A fund with no management fees?

This week's Fund Manager interview is with Luke Cummings, the Chief Investment Officer of Harvest Lane Asset Management, which has quite a few interesting wrinkles to it, both in the way it invests and the way it charges.

Luke, you had a cracking June, more than 5% in that month and we’ll get onto that in a minute.  But I just wanted to – I don’t always start with fees but I just wanted to start talking to you about fees.  Your main fund, absolute return fund, is quite unusual in that it says on your website you don’t take any management fees, you only take performance fees. 

That’s something I’ve been on about for ages, saying that that’s what should happen.  But then I look at your quarterly report and there is a 1.25% capped manager base fee.  But then I look in the footnotes and you don’t take that apparently, it goes to your service providers and it seemed to be quite high for service providers, 1.25% for your service providers.  Heavens above, that’s a lot. 

Look, I mean, they may not necessarily agree but I’m sure that you would know and many of your listeners would know that to run a retail focused fund you need to have a trustee in place, you need to have an administrator in place, you need to have a custodian in place there’s costs associated with all of those things, which aren’t cheap. 

So, in effect our fund pays those expenses out of the fund to external providers.  But I guess importantly from our perspective, none of that is actually going to us and that fee is relatively fixed, it goes to those providers.  In time, as FUM grows in that main fund, that percentage will reduce and in fact it’s actually less than 1.25% at the moment but that’s the cap.  The idea would be that as FUM grows that amount will become less and less each year.  But I think from our perspective we can’t really control those outgoings in terms of what we have to pay externally, but what we can control is what we get paid and hence, our maximum alignment with our investors in terms of being paid in line with our performance and not purely just for turning up.  

Yeah, sure, that’s great.  I suppose the effectiveness of it is, your clients do in effect, have a base fee. 

Yeah look, absolutely.  At the moment there’s no doubt that investors in that fund are paying fees out of the fund.  I guess a distinction that we like to make is, that’s not going to us, so that’s not paying our rent, that’s not paying our computers, that’s not paying staff, that’s not paying anything that’s involved for us in running the cost of the fund which is not an insignificant amount of money.  That all comes out of our pocket and the idea being that obviously we want those outgoings to become as low as possible in time and that fee to become as low as possible. 

Because I think there is a real issue in funds management in terms of investors, and probably rightly so, have a real objection to paying anything in terms of upfront in lieu of performance and I think that we’ve seen how popular passive investments, ETF or otherwise have become in the last few years as a result of that.  I can assure you, no one’s keener than I am to see that fee come down over time.  The flipside of that is there is certain things we need to do is make sure that we’re compliant in terms of running this fund for retail investors and those external costs are things that are outside of our control.  It’s a little bit chicken and egg.  As the fund gets bigger that amount will reduce but certainly for the time being that’s just a reality we face.

Well, congratulations on it really, I think you’re about the first fund that I’ve spoken to that doesn’t take a base fee and only takes a performance fee and I think that’s great.  The performance fee is 25% above the benchmark and the benchmark is the RBA cash rate which is 1.5% obviously at the moment.  What has your performance been since inception 5 years ago?

Net of fees, that’s after that management fee that you referred to and so too our performance fees, we’re tracking just shy of 10% net of all fees over that period of time.  9.66% I think was the annualised return as at the end of July just finished.  We’re reasonably happy with that, this isn’t necessarily designed to be a product that competes with the equity market per se.  The history of this fund was that when we started this back in 2013, I think the reality for a lot of investors, particularly older investors with self-managed super funds, investors who were either retired or coming up to retirement.  I think there was a period, 2008/2009 where if they needed to they could have a fixed 5 year term deposit for roughly 8% per annum.  A lot of that started to roll off 2011-2012 and the renewal rates were probably more like 4% at that stage as opposed to 8%.  I think we noted that a lot of those investors were moving into bank stocks and Telstra and some of these other high dividend yield stocks, not necessarily because they wanted the equity market risk associated with that, but because they felt they needed the income. 

