LIC/LIT IPO Vintage Year Analysis
The listed investment company/listed investment trust (LIC/LIT) sector in the ASX has copped a lot of criticism over the last 12 months, in relation to the apparent mis-selling of new issues and conflicts of interest. We have no interest in revisiting the debate, other than to say that it is one thing for market participants with vested interests in promoting their own non-LMI (listed managed investment) investment vehicles and opportunistic investors pushing for a wind up of supposedly poor performing managers (for example, APL, which we discuss this later in this piece), but it is another thing entirely for a market regulator to do so partly on the basis of a flawed research methodology that highlighted a poor understanding of the very products it is charged with overseeing.
But let the facts speak for themselves. We have assessed risk and return over the last 12 months of all LMIs and compared LMIs issued over the last two years by way of material broker led IPOs with all other, older vintage LMIs. We have also assessed this cohort relative to its relevant unlisted unit trust sector peers.
The former analysis is contained in the chart below with the X-axis measuring volatility and the Y-axis returns over the last 12 months. Those marked in Red represent the last-two-years IPO cohort.
Clearly higher returns combined with lower volatility represents a superior outcome. In the chart, broadly those LMIs to the right of the X-axis exceed the peer median. As evident, the last-two-years cohort as an average has performed materially better. While this cohort represents only 19% of the total LMI sector by number, we note that the top three LMIs, and six of the top ten LMIs by returns, belong to this cohort. We also note five of the ten lowest volatility LMIs also belong to this cohort.
The latter analysis is contained in the three scatter charts available in the full report, which are divided into three peer groups: international equities; absolute-return strategies, and; public debt investment strategies.
In international equities, the growth-oriented strategies have performed particularly well relative to peers. Only the VGI Partners product, VG1, has underperformed the peer median, an aberration relative to its strong historic track record.
In the absolute-returns space, the Regal strategy, RF1, has shot the lights out post March-April 2020, and is the top-performing strategy in the peer group. LSF has regained prior losses, and now credibly is in-line with its peer median, albeit with materially higher volatility.
In the listed public debt space, results are mixed, but IIR maintains a high degree of confidence with respect to the likes of Partners Group (PGG) and KKR (KKC).
In short, the above illustrates that recent vintage LICs/LITs have largely outperformed both LMI and unit trust peers. Are we surprised? Not at all.
This cohort includes some of the stronger managers IIR has reviewed, both the few equities IPOs (Magellan, VGI Partners, Regal) and universally the debt LITs. The irony is that it was the level of due diligence that joint lead managers (JLMs) had to perform and the significant efforts by issuers and distributors to educate the market (in relation to debt and private equity) meant that IPO scale was necessary for 1) the JLMs to back an issue and 2) fund managers to make the exercise feasible. The JLMs were only considering highly regarded managers.
Private debt is the hottest sector among high-net-wealth investors (HNWs) currently, and for good reason. There is hardly a single investment manager out there currently contemplating coming to market by way of a LIT/LIC for a host of reasons, and it’s not related to track-record, ability, quality, etc. Bear in mind, while equity vehicles will move in the direction of active ETFs, private debt or private equity cannot utilise such vehicles, and only do so in a unit trust form with materially lock-up periods. So, there’s two asset classes closed off to retail investors in terms of new managers.
The criticisms directed to debt LITs were particularly ill-informed. For the public debt LITs, criticism was directed to NAV drawdowns. Sorry, did anyone bother to check the historic returns profile of high-yield bonds and bank loans?? There was also criticism directly at private debt NAV stability (can’t win, either way, it seems). Again, completely bogus, and reflecting a lack of understanding that private debt is held to maturity and when it is direct debt, as opposed to broadly syndicated loans, it makes very little sense to factor in public debt pricing by way of the bank loans markets.
Are International Equities LIT/LIC Managers Rubbish??
ASX-listed international equities LITs/LICs have generally traded at more significant and persistent discounts to NTA than many Australian equities mandates, on a broadly comparative market capitalisation basis. The question is, why?
On face value, based on the general drivers of discounts/premiums to NTA, we would suggest two potential fundamental causes.
The first driver may possibly be the relatively low dividend yields of international equities mandates relative to Australian equities mandates, the latter benefiting from a market with some of, if not the highest, payout ratios globally (at the expense of less company reinvestment/future growth – contrast with Amazon’s capital management). To the extent this is a driver, then investors have not invested on a fully informed basis, given comparatively lower dividend yields are a function of investing in international equities mandates.
A more credible driver is the generally relative poor performance of ASX-listed international equities LITs/LICs relative to broad global equities indices, for example, the MSCI World or MSCI ACWI indices. Many of the mandates in question use these indices as their benchmarks. While this may sound like a cop-out, the problem with both indices (effectively the same) is that they have become significantly skewed by way of concentration and performance over the last five years, to growth companies. The result has been to ‘punish’ even style-neutral managers with regards to performance versus the benchmark.
