Great expectations

That there have been few listed investment company (LIC) floats in the past 18 months is hardly surprising given the indigestion experienced with the batch of around 30 vehicles that floated between March 2003 and June 2005.

At October 31, 2006, almost all of these new floats were still trading at discounts to their pre-tax net tangible assets (NTA), with the average discount at around 15 per cent (note that in a small number of cases there are still options outstanding that reduce the fully diluted discount).

Although they cover a range of asset classes, most (including the equity vehicles) have underperformed the All Ordinaries Index since floating.

It should be noted that even this is a significant improvement from 12 to 18 months ago, with average discounts narrowing and some good underlying NTA performance.

Indeed, there have been some excellent opportunities to buy into some funds at attractive discounts and benefit from the ‘double whammy’ of good underlying NTA performance plus a narrowing in the discount to NTA.

The LIC sector periodically offers some excellent investment opportunities in both the older, more established vehicles that have a long track record of performing, and more recently listed vehicles that typically become neglected one to two years after floating.

Rarely, however, are the best opportunities found via participating in new listings that typically launch in a sea of public enthusiasm but then disappoint as they move from a slight premium to NTA (due to float costs) to a discount as underlying returns don’t meet the high expectations of often impatient investors.

Only if NTA performance is excellent from day one can this cycle usually be avoided. If cash is only invested slowly, as is often the case, such stellar early performance is next to impossible to achieve.

Therefore, while the level of disillusionment with LICs has reduced somewhat from one to two years ago, there are still plenty of frustrated LIC float investors (and advisers) around, particularly with many floats still underwater, at least before dividends.

In this environment it is somewhat surprising that we are currently seeing a resurgence of new floats, and, while they are not large in number at this stage, the amounts of money being sought are.

One global equity LIC, the Magellan Flagship Fund (MFF), is seeking to raise up to $378 million, which I believe would make it the largest local raising by a LIC ever (if we exclude the so-called private equity cashboxes).

Meanwhile, AMP China is seeking $270 million, while several other smaller funds are also conducting smaller raisings.

MFF is the first fund of a new funds management entity called Magellan Financial Group (MFG) headed by Chris MacKay and Hamish Douglas, two ‘star investment bankers’, as the almost universally friendly media likes to call them (ex-UBS and Deutsche respectively). They are clearly smart, have obviously made a lot of money in investment banking and clearly have some prominent friends and backers with plenty of money.

However, the most surprising element of this launch is that neither of the key people have any track record or experience managing investments publicly.

While they are in the process of hiring a team, the hirings to date have been relatively junior and it has been clearly flagged that Chris MacKay will manage MFF.

This fact does not seem to bother the stockbrokers who, at the time of writing, seemed keen to commit around $300 million of their client’s money to the float.

When asked why they were so keen to back someone without any experience managing public money, one senior broker reportedly said because they ‘have good connections’.

If only stock picking (and selecting managers) was that easy.

They clearly do have connections. MFG is being formed by the restructure of the listed Pengana Managers Group and is being backed by, among others, James Packer of CPH (it is assumed he is also putting some money into MFF).

Other prominent backers of the management vehicle (and the LIC) include Naomi Milgrom of the Sussan Group and Simon Leversha, previously of hedge fund group Citadel.

While this is assumed to be the ‘smart money’, investors should be wary of adopting a simple lemming-like following of such prominent people. It is interesting that of the previous batch of listed investment vehicles, the ones that attracted the most ‘high profile’ investors were so-called private equity cashboxes, and these have also been the worst performers since launching.

At October 31, 2006, Allco Equity Partners, Babcock & Brown Capital and Macquarie Capital Alliance were trading at discounts to their issue price (including instalments paid) of 42 per cent, 16 per cent, and 14 per cent respectively. It is also worth noting that, like Magellan, these are managed by individuals with corporate transaction/investment banking backgrounds rather than an investment management one.

Babcock & Brown Capital attracted Robert Champion de Crespigny as a major investor and initial chairman (who later resigned and sold much of his holding at a loss). Macquarie Capital Alliance attracted a number of well-known hedge funds. Allco Equity Partners managed to get AMP and the Liberman family as cornerstone investors. Although, unlike the latter, AMP did not receive any shares in the management company and has since sold part of their holding at a loss.

While these vehicles look like more interesting value now, the lesson is that just because an investment is backed by high profile people does not necessarily mean it will be a great investment success, particularly in the shorter term.

Mackay and Douglas do stress that they have been followers of Warren Buffett for years, but a sceptic might say ‘isn’t almost everybody in the investment industry these days?’. In any case, is investment success as simple as trying to emulate him?

I was lucky enough to attend Berkshire Hathaway’s annual general meeting in Omaha this year, found it quite enjoyable, and it was hard to disagree with much of what Warren Buffett and Charlie Munger said on the day.

However, sitting there with 20,000 other people, I couldn’t help feeling I was in some mass religious cult, and we know that being in a cult can seriously impair the ability to think independently, probably the key attribute required for long-term investment success.

The challenge in using these principles is probably greater when you are only dealing in the world’s largest 500 companies and trying to select the ‘best’ 50 or so of them, as MFF is aiming for.

Because they believe they will qualify for the (very strict) LIC capital gains tax discount, it also suggests that fund turnover will be extremely low (that is, less than 10 per cent).

