FSD - ACP: About To Get Larger Again (Rating Downgrade)

2023-10-24 22:29:43 ET

Summary

• Abrdn Asset Management is acquiring several closed-end investment companies advised by First Trust Advisors, increasing its assets under management.
• The abrdn Income Credit Strategies Fund is set to acquire the First Trust High Income Long/Short Fund, with the merger subject to shareholder approval.
• The market currently values ACP more positively than FSD, with ACP trading at a -6% discount to NAV compared to FSD's -13% discount.
• Once the merger is completed, the discount will likely move closer to ACP's historic level, presenting an arbitrage opportunity for investors who buy FSD before the merger is finalized.
• ACP has a very large 'CCC' bucket when compared to FSD, the First Trust CEF having a much more conservative collateral build.

Thesis

Abrdn asset management is on a shopping spree these days. After announcing a couple of months back the acquisition of Tekla's closed end fund business (acquisition which has not been consummated yet), the fund manager has made yet another CEF purchase:

PHILADELPHIA, PA / ACCESSWIRE / October 23, 2023 / The Board of Trustees of each of the Acquiring Funds, listed below, announces the proposed reorganization of several closed-end investment companies advised by First Trust Advisors, L.P. into the respective Acquiring Funds ("Reorganizations"). The proposed Reorganizations are subject to the receipt of necessary shareholder approvals:

The combination of the merging funds will help ensure the viability of certain Funds, increasing scale, liquidity and marketability changes that may lead to a tighter discount or a premium to NAV over time. Following the Reorganizations, shareholders of each Acquiring Fund will experience an increase in the assets under management. There are no proposed changes to the current objectives or policies of the Acquiring Funds as a result of these Reorganizations.

However, shareholders of ACP will be asked to approve the issuance of shares at a special shareholder meeting tentatively scheduled for January 19, 2024 (the "Meeting"). The Board of Trustees of ACP has fixed the close of business on October 23, 2023 as the record date for the determination of shareholders entitled to vote at the Meeting and at any adjournment of the Meeting.

We can see from the above notice that the abrdn Income Credit Strategies Fund ( ACP ) will incorporate the First Trust High Income Long/Short Fund ( FSD ). ACP currently has around $340 mm in AUM, while FSD has $394 mm in assets. ACP is basically more than doubling in size after its latest purchase.

What is surprising is that ACP is becoming larger, yet again, after just closing in March on its Ivy High Income Opportunities Fund (IVH) acquisition which we covered here .

What does this mean for ACP shareholders

While longer term this acquisition is beneficial, with ACP closing in on the $1 billion AUM mark, short term it is not. Absorbing another entity is no easy feat, especially in today's environment, and especially since ACP is still digesting its IVH acquisition.

When you take over a new fund, management changes occur, with the new team having to go through all the collateral tape and decide what credits fit with the new fund strategy, review the leverage and funding profile, and merge the risk management, reporting and trading platforms. It takes time to streamline operations, assets and strategies.

As a reminder CEFs obtain leverage via preferred shares and Repo/TRS structures, thus a merger/acquisition involves the potential renegotiation of the respective funding documents, with potential new funding spreads and termination clauses. There is a significant amount of work that goes on in the background to integrate a new asset structure in a different fund in a seamless manner.

Acquisitions are marred by volatility and management focus on the new structure and portfolio managers, thus distracting individuals from the daily fund responsibilities.

ACP shareholders will be asked to approve this merger at a special meeting in January 2024. Shareholder approval is necessary for this merger to be consummated.

While long term we view this merger as beneficial for ACP, short term it will just increase uncertainty and volatility, thus a negative for current shareholders.

Merger Arbitrage Opportunities

In the CEF space a merger can bring about significant arbitrage opportunities via the structure's discount profile. This one is no different:

The market has a more positive view on ACP when compared to FSD, with the abrdn fund sporting a tight -6% discount versus -13% for FSD. We can see that ACP has a high beta on its premium/discount to NAV, with large swings in the respective figure in the past years.

Currently we can observe a 7% gap between the discounts for the two CEFs. Once the merger is consummated there will be only one entity left, namely ACP, and the discount will move towards the historic one for ACP. If the merger were to be finalized tomorrow an investor purchasing FSD would get an instantaneous 7% gain.

This corporate action will take to play out, and we expect it to eventually be approved and consummated. In the interim expect the FSD discount to narrow slightly.

What will happen in the interim

Until the merger is approved by shareholders, the two CEFs will be run as they are now as two completely separate entities, with different assets and views on the market. To that end, FSD is a much more conservative fund when it comes to credit risk:

The CEF is overweight BB names and has a very low CCC bucket. Conversely ACP has a massive CCC bucket which exceeds 30% of the collateral pool:

This translates into ACP exposing a much higher market risk when it comes to credit spreads. If we have a significant market risk-off event, ACP will sell-off much more than FSD. Mind you, the sell-off references the actual underlying performance rather than the discount to NAV.

The two funds will have their NAV performances fully embedded in their market price until the merger gets consummated. So in a risk-off scenario FSD is going to fare much better than ACP. With default rates on the rise, this is not a far-fetched scenario:

A retail investor needs to understand that until the merger is complete each fund will run its own market risk with its own returns. To that end FSD looks very attractive when compared to ACP due to its more conservative collateral composition.

What is the trade to be had here?

We are of the opinion that the latest wave of purchases by abrdn will be successful, just like the past ones, but will take around six months to complete. Once the merger is consummated FSD shareholders will get the benefit of a narrower discount to NAV, discount which as of today points towards a 7% gain.

In the interim though each CEF shareholder runs the market risk associated with the underlying collateral, and ACP is very poorly set-up for a risk-off event here. We believe the best trade to be had via this corporate action is to sell ACP (if you are a holder) and buy FSD. This trade take a view on a successful merger completion, a 7% gain from the narrowing of the discount to NAV and a less volatile collateral in the interim until the merger is completed.

Conclusion

ACP is a fixed income CEF from abrdn. The fund is set for yet another merger after absorbing IVH earlier this year. Abrdn has announced the purchase of a handful of CEFs from First Trust, corporate action which will see ACP's AUM more than double from the current levels.

FSD is the credit CEF from First Trust which is set to be absorbed by ACP, and FSD is currently trading with a much larger discount to NAV when compared to the abrdn fund. We expect the merger to be completed and the FSD shareholders to benefit from a lower discount to net asset value. FSD's collateral, while below investment grade, is much better rated than ACP's (ACP has a significant concentration in CCC assets).

With significant macro risks abounding we feel the appropriate trade for this corporate action is to 'wait out' the merger in FSD given its conservative build and larger discount to NAV. We are therefore of the opinion that ACP shareholders should Sell ACP here and Buy FSD on the back of this corporate action.

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