The In-Kind Tender Trap At The New Ireland Fund

Introduction Country Funds — closed-end funds that focus on particular foreign markets — were all the rage back in the 90’s, as a way for individual investors to explore the world outside the U.S. Since then, maturing foreign markets and the rise of exchange traded funds have made country funds obsolete. No longer Wall Street’s darlings, they now trade at sizeable discounts to asset value – some over 15%. [As of 8/12, country fund discounts ranged from 19.1% (NYSE:CAF) to 8.2% (NYSE:KEF); none were at a premium.]

Such discounts excite the interest of “activist” institutions that manage pools of capital as large as or larger than the funds themselves. After building up sizeable positions at discounted prices, the activists press fund managers to “realize net asset value” through share buybacks at prices near NAV, open-ending, or liquidation. Such moves have been quite effective in thinning the ranks of country funds: who now remembers the France Fund, the United Kingdom Fund or the Scudder New Europe Fund? How many tears are shed for the loss of funds focused on Emerging Germany, Pakistan, Vietnam, Brazil, Brazil Equity, Southern Africa, Argentina, Austria, Spain, Portugal, First Iberian, Jakarta Growth, Malaysia, First Philippine or the Czech Republic?

The action continues at the remaining country funds. For example, the JP Morgan China Region Fund (NYSE:JFC) recently announced merger talks with the Korea Equity Fund, with their fusion to be followed by buying back 50% of the shares at close to net asset value. It is no coincidence that the City of London investment firm controlled over 40% of both funds, and was planning a proxy fight to terminate KEF’s manager. Currently, JFC and KEF trade at discounts of 8.7% and 8.2% respectively, the closest to NAV among country CEFs.

1. Rewards and Risks

Gwailo has long maintained that small investors can Make Money With Closed-End Fund Activism by looking for funds with large trading discounts, significant activist holdings and some potential catalyst for unlocking asset value. But there’s a catch. Piggybacking on activists only succeeds if fund managers respond with discount reduction measures that are available to all investors, large and small. From the standpoint of the activist institutions, however, this is a classic “free rider” situation: they bear all the costs but reap only a fraction of the rewards. Challenging an entrenched fund manager can be difficult, proxy fights and litigation are costly and time-consuming, and it may not be possible to exit a large position gracefully in case of defeat. Institutions and individuals have a common interest in reducing CEF discounts, but when it comes to specific measures, they may fall out of alignment.

The New Ireland Fund’s (NYSE:IRL) recent announcement of a proposed in-kind tender offer for 25% of its shares illustrates the problem.

2. IRL Plans an Offer

IRL is a relatively small ($70mm) closed-end fund focusing on Irish stocks. It historically has traded at a substantial discount [@15%] to net asset value. As an investment vehicle it is overshadowed by the iShares MSCI Ireland Capped ETF (NYSEARCA:EIRL) a $125mm exchange-traded fund set up in 2010. A glance at Morningstar shows that both funds have had similar returns over the last several years, even though IRL’s expense ratio is 1.68% compared to EIRL’s 0.48%. Active portfolio management at IRL seems to have covered its own cost but little more. EIRL has somewhat lower turnover and almost triple the average volume, making it the more liquid choice for those who simply want to add a touch of the Emerald Isle to their holdings.

What IRL announced on June 28 was actually two alternative buyback offers. The primary one was a “Modified Dutch Auction” tender for 25% of its shares at 95% to 97% of NAV, with payment to consist of pro-rata slices from its portfolio holdings in 23 Irish companies, subject to receiving an exemption Order from the Securities and Exchange Commission by March 28, 2017. The alternative, in case the SEC does not issue the exemption by that date, would be to repurchase 30% of IRL’s shares at 98% of NAV, paid in cash. Since the announcement, IRL’s discount has ranged near its current 11.7%; the last year average was 13.4%.

Some background will help when evaluating this complicated proposal. IRL is no stranger to activism. Back in 2012, after Bulldog Investors under the management of legendary CEF activist Phil Goldstein accumulated 13.4%, IRL agreed to self-tender for 15% of its shares at 98% of NAV, paid in cash. In return, Bulldog promised not to challenge or oppose the incumbent management for five years. The offer was over-subscribed: 41% of the stock was tendered, and with only 15% accepted, pro rata, Bulldog and other participating holders received cash for 15/41 = 36.5% of their shares. Bulldog gradually sold the rest, and was under the 5% reporting threshold by year-end. IRL’s discount, which had been @ 14% before the offer, briefly dipped to @ 8%, and then rebounded to the 13% to 15% range, where it remained until recently.

