VCIF - VCIF: The Type Of Surprise You Do Not Want From A CEF

2023-07-12 17:08:36 ET

Summary

• Vertical Capital Income Fund is a closed end fund that invests in mortgage whole loans and was down -15% on July 11.
• The fund's portfolio was sold at a loss to NAV, which means that shareholders received less than the theoretical value of their shares.
• The sale was part of a larger reorganization, where Carlyle is now becoming the investment adviser to VCIF and the fund will re-focus on CLOs going forward.
• This sale is a reminder that illiquid assets can trade at a significant discount to their theoretical value.
• Small, independent investment advisers may have different incentives than large asset managers, so it is important to do your research before investing in a fund managed by a smaller firm.

Thesis

Vertical Capital Income Fund ( VCIF ) is a fixed income closed end fund. The vehicle came on our radar screen due to their investment in mortgages, and more specifically in whole loans:

The Fund’s investment objective is to seek income by investing primarily in performing non-agency residential whole loans secured by residential real estate. As a secondary strategy the Fund seeks to provide total return by acquiring performing residential loans at a discount to their Unpaid Principal Balances. The Fund realizes capital gains as loans are paid off before maturity. The Advisor intends to primarily allocate the Fund’s assets among debt securities that represent attractive risk-adjusted income producing investment opportunities.

So instead of buying MBS securities, which are securitizations of packaged mortgages, the fund invests directly in whole loans, similarly to a commercial bank. It is one of the few exchange listed vehicles that does that.

However yesterday saw a shock price move for VCIF, down -15%:

In this article we are going to look at what happened and the lessons that can be learned from this occurrence.

Sale to Carlyle

Let us firstly have a look over the press release VCIF put out:

Vertical Capital Income Fund Announces Sale of Majority of Investment Portfolio in Advance of Expected New Investment Advisory Agreement with Carlyle DALLAS, July 11, 2023 /PRNewswire/ -- Vertical Capital Income Fund ((VCIF)) (the "Fund") announced today that after engaging a third-party broker and conducting an extensive competitive bidding process, it has selected two winning bidders for a significant majority of its investment portfolio. Each winning bidder has acquired a portion of the Fund's investment portfolio in a sales process conducted to satisfy certain conditions to the closing of a previously-announced and shareholder-approved transaction (the "Transaction") with an affiliate of global investment firm Carlyle (CG). The Fund will invest the sales proceeds in cash equivalents in anticipation of the closing of the Transaction (which remains subject to other closing conditions). Consequently, the Fund will generate reduced investment income while the proceeds are in cash equivalents. Based upon the expected proceeds from this sale, which resulted in aggregate proceeds lower than the book value of the combined assets due to the significant sale needed to facilitate the Transaction, the Fund has adjusted its net asset value per share ("NAV") from $9.96 as last reported on June 30, 2023, to $8.27 as of today. Additionally, the current Fund Board has terminated the Fund's Managed Distribution Plan and suspended its existing distribution policy, and the Fund will not declare its typical regularly scheduled July distribution in anticipation of a new dividend declaration that is expected to be made by Carlyle and the Fund Board before month's end following the closing of the Transaction. As part of the Transaction with an affiliate of Carlyle, Carlyle Global Credit Investment Management L.L.C. ("CGCIM") will become the investment adviser to the Fund. In addition, the Fund's investment mandate will change to focus on investing in equity and debt tranches of collateralized loan obligations ("CLOs") in order to drive potential shareholder value.

Basically the fund is doing the following:

• it has now liquidated its entire portfolio, but at a loss to NAV
• the current investment adviser is exiting the business, with Carlyle taking over
• the fund's objective / collateral will change, and it will focus on CLOs going forward

Implications

The same way a CEF can trade at substantial discounts to NAV and shareholders fight for that figure to narrow (even by a potential liquidation), a CEF can liquidate for different motives (such as the investment manager exiting the business in this case) and create a loss. Anytime a portfolio contains illiquid assets, the propensity for them to get NAV in a liquidation is very slim. Theoretical mark to market versus a firm bid for notional are two very different things. We have argued around this point in respect to a technology private investments fund here , where we repeatedly stated that actual valuations upon exit would be much lower, especially in a tough market.

Secondly, fund families matter. Small, independent CEF advisors have different incentives when compared to large asset managers running CEF platforms. We are seeing a consolidation in the space with Tekla being acquired and the Delaware funds having been sold last year. If you own a CEF from a very small fund family then you are running additional risks.

Thirdly there seems to be a bid for the CEF 'shell' these days. As a reminder a CEF is an actual company. Not an operational one (i.e. it does not make widgets) but it is a corporation that owns financial assets. By virtue of becoming the investment manager, liquidating the assets and switching the objective to owning CLOs, Carlyle has basically bought itself a CEF rather than IPO-ed one.

If you are still a VCIF holder you need to understand that your risk profile has changed 100%. This is no longer a vehicle exposed to whole loans backed by houses, but an entity that is now sitting on a cash balance that will eventually be invested in CLOs.

Conclusion

VCIF is a fixed income closed end fund. The vehicle had a massive down day yesterday, losing -15%. The reason behind this shocking move was the sale of its entire portfolio, which came in at a value below NAV. The fund was invested in mortgage whole loans, a more illiquid asset class. The move is part of a larger reorganization, where Carlyle is now becoming the investment adviser, and the CEF will re-focus on CLOs going forward. In a nutshell, the existing investment adviser is exiting the business at a cost to shareholders. What is interesting to notice as well is the fact that there is a bid for the CEF structure, Carlyle basically foregoing the IPO of a new fund via their VCIF investment. The lessons here to be learned are that small investment advisers carry additional risks in the CEF world, that illiquid collateral can trade on a firm basis substantially below NAV, and that large fund families do offer more predictability.

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