On June 13, 2016, Steven Stein, the President of Etude Capital, LLC sent an open letter to the Board of Directors of the Renn Fund. At the time, Etude Capital and its affiliates held 12.4% of the outstanding shares of the Renn Fund (NYSE MKT:RCG). Two months earlier, a shareholder meeting had voted in favour of a voluntary liquidation of the Renn Fund.
In his letter, Stein argues that significant value would be lost in a liquidation. According to Stein, the accumulated tax loss carryforwards of the company if utilized could represent as much as $2 in value per share. The solution that Stein proposes to salvage and unlock that value for shareholders is to turn the management of the fund over to Horizon Kinetics.
A Short History of the Renn Fund
Originally incorporated as Renaissance Capital Growth & Income Fund III, Inc., the fund was formed in Texas in 1994 as a non-diversified closed-end Fund. Closed-end funds differ from (open-end) mutual funds in that closed-end funds do not redeem their shares at the option of the stockholder and generally list their shares for trading on a securities exchange.
The fund was initially capitalized by Russell Cleveland, who would serve as its Chairman and CEO, through a purchase of 10,000 shares of common stock for $10.00 per share. On February 25, 1994, the Renn Fund filed a registration statement on Form N-2 for the sale of up to 10,000,000 shares of common stock at an offering price of $10.00 per share.
As a result of the offering, the Fund sold 4,158,897 shares in 1994. After extending the offering period into 1995 and with certain shareholders reinvested their dividends in the Fund during 1995, an additional 45,592 shares were issued. As a result, total shares issued at December 31, 1995, were 4,244,630.
A shareholder who had participated in the offering in 1995 at $10 would have experienced its value dwindle down to $1.37 per share by the end of 2016. In July 2007 those shares still carried value of over $9 per share but the fund was hard hit by the years of the financial crises. As Net Asset Values of the fund shrank the unit cost of running the fund increased, gradually becoming unsustainable. This lead to the decision to liquidate the fund in early 2016.
Horizon Kinetics Assumes Control of Renn
We have been long-term followers of Murray Stahl and Steve Bregman at Horizon Kinetics, an asset management company with over $5 billion of assets under management. A big theme in the investment philosophy of Stahl & Bregman relates to finding opportunities in structural constraints.
A typical structural constraint is a spin-off, whereby a company gives a subsidiary independence by listing its equity on a stock exchange and hands those share to shareholders through a special dividend.
When a publicly listed company performs a spin-off, the spun-off company has no listing history, is comparatively small compared to its former owner and has no analyst coverage. Institutional investors have mandates that often prohibits them to invest in companies with these limitations. These institutions would, therefore, be required to dispose of the shares that they would receive of the spun-off company.
Another avenue of structural constraints that Horizon Kinetics is known to invest in, are pre-packaged bankruptcies and liquidations. Being in the asset management business and having a particular focus on corporate restructurings, it should not have come as a particular surprise that Horizon Kinetics would take interest in the situation at Renn.
In October 2016, it was announced that Renn had signed a letter of intent with Horizon Kinetics to assume control of the investment management of the fund. At the end of June, a special meeting of shareholders was held, in which all proposals by Horizon Kinetics where approved and the company effectively took over as investment manager of Renn.
The following proposals were made by Horizon Kinetics:
- Horizon will waive its management fee until net assets reach $25 million. Thereafter, Horizon will only charge a management fee of 1% of fund net assets above $25 million, well below the current fee of 1.75%.
- Horizon intends to make full use of the Fund’s considerable tax loss carryforwards, subject to tax and regulatory restrictions, which is an asset to shareholders that might not be fully utilized in a liquidation scenario.
- Horizon intends to lower operating expenses by leveraging its resources and relationships with existing vendors.
- Horizon intends to grow the assets of the fund to more sustainable levels, both through asset appreciation and a rights offering or other available recapitalization mechanism.
The benefits of the Horizon proposal, from the perspective of Renn shareholders, is easy to see. At its current size, the cost structure has become unviable. After years of underperformance, it would be next to impossible for prior management to raise funds. However, by liquidating the fund, the shareholders would forfeit the companies tax loss carryforwards.
Horizon would be able to lower the cost structure by leveraging its existing investment research. In addition to that, the company would the administration of the fund in-house and it could potentially draw on its existing sales network in any capital raising activities.
The Rights Offering
Even with the involvement of Horizon, it was apparent that any effort to raise additional funds for Renn would not be an easy sell. One option would be to assign the fundraising to an investment bank. This would, however, be costly, with total costs unlikely to be below 5% of the raised capital.
A rights offering is much less costly, as the rights are issued and given to existing shareholders, which gives them the right to participate in the succeeding share offering. Most of the time, rights offerings are structured in a way that shareholders are disadvantaged by not making use of their rights to the offering.
Renn Fund announced the anticipated rights offering in September 2018, which they updated with amendments in November 2018. The terms of the offering were as follows:
- Each shareholder would receive 1 right for each outstanding common share.
- For every 3 rights received, a shareholder would be entitled to buy one new share.
- The rights are non-transferable, thus cannot be sold or bought.
- The offering will expire on December 28, 2018. All unused rights will expire worthless after that date.
- Horizon Kinetics will purchase any of the newly issued shares not acquired through the rights offering.
- The subscription price per share will be the lesser of:
- 105% of the average closing NAV per share over the three days of trading leading up to and including the expiration of the Offering and
- 90% of the average closing market price per share over the three days of trading leading up to and including the expiration of the Offering.
In order for the prior option to be the lesser value, the units would have to be trading at a 16.7% premium to its net asset value. Seeing as the shares have been trading at a discount to NAV historically, odds are that it will remain the case. If the shares will be trading at discount to NAV at the expiry, the new shares will be issued at an additional discount to NAV.
Note that there is a relatively long time between the issuance of the rights and the closing of the offering. This would disadvantage anyone who would buy shares after the rights were issued, as their shares will be diluted with the offering, without them being able to participate in it. As a result, what you would expect from the design of the offering, is that the NAV discount would widen until after the new shares have been issued.
We believe that his design of the offering by Horizon was deliberate. Perhaps, for one reason or the other, they anticipate that a significant portion of the Renn shareholders will not exercise their rights even though they would be disadvantaged by not doing so. Time will tell if that is indeed the case.
The Subscription Price of the New Shares
At the end of September 2018, the net asset value of the Renn investment portfolio was $9.44 million, which was a 25% increase from three months earlier. Despite NAV having grown to its current level from $6.5 million at the end of 2017, Renn shares are trading at essentially the same price as at the start of 2018.
Based on the latest calculation of NAV, the discount is now 25%. If this will also be the case on December 28, when the rights offering expires, then the new shares will be issued at 67.5% discount to NAV. Since the offering is increasing the share count by 33%, this would result in a dilution of NAV per share by more than 8%.
There are 4,463,967 shares outstanding and 1,487,989 new shares are being issued. If they would be issued $1.35 ($1.50 x 90%), NAV would increase by about $1.8 million, assuming that the cost of the offering will be about $200k.
However, this brings us to another quirk in the offering. Even though shareholders received the rights on November 19 and the offering not expiring until November 28, the eventual subscription price will be based on the average closing market price per share over the three days of trading leading up to and including the expiration date of the offering.
Over the last 90 days, the average daily trading volume was 14,445 shares. In other words, about 0.32% of the outstanding stock changed hands per day on average. That would be a very low turnover rate by almost any comparison. Due to the illiquidity of the stock and the short timeframe of only trading days to determine the subscription price, the trading activity during these three days could have a meaningful impact on the closing prices.
The Renn Fund Turnaround
It will be interesting to follow the developments of the rights offering. Although the investment performance of the portfolio has been outstanding, AUM need to grow considerably to bring down the cost percentage of the fund. We believe that this will be the first of a series of offerings.
From the perspective of Horizon, operating closed-end funds presents an interesting option for the asset management company as portfolios can be constructed with a longer-term perspective as there is no risk of sudden drawdowns of capital.
Full disclosure: We hold a long position in FRMO Corp which is a shareholder in Horizon Kinetics.
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