QD view – your vote will count in Arb fight

Discounts in the investment trust sector are almost double their average[1], with the combination of cost disclosure rules and rising interest rates creating widespread selling pressure. It is perhaps not surprising that this has caught the attention of activist investors who spot an opportunity. Saba Capital is the latest arbitrageur on the block, thought to have invested over £1bn in a number of trusts in the sector.

According to its portfolio disclosure, Saba has built up stakes in a variety of trusts, including Herald, BlackRock Smaller Companies, Polar Capital Technology, Schroder UK Mid-Cap and Baillie Gifford’s Edinburgh Worldwide and US Growth. In the group’s accounts to the end of July, it had stakes in around 15 trusts. In general, these stakes have been built ‘quietly’, through nominee accounts, with Saba not yet publicly showing its hand or declaring its intentions.

The one exception has been European Opportunities Trust, where Saba intervened in the company’s conditional tender offer, calling it “woefully insufficient”, given the trust’s recent underperformance. Saba confirmed its position against continuation, “unless a full liquidity option at NAV is provided to shareholders”, and said it would encourage other shareholders to vote against continuation. It then pushed the board for a 50% tender. The board has launched a 25% tender offer and got through the continuation vote, but Saba has now doubled its shareholding to 10%.

The EOT experience gives a clear indication of what may be coming next for other trusts in which Saba has taken a stake. The arbitrageur has been undertaking similar activities in the closed-ended sector in the US. His success has been mixed, but he has managed to push for a change of investment strategy, a wind-up of the trust, or conversion to open-ended funds in a number of high profile closed-ended funds.

Understanding Saba’s strategy

At first glance, Saba’s choice of trusts looks eccentric. These are neither where the largest discounts lie, nor where there is most obvious distress, which are the conventional targets for arbitrageurs. They are simply trusts that have had a rough time because of the rotation from growth to value. They also have lots of retail shareholders, which may be difficult to marshal into action. Norman Crighton, who has served on the boards of eight investment trusts, points out: “The success of any arbitrage depends on the response of the other shareholders. The arbitrager can’t do anything in isolation. They need to convince the shareholders that the alternative is better than the status quo.”

He says it is rare for arbitragers to target trusts with lots of retail investors. They tend to prefer institutional shareholders that they can negotiate with. Ben Yearsley, director, Shore Financial Planning, says: “European Opportunities was an odd choice. Its discount was relatively small. It had lots of loyal investors. Certainly, the underlying holdings were liquid, so could be sold orderly and quickly, but that doesn’t apply to some of the smaller companies trusts.”

Saba’s actions in the US closed-ended sector may provide some clues. Manager Boaz Weinstein said in an interview with Simplify Asset Management: “I’m interested in funds trading on a discount that have nothing broken about them. That discount could be closed if the manager snapped their fingers and made the closed-ended fund into an open-ended fund.”[2]

He aims to take no risk on the underlying assets, so will be long the trust and short the underlying. The strategy aims to deliver pure exposure to the discount. “With all my closed-ended funds. I’m trying to fully hedge the underlying and make it just about the discount,” he says. The hedging inevitably can’t be a ‘pure’ hedge, because the group won’t know the full underlying portfolio, but it will be as close as possible.

This begs the question of why pick funds with high retail shareholdings. It may be, as Weinstein says, that he is on the side of the retail shareholder that doesn’t have the power to take collective action. Though this assumes that shareholders will trade a short-term exit at or near-NAV, for the long-term performance of the trust.

More cynically, it may be that a lot of retail investors buy investment trusts through platforms and don’t vote. It is a cumbersome process that few private investors have the time or inclination to do. As Ben Conway, head of fund management at Hawksmoor Investment Management points out, votes go through on 50% of votes cast, rather than 50% of shareholders. If a trust has a large retail shareholder base, it is enough that they do not vote, rather than that they are against it. This may make it easier to force action from the board.

