Thursday, September 13, 2012

Special Opportunities Fund (SPE)

So someone posted a recommendation for SPE in a comment on this blog so I decided to take a look.  As I posted before, I am not a big fan of closed-end funds, and it turns out this is a closed-end fund that invests in other closed-end funds (and other things).  So my initial reaction, of course, is that the total expenses/fees would be too much for this to make any money (double layer of fees!).  This is why I'm not a big fan of fund of funds either.

But of course, this one is different.  It is run by none other than Phillip Goldstein of Bulldog Investors.  Goldstein is known as an activist investor that pressures closed-end funds to do something to close the discount.

Obviously, this means that this is not going to be a vehicle where someone just keeps it going without much effort just to retain the fee income.  Goldstein will be very motivated to make this perform well and if this trades at a discount too long, there will obviously be some action taken to close the gap.

(The manager is Brooklyn Capital Management (no relation to this blog), which is basically Phil Goldstein, Andrew Dakos and Steven Samuels. BCM was set up to become the advisor to SPE).

There is a lot of stuff on Goldstein on the internet so I won't go too much into his past.  He is most known for his activism with closed-end funds and his lawsuit against the SEC.

He is an interesting character; he doesn't come from a Wall Street background, but was a NYC employee for years until his late 40s when he started to manage money full time.  It's a great story.  (Here's a link to one article:  2008 Fortune magazine article.)  There's also a video interview on Opalesque TV on Youtube:  video interview.    (By the way, I don't know what Opalesque TV is but it has some great video interviews with hedge fund managers including Izzy Englander; I've never seen this very secretive, publicity shy person on screen before).

One story that is great (I think from the above article) is how Goldstein, when meeting with an early investor, wasn't allowed into a restaurant because he was wearing shorts.  He went next door and bought a pair of sweatpants, then went back to the restaurant, had dinner, and then afterward returned the sweatpants at the store (next time I buy a pair of sweatpants I'll try not to remember this story).  Cheap is good.

This reminds me of someone making Buffett wait; he was busy driving around looking for a free parking spot (my reaction, though, was how the heck can you make Buffett wait to save a few bucks?!).  Buffett knew immediately that he was dealing with the right person.

Goldstein has that quality, obviously.  He stays in $70/night hotel rooms in Vegas instead of the more expensive, fancy places.  So you can check mark that box.

So How Has He Done?
As is often the case with people who run hedge funds, sometimes it's not easy to find out how they have done over time.  The big ones are usually known as people talk about them all the time and letters to investors float around and their returns are published in magazines etc. 

So I have to just scrape up some information from the internet to see what I can put together (I don't have access to expensive hedge fund return databases, but that's OK).

According to the Fortune magazine article of June 2008, Bulldog Investors had $500 million in AUM and the main fund had an annualized return of 15%/year in the 16 years since 1992 (when the first fund was formed in December 1992), and never had a down year.  $1 million invested in the S&P 500 index was worth $4.5 million versus $8.9 million for the main fund during this period (using 16 years which may not be exact, that's 14.6%/year versus 9.9%/year for the S&P 500 index).

That's actually pretty impressive.  The outperformance, of course, is nice but the fact that they didn't have any losing years between 1992 and 2008 is pretty good.  Of course, this is before the financial crisis really gets going, but it does include one of the worst bear markets in history between 2000-2002.  It is a validation of Bulldog's approach emphasizing capital preservation. 

According to the video interview dated January 2011, the Full Value Partners fund (flagship fund formed in 2001) returned 10%/year between 2001 and presumably the end of 2010.  The cumulative return over that time period is 125.29% versus 32.45% for the S&P 500 index.

In the interview, Goldstein says that over 18 years, the Opportunity Partners fund has done 5-6% better than the S&P 500 index with only one down year.

In the November 2009 letter to investors of SPE, Goldstein said that over 17 years, the Opportunity Partners L.P. earned +12.8%/year (net of fees) versus +7.4%/year for the S&P 500 index with a loss in only one year during that period.

In the 2010 interim report to SPE shareholders, he said that the hedge fund he managed earned +17.5%/year in the period 1995-1999 while the S&P 500 index gained +28.6%/year.  In the period 2000 - 2002, the S&P 500 index fell -37.6% while the hedge fund gained +24.2%.  He wrote that to illustrate the conservative nature of his approach:  he will underperform in strong markets but will do well in choppy, flat or down markets.

So these are some of the data points for Goldstein.  They all look pretty good to me.

What About SPE?
OK, so what is SPE?  SPE, in short, is a fund that Goldstein took over after a proxy fight.  To save some time from typing and also to display my excellent "snip"-ing skills, here's a cut-and-paste from one of SPE's annual reports:


From the first letter to shareholders (interim report 2009), this is how they introduced themselves to shareholders:


And the last paragraph of that letter was (after taking about the various types of investment funds including closed-end funds):


And to show that he means it, he has put his money where his mouth is (even though I don't know who owns how much at this point):


In the June 2011 letter, Goldstein after showing return data, wrote:


And then he listed some of the horrible things that happened in 2011 and pointed out that the market was UP.  Sounds like a Brooklyn Investor blog post!

Anyway, the letters to shareholders for the SPE fund are all great reads and Goldstein explains why he is investing the assets in SPAC (special purpose acquisition corporations), auction rate preferred shares, closed-end funds and other special situations.  The latest interim report of June 2012 (not on the SPE website but is available at sec.gov) is a fascinating read with updates on current holdings (including such hairy special situations like MYRX, IFT and GYRO, progress on some closed-end fund liquidation (potential), SPAC deal closings etc.).

Here's the website for SPE:  SPE Reports
Here's the SEC page for SPE's filings:  SPE's SEC page

I think it's a great place for special situations investors to look for ideas (particularly small cap ideas; these ideas won't work for big funds).

Current Asset Allocation
SPE is not top down; I don't think they choose asset allocation, but the allocation is just a result of the opportunties available (they don't target portfolio allocations etc.).

Here is their current breakdown of assets (as of June 2012):

Closed-end funds:                      53.30%
Auction Rate Preferred Shares:   5.34%
Business Development Co:         2.32%
Common Stocks:                       31.65%
 (of which SPAC:                      25.71%)
Promissory Notes:                       0.39%
Standard Life Settlement Notes: 0.46%
Warrants (SPAC):                       0.56%
Money Market Funds:                 6.41%

So it's easy to see why this portfolio is conversative.  26% of the assets are invested in SPACs, many of which are just cash.  If a deal can't get done, the cash is returned to investors with no downside risk.  Closed-end funds too have downside protection as they only buy funds at deep discounts to NAV and where they feel they can initiate some action to close the gap (I think Goldstein said in the interview that if they buy at 15% discount to NAV and can get some sort of action (like tender offers) within two years, that can explain 5-6%/year in alpha (versus the market).  They are usually agnostic to market direction of the underlying portfolios.

If you look at their other common stocks and other holdings, you will see that they are not market correlated but are very specific special situations where the value is realized (or destroyed) by company specific events.


SPE Performance
So how has SPE done since they took over?  SPE dates the beginning of their new strategy at January 25, 2010.  Up to then was basically the liquidation of the old portfolio etc.  So that's the date SPE sees as the start date for the new strategy.

According to the June 2012 interim report, SPE returned an annualized +9.00%  versus +11.65% for the S&P 500 index from January 25, 2010 to the end of June 2012.  So it's lagging a little bit, but then the time period is a little too short.  This is not one of those "I guarantee you 1%/month in any market no matter what (or until I blow up)" funds, so this short term result isn't indicative of anything.

For the  first six months of 2012, SPE returned (on a NAV basis) +5.87% versus +9.5% for the S&P 500 index.

As Goldstein explained and illustrated above, SPE will lag strong up markets but will do well in choppy, flat or down markets.

Fees and Expenses
Despite the great track record, the management fee charged to SPE is only 1.00% and there is no incentive fee.  Can you imagine that?  A manager that beats the market by 500-600 bps/year charging only 1.00% with no incentive fee.  That's like getting a big suite at the Bellagio for $70/night, isn't it?

The expense ratio is around 1.5% (this includes the management fee), so that's reasonable given that you pay 2%/20% to hedge funds.  You often pay similar or more to equity funds that can't even outperform the market, ever.

Value
As Goldstein says, the great thing about closed-end funds is that it's easy to value.  In this case too, the NAV of SPE is published weekly.  As of the end of last week, the NAV was $17.48/share.  The stock is currently trading at $15.37/share, so that's a 12% discount.

A 12% discount for a fund that only charges 1%/year management fee, no incentive fee and that has a long track record (assuming SPE invests similarly to Bulldog Investor's hedge funds) of outperforming the S&P 500 index by 5-6%/year?

It seems like a no-brainer to me.

Conclusion
So this is a really interesting situation.  Goldstein is 66 years old so not so young.  There isn't a 30 or 40 year runway here.  But 66 is a lot younger than say, Buffett.  He probably has a good 10, 15 years or more.  If Dakos is good, he is in his mid forties; plenty of runway there.

Other points are:
  • The size of the fund is very reasonable, at a little over $100 million these guys don't have the size issues that a lot of the other alternative asset managers I look at have.  Maybe they now have to manage $500-600 million including the other hedge funds that they manage.   A lot of the private equity/hedge fund guys I really respect had their best years managing $500 million - $2 billion, maybe.  And now they are trying to swing $10-20 billion around or more.  That is a very difficult thing to do.
  • Of course the fee structure and discount stated above is a big positive.  1% management fee, no incentive fee for 5-6%/year in outperformance?  What's not to like?  
  • The market insensitive nature of this strategy (focus on special situations and take positions only where they feel they have a true edge) is also good and may be reassuring to people who don't want a whole lot of long equity exposure.  Of course, the closed-end funds have market exposure, but as I mentioned above, the alpha generated from the discount purchase price and potential catalyst to close the discount should make up for that market risk over time (may lead to continued attractive risk-adjusted returns).
  • Their historical returns seem pretty consistent.  Goldstein's funds seems to have done really well over their entire history, but also pretty good since 2001 which is reassuring as the market has been flattish since then.  The fact that they can earn 10%/year in a flattish market (2001-2010 for Full Value Partners) shows the consistency of their alpha-generating ability.  (I can't believe I just typed that sentence; I sound like some financial magazine writer! Not that there's anything wrong with that).
  • The fact that they made money in 2000-2002 is good too, particularly for people worried about a prolonged bear or flat market.  It seems that SPE is not a bull market dependent strategy.  I wouldn't say SPE is bear market-proof as all bear markets are different.  But it seems to be bear market resistant.  The strategy has been stress-tested through a few cycles.
  • Great letters to shareholders.  When was the last time you read a letter to closed-end fund investors?  Of course, why would anyone.  They are horrible.   Goldstein's letters for SPE are really good.  They offer clear thoughts on what they are trying to do and specific ideas with some details on them.  This is exactly what you want from a manager of your money.  Most fund letters seem to be so focused on blaming and excuses; "The Euro crisis worsened during the period and our exposure to cyclicals caused our severe underperformance versus our benchmarks but it's not really our fault so don't blame us! It's Bernanke's fault!  It's Merkel's fault!"

So given all of the above, I think SPE is a really interesting opportunity and I wouldn't be surprised if it did very well over time.

I think this is the first time (in a very, very long time) that I would ever recommend a closed-end fund.

What was that Tom Cruise movie?  "You had me at 'hello'".  Well, maybe Goldstein had me at "sweatpants".

But then again, do your own work.  This is just my opinion and I could be wrong.  Anyone who buys something after reading about it on the internet deserves to go broke!

16 comments:

  1. Phil Goldstein is the real deal.

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  2. Should also be pointed out that the current 12%+ discount is the deepest since the dark days of 2008/2009.

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  3. Very interesting. So why is he involved here when he's got a HF (with better fee structure) where he could make these same investments?

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    1. That's a good question. They won a proxy fight and took over management and decided to do their thing with it. Maybe it has to do with wanting permanent capital like everybody wants. But Bulldog doesn't strike me as a hedge fund with fast, flakey money investors.

