Managed Management: A Conversation With A Closed-End Fund Advisor, Pt. 2
John Cole Scott is the Chief Investment Officer and Chief Compliance Officer for Closed-End Fund Advisors, an investment firm that specializes in discretionary management of closed-end fund assets. Recently, CEF Advisors launched 26 daily-priced indexes covering the closed-end fund and business development company landscape.
Marketfy Maven Tim Melvin recently spoke with Cole about the role of activist investors in closed-end fund investments as well as how Business Development Companies (BDC) factor into CEF Advisors' portfolio.
Below is part two of their interview, edited for length and clarity. Click here to read part one.
Melvin: Okay, now that brings up one of my favorite things to talk about, my much loved small bank stocks and closed-end funds. There are several activists in this space. Do you track them at all?
Scott: We sell data to many of them. We're friends with many of them. I always tell people we feel like we're Switzerland. We interview fund sponsors, we chat with activist investors, we partner with hedge funds, we have our own services that we can do. We are pro closed-end fund, I mean we're called closed-end fund advisors. I can't care about operating companies' ETFs and open-end funds because it's not my purview, and there are some times where activists go after funds or activists' followers that think that the funds are good and they shouldn't. There are times where I can't wait 'til they get rid of those funds because they're giving the sector a bad name.
So, activism as a whole is good. The well-known ones are Bulldog and Karpus. Newer players, Saba Capital, which is not a pure activist, but they've done a couple of successful things like tenders and an open-ending. So they get into it when they don't like what they see; they don't do it as their only strategy[...]
Again, I'm not saying that they always do what's best in the interest of all shareholders[...]but I love it when the activism supports good behavior, supports good funds, and gives people a chance, like in managers to prove their worth. Now we've sold data to activists to tell a fund where they see opportunity to improve, and we've sold data to fund sponsors to remind activists where they're doing a good job. So, data can be interpreted, having tons of it, we can visualize it in lots of cool ways.
Melvin: I want to touch on the BDCs. Because we've mentioned them several times. I can tell you after three decades in and around the markets, working primarily with high net worth individuals, most people have no idea what a BDC really is at this point, except it's something that you can buy that has a big dividend.
Scott: It is. When we brought our unit investment trust to market, I pitched it to the sponsor because I said, "There are now 42 debt or loan-focused BDCs." 'Cause the original BDC was a venture equity fund. This was 1980, under Ronald Reagan, Congress did something rather useful. They said, "Okay, US companies need access to capital and US investors need alternative sources of investments than their traditional stock and bond."
Congress was thinking about this 37 years ago. And they created the BDC wrapper, which is very much like the closed-end fund wrapper as in that fixed capitalization. The difference is that you can charge hedge fund-like fees because you're doing much more complicated work. You can have a little bit more leverage. But nowadays, and there's 40 of these debt-focused funds, where they're around 90 percent loans versus 10 percent non-loans. They're yielding around just under nine right now, their guts are typically 50 to 150 loans—typically $5 to $25 million loans—to companies five to 10 years old in every state in the country. They're focused in some areas you might expect, like Texas, California, and New York.
It's like a five-year loan, four-year loan. It's a first lien loan, usually over half the time. And so you're getting secured loans to private or very small companies, and you're often getting variable loans, usually about...I think right now in our index...about two-thirds of loans right now. And it's a nice way for a non-accredited investor to potentially gain access to a money manager who specializes in mezzanine and middle market debt and finance.
You can go to many of these BDCs as an accredited investor locking $3 million for a year or two, and they'll do the loans and you'll make your money, but what I tell our data clients that are new to BDCs, so if you don't know about them, don't feel bad. BDCs are more liquid than closed-end funds.