IRL’s current proposal for an in-kind tender follows reports that two other firms have accumulated shares: Karpus & Co. has 17.1% and 1607 Capital has 8.8%. The catalyst is a change in control of IRL’s manager, Kleinwort Benson Int’l (“KBI”), which was acquired earlier this year by a French firm with the unlikely name of “Oddo & Cie”. Such a change in control needs to be ratified by a vote of the fund’s shareholders, or the management contract will terminate. Approval requires either > a majority of all outstanding shares, or > 67% in favor at a meeting where over half of all shares are represented in person or by proxy. IRL had scheduled a special meeting for June, but was upstaged when Oddo announced it was re-selling KBI; the buyers are Amundi (a French asset manager in the Credit Agricole group), together with key employees at KBI who are to get 12.5% of the equity in the firm.

There seems to have been a backstage concern that this double shift might not win enough votes for approval. The year before, an incumbent director running unopposed got only 3.2 million votes from the 5.3 million shares outstanding, while proxies for over a million came back marked “abstain”. In any event, on the same day that IRL filed for a new special meeting and announced the offer, Karpus filed a Form 13D disclosing the “Compromise and Standstill Agreement” it had just made with IRL. The gist of the deal: Karpus agreed to vote all its shares “For” the new management contract, and to keep on voting as IRL’s Board directs for the next three years. In return, IRL agreed to make the in-kind offer, – if the SEC approves – with the cash offer as backup.

In order to use portfolio slices instead of cash to pay for the buyback, IRL needs SEC approval, because §17(a) of the Investment Company Act generally prohibits purchases and sales of securities between funds and their “affiliates” – a term that in this context includes Karpus and 1607 Capital, because they hold over 5% of IRL. Section 17(b) allows the SEC to grant case-by-case relief from the general rule: a proposed transaction can go forward if the evidence establishes that “the terms are reasonable and fair and do not involve overreaching on the part of any person concerned”, and the transaction is consistent with fund policies and with the general purposes of the Investment Company Act. That Act:

“[E]xplicitly recognizes that ‘the national public interest and the interest of investors are adversely affected . . . when investment companies are organized, operated, managed, or their portfolio securities are selected, in the interest of… other affiliated persons thereof… rather than in the interest of all classes of such companies’ security holders.'” 15 USC § 1(b)(2).

3. To Ride or Not to Ride

Consider the discount reduction proposal from the standpoint of a small investor seeking to ride the coattails of the activists. As Yogi Berra said, “It’s hard to make predictions, especially about the future,” but let’s try to spreadsheet the costs and benefits to the extent possible. Hold all else equal, and assume that Mr. Market has already factored Brexit, earnings forecasts, etc. into the share prices of the companies in IRL’s portfolio.

3a) A cash offer is relatively straightforward. If everyone tenders, then buying $100x of asset value now at a discounted cost of $88.3x would yield repurchase proceeds of 30%*98%*$100x = $29.4x. If the 2% haircut is added to the remaining fund assets, the shares not repurchased would have a NAV of $70.6x, and assuming the discount reverts to @14% as it did in 2012, they could be sold for $60.7x.

The participation rate is the key. Consider the result if only 41% of the shares are tendered, as in 2012. Repurchasing 30/41=73.1% at 98% of NAV would yield $71.7x in cash. The remaining shares with a NAV of $27x could be sold, discounted, for $23.3x. The total proceeds (before commissions and taxes) would be $95x on an investment of $88.3x “holding all else equal”, which means the $6.7x spread would be pure alpha, over and above underlying investment returns.

3b) An in-kind tender involves additional costs, in money, time and effort. In order to receive the shares in the 23 Irish companies sliced from IRL’s portfolio, investors (or their brokers) must have accounts set up at CREST, the central depository that Euroclear U.K. and Ireland operates for the Irish Stock Exchange. To sell the grab-bag of securities received, investors must pay currency exchange fees (Euros to $) as well as commissions (Schwab’s list price is $100 per foreign trade while Fidelity charges $50 plus.) Large investors have economies of scale: Karpus has 912,000 shares but probably won’t pay 912 times as much to cash out as would someone with 1,000 shares. It is the smaller holders who may be blocked or discouraged from participating.

IRL (or rather, the folks managing IRL, since a CEF is a legal construct, not a sentient being) doesn’t see this as a problem. According to the application for exemption (the “40-APP”) that IRL’s attorneys at Willkie Farr & Gallagher (a white-shoe firm in midtown Manhattan) filed with the SEC on July 18, the fund:

“[B]elieves that the broker-dealers used by most stock-holders will facilitate stockholders’ participation in the In-Kind Repurchase Offer by making it easier for such stock-holders to receive portfolio securities and, if necessary, establish offshore bank or brokerage accounts for participation in the In-Kind Repurchase Offer.”

