Recently, Vertical Capital Income Fund filed a definitive proxy through which the board of directors is seeking shareholder approval for eliminating the fund’s fundamental policy of making quarterly repurchase offers for a minimum of 5% of the total outstanding shares at NAV. This post will explore the implications of such a path, and briefly consider alternatives that might meet shareholder liquidity needs and better preserve shareholder value.
First, some background on the fund. Vertical Capital is an interval fund that began raising capital in 2011 and built out a portfolio of predominantly restructured residential mortgage notes. These restructured mortgages typically included concessions to the borrower, who usually had experienced some hardship precluding payment under the original terms of the mortgage. These concessions may have included either extending the maturity date or reducing the interest rate on the note. Vertical Capital focused on purchasing performing restructured mortgage notes. Vertical Capital currently has a portfolio totaling approximately $145 million in mortgage notes, based on principal balance, which it acquired at a cost of approximately $118 million. Vertical Capital had a distribution rate of 5.8% in 2018, based on its most recent NAV per share of $11.99 per share as of December 14, 2018, and inclusive of a special distribution of $0.30 per share in December 2018.
Seeking a better liquidity solution
The fund has had a recent string of repurchase offers in which shareholders have tendered shares in excess of the repurchase offer amount of 5% of total outstanding shares. The two most recent quarterly repurchase offers in 2018, for which data is available, indicate that 37% and 40% of outstanding shares in the fund were tendered by shareholders for repurchase. The fund repurchased 5% of total outstanding shares in each respective offering period. Repurchase offers dating back to 2016 have been oversubscribed.
This backlog in redemption requests has led the board to consider a listing of the shares on an exchange to provide shareholders with liquidity. However, in exchange for pursuing a listing, the board is asking shareholders to give up the fundamental right, as an interval fund, to require the fund to periodically redeem a minimum of 5% of the outstanding shares. There is no assurance that if shareholders vote as the board recommends that a listing of the shares on the NYSE will occur, in which case the board has indicated it will not implement the proxy proposal.
The board’s requirement of shareholder approval of the proxy proposal as a condition precedent to a listing of Vertical Capital’s shares on the NYSE is a little puzzling, as there is no restriction precluding an interval fund from listing on an exchange. And interval funds have been listed on exchanges in the past, per research from Intervalfundtracker.com. For example, BlackRock Enhanced Government Fund Inc. (NYSE: EGF), an interval fund that is currently listed on the NYSE, makes annual repurchases of 5% of its outstanding shares. Interestingly, EGF has traded at approximately a 5% discount to its NAV, presenting an opportunity for modest profits for traders upon tendering the shares for repurchase (even factoring in a 2% redemption fee). EGF’s most recent repurchase offer was oversubscribed.
Vertical Capital’s board has also noted that, based on the report of a third-party consultant, upon listing, the shares are anticipated to trade at an estimated short-term discount of 12% to 20% to NAV as shareholders seeking liquidity sell their shares. Over the long-term, the board anticipates a discount of 0% to 12% to NAV. (However, the board notes that without a pure comparison to the fund that is currently trading, there is a certain amount of uncertainty in how the shares will likely trade upon a listing.)
Will elimination of the repurchase policy have other benefits?
The board anticipates that elimination of the fundamental right to repurchase shares will also be beneficial to the performance of Vertical Capital over the long term, including expense reductions anticipated to be 0.25% to 0.50% per year, as well as negating the need to hold as much cash and manage the portfolio to meet liquidity needs pursuant to its present repurchase obligations. We note that cash as a percentage of total assets was 5.5% and 4.4%, respectively, and investments as a percentage of total assets were 93% and 94%, respectively, as of year ends 2017 and 2016, providing limited opportunities for additional increases in the investment portfolio in the absence of requiring cash to meet redemption requests.
Overall, the board’s proposals present shareholders with a unique choice:
- continue as an interval fund with an oversubscribed tender offer or
- give up the fundamental policy of periodic liquidity that is the core of an interval fund and pursue a listing of the shares on the NYSE.
A listing would potentially lead to a volatile trading price and possibly steep discounts to NAV in the short-term, which the board expects would moderate in the long term. It would be interesting for Vertical Capital to alternatively pursue a listing on an exchange as an interval fund, maintaining its fundamental repurchase policy. Such a course would provide some modest support for shareholders in the prospective choppy waters of a listing, while simultaneously allowing shareholders a full and quick exit if they desire. Or the fund could provide some guidance on supporting the share price post-listing, which could be accomplished by tender offering for shares in the market post-listing.
Vertical Capital shareholders will need to vote their shares prior to a special meeting to take place on March 8, 2019.