The average yield right now for the sector is 9.23, and the taxable bond market is, I think, just in the high 7. But 150 basis points more "market yield," twice the liquidity than the average taxable bond fund, and far more less homogeneous, as in, if you buy the wrong BDC or the right BDC, you have a much different outcome when you buy the wrong senior loan fund, or the wrong convertible bond fund, in my opinion. I can't guarantee that, but historically, you could see in one month, a BDC versus another one do 20 percent difference based on an earnings quarter. I've never seen that in another closed-end fund sector.
So, it's liquid access. You can trade daily if you choose to, obviously we do not trade daily because that sounds ridiculous. But it's this way to make money through rising rates, where again, right now, they're generally premiums, but small premiums are normal because you can't do this anywhere else. You can't put BDC guts in an open-end fund.
Melvin: And BDCs, we're measuring premiums to book value, right?
Scott: We do. You have to remember, book value I publish four times a year for a BDC, so potentially the book value could be higher but it also could be lower. We look at the volatility.
When you analyze a BDC, it's not just, "Oh my goodness, this is at a 10 premium, this is at 10 discount," you clearly sell the premium by the discount. That is important to think about, but much more important is, is the fee structure fair to shareholders? Do they have a hurdle rate? Do they have a lookback provision? Can they book and send a revenue while cutting your dividend? But that is bad corporate governance, bad shareholder behavior. Some have done it, some have not. That is some of the discount pricing. Then you look at the portfolio. Do they write good loans? Do they have a history of getting paid back? 'Cause essentially a BDC is a diversified regulated bank with less leverage than a bank and more oversight than a bank.
The '40 Act oversight to me is more oversight than any bank will get under the regular operating company, common stock rules, and because the portfolio can only be levered to a one-to-one debt equity ratio, the leverage usually looks like 40 percent versus 200 percent, which is normal for a bank. To me it's leveraged, but less than banks. More regulation, more transparency.
So if a BDC has a hundred loans in a portfolio, every 90 days you're gonna get data on, is the loan performing? The BDC has to price every investment every 90 days. It doesn't mean that they price them all the same and there's no way for BDC to overprice a loan, but if you overprice loans and you have a fair market value committee, and then it can be proved that you didn't do a reasonably good job doing it, there's a lawsuit there. Versus if you don't disclose how you mark every loan 'cause you're a bank, and a loan doesn't perform, there's no recourse.
Nothing's perfect. Right now, there's 29 of these BDCs that trade over a million dollars a day which are liquid, and we do offer a limited data for free on the sector because no one else had them. BDCuniverse.net has limited data, updates daily. If you click the ticker symbol, you'll see a fund profile page, again, part of our free offering to help educate the people about the sector, to get an idea of how the funds are different. But yeah, they're a sector of the market. They're not the whole answer, but they're definitely a good complement to the taxable bond portion of your closed-end fund or regular portfolio.
Melvin: Any final thoughts, predictions, suggestions that you might have for readers who are putting together a portfolio, closed-end funds or business development companies?
Scott: I would say that the rules of thumb that we find useful, I said a couple, but one is, remember the bonds are equities that derive their value from bonds. The market price yield you see quoted in our system or anything else, a Bloomberg Terminal, Morningstar, anything, is the current policy of the board based on the current market price of the funds. So don't think of a 7-yield or a 10-yield, as being, I hate to say, guaranteed. But the last time rates went up, it was about a 4 percent move and 97 percent of closed-end funds changed their dividend policy. Now there were increases and decreases, so we find a lot of people think of dividend policies almost as promises, and they're not.
I would say that balancing discount direction, good net asset value exposure, and performance, and that dividend analysis is how you balance out some of the risk of a portfolio. And be willing to be patient and diligent. If you don't get your shares today, there'll be another fund tomorrow. I find a lot of people fail because they have to get the trade today, and if you're a larger client, that may push the price too much and that may be a bad investment decision. I tell our traders, "I want this discount. Sell me a five discount, buy me a 10. If you don't get it, I don't care, because I don't want it if I can't get both." Ttake that perspective of being patient, diligent, and understanding that there's a net asset value and a market price, and there's more going on than just either.
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