This looks like “make-believe“, rather than a statement of fact. How do the folks at IRL know what the brokers used by “most” investors are going to do, or what fees they will charge to “facilitate”. Are all financial advisers ready and willing to help individual clients go offshore? Will account executives highlight the heavy penalties for failing to disclose offshore holdings on tax returns, or forgetting to file the annual Form 114 with the Financial Crimes unit?

The 40-APP says small investors will be protected by a provision in the offer that would cash out “each portfolio security as to which a stockholder would receive a distribution fewer than 10 shares (a ‘Small Lot’)” (p. 8). The relief, however, is illusory, because IRL holds many, many low price shares in some companies. As of August 1, for example, IRL owned 15.3 million shares in the Bank of Ireland, each worth the equivalent of 21 U.S. cents. If IRL were to redeem 25% of its 5,337,618 shares in-kind at 96% of NAV and pay by distributing 24% of every holding, pro rata, then someone who has just 4 IRL shares accepted will find that their “slice” includes 10 shares in the Bank of Ireland – worth about $2.10, but not a “Small Lot” by this definition. If this micro-investor did not have a CREST account ready to receive this “non-small” lot, they might well be disqualified from participating in the offer. Other holdings that would quickly flunk the small lot test include Amryt Pharma PLC (10.4 shares valued at 18 cents each if 25 IRL shares are redeemed) and Independent News and Media (10.3 shares worth 15 cents each if 28 IRL shares are redeemed.) Someone who had 1000 shares of IRL accepted would receive only 5 “Small Lots” in addition to 18 “not-small lots”, with 12 of the latter worth less than $500 apiece.

The 40-APP cites an earlier in-kind tender proposal by the Singapore Fund (NYSE:SGF) as precedent, but IRL’s useless “small lot” rule is quite different from the way SGF handled “round lots” – a term that in Singapore refers to 1,000 shares. In its press release reporting the results, SGF explained:

“Due to the large size of the conventional minimum trading threshold in Singapore, any stockholder that tendered fewer than 5,621 Shares in the Offer will be allocated fewer than 1,000 shares with respect to each of the portfolio securities and will therefore receive solely cash in exchange for their Shares in the Offer.”

There is a big difference between an offer that cashes out everyone tendering less than 5,621 shares and an offer that only protects those with less than 4 or 25 or 28 shares.

3c) Transaction costs are a major impediment to participation by small investors. Too bad, because if they weren’t a problem the in-kind tender could be almost as profitable as the cash alternative. Again, the participation rate is the key. If just 30% of the shares are tendered and IRL accepts 25%, pro rata, the payment in kind at 96% of NAV is worth $80x and the remaining shares with a new total NAV of $16.9x could be sold at a discounted $14.5x. The $94.5x total has almost as much alpha as the cash tender with 41% participation.

Since acceptance is prorated, large holders able to handle payment in-kind stand to benefit if other investors decide not to participate. The 40-APP assures us that the in-kind offer is fair, reasonable and devoid of over-reaching because

“In particular, no Affiliated Stockholder has had, nor will have, any influence on the determination of the terms for the In-Kind Repurchase Offer.”(p. 18).

With all due respect, this is a “terminological inexactitude”, what non-attorneys might politely refer to as a “falsehood”. IRL’s application never mentions the ownership change at KBI, the interest of KBI’s “key employees” in getting shareholder approval, or IRL’s vote-buying contract with Karpus. Their “Compromise and Standstill Agreement” begins: “IRL agrees, contingent upon Karpus’ mutual acceptance of the terms of this Agreement, to the following measures…” which are then stated in exquisite detail. No influence? None at all?

Conclusion

The cash offer would be reasonably attractive, but will only take place if the SEC doesn’t exempt the in-kind version. A careful examination of the 40-APP suggests that the case for exemption is quite weak. In addition to the problems already mentioned, the claim that paying in-kind to redeem 25% of IRL’s shares will only reduce net assets by 8.8% — from $68.1 million to $62.2 million – looks like an error in arithmetic, and the discussion of the cash alternative exaggerates the capital gains tax impact. But if the 40-APP is unopposed — if no shareholder asks for a SEC hearing once notice has been posted or if the defects are never brought to the attention of Commission staff, then bureaucratic routine may well grant IRL the exemption it seeks.

Gwailo did not own IRL before the announcement, and does not want to make book on what SEC staff may do. Gwailo will pass on this one. His concern has to do with the terrible precedent this in-kind tender would set for other CEFs, were it to take place. The presence of large “activist” investors in CEFs helps protect smaller owners, who otherwise would be at the indifferent mercy of incumbent managers and directors. Letting the big guys exit their positions on favorable terms is not one of the purposes of the Investment Company Act.

Disclosure: I am/we are long JFC AND KEF, BUT NOT IRL OR EIRL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.