I think we just felt that there was probably a better alternative for those people whereby admittedly of course they’re getting some equity market risk in this portfolio that we’re running but it’s certainly not 100% of equity market risk.  We kind of like to think of it as probably a hybrid between a term deposit, in so much as our money is held in cash so the funds in there are held in cash if they’re not being used.  But we’re looking to exploit the money that we do have into equity investments in the right circumstances.  So, from that perspective, we’re not chasing the return of the ASX, we’re just chasing a return that we think could be meaningful for investors over the investment timeframe. 

Typically, three to five years is the minimum, which I guess most managers are encouraging people to look towards and ideally with a lot less volatility and correlation to equity markets broadly, which I guess in this case is most relevant for a lot of your listeners is probably the ASX.

We’ll get onto exactly what you do in a moment.  One of the other things worth noting about your fund is I think that you call it a retail fund.  Does that mean that you don’t have to be a sophisticated investor to invest in it?  It is a fully retailed fund, is it?

Yeah, that’s right.  To your earlier point, that’s certainly where some of the costs come from in terms of some of these outgoings we have from the fund.  But to our mind, there’s a lot of these types of products, not necessarily earning returns in the way that we do, but certainly these type of targeted products where they were available to wholesale investors or sophisticated investors.  We feel that typically your wholesale or sophisticated investors get the best opportunities available.  It’s not typically your retail clients that have access to these types of things. 

We felt, for the aforementioned reasons in terms of who we think this product is suitable to.  We thought it could be a nice fit for some self-managed super funds and older investors who aren’t typically sophisticated or wholesale necessarily, but would value the type of return stream that this product could offer. 

What’s the minimum investment?

Into the retail fund it’s just $5,000 upfront.  People can setup the savings plan ongoing if they’d like to do that.  I think that’s really quite low by retail fund standards. 

Can the savings plan effectively work as a dollar cost averaging plan that you’re buying a fixed unit in the fund, is that how it works?

Yes, I mean the regular savings plan just means that on whatever day of the month that you choose to be investing into the fund, this is a daily priced fund so whenever you want that to flow into the fund on a monthly basis, obviously allocated new units, based on whatever the unit price is at the time.  We’re aiming of course to have the unit price higher each month than it was the month prior, but it obviously doesn’t always work out that way.  Absolutely, in the same way that you can dial the cost average into the market through good times and bad, having a savings plan attached to the fund just allows you to do exactly the same thing. 

One of the things about June where you made a 5.78% return just for the month, one of the things you said there was something like it took a while to get that and we’re a little surprised that it hadn’t done so earlier and you were frustrated at that.  You felt that the portfolio was poised to start delivering those kind of returns, but it took a while and now it has.  What are you saying there?  I mean, what does that mean?  Are you saying that those kinds of returns are now likely to keep going?

Look, I think that’s a pretty extreme month for us.  In terms of the return, I think that north of 5% for a quarter is a good result for us, let alone a month.  I think the historic context for that was – and we’ll get, I guess, to talking specifically about the strategy that we run for this portfolio.  But we have an event driven strategy which involves M&A focused targets.  Fairfax obviously being a current example that a lot of people would be familiar with and there’s certainly been plenty more M&A targets in recent times. 

Because of the nature of what we do, we’re not trading M&A or events because we’re specifically interested in them per se, but they deliver a very nice return stream that’s quite independent of the market more broadly and I’m happy to talk more about that a little later on.  I guess from our perspective, if you kind of look back to almost 12 months ago, August or September last year was when we really first started to notice a pickup in M&A activity generally.  But one thing that there was an absence of over that period of time was improvement in bid terms or counterbids or counter-proposals for some of the securities under consideration. 

Our strategy makes money not just through counter-bids or counter-proposals.  Transactions alone are enough for us to get pretty close to our return target on a yearly basis, but improvement in bid terms, certainly helps boost return and I guess that my comment in our newsletter was that for a number of months now we’ve had a portfolio that we felt was poised to deliver in terms of some things that were probably undervalued or right for better prices going forward.  We hadn’t seen that and rightly or wrongly, it was frustrating to see that we were poised for outperformance, but it wasn’t occurring and then all of a sudden it sort of came not just in June but in a couple months prior had been good for us as well. 

