23rd April 2018
The Board of Directors
Blue Capital Alternative Income Fund Limited
100 Pitts Bay Road
Pembroke, HM 08
Staude Capital Limited
222 Regent Street
Dear Members of the Board:
Under the regulatory license of Mirabella Financial Services, the investment personnel seconded from Staude Capital Limited act as the portfolio management team for the Global Value Fund, an investment company which holds an investment in Blue Capital Alternative Income Fund (the “Company”).
Given the poor market rating that the shares of the Company have attracted for some time, we commend the Board for giving shareholders an opportunity to vote on whether the Company should continue.
We find ourselves baffled however, by the unanimous decision of the Board to recommend that shareholders vote in favour of continuation. The arguments that the Board has put forward to justify its position we find to be unconvincing and lacking in rigor. Furthermore, the Board has made no appropriate mention of the benefits available to shareholders from voting against continuation. We find on balance that these benefits far outweigh the arguments that the Board has put forward, and we urge the Board to reconsider the support it has given to the continuation of the Company.
In reaching our conclusion that it is in the best interests of shareholders to vote against the continuation of the Company, we have considered a number of factors, the most important of which we describe below:
Continued unacceptable discount to NAV
For the past three years the share price of the Company has traded at a continuous and unacceptable discount to Net Asset Value (NAV). This discount was entrenched well before the poor performance of 2017. The Company was unable to satisfactorily address this issue during years of positive investment performance and buoyant general equity market conditions. The Company is now subscale and the Board has stated that its discount management program is ineffective. Despite this statement from the Board, no practical alternative proposals have been put forward to resolve this important issue. Given this, we believe a liquidation of the Company provides shareholders with the only realistic option available to realise the full value of their investment.
At its present size we believe the Company is a markedly subscale investment proposition for both new and existing shareholders. We estimate the annual operating costs of the Company at its current size to be c.2.9% of its market capitalisation per annum, a substantial cost overhead to investors.
The Board has stated that it intends to grow the Company to improve its liquidity and scale through a share issuance program, and that this program will commence with an initial issue of C Shares. This appears to be an extraordinary aspiration for the Board given the excessive discount to NAV the ordinary shares in the Company trade at. If the Company is unable to successfully market its existing shares when they trade at >10% discount to NAV, how does it propose to sell new shares to investors at NAV?
We do not believe a C Share issue is plausible and find ourselves surprised that the Board has put this forward as a viable solution for addressing the Company’s discount. If the Board disagrees with our assessment, we urge the Company to engage independent closed-end fund bankers and brokers to determine the plausibility of their strategy.
Of much greater concern to us is the commentary the Board has attached to the second special resolution being put to shareholders. This states that the Board may in fact issue new Ordinary Shares instead of C Shares. We find it highly distressing that the drafting in this section of the 2017 Annual Report contains errors which, in our opinion, make an understanding of what shareholders are being asked to vote on impossible. We refer the Board to the final paragraph on page 80 of the document. We urge the Board to publicly state that any capital raising program the Company undertakes will not include the issuance of new shares at a discount to the prevailing NAV per share of the Company. In our opinion, any attempt to conduct a dilutive share issuance would put the Board into open conflict with its independent shareholders, and disqualify any Director that supported this action from serving on the Board.
An orderly windup offers greater certainty and the potential for substantial shareholder returns
Since IPO in 2013 through to the 20th of April 2018, shareholder total returns have been -5%. The Company currently trades on a discount to NAV of >10%. Our judgement is that an orderly windup of the Company would offer greater certainty of returns to shareholders than the uncertain returns available from the continuation of the Company, considering the total shareholder returns generated to date.
Rebuttal of the Board’s arguments for continuation
In reaching its decision that shareholders vote in favour of continuation, the Board set out several arguments which it believes supports the Company’s continuation. We find these arguments underwhelming and respond to each in turn below:
The Company listed on the London Stock Exchange in 2013 with a stated net annual portfolio return target of LIBOR plus 10%. This return target also served as the hurdle rate for the payment of performance fees to the manager. Having failed to generate this return target in either 2014 or 2015, the Board announced that the Company would lower its return target to LIBOR plus 8% from 2016 onwards. The Board then recommended shareholders approve a resolution amending the terms of the performance fee arrangements with the manager, such that this new lower return target would serve as the hurdle rate for the payment of performance fees. The passing of this resolution permitted the investment manager to be paid a US$1.2M performance fee in 2016 which it would not otherwise have been paid.
