FPL - FEI: Proposed ETF Conversion Offers Arbitrage Opportunity

2023-11-28 12:14:50 ET

Summary

• First Trust MLP and Energy Income Fund Common is a top-performing MLP/midstream CEF.
• A proposed ETF conversion offers arbitrage opportunity for FEI investors.
• The merger is expected to eliminate the CEF discount and provide an opportunity for investors to exit at NAV.

FEI: A top-performing MLP/midstream CEF

First Trust MLP and Energy Income Fund Common (FEI) is a closed-end fund, or CEF, focusing on MLP/midstream companies. These are a popular type of investment among income investors because of their steady distributions, tax advantages, and ownership of essential income assets. FEI is owned in our Tactical Income-100 portfolio.

The basic CEF statistics for FEI are shown below:

• 1-Year Z-score: +2.16
• Discount: -9.33%
• Distribution Yield: 7.02%
• Expense Ratio: 1.96%
• Leverage: 17.74%
• Managed Assets: $427billion
• Structure: Perpetual.

Among MLP/midstream CEFs, FEI uses a relatively conservative investment strategy. It uses leverage of around 18%, which is lower than most peers, and also has Enterprise Products Partners (EPD), often known as the gold standard of MLPs, as its top holding.

Performance-wise, FEI ranks 2nd out of 12 MLP CEFs on the basis of 10-year NAV total returns according to CEFdata.

FEI owns a diversified mixture of MLP/midstream companies. This includes 26.24% in natural gas transmission, 25.67% in petroleum product transmission, 19.86% in electric power and transmission, and 12.60% in crude oil transmission. This diversification helps to smooth out potential fluctuations in returns and provides a more stable investment environment.

Proposed ETF conversion offers arbitrage opportunity for FEI

Recently, FEI has been proposed by its board of directors to be converted into a newly created actively-managed exchange-traded fund ("ETF"), the First Trust Energy Income Partners Enhanced Income ETF. This presents an upcoming arbitrage opportunity for FEI investors.

Besides FEI, other First Trust MLP/midstream CEFs including First Trust Energy Income and Growth Fund ( FEN ), First Trust New Opportunities MLP & Energy Fund ( FPL ), and First Trust Energy Infrastructure Fund ( FIF ) are also implicated in this conversion. For disclosure, our Tactical Income-100 portfolio also holds FIF.

From the press release :

First Trust Advisors L.P. ("FTA") announced today that the Board of Trustees of each of First Trust Energy Income and Growth Fund (NYSE American: FEN), First Trust MLP and Energy Income Fund (NYSE: FEI), First Trust New Opportunities MLP & Energy Fund (NYSE: FPL), and First Trust Energy Infrastructure Fund (NYSE: FIF) (the "Target Funds" or each, individually, a "Target Fund"), each a closed-end management investment company managed by FTA and sub-advised by Energy Income Partners, LLC ("EIP"), approved the Merger of each respective Target Fund into First Trust Energy Income Partners Enhanced Income ETF, a newly created actively managed exchange-traded fund ("ETF") managed by FTA and sub-advised by EIP ("EIPI"). The Mergers have also been approved by the Board of Trustees of EIPI. EIPI will be the surviving fund.

EIPI will be an actively managed ETF that seeks to provide a high level of total return with an emphasis on current distributions paid to shareholders. EIPI will pursue its investment objective by investing in energy companies. EIPI will also deploy a partial covered call strategy to enhance its income.

The mergers are subject to shareholder approval of each respective fund, and the merger of each fund is not contingent upon the others. The merger is expected to close in the second quarter of 2024.

The announcement of the proposed merger caused a big pop in the share prices of FEI and these other CEFs, driven by investor anticipation of narrowing discounts to zero as the conversion into an ETF draws nearer.

This discount contraction was accompanied by a surge in share prices, to the benefit of our portfolio position in FEI.

As a reminder, CEFs often trade at premium or discounts to their net asset value ("NAV") due to various factors, such as market sentiment, investor perceptions, and supply-demand dynamics. However, the proposed formation of an ETF through the merger of these CEFs represents an opportunity to eliminate this discount altogether, as ETFs always trade close to their NAV due to their functioning creation/redemption mechanism.

I do expect the votes to go through because shareholders will benefit from being able to exit at NAV. With FEI still at a -9.33% discount respectively (as of 11/27/2023), we're content to hold onto this fund in our Tactical Income-100 portfolio and continue to harvest the alpha that would come from discount contraction as the merger date nears.

The press release does mention that FEI as well as FEN and FPL may be required to recognize a decrease to its NAV prior to its merger due to taxation issues:

In connection with the proposed mergers of FEN, FEI and FPL into EIPI, each of these Target Funds may be required to recognize a decrease to its NAV prior to its merger, with another potential final adjustment to be made to the NAV of EIPI following the mergers after the receipt of year-end tax information to be provided by the master limited partnerships ("MLPs") that had been held by such Target Funds. The amount and timing of such adjustments, if any, will depend in part on the market prices and composition of each such Target Fund's portfolio securities.

This is because FEI, FEN and FPL are structured as C-corps, allowing them to own more than 25% MLPs, but this subjects them to taxation at the fund level. FIF in contrast is structured as a registered investment corporate ("RIC"), which is the standard structure for most CEFs, and does not have to pay taxes at the fund level as long as they pass through the majority of their investment income and realized capital gains to shareholders each year. This uncertainty with the NAV adjustment could be why FIF is trading at a modestly narrower discount than FEI and the other two MLP/midstream CEFs.

Why did the managers unilaterally decide to recommend a merger of FEI into an ETF, which is something that is not typically voluntarily offered by managers? CEFs are a reliable source of captive capital for managers, generating a steady stream of fee income. In contrast, the ETF structure is subject investor inflows and outflows.

While a successful fund can experience increased AUM through inflows, leading to higher fee revenue for the managers, outflows can have the opposite effect, reducing fee income and potentially even triggering the closure of the fund if AUM reaches critically low levels. The activists Saba have been accumulating a 7.49% stake (worth around $32 million) in FEI, but I have not seen any evidence that this ETF conversion proposal was instigated by Saba.

Together with the news of other First Trust CEFs being proposed for merger into abrdn funds, I see this move as First Trust simply trying to completely exit from the CEF business.

Takeaway for FEI investors

I recommend that investors owning FEI to vote for the conversion of the CEF into an ETF in order to realize the alpha from discount contraction. However, investors who strongly prefer for FEI to remain as an independent CEF should vote against the merger.

The logic is similar for FPL, FEN and FIF investors.

For further details see: