Evans Dixon case shows it matters who else is investing in your LIC

Assessments of LICs/LITs tend to be primarily about the manager, the investment strategy, performance, the portfolio, fees, and importantly, the discount or premium to net tangible assets (NTAs). Apart from the last element, these are generally the same primary things you would look at for an unlisted fund.

However, in addition to the discount/premium to NTA, there is one other important element that should be considered with listed funds which usually doesn’t matter a great deal for unlisted funds. That is the makeup, and motivations, of the other investors holding the vehicle (or shareholders in the case of listed investment companies and unit holders in listed investment trusts).

Clearly, in the case of unlisted funds investing in liquid, listed assets this is something you rarely need to pay much attention to. If you are dissatisfied with your investment you can simply redeem at net asset value (NAV) and what other investors do won’t normally have significant implications for your own investment. There are, of course, exceptions to this rule.

For listed fund vehicles, though, the dynamics are somewhat different. Investors can’t force the sale of assets just by selling shares, although they can help drive the share price to a large discount to NTA. Still this certainly impacts investor returns. Therefore, irrespective of whether the underlying assets are liquid or not, the makeup and actions of the listed shareholder or listed unitholder base can be a significant driver to investment returns for investors and ultimately even impact the structure and future of the fund vehicle.

Shareholding matters

A prominent example recently is the case of several Dixon Advisory – now Evans Dixon – sponsored listed funds, managed by Walsh & Co., an Evans Dixon subsidiary. Ignoring the question of whether building a portfolio heavily focused on in-house managed, closed end listed funds is in the clients’ best interest, it has been clear that such a portfolio comes with some additional issues and risks that investors are only beginning to realise.

No doubt the Dixon business model worked well while it was strongly growing the client base. Advertising heavily in the financial media, the business focused on, and benefited from, the strong industry wide growth of SMSFs. New clients were available to take up the issuance of new listed vehicles and to absorb any selling from existing clients. As such the funds typically traded around NTA albeit with low liquidity.

However, with most of the share/unit holders being Evans Dixon clients, one could argue this was not a true and fair market. Indeed, a case could be made that some investors were paying more than what these funds would typically trade at in a more normal secondary market with a more diversified share/unitholder base.

Because the assets are held in individual names (or SMSFs), Evans Dixon never had to report its clients’ held a substantial position to the ASX no matter how much of the vehicles its clients owned or were effectively controlled via recommendations to clients. This is quite different for a single institutional investor, a large super fund or managed fund or even platforms that need to disclose if they reach substantial at 5 per cent and in 1 per cent increments beyond this. Large holders are also generally required to make a take-over they reach 19.9 per cent of the vehicle, or else increase their holding beyond this only very gradually under the ‘creep’ provisions.

Then there is the question of how objective Evans Dixon and its advisers can be, in practice, regarding recommendations on these funds. Any broad sell recommendations to its clients would be potentially disastrous for investors and probably impossible to implement without winding down/closing a fund. With little outside ownership there is little if any research house or broker analyst coverage of the funds to provide alternative independent research/recommendations.

Self-perpetuating cycle

In any case, it was inevitable that as the growth of the Dixon business slowed, perhaps in line with slowing industry SMSF growth, some problems would emerge. Lacking enough new investors to absorb sellers, and with little broader market ownership and support, any additional selling would result in some funds dropping to a growing discount. This could also occur as some dissatisfied investors left their adviser, with advisers leaving the group and clients following another possible driver. This can result in a self-perpetuating cycle as disappointed investors and advisers sell at increasing discounts to NTA, which leads other investors to sell because of the poor ‘mark to market’ returns, worse than those of the underlying NTA.

The negative perception around a fund can be reinforced with adverse media or the risk of potential regulatory action. Investors are also more likely to focus on problematic issues such as high fees/costs or conflicts at such times when their investments are seen to be performing poorly. The most prominent fund affected has been the US Masters Residential Property Fund, which now trades at close to a 50 per cent discount to pre-tax NTA although the fund faces some specific challenges beyond the scope of this article.

This is not to suggest that there are not some good managers and assets in the Evans Dixon/Walsh & Co fund stable (URF). Indeed, some funds have been largely unaffected by the broader negative news and are currently trading around NTA. However, it is likely more funds are vulnerable to some of the same negative sentiment and selling pressures that have impacted the URF fund, particularly in periods of poorer underlying NTA performance and if there is ongoing scrutiny of the Evans Dixon business model.

Of course, this negative investor sentiment is exactly what can create great investment opportunities at some point as money is ultimately transferred from impatient, disappointed investors to more patient and contrarian ones.

Another current example where the make-up of the shareholders matters a lot is the pirate themed LIC Benjamin Hornigold (BHD), a fund I’ve devoted a previous column to. If you know anything about the story of this fund you’ll know there’s more that needs to play out, but what’s certain is the current mix of shareholders and resultant voting power has had significant implications for the future of the vehicle and ultimate return to investors.

Another interesting LIC currently in play where the makeup of shareholders is crucial is Blue Sky Alternative Access Fund. Prior to the appointment of administrators to the manager, Blue Sky Alternatives the BAF board was engaging with Wilson Asset Management to replace Blue Sky as investment manager. However, BLA ceased such discussion in its dying days, perhaps over concerns Wilson would look to offload some of the illiquid Blue Sky fund assets, causing additional problems for the manager.

This situation is clearly complex because the approach of the administrators in realising BLA’s unlisted fund holdings will be a factor in investor outcomes for BAF. Still, trading at more than a 35 per cent discount to last stated NTA, under this uncertainty and negative investor sentiment, there seems to be considerable value even if reductions in certain underlying fund values occur. Several activist funds also have holdings in BAF that suggest protecting and or realising NTA will be a major focus of a significant part of the shareholder base going forward. I should disclose I personally have holdings in BAF.

Activists and insiders

The role of such activist investors can therefore be a crucial factor in the future course of a listed fund and investor outcomes. Typically, when a listed fund performs poorly and/or moves to a large discount to NTA it attracts the interest of opportunistic investors who build stakes and pressure the board/manager to take actions that can narrow the discount through improved marketing or a clearer dividend policy and/or be accretive to NTA such as on or off market buybacks. In extreme circumstances where such measures fail – or are resisted – there can be attempts to wind up the fund or facilitate a merger with another fund.

A related issue regarding the shareholder make-up is how much the investment manager and associated parties own of the fund vehicles. When it comes to unlisted funds, investors generally pay little attention to how much the manager has invested in the fund. In most listed vehicles there is more scrutiny of this, partly as LIC directors must disclose any purchases or sales.

Director/management buying of a LIC is generally a good thing. It usually demonstrates a belief in the investment strategy, the portfolio and current pricing and a willingness to risk their capital. However, sometimes there are other motives such as holding off activists and/or trying to ensure the existing board and/management remains firmly in place, often to protect the fees the vehicle is generating. Trying to understand the motivation of the various parties can become very important, although sometimes is far from easy.

LICs and LITs can be great vehicles to invest in but two inter-related characteristics that most distinguish them from unlisted vehicles – the discount/premium to NTA and the makeup, motivations and activism of the shareholder base – can often be the difference between success and failure for investors. After a booming few years where a range of new funds have been listed, we are beginning to see examples of the importance of these issues in practice. Such a more dynamic and complex environment brings more risks, but it also brings more opportunities.