Neil Woodford’s controversial swap deal, transferring £73 million of unquoted stocks from his Woodford Equity Income fund to his Woodford Patient Capital (WPCT) investment trust, has exposed the challenges facing the fund manager to keep within the City regulator’s rules as investors continue to pull money from his flagship fund.
A whopping 17.9% of the Woodford Equity Income fund’s assets are tied up in unquoted stocks, a huge amount for a mainstream equity income fund, and well above the headline 10% limit applied to funds.
The swap deal announced on Friday, in which the Equity Income fund will receive shares in the Patient Capital trust in return for offloading stakes in five unquoted companies, will make only a dent in that figure.
Instead, Woodford is pinning his hopes on unquoted companies delivering on promises to float in order to keep his fund within Financial Conduct Authority (FCA) rules and provide much-needed liquidity.
The FCA’s rules dictate that unquoted stocks do not count towards that 10% limit if at the time of a fund’s latest investment the company has committed to float and does so within 12 months.
Woodford has only topped up his investments in a handful of unquoted stocks in his Woodford Equity Income fund in the last 12 months, and hasn’t invested in a new unquoted company through the fund since June 2017.
Could these stocks float to the rescue?
We could find out very soon whether some of this small band of companies will deliver the flotations, like that of Proton Partners (PPI) last week, which the manager needs to bring his sprawling exposure to unquoted stocks back below the 10% limit.
Crucial to that process could be Benevolent AI, the artificial intelligence company that is by far his biggest single unquoted investment, representing 4% of the Equity Income fund.
Woodford’s latest investment in the company was in April last year, although it is unclear whether his participation in the funding round was on behalf of the Equity Income fund, the Patient Capital trust, or both.
But if that $115 million funding round, which valued that company at $2 billion, included a commitment to float, delivering on that next month would go a long way towards bringing the Equity Income fund below the FCA’s limit on unquoted stocks.
Sabina Estates, the Ibiza property company that also ranks among his largest unquoted investments, is another the manager has been adding to in the last year, taking his holding to 1.7% of the fund.
The group’s latest funding round, in which Woodford participated, took place as recently as December last year.
Woodford meanwhile ploughed over £10 million of the Equity Income fund’s assets into the latest fundraising by Ombu, itself an investor in early-stage companies, in the first half of last year. Were Ombu, a 0.75% position in the fund, to float, it would further chip away at Woodford’s unquoted exposure.
Flotation of all three, coupled with the 1.6% in unquoted assets being transferred to Patient Capital, would be enough to bring the fund’s unquoted assets just below the 10% mark.
Forced disposals could be on cards
Should they fail to float, Woodford could then be forced to reduce his unquoted holdings in order to meet the FCA rules. This would impose an unwanted additional burden for a manager already dealing with the challenge of returning cash to departing investors, although Woodford Investment Management says the level of redemption requests is now much less severe than at the height around 18 months ago.
Woodford’s flagship fund has halved in size, from a peak of £10.2 billion in May 2017 to £4.8 billion at the end of January, as the manager’s performance has deteriorated.
Heavy share price falls for the likes of Provident Financial (PFG), Capita (CPI), Prothena (PRTA.O) and Allied Minds (ALML) have dragged down the fund’s performance, prompting investors to redeem their holdings.
Woodford has been forced to fund those withdrawals largely by exiting positions in some of his larger, listed holdings: once heavy positions in Capita, AstraZeneca (AZN) and Lloyds (LLOY) are now absent.
Unquoted positions have largely remained untouched, given the relative difficulty of disposing of these stakes. Woodford’s sale of his stake in AJ Bell ahead of the online stockbroker’s flotation last year is a notable exemption, although the stellar gains the manager has since missed out on perhaps serves as an example of why he has been reluctant to fund liquidity in this way.
Big share price declines for some of the larger listed holdings coupled with funding of redemptions from more liquid quoted stocks have combined to inflate the relative size of unquoted companies within the portfolio.
More swap deals in the offing
Further swaps such as those announced on Friday would seem the most likely path to reducing this, given Woodford Investment Management’s positioning of the move as ‘the start of a strategy to switch the fund’s unquoted exposure from individual unquoted holdings to shares’ in the trust.
Woodford Investment Management has however insisted that last week’s announcement was not driven by the need to keep unquoted exposure within the regulator’s limit, but a response to investor demand.
Further swaps will first need the approval of Patient Capital’s shareholders. Last week’s deal, which hands the Equity Income fund over 81 million shares in Patient Capital, uses up the bulk of the trust’s authority to issue new shares for the current financial year.
