schroders' philip middleton expects more arbitrage activity after laxey moves its sights from Barings investment trust to Legg Mason vehicle
The success of Laxey Partners in forcing the Baring Emerging Europe Trust (BEET) to give in to its reconstruction demands will open the way to further aggressive arbitrage plays.
Laxey is demanding the £134.4m fund be reconstructed, allowing it a cash exit at close to NAV.
The move by Laxey comes at a time when trust managers are already having difficulty keeping hold of investor funds amid a bear market and a decline in the investment trust sector not helped by the implosion of split-cap trusts.
The decision by Barings to give in to Laxey's demands followed months of negotiation between Laxey and the board. Laxey holds around 10% of BEET's share capital and had proposed to stand two of its own directors for appointment to the trust in order to push for a wind-up of the trust.
Laxey has now built up a 15.36% stake in the £27.7m Legg Mason Investors Enterprise investment trust and is in negotiations with the board amid speculation it is preparing to campaign for a reconstruction there to.
Schroders' associate director Philip Middleton said he expects no let-up in arbitrage activity in the near term.
'When you see lots of trusts on big discounts, it is a big opportunity for arbitrageurs if they can build up a big enough stake and try to get the trust wound up, and therefore benefit from the discount closure,' he said.
'In the current bear market, with discounts wide, I would expect it to continue.' The market is not all about discount, arbitrageurs need to seek out trusts with liquid asset portfolios and a narrow spread of mainly institutional shareholders if they are to maximise their chances of successfully forcing a cash exit or wind-up.
'A typical target trust is one which has a large institutional shareholder base and liquid assets which are easily hedgeable,' said Dresdner RCM head of investment trusts Simon White.
Tight share registers allow arbitrageurs to accumulate a large holding more cheaply by buying from institutions in large chunks rather than standing in the market purchasing small stakes from a large number of retail stockholders.
In the current market, trusts generally need to sell assets if they are to give arbitrageurs the cash return they seek, and may need to wind up completely if other stockholders support the proposal.
Investors typically require a 10% stake to call an EGM, but may not put the company to the expense if the board agrees to their demands.
'If it is a diversified UK trust, an arbitrageur can buy in at a discount, hedge the underlying market exposure by selling an equivalent future or put option against it, call an EGM and then try to get other shareholders to vote with him,' White said.
Some investment banks that operate trading desks have jumped on the bandwagon during arbitrage campaigns in order to benefit from discount closure but are generally not the aggressors.
Despite the short-term gains available to shareholders buying at a discount to NAV, White said trust boards need to take the views of all shareholders into account, not just those seeking a quick profit.
'An arbitrageur needs to believe that other shareholders will support him ' if they don't, he will end up isolated and a reluctant shareholder on the register, which does no-one any good,' he said.
Longer-term shareholders can suffer when assets are sold, with the realisation price typically lower than NAV, particularly with illiquid assets such as small cap or emerging market shares, eroding the discount the arbitrageur hoped to take as profit.
'Also a lot of trusts have debt that dates back to the 1980s and requires a premium to repay, so a discount of 20% can quite quickly turn into 8%, and then there are advisors' costs and liquidation costs and so on,' White said.
But even if the eventual discount pick-up achieved by the arbitrageurs is only 5%, on a trust the size of the Baring Emerging Europe they stand to make a profit of £67,200 for every 1% of stock they hold.
Middleton said there is little trust managers can do to safeguard their companies from arbitrage beyond working to keep their discount as narrow as possible and maintaining shareholder support.
'Performance will keep the discount in check. If you're performing better your discount should be narrower than the competition,' he said.
'Demand for the stock is also important, talking regularly to shareholders, having savings plans, and a big retail client base can make it quite difficult for some of the arbitrageurs to get stakes in the trusts.'
Jupiter head of investment trusts Andrew Watkins said the discounts available in the split-cap sector and the existence of maturity dates makes them natural arbitrage plays
'The opportunities are there in split-caps for them to take a natural uplift as the trust winds up, without the aggravation of trying to wind it up,' he added.
'Split-caps have an end-goal in mind. Investors know that it's NAV that will be repaid, not share price. So share price at the moment isn't reflecting what they think will be the eventual asset value payout in one or two years' time.'
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