But I think in terms of the public consciousness of merger activity, it’s probably as high now I would say as any time, not just in the five years that we’ve been running the fund, but probably back to pre-GFC days I would say.  Our strategy isn’t wholly reliant on buoyant M&A activity to make money but it certainly helps us.

Do you buy target companies after the bid has been announced or do you try to pick companies that are going to be taken over?

No, look, we’re typically buying them after the initial bid has been announced.  The reason for that really is just a return profile that we’re seeking for investors.  Obviously if you buy one of these stocks before any bid for and your timing is good, then you’re typically looking for a 25-30% windfall overnight in some circumstances.  The problem with that is for buying target stocks that you think may get a takeover at some stage, they don’t always get one.  The price that they get it at won’t necessarily be higher than where you’re buying it now. 

What actually interests us about M&A transactions specifically is the fact that once the transaction is announced, assuming there are fairly minimal conditions and in particular if it’s a cash transaction then the value of that security shouldn’t change considerably in line with the market, thereafter it should be driven more so by the events specific to that underlying transaction.  As an example, Company ABC is trading at 70 cents today and they announce a takeover bid at $1.  Fairly low conditions in terms of what’s needed for completion. 

Expected payment date was in 3 months’ time.  I would expect that stock should probably resume trading and there are a few variables, but maybe 97 cents in that there would be roughly 3% on offer is the deal completes over the next 3 months.  Importantly, if the market were to drop 15% tomorrow, that stock should be barely moved and if it does move down it should only be temporary, because if there’s no funding condition or there’s no market out clause or similar in the terms of the bid and the bid is binding.  There’s no reason that stock should now trade in line with the broader market. 

Importantly, not only does it not have correlation to the broader market, but if we have a portfolio full of these opportunities then we also should have no correlation to each other.  That’s why really, I’m not sure if you’ve seen the lack of correlation we’ve had in our returns over that 5 year period but it’s almost zero market correlation and zero beta.  That is just because of the way that we structure the portfolio to try to not be influenced by market movements.  Because I think the thing for us that we’re not comfortable with and particularly for old investors who maybe had a bad experience through the GFC in terms of their equity investments, no matter how strong your portfolio is or how high the quality of it is, typically if a market goes down 10-15-20% in a short period of time, your portfolio’s going with it. 

Now, you can argue the stronger stocks recover more quickly and I’d certainly agree that that’s the case.  But they’re probably going down in the short term and depending on your financial circumstances, when you need that money, also emotionally how that’s likely to affect your life.  We’re trying to avoid that to the greatest extent possible, so M&A is interesting to us because we get that downside protection, I guess, against adverse market movements more broadly. 

What we’re really aiming to do is, that stock that we buy at 97 cents, we end up getting paid $1 for in 3 months’ time, that’s okay.  In terms of the annualised return to maturity at that transaction, but ideally what we would like every now and then is a counter-bid at $1.10-1.20, something along those lines which can obviously really boost up our returns over the period of 12 months and we don’t need a lot of those to kind of make a meaningful difference to the portfolio.

I imagine one of the problems you have these days is that most of the bids are non-binding, particularly when they first announced them.  They come out with non-binding indicative offers.  What do you do then?

Yeah, look.  We call it the private equity put.  In terms of the strategy and the return profile we’re trying to achieve.  Non-binding doesn’t really work for us and indicative doesn’t really work for us because the problem there is that if you have a bidder who’s looking at something and it’s non-binding and it’s indicative, well if the market falls 20%.  What’s the likelihood that they’re going to follow through with that transaction, certainly under initially proposed terms is probably quite low or nil, so what we’re really looking for is a situation where we have certainty over at least one outcome ideally and then whatever happens from there will happen.  There are definitely exceptions to that on a stock specific basis.  But by and large, indicative non-binding doesn’t work for us, we want something that’s more concrete than that.

I think the Fairfax from Nine is binding.  Did you buy in after it was announced into Fairfax, because I think you could have got it at 80 cents 2 days after the bid was announced and if you did you’re now looking at 7.5% gain. 

