a discount to NAV.

That’s fine if the manager has a complacent / scattered shareholder base. But if an activist comes in and threatens to liquidate, the manager will do everything in his power to narrow that discount including reducing assets under management. The reasoning here is simple: he can either reduce assets under management and reduce his revenue stream, or he can not do anything, see the fund force liquidated, and lose the entire revenue stream.

So now let’s bring this back to incentives and edges. By grabbing a large piece of the fund, SPE has aligned the fund manager’s incentives with shareholders: reduce the NAV discount and show good returns or else the activist will liquidate you. And because SPE has used their size and reputation to achieve an outcome that wouldn’t be possible without them, they have a HUGE edge. Think about it- they effectively serve as their own catalyst to shrink a 15% discount to 10% (in this case so far) and normally to 5% or even 0% (in a liquidation). That’s the true definition of an edge: they’ve invested in something and created an outcome that small investors can’t and large investors won’t because of reputational risks / the fact large investors are also the people who run these funds!

Fascinating stuff.

Disclosure: Long ETJ, SPE

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Rating: 4.7/5 (3 votes)

Comments

AlbertaSunwapta
AlbertaSunwapta - 10 months ago
Excellent discussion! Thanks for presenting it.
jonmonsea
Jonmonsea premium member - 10 months ago
What do you think about BTF, a closed end fund selling at 22% discount to NAV that is Berkshire Hathaway stock?
jonmonsea
Jonmonsea premium member - 10 months ago
*40% composed of BRK, I should have written. Thanks.

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