Reducing Discounts on Closed-End Funds

Closing the discount on an exchange-listed, closed-end fund can be a tricky and frustrating process. Asset management firms are fiduciaries in the management of investors’ capital and are charged with creating value for their shareholders by offering long-term growth of capital while also guarding against permanent loss. But there are risks inherent in liquid “supply and demand” markets and external economic conditions that are outside of an investment manager’s control.

Because a closed-end fund’s shares trade in the stock market based on investor demand, the fund may trade at a price higher (premium) or lower (discount) than its net asset value per share, or NAV, depending upon market perceptions, investor sentiment, or general market volatility.

The managers of closed-end funds may take various measures in an attempt to reduce those discounts. Of course, these measures must be approved by the fund’s Board of Directors as consistent with the best interests of the fund. With total assets of over $309 billion managed amongst 461 closed-end funds as of the end of 2021 (as reported by the Investment Company Institute), narrowing the discounts that a closed-end fund trades at relative to its NAV is an important issue for a sizeable swath of the asset management industry.

To better explore the issues and potential actions involved, we reached out to Institute members Kevin Rendino, CEO and Portfolio Manager, and Daniel Wolfe, President and Portfolio Manager of 180 Degree Capital Corp. - a publicly traded closed-end fund (NASDAQ: TURN) and registered investment adviser that manages its own capital alongside outside separate investment accounts. 180 focuses on positively impacting the business and valuation of microcap companies through a process they call “constructive activism.” Their goal is to invest in and provide value-added assistance to undervalued, small, publicly traded companies that have potential for significant turnarounds. These efforts are geared to help lead a potential reversal in the direction for the share price of these investee companies, in other words, a “180-degree turn”. It will be interesting to hear their perspective on actions possible to address their discounted closed-end stock price, which bears some similarity to the work they perform for their portfolio companies.

Hortz: From your experience, what are some of the forces at play that can lead to a large discount on closed-end funds like yours?

Rendino: Before talking about discounts, it should be noted that the most important factor in creating value for shareholders is the absolute growth of the NAV.  The primary job for a manager of a closed-end fund is to generate returns that enable the NAV to grow. One of the reasons why the discount can be larger from one closed-end fund to another is the performance of the management team in growing its book value. 180 Degree came to be because its predecessor company reported declining book values year-after-year resulting from its bloated cost structure and poor investment results for its venture capital strategy.  One would expect a wider discount if a management team produced consistently poor results. This discount grows wider as investors lose belief that an asset manager can actually grow its book value. As such, faith in an investment manager’s ability to generate returns above the market is a significant factor in understanding the discount between a share price and its book price.

In addition, closed-end funds are listed on an exchange and are subject to the structural risks involved with short-term supply and demand situations, market liquidity pressures, and external economic conditions that are largely outside of an investment manager’s control. Also, if an area of the stock market or a particular industry is not doing well or coming under substantial near-term disruptions, that pressure can take down all stocks in that area in fear and sympathy, including closed-end funds regardless of their book value growth.

The two “beta effected” closed-end fund scenarios described above can be looked at as potential opportunities for long‑term investors looking for undervalued assets with growth potential. Because the discount for our closed-end fund remains wide despite current management’s historical record of growing our book value, our management team has opportunistically bought 180’s stock, primarily with after-tax income, in the open market.  In total, our management team has purchased 800,000 shares (nearly 8% of the company) over the last 5+ years. These purchases and meaningful ownership align management’s interests with that of shareholders, i.e., we are all rewarded when 180’s stock price increases in value.

Hortz: Traditionally, what are some of the tools or actions that can be wielded by asset managers to try to address a large discount to the net asset value of their closed-end funds?

Wolfe: Some of the major actions that can be taken by asset manager sponsors of closed-end funds include:

  • management purchases of the stock in the open market
  • using leverage to enhance returns
  • share repurchase programs
  • dividends and dividend hikes
  • the liquidation of the fund at or near NAV and return of capital to shareholders. 

As Kevin mentions previously, the management of TURN have purchased a substantial amount of stock in the open market and continue to do so.  We have active discussions with our Board and our shareholders on the merits and detriments of the other actions listed above.  There is no “silver bullet” for narrowing the discount, but we continue to evaluate all options available to do so.

Hortz: In general, does the investment style or area of the market you are invested in provide any special or additional challenges?

Wolfe: We actively and purposefully chose an asset class that has asymmetrical characteristics to the “rest” of the market, and one that, if you get your stock picking right, can lead to significantly higher return potential than other asset classes.  With that said, the microcap space is more illiquid than other asset classes; and in “risk off” markets like 2022, that lack of liquidity can lead to periods of underperformance.

Hortz: Are there any particular issues that can arise between the portfolio manager and the board in trying to resolve the discount? What kind of dynamic can be at work between the two?

Rendino: A board is responsible for the oversight of a business while the management team is responsible for the day-to-day operations of a business. A successful business is one where the management team and Board are aligned with the overall view that shareholder value creation is the number one priority.  If a Board believes the best path forward is to liquidate the business, that may be the best outcome for shareholders and may come at the expense of the management team retaining their jobs.  Fortunately, at 180, our management team are significant shareholders of 180 stock so that conflict does not exist for us.

Hortz: Can you please share your personal perspective with us on what are some of the biggest challenges and frustrations that can develop for asset managers in trying to narrow the NAV discount?

Rendino: We do not control the stock market. We control the operations of the business and are responsible for generating returns and net asset value growth. If at any given point and time a shareholder feels a necessity to sell their position (the stock is illiquid to begin with), that can result in a material decline in the stock, irrespective of the business/investment results. Our closed-end fund is no different than some of the stock positions we own from that perspective. In contrast to TURN’s stock and many of our portfolio holdings, if someone wants to sell Google, or Verizon, or Exxon Mobil, there is ample liquidity and impacts to those stock prices can be minimized by such liquidity.  

We have had multiple conversations with investors regarding share repurchase and dividends. Some prefer share repurchase over dividends and others prefer the opposite. Many prefer none of those options and wish for us to maintain our permanent capital and invest it exactly the way we have as we have created more net asset value growth than any share repurchase program or dividend would have yielded.

Permanent capital is the best form of capital because nobody can take it away from you. It has proven to be very useful during market dislocations like 2022 when there was an avalanche of indiscriminate selling. Convincing yourself that there is a better use of our capital over buying back stock at 67% of net asset value, is a challenge. But we do the math and the math decides what is the better ROIC. It is as simple as that.

Hortz: Any thoughts you can share with advisors and asset allocators about investing in closed-end funds? Is this a particularly good time, during a market downturn, to be looking at this investment area?

Rendino: It is always a good time to be looking at portfolio managers who have a successful track record of NAV growth during periods of market dislocations and when their asset class may be under assault.  With regards to 180, an investor has the ability to buy such an investment management team at a time when the closed-end share price is down 35% from its high and trades at 67% of its net asset value. As a result of the 2022 market downturn, and because our stock trades at a wide discount to our NAV, we are a great example of some of the current opportunities available in listed closed-end funds.

Related: Investing in the Collision of Two Energy Megatrends

Disclosure Note: Any discussion of past performance of 180 Degree Capital Corp. is not an indication of future results. Investing in financial markets involves a substantial degree of risk. Investors must be able to withstand a total loss of their investment. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but no representation or warranty is made, expressed or implied, with respect to the fairness, correctness, accuracy, reasonableness or completeness of the information and opinions.