Following the Company’s substantial losses last year, the Company has provided much commentary about how reinsurance pricing has greatly improved. Despite this, the stated mean expected return for the Company in 2018 remains 8%, in-line with the Company’s now lowered return target, and a figure that, despite the narrative of significantly better market conditions, is not greatly different to the mean expected return targets published for both 2016 and 2017.
Given the modest improvements to average 2018 expected returns, it is hard to understand the Board’s unanimous decision to recommend the continuation of the fund on the basis that market conditions have so greatly improved.
Even with price increases that are the “largest since the Company’s inception”, prospective shareholder returns remain substantially below those set out by the Company when it issued its IPO prospectus to shareholders. Moreover, first quarter investment returns for the Company in 2018 have been -2.2%, which represents the worst first quarter of returns the Company has generated in the six years that it has been in operation.
The Board cites the historical investment performance of the Company as one of the most important factors underlying its decision to recommend shareholders vote for continuation. In presenting this argument the Board states that, “the Company consistently outperformed its benchmark during its first four years of operations”. While this might be the case over the four years in question, plainly the Company has been in operation for five years, not four. To present a case that an investment manager’s historical performance justifies the continuation of a fund due to outperformance during good years, while ignoring underperformance during bad years, seems lacking a much greater, and necessary, analysis.
To determine whether the manager has in fact done a good job for shareholders requires an understanding of whether the risks shareholders have borne, have been satisfactorily compensated for by the returns that the manager has generated.
Between 2014 and 2017, the Company made constant reference to the deteriorating terms available to its reinsurance underwriting because of a marked increase in competition that was greatly reducing pricing. Without more information than has been provided, it is right for shareholders to wonder if the manager had in fact meaningfully increased the risk profile of the fund during these years to meet its return and performance fee targets. If investment risk was being increased over this time, then it would seem especially relevant that a proper analysis of the historical performance of the fund should include the losses realised during 2017.
Since IPO, through to the end of March 2018, the annualised portfolio returns generated by the manager have been 1.1%. This is the actual historical performance of the manager which the Board needs to assess in forming its opinion as to the merits of the continuation of the Company.
The Board refers to the ongoing support and commitment of its largest shareholder, Sompo International (Sompo), as a basis for the continuation of the Company. As the Board is aware, the investment manager is wholly owned by Sompo. That the owner of the investment manager is supportive of the fund’s continuation is an underwhelming argument for a Board to present to its shareholders. Clearly the economic interests of Sompo are not aligned with those of the independent shareholders in the Company.
The Company invests substantially all the funds that shareholders have provided it, into fully collateralised reinsurance-linked contracts that cover annual periods. Given this, and absent a major loss event, it would seem manifest that the vast majority of shareholders’ funds could be returned within a twelve-month period. Importantly, the realisation of the Company’s portfolio would not require market sales, or indeed, much administrative oversight, given the contracts into which the Company invests are largely annual buy and hold instruments.
Shareholders who participated in the November 2016 tender offer had 96% of their investment returned to them within nine months of submitting their tender request. The final 4% was returned to these shareholders four months later.
Given these circumstances, the Board’s argument that the illiquidity of the portfolio presents a significant impediment to the winding-up of the Company is hard to grasp. To present this as a valid argument to shareholders, it is incumbent on the Board to provide much greater information than it has with regards to what a realistic estimated timeline for the winding-up of the Company might be, and what the additional costs the Board alludes to involve.
Since listing in 2013, the investment manager to the Company has changed three times. Further, according to the Company’s statements, the pricing environment in which the manager operates has substantially deteriorated since IPO. Based on the Board’s annual outlook statement, risk adjusted pricing fell by 29% between 2014 and 2017. Thus, even with the increases referred to in 2018, the opportunity set into which shareholders are being asked to invest remains significantly inferior to that when the Company listed.
The Company was unable to satisfactorily address its unacceptable discount during years of positive performance and when it was substantially larger in size. The Board itself has said that its current discount management program is ineffective, yet has not put forward a viable alternative to address this issue.
When we consider these factors together in a dispassionate manner, it is clear to us that the Company will be unable to address its unacceptable discount by continuation. Against this, an orderly windup of the Company should offer shareholders far greater returns than have been generated to date. We greatly appreciate the service of the Board and the manager over the years of the Company’s life, and we understand the inherent aversion a Board has to recommend against the continuation of a Company on which they serve. We ask the Board however, to objectively consider the facts set out in this letter and reconsider the unanimous support they have given to the continuation of the Company.
Director, Staude Capital Limited
Director, Staude Capital Limited