Yeah, look, the tricky thing about Fairfax is that that bid is predominantly scrip based.  The problem with a scrip based bid, if you’re looking at our strategy, and you’ve seen this to some extent despite the fact that the Fairfax share price has increased.  All else being equal, as the Nine share price goes down, then the implied value of the bid goes down in terms of what they’re paying for Fairfax because Nine stock is worth less now than it was when the bid was first announced.  The interplay of those two factors is interesting because in some ways the lower than Nine goes in the short term, the more likely that Fairfax probably attracts another suitor.  If the Nine share price was to increase, obviously the see-through value of the Fairfax transaction increases also, therefore, likely deterring counter-bidders.

In a scrip based transaction, if we can’t fix the value we’re typically not interested.  The way you can fix the value of the transaction though, at least in part, if the acquirer, Nine in this case, if Nine’s shares can be borrowed and short-sold – and I know that’s a dirty word for a lot of people, but in this instance it’s not a view on Nine necessarily, it’s purely just a hedge to fix the value of the Fairfax transaction.  Then that’s something that makes sense to be in our portfolio in this case in particular because I think – and you’re probably more of an expert in this area than I am, but I think that another bid or an improved bid for Fairfax is certainly not out of the question.  To answer your question, yes we do have a position in Fairfax at the moment, partially hedged through the transaction in Nine…

But do you only buy these target companies in order to accept the offer?  Don’t you sell into the market before the offer?  I mean, you could get cash for Fairfax by selling now at 86 cents.

Yeah, absolutely.  I think the answer to your question is both.  I think we are buying ultimately with the intent of getting as much value out of these situations as we can.  Whether we see early or not really just becomes a function of what we can take now versus the expected future path of the transaction.  I think that 7.5% be as it May, what you’re really looking for and what we like from this strategy aside from the downside protection is you really have this embedded call option if you like over future increases in the value of the bid if we’re talking about Fairfax specifically, whether it be from Nine or someone else, what you really have is optionality over further upside. 

We typically wouldn’t want to be turning around and taking money off the table that quickly on the basis that I think reasonably it could be said that the likelihood of Fairfax being taken out now at 86 or 86.5 cents where the stock’s trading right now is probably quite low.  I think history has shown us that sometimes – and I’m certainly not suggesting that it will happen in Fairfax, but often these things can take on a life of their own if a second party enters the fray.  For the most part, we’re wanting to maintain our exposure to these situations.  If for some reason Fairfax was trading at a largish premium to the implied value of the bid, so if the bid was currently valued at approximately 87 cents and Fairfax was trading at 94-95, we’d be looking to take some money off the table then.  We have a fairly systemic approach around when we do want to be lightning exposure.  I think if another bid is forthcoming, the likelihood of it being more than 10% above the current terms is probably quite low. 

The option of being able to sell down some exposure at that point, knowing that you can always buy back in probably not much higher than where you’ve sold in the event another transaction is forthcoming is a good scenario for us and then of course, if it falls back towards the implied value of the bid then we obviously have the option to increase our exposure then again also.  We’re managing that within a parameter range of values but typically we’re trying to maintain that optionality over future bids for as long as we can within reason.

You must look pretty closely at the data on this sort of area.  What’s the proportion of bids that do get higher counter-offers.  Is it more than 50%, three-quarters or what?

It very much depends on the data set that you’re using and the time frame that you’re using.  When we first started trading this idea kind of pre-FUM days when it was still just a concept that we were exploring.  Absolutely, numbers as high as 50% are definitely possible in the right market circumstances.  I think the counter argument to that though is probably what we’re talking about before where I’d said that, we were kind of frustrated late last year and early this year, that we weren’t really seeing any counterbids at all because you think out of 10 or 20 transactions announced, what percentage are going to get counterbids, the reality was for a while that it was virtually zero.

