A profitable and (in my view) simple deep value strategy is to invest in closed end funds (or “investment trusts” as they call them in the U.K.) trading at unjustifiable discounts to NAV. I’ve had successes in the past with Princess Private Equity (PEY:LSE) and Murray International Trust (MYI:LSE). My only closed end fund investment at the time of writing is in Bill Ackman’s much-maligned Pershing Square Holdings (PSH:AEX). While a relatively small weighting in my portfolio (~4%), this is the largest entity in my portfolio by market capitalisation and my only real exposure to US equity markets. I believe there are a number of catalysts for a narrowing of the discount to NAV coupled with an opportunity to profit from a turnaround in Ackman’s fortunes. I entered this position on 29/01/18 for a purchase price of $14.32, returning +5.45% (+12.84% in € terms) to date.
Pershing Square Holdings Ltd
Pershing Square Holdings Ltd is the listed version of Ackman’s activist hedge fund. It is a Guernsey-domiciled closed end investment company which raised around $5 billion from 2012-2014 through private placements and an IPO in Amsterdam. The fund has since listed US dollar and British pound denominated shares on the LSE. Most of my readers will know that the fund invests in US large cap stocks and attempts to use activist techniques to generate returns for its shareholders (and lots of fees for Bill). While Ackman managed to compound at 20.5% annually over a 12 year period from 2004 to 2012, a series of well-publicised disasters (i.e. Valeant and Herbalife) has resulted in substantial underperformance in recent years. Since its IPO in 2014, PSH has destroyed around 23% in NAV per share and its share price has dropped by 40%. Happily 2018 performance has been much better at a healthy 11.0%, with an impressive 27.4% return in Q2.
Source: PSH Annual Report 2017
Source: PSH Annual Report 2017
The fund is highly concentrated with just 10 holdings (all long): Automatic Data Processing, Inc. (ADP), Restaurant Brands International Inc. (QSR), Chipotle Mexican Grill, Inc. (CMG), The Howard Hughes Corporation (HHC), Mondelez International, Inc. (MDLZ), Platform Specialty Products Corporation (PAH), Fannie Mae (FNMA) / Freddie Mac (FMCC), United Technologies Corporation (UTX) and Lowe’s Companies Inc (LOW). PSH is levered to the tune of 18% though the use of debt and derivative instruments such as options and swaps.
It is worth noting some interesting features of the fund:
- There is a Special Voting Share which controls 50.01% of the voting rights of the company. (see Art 4.10 of the Articles of Association https://assets.pershingsquareholdings.com/media/2018/03/26000532/PSH-Articles-of-Associated-2018-Proposed-Amendments-3.26.18.pdf). While some exceptions do apply under UK listing rules, PS Holdings Independent Voting Company Limited (“VoteCo”) essentially controls the fund. It is disclosed in the Annual Reports that the VoteCo’s sole objective is “to vote in the best interest of the Company’s shareholders as a whole” and that it is wholly owned by a charitable trust. The Investment Manager supposedly has “no affiliation with VoteCo.” In essence, this is a legal mechanism to prevent activist liquidations.
- The fee structure is somewhat favourable to investors (at least on a relative basis). There is a 1.5% p.a. management fee with a 16% performance fee. This is less than the “2 and 20” charged to investors in the open-ended version of the fund. On top of that, shareholders in the listed entity are entitled to a reduction in the performance fee equal to 20% of the performance fees that Ackman collects from investors in the open-ended vehicle. So I would estimate that the performance fee is actually around 11-13%. However the high water mark is currently at $26.37, so don’t expect to be paying it any time soon.
Investment Thesis
My thesis is simply that I believe the discount will narrow and there is a chance that the NAV will improve. I believe we are both protected on the downside and levered on the upside. Furthermore downside risk can be eliminated through hedging if desired. The crux of this investment is clearly the 21% discount to NAV. The average discount for UK investment trusts is approx. 4% and US closed end funds is around 5.5%. On this overly simplistic basis, PSH is clearly undervalued.
