IN-DEPTH: Closed funds, open battle
This article was first published on Activist Insight Online on January 16, 2020. For more information about the product, click here.
Despite the longevity of closed-end fund activism, new Securities and Exchange Commission (SEC) provisions could turn the tables. Some people, including the SEC, argue closed-end funds cannot protect themselves from raiders, while others blame underperformers charging high fees. Yet, the closed-end fund world is not far off from traditional activism.
Earlier in September, U.S. Congressman Gregory Meeks expressed his concerns about closed-end fund activism to the SEC member Robert Jackson. “These proxy contest[s] and related lawsuits… are not about improving governance, but rather coercing closing funds that cannot adequately protect themselves,” Meeks said, adding that “mom-and-pop retail investors” are the victims of this practice.
Commissioner Jackson told Meeks that he shared those concerns and that the SEC is committed to working on the matter to make sure that the “ordinary” investors are protected.
Trading gap
For activists, the idea is to find targets with a dislocation between the trading price and the net asset value, and then push for a liquidity event such as open-ending or share repurchases. Along with these economic demands, activists will often ask for governance improvements, such as the declassification of the board. Activist investors commonly engaged in the world of closed-end funds include Saba Capital Management, Karpus Investment Management, and Bulldog Investors.
In 2019, 23 closed-end funds were subjected to public activist demands worldwide, compared with 24 in 2018 and 21 in 2017, according to data compiled by Activist Insight Online. So far this year, two closed-end funds have been targeted by activists worldwide. In the U.S., the number of closed-end funds targeted by activist investors has tripled since 2013 – from seven to 20 in 2019. Activists have mostly aimed for board representation, with 73 such demands advanced since 2013, followed by share repurchases with 38.
Public backlash
“There has been a public backlash against some of this kind of tactics,” Richard Grossman, a partner at law firm Skadden, Arps, Slate, Meagher & Flom, which defends closed-end funds from activist investors, said. The criticism is that activists use governance hooks in order to achieve an economic end-goal.
Ele Klein, a partner and co-head of the global shareholder activism group at law firm Schulte Roth & Zabel, told Activist Insight Online Meeks’ focus on activist tactics is an attempt to “divert attention from what is really the issue,” namely consistent underperformers charging high fees.
Saba Chief Investment Officer Boaz Weinstein told Activist Insight Online that “the closed-end fund structure has protected underperforming high-fee funds from the rigors of the marketplace, and the lack of genuine independence from boards has left fund investors without an advocate.”
“The evidence is irrefutable that closed-end fund activism benefits all shareholders, particularly the small investors who are the most significant holder of the funds. Following a successful activist campaign, the funds have an improved net asset value and/or a decreased discount to net asset value. In the case of a liquidation, the investor recoups their full loss from the discount and can reinvest into dozens, if not hundreds of similar investment products with lower fees, such as ETFs, mutual funds, and closed-end funds,” Weinstein added.
Different targets, same dynamic
Grossman said that, unlike the corporate world, the strategies to unlock value is limited for activists who target closed-end funds. Yet Grossman noted activists in this space share ideas about campaigns “the same way regular activists do,” causing the same “wolfpack phenomenon” that occurs in the corporate world. As a result, activists like Bulldog and Saba often target the same funds, such as Nuveen Credit Strategies Income Fund and Western Asset High Income Opportunity Fund.
Yet activists may not have it easy when it comes to pushing for changes at closed-end funds. “It is much more difficult to run an activist campaign against a closed-end fund than it is in a typical operating company,” partner and head of the regulated funds group at Schulte Roth & Zabel, John Mahon, said in an interview with Activist Insight Online. According to Mahon, legal rules specific to closed-end funds “limit how things can be done.”
Skadden noted that these campaigns are often difficult as many closed-end funds have significant ownership by retail investors, who historically tend to support management, whereas institutional investors might be more receptive to campaigns both in the closed-end and corporate space.
“Some of the funds have been more aggressive implementing anti-takeover provisions and putting up barriers to shareholder democracy,” Bulldog Investors founder Phil Goldstein noted in an interview with Activist Insight Online.
When asked about the future of closed-end fund activism, Grossman said we will continue to see this type of activism, “as long as there are trading discounts.“ Klein cautiously agreed, “People who play in this space will continue to bring campaigns to underperforming closed-end funds, but it is a challenge.”