垂直资本反击

Activists have attacked this orphan fund - and for good reason, given the antics by management.

There is nothing special about this fund which simply holds a bunch of individual mortgage loans that it attempts to buy at a discount on the secondary market.

Proxies have gone out for the activist proposals which could force a liquidation eventually.

We initiated a position into

Vertical Capital Corp. (

)

shortly after we recommended it in our July monthly letter. Our thesis on the fund rested on our notion that activists would soon attack the fund and attempt to exploit it via some sort of corporate action. We were very quickly proven correct.

VCIF can be thought of as an unlevered bank. The fund simply buys mortgage loans on the secondary market at a discount to their unpaid principal balance. There is no leverage in the fund, and there really isn't anything special or unique about it either.

The fund started as an interval fund in 2011. An interval fund is a mix between an open-end fund and a closed-end fund. The interval fund is better than the open-end fund structure but still inferior to the closed-end fund wrapper when looking at fixed income securities. The industry is attempting to "fix" the ability for investors to get daily liquidity that invests in a market that is illiquid. So, they came up with the interval fund to put up gates on the outflows but still allow lots of inflows. (see "What is an Interval Fund?" for more information)

The mutual fund industry doesn't like the closed-end fund structure since these funds cannot take in new assets and grow to tremendous proportions (see PIMCO Income). The ability to lever their fixed costs in an open-end fund is quite attractive. Incremental margin after an open-end mutual fund hits $2B in assets is very high (typically north of 90%!). You can see why the mutual fund industry loves open-end mutual funds.

A closed-end fund, conversely, cannot grow, and the fee revenue and profit margins are fixed. But they are superior for shareholders since the portfolio manager is not forced to create liquidity to meet redemption requests when the market turns ugly. In other words, they are forced to sell at the most inopportune time.

Back to the interval fund. This was created as a recognition of the superiority of the closed-end fund structure while allowing the fund to grow significantly to increase fee revenue. But they threw on redemption gates (only allowing redemptions every month or quarter) to make it more shareholder-friendly.

Now, back to VCIF. The fund was set up as an interval fund and managed by Oakline Advisors. The second mortgages it purchases are just plain vanilla loans made by banks or third-party originators that they were unloading.

As of March 31, 2019 (the last semi-annual report that has been released), the fund had $129 million in assets, comprised of 786 individual mortgage loans. The fund is small and has gotten smaller due to the interval offer system. A year before the fund had $152 million and 900 loans. But investors pulled money in the fourth and first quarters reducing the size.

In response, Vertical shifted the fund to a closed-end fund structure to allow the fund to remain viable going forward. In reality, they should have just shut down the fund, but they have no other source of revenue if VCIF goes away. The NAV is only struck monthly - so, you won't see a change on a day-to-day and week-to-week basis.

Management has had to reduce the distribution in order to pay the expenses associated with the conversion from an interval to a closed-end fund. From the release on June 28th:

On the statement of operations in the semi-annual report, they reported $120K of fund reorganization expenses over the prior six months. But that is only through March and likely of the expenses related to the conversion occurring after the date of this N-CSR report.

It didn't take long for others to recognize the opportunity. An opportunity that only existed because management was not thinking of the shareholder first but only keeping their gravy train going. Bulldog Investors run by Phil Goldstein built a position and initiated the proxy process for the annual shareholder meeting. The proposals intend to oppose the approval of a new investment advisory agreement between the fund and Oakline, the subadvisor.

By the end of July, filings with the SEC show that they had a 7.6% position built. In the press release, Goldstein commented:

Obviously, fund management is going to fight this one off as best as they can, though they have few tools to do so. When we assess activism, we typically look at the track record of the activists and against whom they are attacking. If they are going up against Nuveen or PIMCO, there is a strong likelihood that these large fund sponsors with deep pockets will attempt to fend them off. These fund companies have a track record of defending their "children" and the experience to put up a decent fight.

The orphan one-fund shop is the ultimate target for an activist. They likely do not have the resources to mount a huge fight (heck, they didn't have the resources to eat the conversion costs to a closed-end fund) nor the know-how of how to defend themselves. This is clearly the case here as VCIF has no real effective tools to fight back. This gets us to the latest developments.

That brings us to the latest current events that have materialized. On August 15th, VCIF sent out a proxy card (14a filing) in which some interesting items were stated.

This is a curious and somewhat dangerous path to take. The advisor (Oakline) is attempting to scare shareholders into voting against Goldstein and Bulldog (or FOR the proposal to renew the advisory agreement). The fund may be legitimately concerned on whether they can liquidate the portfolio in a timely and orderly manner (close to NAV). However, the market for secondary mortgage loans is fairly liquid, and they should be able to do so close to NAV (maybe at a 2% discount). If they were to "burn the bridge" so to speak and blow out the portfolio taking significantly lower marks, they then open themselves up to lawsuits and other litigation.

VCIF also stated:

Here, the advisor clearly is attempting to 'guilt' them into holding their shares and not siding with Bulldog for 'short-term profits.' I don't see how trying to guilt and remind shareholders that they are in it for the long-term is a good strategy. Most of the investors wanted out to begin with which was the impetus for the shift from an interval to a closed-end fund structure in the first place. The redemptions were far greater than new assets coming in via subscriptions.

As we noted, there is nothing special about the fund. Essentially, they are a $100M unleveraged bank with no unique portfolio management or alpha-producing skills. Given the path they are taking, they are walking a fine line with the SEC and possible fines and other legal fees.

We initiated an alert for our Flexible Income Portfolio (where our shorter term, more speculative positions are held) in early June when the shares were trading at a massive -26% discount. The price had closed to *just* a 16% discount before the market volatility kicked in a couple of weeks ago. The current discount is now back to -20%.

Shareholders who were on record June 18th would have received the proxy voting card (shown below). If you are siding with Bulldog, you are voting AGAINST the new contract (section 1) and FOR the opposition proposal (section 3).

(Source: VCIF Proxy Card)

It is highly likely that the shareholders will align with the activists and ultimately force the liquidation of the fund. This is a capital gain play over income, given the lower yield.

At a -20%, I do think there is still upside to this speculative play if you have some excess cash laying around. It is hard to know exactly what the length of the timeline to liquidation would be. But should Goldstein win this proxy vote on August 30th, the fund should increase significantly in price and start incorporating a higher likelihood of being liquidated.

I am/we are long VCIF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.