Nick Greenwood, manager of the MIGO Opportunities trust, says: “If retail investors don’t vote, they can achieve more leverage with a 10% holding. However, it is also true that many shareholders will have bought a trust for a reason, they want it to do a job in their portfolio and won’t want to kill it.” In the case of European Opportunities, Saba came up against a committed and loyal shareholder base who wanted to stay in the trust.

Longer-term consequences

Saba enters the fray at a vulnerable moment for the investment trust sector. There has been significant selling among institutional holders of investment trusts – a response to the cost disclosure rules in particular, but also to rising interest rates and the range of new income options that have emerged.

If the group is successful, it would argue, the discount closes, or the fund is wound up and investors can redeem at par. Conway says: “It’s a little bit like wasps in nature. You may not like wasps, but they perform an important role in making the system work.”

“These investors couldn’t do what they do if the opportunity didn’t exist. While there can be some snobbery because they are not long-term investors, they are entirely necessary to ensure the efficient functioning of markets and instilling discipline.” Crighton agrees: “These investors are getting the stock from somewhere. They are not creating a problem out of nowhere. They are getting their positions from institutions that want to sell.”

One difficulty is that part of the investment trust discount ‘problem’ is not of its own making. The problem is the selling pressure created by cost disclosure rules, combined with Consumer Duty rules. Conway: “We have a regulatory and legislative framework that is actively discouraging investment in investment trusts.” It is not clear that Saba’s strategy would address this issue.

Equally, Saba’s is a short-term view. While Saba argues it is on the side of the shareholders it is possible that disenfranchised shareholders end up being passive participants in the winding up of a trust they wanted to hold for the long-term. Decent trusts with strong long-term performance could be wound up because of temporary problems, to the longer-term detriment of the shareholders.

There is also the concern that in the case of some smaller companies investment trusts, the discount may prove illusory if there is a forced and rapid wind-up. The UK small cap market is not the Russell 2000 and has little liquidity as it stands. There are no guarantees that in a wind-up situation, investors would get out at par. That might be good for short-holders of the underlying stock but it might not achieve the desired result.

The role of boards

In the US, closed-ended funds don’t have independent boards, and this may prove a crucial distinction in whether Saba succeeds or not. Saba will often force buybacks – its 10% holding has galvanised Keystone Positive Change to start buybacks and promise a continuation vote. This will shrink trusts, making them less liquid and – possibly – less efficient.

Conway says: “Once they are in, they usually encourage the board to buy back, but the environment they leave is a sector that has shrunk. If demand is falling, the only other way to narrow the discount is to reduce supply, so it is possible that the IT sector needs to shrink before it can grow.”

Greenwood agrees that some shrinking of the sector may be necessary to get supply and demand back in balance. It is also plausible, he says, that Saba is defeated on one or two trusts, investor risk appetite comes back as interest rates stabilise and the cost disclosure problems are resolved, bringing some marginal buyers back to the market. This could resolve the situation naturally, he says, though admits this is an optimistic view.

Crighton says: “Trusts need to speak to the arbitrageurs and speak to the shareholders. The shareholders appoint the board and the boards have to be proactive. Doing nothing is not an option. Shareholders are worried already because if they weren’t, they wouldn’t have been selling.” Nevertheless, this highlights another problem, one of time and resources. Any investment trust targeted by an arbitrageur has to employ lawyers, negotiate with shareholders, and divert resources. It is a huge distraction from the day to day running of a trust.

It also doesn’t get to the largest discounts, which are in areas such as renewables, infrastructure or commercial property. These trusts have little interest for arbitrageurs because they cannot short the underlying stocks. Conway says: “For these trusts, cost disclosure is a much more pernicious problem.”

The investment trust sector has dealt with arbitrageurs before, and at times, they have proved a motivating force to realise value. However, there can be unintended consequences to their actions, and they may distract board and investment manager attention, without delivering the hoped-for uplift in the share price. Saba certainly means business, but the details of the strategy will only be clear over time.

[1] Association of Investment Companies

[2] https://www.youtube.com/watch?v=cy50pjqpKNM