While some investors may question why some investment managers ‘religiously’ adhere to a value or growth investment style, IIR would counter that an investment manager must adhere to its tested investment philosophy and process, maintain investment process discipline and not engage in style drift. If an investor favours growth over value, then she should action that preference by way of selecting such managers. Should that preference change over time, a tactical switch is rational. However, perhaps this dynamic, or actioning of any such preference, has partly explained the imbalance of supply over demand in all but the overtly ‘growth’ international equities managers, contributing to the persistence and degree of discount to NTAs.
As to whether these managers are rubbish, how have they performed relative to their unlisted unit trust cohort? This being the definitive evidence of relative manager skill.
Dividend and Distribution Yield Heroes
Yield-seeking investors are no doubt aware of the dividend deterioration with many stocks in the Covid environment. To what degree this continues, and the duration is probably the same equation in relation to Covid itself. Whatever the case, risks currently exist.
In this context, LICs come with a substantial advantage to their unit trust peers – the ability to retain earnings as a dividend buffer for future periods, thereby facilitating the maintenance of past levels (at least for a period, and partly determined by how many times multiple the dividend buffer represents of past dividend amounts).
With respect to debt LITs, in contrast to equities LICs where past dividend amounts provide only some indication of future dividends (notwithstanding the above point), with public debt LITs investment managers detail the yield to maturity (YTM) of the current portfolio. This measure represents the total return of the portfolio if all underlying holdings are held to maturity, assuming a zero-loss given default on holdings (not guaranteed in this environment). The running yield is the measure of this figure when a discount/premium to NAV is factor, and is relevant to new investors.
With respect to private debt mandates, this is one asset class where manager skill can materially drive performance. We would expect a slight increase in yield over the foreseeable future given the dynamics in the Australian private debt market, about which we have previously written extensively in LMI Monthly publications.
Discounts to NTA by Market Cap
We have previously written about the segmentation and correlation of the LIC sector to discount-to-NTAs by market capitalisation. The reality is that LICs of sub-$200 million market cap persistently trade at material and wider discounts to larger peers. In our view this is driven by several factors:
- A lower degree of ‘market relevance’ by way of a smaller shareholder base and adviser support/interest and resources to support distribution (less marginal buyers/sellers in which to generate price friction);
- The persistence of these discounts in turn creates a vicious cycle, in which existing and potential investors lack confidence of a compression in discounts. It has been academically shown that past persistence of a discount to NTA is a strong predictor of future discounts to NTA;
- Relatively poor performance, particularly among the Australian equities mid/small-cap peer group;
- A lesser willingness to implement discount control mechanisms given the already limited degree of capital. Doing so may materially impact fees – there is implicitly a greater potential conflict of interest between investment manager and boards with investors in lesser market cap LICs.
In our view, the bad news, particularly for Australian equities LICs, is that even with strong performance, it’s difficult to break the cycle. We think that strong performance is less of a driver to discounts to NTA than one would naturally think (but more so for international equities LICs where the dividend factor is less significant to investor focus).
A case in point is, if you look at the large old-school LICs – AFI, ARG, MLT – these LICs are quite mediocre performers from a total-return perspective. However, what they do deliver, to a largely older-demographic shareholder base, is solid and fully franked dividends, and with strong retained earnings buffers to support this in the event of negative markets. They provide sufficient capital growth to grow nominal dividends. That is, these LICs have a high degree of investor suitability for their respective shareholder base.
Furthermore, many of their long-standing shareholder base actually do not mind these LICs swinging to a discount to NTA, seeing it as an opportunity to top-up, with the knowledge that such discounts historically have reverted to premiums.
It is our view that the material discounts to NTA in the lower market cap segment will persist. As such, the boards and managers in the sector need to start acting in a way that overcomes a range of issues in the sector, and which serve to firmly act in the interests of both, versus investors.
Unlike open-end funds, for which there exists a convex flow-performance relationship as investors react to past fund performance, in the closed-end fund industry, management companies expand their assets under management when investor demand is strong, but fail to reduce them when investor demand is weak.
Investors in open-ended funds have a greater balance of power versus closed-ended funds – they can redeem in the context of poor performance. This also in theory leads to an adverse survivorship in the LIC sector versus the unlisted unit trust sector. Remedies:
- Propose a conversion to an exchange traded managed fund (ETMF) or a wind-up;
- Introduce annual continuation votes for vehicles with a life of five years and greater (which allows sufficient time to recoup IPO costs), as per the bulk of UK-listed closed-ended vehicles. This is likely to increase the prospect of seasoned capital raisings (secondaries, tertiaries, etc). On the other hand, managers that generate a large discount may become entrenched.
- Engage in more effective control mechanisms (DCMs), such as setting discount-to-NTA ‘floors’ to guide buy-backs. These need to be telegraphed to the market – the messaging is important.
This is a shortened article from the full investment report produced by Rodney Lay of Independent Investment Research, which can be accessed here.
Written by Rodney Lay, Independent Investment Research