Shareholders will likely vote on renewing the trust’s ability to issue new shares at the next annual general meeting in June. Although we can take a guess at how one of the newest and largest shareholders, Woodford Investment Management, which now owns 9% of the shares, will cast its ballot. Whether it will vote is not yet clear: broker Stifel has called for Woodford to abstain on ‘any votes that have an impact on the management group or its financials’.
This approach has limits, however, as FCA rules dictate that funds cannot hold more than 20% of the shares of a particular company. The transfer of assets announced on Friday will hand the Equity Income fund 9% of the enlarged Patient Capital share capital, so the fund only has scope to undertake one more of these transfers of a similar scale, barring further, unlikely, large-scale share issuance to other investors.
Window-dressing for income fund
Whether this arrangement represents anything more than window-dressing is open to question, however. By shifting assets around in this way, Woodford can claim to be improving the liquidity of the Equity Income fund: individual unquoted stocks are being replaced by shares in a FTSE 250-listed investment trust.
But the liquidity of the trust’s shares should not be overstated: an average of 1.9 million of the shares change hands every day, according to Refinitiv data, around 2.3% of the number the Equity Income fund is taking on in the swap deal.
That’s why the fund sold its unquoted stocks for newly-issued shares in the trust, paying above the share price in doing so, rather than buying them in the secondary market.
As Woodford Investment Management put it on Friday: ‘we have explored how much it would cost the fund to purchase the equivalent position in the secondary market and our analysis suggests it would cost considerably more and take considerably longer’.
But just as Woodford would have struggled to buy that size of stake in the market, so he would struggle to sell it. The fund’s stake in Patient Capital is likely to prove just as untouchable as the bulk of its unquoted holdings should Woodford be forced to fund more redemptions.
This touches on a wider issue of liquidity for the Woodford Equity Income portfolio. Just because a stock is listed doesn’t mean it can be easily disposed: for some of Woodford’s quoted holdings, engineering an exit could be just as challenging as disposing a stake in an unlisted investment.
Heavy holdings present challenge
That’s because Woodford has built up dominant positions in the share register of a number of companies he owns. In the case of some admittedly smaller holdings, Woodford’s stake has even passed the 30% threshold that would normally require him to launch a takeover bid for the companies.
His stakes, held across the various funds he runs, account for more than 20% of the outstanding shares in just under a third of the quoted companies he holds in the Equity Income fund, according to Refinitiv data.
That includes four of the Equity Income fund’s top 10 holdings. Woodford Investment Management holds 24.7% of Provident Financial, 22.2% of Theravance Biopharma (TPBH.O), 29% of NewRiver Reit (NRRT) and 29.7% of Autolus (AUTL.O).
In some cases, Woodford Equity Income’s holdings have crept close to 20% of company shares a single fund is allowed to own.
Selling out of such positions without sending the shares lower would be a tricky task. Evidence of this can be seen in Woodford’s disposal of the Equity Income fund’s stake in brick maker Forterra (FORT), in which the fund group had built up a holding of over 19% of the shares, last year.
Rival income managers Clive Beagles and James Lowen, who run the JOHCM UK Equity Income fund, pounced on the fall in the shares they said had been exacerbated by the ‘persistent’ selling of ‘its largest shareholder’.
Income investors pay high price
Woodford’s swap deal has meanwhile drawn a note of concern from one of the manager’s strongest supporters, Hargreaves Lansdown.
The online stockbroker raised the issue of potential double charging for Equity Income investors. Investors already pay the fund’s annual management charge and could be levied a performance fee on the small proportion of the fund’s assets that will now be invested in Patient Capital.
Though as Hargreaves acknowledged, the triggering of that performance fee looks some way off yet. Woodford would need to lift the net asset value (NAV) of the trust, currently 96.3p, above 156.7p by the end of this year to start earning a performance fee. Otherwise investors only pay a 0.18% annual charge to cover costs such as auditing.
Of much more significance is the near 15% hit investors in the Equity Income fund will be taking on their newly-acquired Patient Capital stake. By buying newly-issued shares at NAV rather than picking them up on the secondary market, the fund will shoulder an immediate loss of nearly £11 million on its £78.9 million investment, given the discount at which the shares trade.
Unless Woodford can succeed in closing that discount, investors in Woodford Equity Income will continue to pay a steep price for any further swaps to reduce the fund’s heavy unquoted exposure.