The world’s largest 500 companies are not normally the most inefficient part of the stock market, and their almost passive approach does not leave a lot of room for active management in any case.

Further, while some very experienced fund managers have been successful in doing it, running global equity funds from Australia is by no means easy.

Beyond the investment story, the real carrot being used to attract investors into the MFF float is the one-for-15 entitlement to buy into the manager MFG at its post-construction NTA.

Investors still holding MFF in March/April 2007 will receive a one-for-15 entitlement to buy shares in the management vehicle at 97.5 cents, as well as a one-for- 15 option at $1.20 (plus another $1.30 option if they exercise that).

This sounds pretty attractive, with the management vehicle trading at more than 2.5 times NTA at the moment (and is worth around 15 cents per MFF share at that price).

The problem is that before and around that time there are likely to be as many as 100 million new MFG shares issued to add to the 30 million currently trading in the market (as well as many million options).

The structure clearly shows the use of investment banking skills to create price tension in the MFF float process. The entitlement makes the MFF float more attractive, and this in turn helps to ensure the float will raise more and make the MFG entitlement worth more.

The circularity of it all is somewhat ingenious at a time when fund management businesses are highly sought after.

It seems the original capital raising and rights issue to existing PGN shareholders has been pushed out from November/ December to March/April to further build this tension and increase demand for MFF and help ensure that it trades initially at or more likely above NTA.

However, the aftermath of the float and the entitlement issue could see a quite different picture, and MFF investors could face some disappointment.

Firstly, the new issuance of shares and options in the management vehicle could make the entitlement less attractive as some investors sell, perhaps (rightly) concerned that the broader funds management vision may take longer to eventuate or become as profitable as the market seems to currently expect.

Secondly, if many investors are buying primarily because of the entitlement, and the float has been dominated by brokers with a typically short-term horizon, the selling pressure once it goes ex the entitlement could be dramatic.

Assuming the entitlements and rights issues are taken up, MFG will be a vehicle with around $140 million in net assets and significant plans to launch a series of unlisted global sector funds, as well as partnering with and seeding other fund managers. It is an ambitious plan, even in a booming funds market, and even if the key people do have long and strong investment track records.

The problem is that building a coherent investment team — whether picking stocks or managers — is no easy task. Indeed, I would suggest that getting teamwork and culture right is the biggest challenge to building a successful funds management business and a much more important issue than in investment banking, where the business is obviously transaction orientated.

High-level connections might work in investment banking, but they are just a small part of the game in long-term investment management.

Given the cost of investment management resources and infrastructure (primarily people) and the relatively modest fee levels, MFF alone is unlikely to make MFG highly profitable, even if it raises the maximum $378 million.

True success will rely on the rollout of other funds, more likely to be unlisted funds primarily targeting the financial planner and direct investor market.

Time will tell, but it would not be the first fund manager to underestimate the difficulty and time involved in getting into this market, especially if one is starting largely from scratch.

MFF offers some positive elements from a corporate governance perspective, and these should have some positive implications for the LIC sector generally, where good corporate governance has often been an afterthought.

The fees are not low but reasonably well structured, and there are no gimmicks such as ‘free options’ in the LIC (although there are obviously options being offered in MFG).

There is an independent chairman and board and the board has the ability to terminate the manager for two years underperformance.

While welcome from a corporate perspective, the latter clause is perhaps surprising because even the best managers can underperform over a two-year period, and I doubt many other managers would actually agree to such a term.

The real thing missing from a corporate governance perspective is a formal commitment to manage the risks of it trading at a discount to NTA.

MFF seems to be relying on the fact that Platinum Capital trades at a 35 per cent premium as indicating an excessive demand for listed global equity funds. Explaining the anomaly of Platinum’s persistent premium in recent years is difficult, but it should not be seen in isolation when others global LICs such as Hunter Hall Value and Bentley trade at persistent discounts of 15-20 per cent.

It is also worth noting that Platinum Capital traded at a discount for much of its first few years (as high as 25 per cent).

There are a number of indicators that the principals are new to the fund management industry. For example, making your first and ‘flagship’ product a LIC given the brand damage and business risk that a discounted and poorly performing publicly listed vehicle can create. If this occurred it could easily be a major constraint on the ambitious plans the group has. Most groups that have both listed and unlisted funds have tended to do a listed vehicle later, when their investment management brand is already well developed, although even then it can cause problems.

Why even call the fund ‘Magellan’ in the first place? Magellan is, after all, already the world’s largest active mutual fund at some US$45 billion (down from over US$100 billion at its peak) and part of the Fidelity retail stable.

Apart from any concerns Fidelity might have with the use of the name, the fund has a reputation as a floundering giant that has basically had ongoing problems since Peter Lynch left after managing it in the 1970s and 80s.

MFG has a funds management vision that is clearly ambitious. The relative success or failure of MFF will be crucial in determining whether, and how quickly, that vision can be realised. This can only be properly judged on how MFF performs and trades over a number of years, not on how much money they raise or even how it trades in the first few months of listing.

In expressing some caution and scepticism I know I am swimming against the tide of so many believers who seem convinced of its certain success. I will be happy to be proven wrong — after all, more LICs and better corporate governance in the area is very welcome. Time will tell.

Dominic McCormick is the chief investment officer at Select Asset Management.