Source: FT
Clearly a simple discount to NAV wider than the market average is not sufficient for an intelligent investment thesis. A wide discount could perhaps be justified or could remain for a long period of time. Indeed the most comparable listed fund, Third Point Offshore Investors Ltd (TPOU:LSE), a feeder fund of Dan Loeb’s hedge fund, trades at a discount of 18%. So what are the factors which make this an attractive value investment?
The phenomenon of closed end funds trading at a discount to NAV is a well-researched area by academics. One of the best pieces on the subject is by Lee, Charles MC, Andrei Shleifer, and Richard H Thaler (https://scholar.harvard.edu/files/shleifer/files/investorsentiment.pdf) which holds that investor sentiment is the primary driver of discounts. While the NPV of fees and illiquidity of underlying assets are relevant factors, they are not the primary drivers of discounts. For instance, there are plenty of high cost listed private equity funds and investment trusts that trade at large premiums e.g. 3i Group trading at a 23.61% premium or Lindsell Train IT’s 40 % premium. In PSH’s case, fees (while still high) are not excessive and the underlying assets are large cap stocks that can be easily bought and sold. The primary drivers of PSH’s discount narrowing will be improved investor sentiment or some corporate action forcibly realising value (by way of liquidation, tender or otherwise).
On an intrinsic basis (as opposed to a relative basis), it is illogical that an instrument should trade at such a steep discount to its readily ascertainable net assets. The underlying assets of PSH are highly liquid and, in general, solid US businesses which can be easily and quickly liquidated at the stated NAV. A counterpoint to this argument is that the liquidation value of marketable securities is subject to rapid and unforeseeable change. A further problem is the legal structure of PSH which prevents liquidations by activist investors.
Ackman appears to have a renewed investment focus and has produced impressive results over the last few months. Clearly Bill had lost his way with his failed battle with Carl Ichan in shorting Herblife and his blind faith in former Valeant CEO Mike Pearson. Ackman seemed to be spending more time increasing his profile on CNBC than on conducting research and due diligence. He even hired his tennis coach and his fly fishing instructor onto his research team. (https://www.forbes.com/sites/monteburke/2012/06/29/the-fishing-guide-who-hooked-hedge-fund-titan-bill-ackman/). Now Ackman is taking a step back from investor relations, has fired a bunch of his unnecessary staff (including his driver) and is focusing solely on investing. The investment team are now all highly qualified (see below). Furthermore, Ackman’s portfolio now consists of the types of business that he’s had previous success with: business services, consumer staples, restaurants, retail and real estate. As mentioned above, the primary driver of discounts is investor sentiment and the most obvious catalyst for PSH is improved investment performance.
Source: PSH London Investor Meeting 2017 Presentation
A turnaround in performance will be compounded by the fund’s use of leverage (at around 18%) and the absence of performance fees until the NAV hits $26.37. Of course, Ackman is still highly concentrated and will continue to swing for the fences; so there’s no guarantee of a turnaround in performance and there is a real risk of further underperformance. The steep discount provides a margin of safety against this but will not prevent all losses. Luckily the fund is concentrated and is therefore “hedge-able”, so this investment risk can be minimised quite easily. It should be noted that a previous Ackman fund blew up in 2003, but a complete meltdown of PSH seems highly unlikely (even with the notable level of leverage). (https://www.wsj.com/articles/SB1041909588942528944)
There is a genuine and continued effort to reduce the discount through corporate actions and insider buying. Recent efforts to reduce the discount have included an extensive buyback program, listing shares on the LSE in both £ and $s, a $300m fully subscribed tender offer (which generated 2% per share in accretion for non-participating shareholders) and removing the 5% ownership limit. Ackman himself has purchased $292 million worth of PSH shares in the last 2 months; whether this is prudent or desperate is up to the reader to decide. Of course, all of the above falls short of the most value-generating corporate action of them all: liquidation. The only reason why this has not occurred yet is the fund’s preventative voting structure. However it is not outside the realm of possibility that investor pressure will eventually force action to be taken by management. Indeed Joe Bauernfreund, manager of British Empire Trust, an activist deep value fund and substantial shareholder in PSH, has stated that there exists scope for “more innovative solutions” than buybacks and tenders if the discount persists.
