Investing dramas are often buried in the dullest-sounding documents.
On Dec. 10, Highland Funds II, a series of mutual funds run by Highland Capital Management Fund Advisors L.P. of Dallas, filed a form with the Securities and Exchange Commission stating that it couldn’t complete its annual report on time because it “needs to finalize its accounting analysis for the fair value measurement of a fair valued security.”
Why is that significant? On Nov. 8, investors in one of those funds, Highland Global Allocation, which currently has about $368 million (U.S.) in assets, approved a management proposal to convert it to a closed-end fund.
The issue: Unlike an open-ended mutual fund, a closed-end fund doesn’t give you your money back at net asset value when you sell; instead, you must find a third-party buyer for your shares on a stock exchange. And you might not like the price you get.
That’s a bigger risk if the fund has illiquid holdings.
According to Highland Global Allocation’s Oct. 11 proxy statement, “approximately 33% of fund assets” are illiquid. Most of the hard-to-trade holdings are stock and debt of TerreStar Corp., a telecommunications company that, along with related entities, filed for bankruptcy protection in 2010 and 2011.
“This highlights the risk of stuffing a mutual fund full of securities that are illiquid and difficult to value,” Jeffrey Ptak, an analyst at Morningstar, says of the Highland conversion. “Converting to a closed-end fund doesn’t extinguish that risk; rather, it seems to shift it onto the fund’s investors, who will bear it when transacting in the secondary market.”
Many mutual funds are shrinking as investors desert traditional stock and bond pickers in favor of index funds run on autopilot. If more funds with less-liquid holdings go the same route as Highland Global Allocation, that could disadvantage their investors.
In the existing, open-ended Highland mutual fund, shareholders at least hold the illiquid assets in an investment vehicle they can sell, at will, back to the manager at net asset value.
After the closed-end conversion, they will own the same illiquid assets in a fund they can sell only through a broker to another buyer—and closed-end funds often trade at prices below their net asset value.
A former mutual fund that Highland converted to a closed-end fund last year, Highland Floating Rate Opportunities, traded this week at a 4% discount to its net asset value; the average fund in that category, according to Highland, trades at an 11% discount. Less than 2% of Floating Rate Opportunities’ assets are in TerreStar, although the fund’s less-liquid holdings, including unregistered securities and those estimated at fair value, exceeded 26% of its net assets as of June 30.
To help support the price of Global Allocation after it becomes a closed-end fund, Highland has committed to buy back shares if they trade at less than 97% of net asset value.
Highland declined to comment for this this article. (Full disclosure, Highland Capital is separately litigating with Dow Jones, the Journal’s parent.)
Highland Global Allocation’s investors voted in favor of the conversion even though the manager disclosed, in the Oct. 11 proxy, that it fired its independent auditor after a dispute with that firm over what the TerreStar position was worth.
Global Allocation’s investors may have been encouraged to approve the conversion because the fund’s manager will pay, out of its own pocket, a 3% “consent fee,” or bonus, to all investors who voted in favor and remain in the fund.
The fund’s performance, although volatile, ranks among the top 20% of its peers over the past five years, according to Morningstar. And, says Highland, expenses should fall by at least 0.1 percentage point when the fund converts to a closed end.
What about that illiquid holding that makes up a third of the fund?
TerreStar shares rarely trade. When they do, the prices can be all over the place. “There have been three recent transactions in TerreStar equity,” says the Highland proxy, “including one in July that occurred above ($350 per share) and two in March materially below ($114 per share) the Fund’s current valuation.”
The fund last valued its TerreStar stock at $334 per share, according to the proxy and other filings.
TerreStar’s value, says Highland, depends primarily on two wireless-spectrum frequencies. The license for one of them was terminated by the Federal Communications Commission in October 2017. TerreStar is contesting that decision; if the appeal fails, Highland’s proxy statement says,
TerreStar’s stock “would likely be materially negatively impacted.” Lawyers for TerreStar didn’t respond to requests for comment.
In its proxy, Highland states that it assigns “no weight” to the two $114 trades in its determination of TerreStar’s fair value. The firm “considers these prior sales to be disorderly and ultimately not reflective of fair value,” the filing says.
The Highland Funds’ auditor, KPMG, disagreed with the firm’s decision to exclude the lower-priced trades from the valuation and said they were “orderly,” according to the proxy. Highland later fired the auditor. A KPMG spokesman declined to comment. Highland’s proxy said it was looking to engage a new auditor, but it hasn’t yet disclosed that firm in filings.
To arrive at its most recently reported value for TerreStar of $334 per share, says the proxy, Highland consulted an unnamed “third party valuation service.” That firm’s analysis “relies on significant inputs” from Highland itself, including “the two key assumptions underlying the valuation.”
How “disorderly” were those trades at $114?
A close reading of other disclosures shows that other funds related to Highland were involved in those transactions.
Another fund managed by an affiliate of Highland, NexPoint Strategic Opportunities, bought nearly 22,000 shares of TerreStar in the first quarter of 2018 for a total of $2.5 million.
Highland Floating Rate Opportunities Fund said in its annual report for the year ended June 30, 2018 that it owned 27,134 shares of TerreStar, which it bought on March 16 at a total cost of $3,093,276.
Those purchases by the two other funds, divided by the number of shares, equal $114 per share—the price Highland declared, in its Global Allocation proxy statement, to be “disorderly and ultimately not reflective of fair value.”
In its semi-annual report for the period ended March 31, 15 days after the Floating Rate Opportunities Fund paid $114 per share for TerreStar stock, Highland Global Allocation reported that it was valuing its own TerreStar shares at $278.74—nearly two-and-a-half times as much.
With such gaps in valuation, the independent auditor getting fired and Highland itself saying it isn’t yet ready to finalize its measurement of fair value for the TerreStar holding, investors can’t be sure they will get a fair deal in the conversion.
Investors who own mutual funds with illiquid holdings had better hope deals like this don’t become a trend. If they do, get out while you can.
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