Ispend a fair amount of my time scrubbing around the deep value end of the market, trying to look for funds that have huge potential buried within a lousy share price. It’s a dangerous game trying to find this intrinsic margin of safety – a big discrepancy between net asset value and share price – because there are relatively few candidates and most of them are worthless.
Two key problems present themselves: the first is that many funds trading at big discounts tend to be investing in illiquid assets, usually via
a fairly opaque structure. This makes the second problem even more acute – estimating exactly what is the real net asset value, rather than the ones peddled to investors. If, through patient research and digging about, you can find a company where the mismatch is genuine, the rewards can be huge. In some cases, you can even find a company that will pay a juicy dividend.
The icing on the cake has to be a fund that is in the right niche at the wrong time. It’s a daunting challenge but I’ve started looking at a new candidate – the T2 Income fund. It’s not without risk – the shares crashed to as little as 1p from 100p at launch – and it presents many of the challenges I alluded to above. But I think there’s a chance the fund’s new manager can affect a turnround in its fortunes.
T2 operates in a similar field to another closed-end fund highlighted in this column a while ago – Psource Structured debt. The underlying manager is also US-based and, like PSource, it lends to mid-sized companies that need debt.
The fund lends out at decent spreads over Libor and receives senior secured debt in return. Its borrowers are mainly privately-owned companies – typically coming out of a leveraged buyout, with ratings a notch above or below B – so this is not an asset class that Aunt Hilda should be considering. It’s a high-risk recovery play on corporate credit in the US.
To make life really hard on the fund’s investors – which include some of the great and good of equity income investing in the UK, including Adrian Frost at Artemis and George Luckraft at Axa Framlington – the credit is housed in a separate collateralised loan obligation (CLO) structure, which is, technically, in a spot of bother. On paper, the debt used to fund the loans is long term (another 10 years to go) and on reasonable rates (75 basis points above Libor) but the face value of all the debt in that vehicle is more than the value the market puts on the corresponding loans to those corporates.
Like many financial vehicles of this sort, a mark to market value can be put on those loans to corporates and at the moment virtually all of it is trading at well below par (between 70p and 80p on the pound). Add it all up and technically the CLO vehicle has no actual current value by this strict definition (in fact it’s down $16m) and thus the fund has no absolute value except for about $6m of separate assets including $5m in spare cash. The cause of this mismatch is obvious – the CLO vehicle’s assets are relatively illiquid corporate loans that command a relatively poor market value yet its liabilities need to be valued at the issue price.
No sensible manager would start actually selling those corporate loans (the assets) unless they were going bad. The managers choose to use another method of looking at the value of those loans based on a principle called marked-down to market and that puts the value of those loans much higher, in theory making the fund’s assets worth 84p (the current share price is 27.5p – a big mismatch). By my calculations, you could probably take a sensible middle course and come to a valuation for T2 that was about $35m (or £21m) – a 50 per cent gain on the current share price. Crucially, all those assets (loans to companies) are producing a fairly healthy income stream (even after allowing for the high management expenses and the relatively low cost of servicing the debt) that probably sustainably amounts to $6m or £3.5m a year. Even if we assume that T2’s managers want to keep half of that to rebuild the equity base of the London-listed fund, it could still easily pay out, say, £1.5m a year – it has already restarted dividends and the managers seem to have every intention of maintaining those payments. That stream of payments on a £12m market capitalisation could make all those equity income managers happy again and there’s always the chance that the managers could buy back some of the more junior debt within the CLO, cancel it out and thus raise the value of the equity without even having to work hard on the underlying corporate borrowers (in fact they’ve already bought back $1m of debt for $900,000).
There are, of course, a multitude of risks – lots of things could go wrong including adverse currency movements, massive increases in default and other nasties that I detail in my online diary at www.ft.com – but I think the odds are that T2’s managers will pull it off, rebuild the strength of the loan book and start working that income stream. If they do, the shares will be due a rerating and you’ll also get that income stream.
adventurous@ft.com