I think that the long-run average would be around about the 25-30% mark and I think it’s somewhat market dependent in terms of who attracts further bids.  Some of these things like I said before really take a life of their own.  If you think about Warrnambool Cheese and Butter, the first bid that was made kind of late-2013, I think the initial bid from Bega was part scrip and part cash, was something like $3.75 was the implied value at the time.  You may recall that you ended up with three bidders in there and that the final takeout price from memory was $11.25, albeit that you could have bought the stock initially at like $3.50. 

That’ll happen in the period of four or five months.  They’re few and far between, but back to your point about Fairfax in terms of how quickly we could make 7%.  If you’d said to me back then that we could buy Warrnambool Cheese and Butter at $3.75 and sell it for $11.25 within a matter of months, you would say it’s almost impossible based on the initial value of that bid but it just goes to show that you never can be certain.  I think the interesting thing about Warrnambool at the time was that the market wasn’t particularly buoyant at that time in terms of more generally and there wasn’t a lot of M&A around at the time but the dairy sector I guess at that time was a stand out or a hot sector. 

Really, a hot market will help us, a hot sector will help us and maybe unexpectedly a lot of the time if there’s been a bombed out sector, as that sort of starts to bottom and level out, then you kind of start to see a lot of M&A activity typically as that recovery starts to take hold and I guess mining services and engineering would be a good example of that most recently on the ASX in the last kinds of 12-18 months.  You tend to get clusters of these things that kind of happen as some of these industries start to recover.  It is very variable and our strategy doesn’t need that counterbid or that improvement in terms, but it’s certainly helpful for us and we do need it, happen often enough to make this strategy meaningful.

I imagine in some ways the most important thing is, as long as you buy after a binding bid has been made, your downside is fully protected.

Yeah, look, I think it’s not always that cut and dry and that’s something that we’re certainly aware of in terms of our position sizing and how we manage the portfolio.  The problem for us in this strategy, if there is one, comes if we buy – the example I used before, fictional stock ABC gets a bid at $1 after it’s been trading at 70 cents and we buy it at 97 cents, what would be bad news for us is if the stock goes back to 70 or lower because that transaction falls over.  A binding offer that binds the bidder to completing the transaction is one thing, but of course it’s also shareholder dependent.  To some extent, board dependent in terms of how the board responds to the transaction and how shareholders respond to the transaction. 

Certainly, there have been examples at times where you’ve had company boards that won’t endorse bids which obviously make it much harder for the bidder and it’s not always impossible to complete of course when that happens, but a board agreed transaction is helpful and sometimes even if the board does agree, the other shareholders are not happy with the relative value of the transaction at that point in time.  They’re things we need to be careful of as well in terms of – it’s not just the transaction as it stands currently in terms of it’s binding on the bidder. 

But how a shareholder’s likely to respond to that.  Sometimes if shareholders respond poorly or think it’s undervalued, that’s great because that’s what leads to improved bids or improved terms.  A transaction that falls over though as a result of that is problematic for us.  That needs to be considered as well.  I think recently one that’s probably relevant to a lot of people which started off as kind of indicative and can be I guess, more and more binding as time went on, with the Santos transaction, which ultimately the board still couldn’t recommend.  If you believe the board that shareholders weren’t willing to recommend at that price.  It’s early days so it remains to be seen how that works out. 

We’re not typically longer term investors in these things.  If we were to have a position in Santos in that situation, unlike some of the other shareholders where we’re not typically hanging around for a longer period of time.  We’re trying to take advantage of the situation that exists while the transaction is on foot.  Having said, I’ll be the first to admit that sometimes knocking back transactions is the best thing that a board can do.  I think Transurban’s had a history at times of having had various bids or approaches over the years and in each case they’ve been knocked back and the stock price is a lot higher now than where it was back then.

Treasury Wine is another one, they didn’t get anything binding but they had a couple of private equity approaches a few years back and that share price for the time being is a lot higher.  Sometimes that’s the best that shareholders and boards go ahead and do that, but you do certainly see other situations where boards in particular reject a bid and that doesn’t always end well and I’m sure you can think of a few examples of that as well. 

Yes, indeed.  Well, look, it’s been great to talk to you, Luke, thanks very much.

Thank you.

That was Luke Cummings, the Chief Investment Officer of Harvest Lane Asset Management.