      The interesting question for me was that Goldstein now put himself in a potential position of being a manager of a perpetually discounted CEF. But if he performs well on a NAV basis, his situation would be different than the CEF's he activists on.

      The concern, of course, with anyone managing multiple vehicles is conflict. But in Goldstein's case, he doesn't seem like someone that would use a publicly listed vehicle to benefit his private funds. He just doesn't strike me as that sort of person (very far from it, actually).

      Also, he is now a CEF manager with very public results so he is sort of walking into a glass house. He is very incented to make this thing work. So I don't worry about conflict in that sense too.

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  4. Here's what he should do, this is a guaranteed moneymaker. Own shares of SPE within SPE. When the discount widens, buy shares and boost NAV, which is magnified by the self-ownership. If and when the shares trade above NAV, sell shares and boost NAV. Guaranteed return trade.

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  5. Great posts!

    Can we republish some of them on GuruFocus.com?

    thanks!

    Charlie.

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    Replies
    1. Hi, thanks for the comment. What do you mean by "republish"? You are free to link to it, of course, but I don't know about "republish".

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    2. I hope to publish it in full on GuruFocus.com. could you please email me: charlie at gurufocus dot com.

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  6. A couple comments after a very quick look:

    1) What is your view on the Preferred Security issuance? It is 3% dividend and converts if the fund reaches NAV of $20. I view this transaction as a way to get leverage on the fund, and increase fee paying AUM.

    2) From reviewing the 2011 annual report - which is the last financials - the fund has a good amount of level 2 and level 3 pricing in calculating its NAV. You have to really trust a manager when it comes to level 2 and level 3 pricing. The fund I work for has invested in Auction Rate Preferreds in the past, and his marks did seem reasonable.

    3) A lot of investments are in other funds and SPACs. The closed end funds clearly pay fees, but they also trade at a discount. Do you know if there is any potential that the manager invests in other firms that they control in order to pay fees on top of fees?




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    1. I forgot to mention.

      Relating to point (1). The addition of leverage has caused the total capitalization of the company to trade tighter with NAV. Also, I think 3% plus an option, while not extremely expensive is relatively dilutive.

      If the company over the next 2 years gets to $20 in NAV - the preferreds will return 2 Dividends (6%) + 8% on the conversion (if we assume the NAV still trades at a 10% discount) -- for a total return of 14% in a very senior position in the capital structure.

      Not accounting for dilution from the pfds - the common will return 14% as well. Hence, the pfds will have a higher return in a senior position.

      Note: the preferred prospectus was not on bloomberg or the company's website so I got all this info from the company's press releases.







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    2. Hi,

      The prospectus is availabe at sec.gov: http://sec.gov/Archives/edgar/data/897802/000089418912000070/specialopps_n2.htm

      1) I don't have a particular view on the preferreds issuance. My understanding of the character of the folks at Bulldog is that they don't do things just to increase management fees. Maybe they feel more comfortable with a little more AUM because they 'redeemed' a bunch on the tender (after the proxy).

      2) Again, my understanding of these people makes me very comfortable with the marks they use. I don't worry too much about Level 2, 3 etc.

      3) Same as 2) and 3). They do run the MXE and some others that they own but they own it and run it as activists, basically, not fee-enhancing methods. Goldstein has a history of shaking up CEF managements and he takes pride in that. He is not going to sit there and maximize fees and run some mediocre CEF after all he has done.

      Anyway, as for the preferreds, yes they are interesting. I look at it as a call spread with a coupon; not the most exciting thing in the world.

      As fort he capital structure point of view, I don't think it's a big factor in a CEF like this as it is a low debt fund with mostly liquid assets.

      Anyway, thanks for commenting.

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    3. Thanks for the quick response. I wouldn't have spent the time to look into it if I didn't like the funds strategy and thought there might be something there.

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  7. I guess opportunity funds are the one, about which very less information is available on internet and even very few investors know about this fund. Good informative post about opportunity fund and nice case explained in post.

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  8. Great post. Here's part 2 of the Opalesque Interview in case your readers are interested... http://www.youtube.com/watch?v=x6TjjOcXgms

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