Conclusion
PSH is trading at an unjustifiable discount and there are a number of catalysts which indicate that the discount will eventually narrow. The most obvious of these is improved performance however corporate actions may also play a role. I plan on exiting the investment once the discount is removed (unless some other reason to hold presents itself) as our margin of safety will no longer be present. It is reasonable to expect the discount to evaporate one way or another sometime in the next 3 years. Assuming no change in NAV, here are the upsides/downsides for any changes to the current 21% discount level:
| Discount Level | 30% | 25% | 20% | 15% | 10% | 5% | 0% |
| Return | -11.46% | -5.13% | 1.19% | 7.52% | 13.84% | 20.17% | 26.49% |
While I’m never a big fan of projections of this kind, I will achieve a further IRR of 20.58% if the discount narrows to 5% in 2 years and the fund achieves a compound return of 10%. That is certainly an optimistic scenario. In the event of future poor stock selection by Ackman or a market correction, losses will be limited (but not eliminated) by the discount. A liquidation in the event of future poor performance would substantially reduce losses, but there is no guarantee that this will occur due to the structure of the fund. For illustrative and academic purposes, I annex to the end of this post a range of outcomes based on the timing and level of the discount mean reversion, and also any increase or decrease in NAV.
To eliminate the majority of risk (but also limiting upside), hedging some or all of underlying positions is an option. This is not a tactic that I am employing because I (perhaps naively) buy into the Ackman turnaround story for which I want to capture a substantial upside.
Annex
| IRR Assuming 10% Compound Growth in NAV | |||
| Discount Level | Year 1 | Year 2 | Year 3 |
| Sale at 30% discount | -2.58% | 3.51% | 5.63% |
| Sale at 25% discount | 4.35% | 7.14% | 8.08% |
| Sale at 20% discount | 11.31% | 10.65% | 10.44% |
| Sale at 15% discount | 18.27% | 14.06% | 12.69% |
| Sale at 10% discount | 25.23% | 17.37% | 14.86% |
| Sale at 5% discount | 32.18% | 20.58% | 16.95% |
| Sale at NAV | 39.14% | 23.71% | 18.96% |
| IRR Assuming No Growth in NAV | |||
| Discount Level | Year 1 | Year 2 | Year 3 |
| Sale at 30% discount | -11.46% | -5.90% | -3.97% |
| Sale at 25% discount | -5.13% | -2.60% | -1.74% |
| Sale at 20% discount | 1.19% | 0.59% | 0.40% |
| Sale at 15% discount | 7.52% | 3.69% | 2.45% |
| Sale at 10% discount | 13.84% | 6.70% | 4.42% |
| Sale at 5% discount | 20.17% | 9.62% | 6.31% |
| Sale at NAV | 26.49% | 12.47% | 8.15% |
| IRR Assuming 10% Compound Decline in NAV | |||
| Discount Level | Year 1 | Year 2 | Year 3 |
| Sale at 30% discount | -20.31% | -15.31% | -13.58% |
| Sale at 25% discount | -14.62% | -12.34% | -11.57% |
| Sale at 20% discount | -8.93% | -9.47% | -9.64% |
| Sale at 15% discount | -3.24% | -6.68% | -7.80% |
| Sale at 10% discount | 2.46% | -3.97% | -6.03% |
| Sale at 5% discount | 8.15% | -1.34% | -4.32% |
| Sale at NAV | 13.84% | 1.22% | -2.67% |
Further reading/listening:
https://assets.pershingsquareholdings.com/media/2018/03/26000442/2017-Annual-Report.pdf
Click to access PSH-Articles-of-Associated-2018-Proposed-Amendments-3.26.18.pdf
https://www.barrons.com/articles/ackmans-comeback-how-to-ride-his-revival-1531518675
Quarterly investor conference call taking place on 15 August 2018 on www.pershingsquareholdings.com .
Disclosure: As of the date of writing, I am long Pershing Square Holdings Limited