Part Owner of MGM, $HFRO Now Trading at >25% Discount to NAV

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Quick one, but the closed-end fund HFRO looks like an interesting idea. It currently trades at $10.21, yet NAV is $13.84 as of last reporting. That is a 26% discount to NAV. However, you may think the discount needs to be wider for some of the risks I outline. Either way, I think its an interesting one to watch.

Bottom line: If you give full credit for the liquid assets, the balance of the fund is trading at a 45% discount to reported NAV. 

Should there be some discount? Maybe. But this large? Not so sure… Can you guess when they announced that they want to convert to a holding company?


Background

For background, HFRO is a closed-end fund, but unlike typical funds that just own stocks and bonds, HFRO owns some esoteric assets. For example, they have a preferred stake is a timber REIT with a 10.25% coupon. That is 23% of the fund. Another 12% is a self-storage asset. Interestingly, ~5% of the fund is also MGM, which everyone knows is being acquired by Amazon.  The balance is leveraged loans (12%), CLO equity (21%). Another 8% is a stake in Nexpoint Real Estate Finance, which is a public REIT.

Why does this opportunity exist?

To some degree, people have had trouble with Highland as a manager, which I’ll discuss with their TerreStar stake. Highland, the fund company, also declared bankruptcy and was embroiled in controversy, but that doesn’t mean the funds stopped, it was just the manager who continues to operate.

 The Dallas-based firm founded by Jim Dondero helped pioneer trading of corporate loans rated below investment-grade and managed about $39 billion in 2007, but it took heavy losses during the financial crisis and has been embroiled in lawsuits ever since. The company had been trying in recent weeks to settle some of the litigation it faces, warning its adversaries that it would seek bankruptcy protection if they didn’t compromise, people familiar with the matter said.

Again, this is the manager, not the fund itself. The fund itself is not exposed to these lawsuits.


However, Highland is suing Credit Suisse for marketing some assets in 2007 in Vegas as very valuable that ended up quickly being zeroes. And this lawsuit outcome could be a massive right tail event for HFRO. This is marked at zero right now on the balance sheet of HFRO. However, a jury awarded HFRO, the actual fund, $211MM of damages. This was later knocked down to around $40MM. More detail is on the fund site. Either way, it’s marked at zero and anything above $1 is extra value.


Now, HFRO wants to convert to a holding company. This means it will no longer be a fund, per se, but a holding company. So think of a public private equity firm with permanent capital. Maybe people give even less credit for the marks. Highly encourage you to check out their presentation on why they are doing it.

Look, Dondero has some issues, but he does find some interesting opportunities. The lumber asset, the self storage piece, the REITs and other funds they’ve founded. He is in MGM because he loaned-to-own through their bankruptcy.

People don’t like this pivot. But the asset change over time (below) shows me they will actually be liquidating the assets that can be liquidated. We also know MGM will probably be sold, so there’s another 5%. This means that value will be quickly realized.

Buyback: The fund committed to a $10MM/month buyback program PLUS management buying $10-$20MM stake. $10MM is about 1% of the fund, so pretty significant. However, this only occurs if this approved, though. It also has some pretty damning qualifying language:

Under the terms of the Share Buyback Program, if, at any point during the Buyback Period, the Company’s common shares begin to trade at more than a 25% discount to NAV, the Company will buy back up to $10 million in aggregate value of the Company’s common shares per month

(But hint, voting against the deal is an upside event – if the NAV is widening because people hate this, it is possible this doesn’t go through and it snaps back)

Biggest Risk is Not Believing NAV

Obviously, the biggest risk with owning illiquid things is that no one can easily mark-to-market. However, we now have a quote on MGM. Lumber is obviously doing very well, and yields are super low, so selling a 10.25% coupon preferred does not seem tough to me. Self-storage, too.

This is the majority of assets. I think they could easily liquidate the CLO equity, leverage loans, and Nexpoint stake which are marked-to-market, so that’s 40% of assets alone. Each of these you can get a quote on Bloomberg each day.

There’s only ONE asset I have concern about. It is Terrestar. But note, it is only 70bps of the entire fund. So feel free to mark at zero. Feel free to read up on Terrestar here. But the not-so-great thing about this is Terrestar has been called out in the past as being questionably marked.

Yikes – that is icky.

But again, TerreStar is 70bps of this fund and Highland has been scrutinized for this. Mark it at zero.

Obviously, the larger question then is if you can believe anything Highland puts out? It is a fair question, though a > third of the business is liquid assets.

So you need to decide if the balance deserves a 45% discount (that is what’s implied when you give a 100% credit for CLO equity, loans, and Nexpoint).


In my view, they are clearly telling you they will be liquidating the liquid assets, buying back stock, management will have skin in the game.

It seems like it is getting interesting!

If your response is, “well, the discount can continue to widen…” then what is the appropriate discount for you?

3 thoughts on “Part Owner of MGM, $HFRO Now Trading at >25% Discount to NAV”

  1. What is HFRO not able to as a closed-end fund that they’ll be allowed to do as a holding company? Their deck mentions limitations imposed on them under the 40 act. What limitations is the 40 act imposing on them?

    1. Yeah very good question. It reminds me of TURN and CET if you followed those – both own individual companies or parts. As does HFRO today. I think there’s a few things they are actually targeting, and the wording of it being an “opportunity” is just vague. This is just my stream of thoughts:
      #1: CEFs must continuously disclose NAV under 40 act. As a holding company, my understanding is its a bit easier to tell the story of why something is worth a lot even though it may not be marked at book value there. So think of See’s Candy on BRK’s balance sheet.
      #2: Can carry tax losses forward which is worth something
      #3: 40 act requires that you outline your investment objective upfront in the prospectus, which may limit some investments. Holding company does not.
      #4: 40 act limits leverage and calc’s it as a % of assets (33%) vs. a multiple of EBITDA.
      #5: I think they are req’d to distribute cash out (to avoid fund level taxes) vs. keeping that cash flow and reinvesting it.

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