HFRO ​​CEF: A NAV Pop of Credit Suisse Litigation

Written by George Spritzer, co-produced by Alpha Gen Capital

Author’s note: This article was published for Yield Hunting members on October 9, 2022. Please check the latest data before investing.

(The data below comes from on the Highland Income Fund website, unless otherwise stated.)

Fund history

HFRO ​​is an eclectic closed-end fund that invests in a diverse set of asset classes: real estate, timber, CLOs, fixed and floating rate loans.

The fund is quite controversial. It was originally an open-end mutual fund (HFROX) that invested in floating rate loans. In 2017, when it emerged that the fund could win a large payoff in the Credit Suisse lawsuit, the fund began to attract significant inflows and management won shareholder approval to convert the mutual fund from open-ended investment into a closed-end fund. (NYSE: HFRO).

The fund then changed its objectives and now holds a more eclectic set of assets, not just floating rate loans.

Investment approach

• The main objective is to provide a high level of current income, compatible with the preservation of capital.
• Currently uses effective leverage of approximately 12%, but varies over time depending on market conditions.
• Invests at least 25% in assets directly or indirectly secured by real estate.
• Focuses on real estate securities, floating rate securities, secured and unsecured fixed rate loans and corporate bonds, mezzanine securities, structured products, convertible and preferred securities and equities (public and private) .

Three-year discount history for HFRO

Here is the asset allocation as of June 30, 2022:

Portfolio breakdown

Equity	8.7%
Immovable	63.1%
CLO	7.6%
framework	9.0%
Loans	5.4%
Other	6.1%

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Source: HFRO Q2 2022 Fund Fact Sheet

Portfolio – Top 10 stocks (as of June 30, 2022)

Portfolio review – Recent developments since my HFRO article from last year

• October 2021 – HFRO has announced that it has decided to withdraw proposals to convert the Fund from a registered investment company to a diversified holding company. They have completed a $40 million common stock buyback over the next six months (up to $7 million per month), bolstering efforts to narrow the gap between market price and value Net Asset Value (“NAV”) of the Fund and increasing communications with shareholders to improve understanding of the Fund’s strategy and current portfolio. The Advisor posted a Redemption Status Report on the Fund’s website, which was updated monthly. The buybacks were finalized in March 2022.
• March 2022 – Update on Metro Goldwyn Mayer, Inc. “MGM”

“On March 17, 2022, Amazon announced that it had completed its previously announced acquisition of MGM. Following the closing of the agreement, HFRO received $73,284,758 in cash, reflecting direct ownership of MGM shares by the Fund. The Fund also has indirect investments in MGM, through which it is expected to receive approximately $45 million. In total, HFRO is expected to receive more than $118 million in cash from the transaction. Proceeds from the investment alone direct from the Fund have been received so far.

“MGM’s position has been a significant contributor to value creation in HFRO over the past several years,” said Joe Sowin, HFRO’s co-portfolio manager. “It was a pleasure to work with MGM management throughout the investment lifecycle and we wish them well as a new division of Amazon.”

HFRO’s initial investment was in MGM’s debt, which was converted into equity when the company emerged from bankruptcy in 2010. The Fund’s average cost was $24.59/share. The position generated a return of almost 6 times the initial investment.

Fund performance

HFRO’s net asset value performance has been quite good lately on a relative basis compared to broader equity markets and its Morningstar bank loan fund peers. Over time, HFRO evolved from a floating rate bank loan fund to a real estate-focused hedge fund.

Here is the record year-by-year total return performance since 2018, when the fund converted to a closed-end fund format:

	NAV HFRO performance	HFRO ​​market performance	Bank Loan Net Asset Value Performance	Rank in category (NAV)
2018	+1.53%	-12.15%	– 0.47%	seven
2019	+1.48%	+4.20%	+8.82%	94
2020	+4.36%	-8.38%	– 1.26%	1
2021	14.76%	+16.35%	+12.29%	16
YTD	+8.73%	-1.79%	-7.22%	1

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Annualized performance of the fund over three years

HFRO ​​Awards	+2.03%
NAV HFRO	+9.16%
NAV bank loan	+2.62%

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Alpha is generated by high discount + high distributions

One of the main reasons to invest in HFRO now is the potential to capture high discount “alpha” and the possibility of future shareholder activism.

The 9.10% distribution rate combined with the 31.5% discount allows investors to capture some alpha by recouping some of the discount each time a distribution is paid.

When you recover the net asset value of a fund selling at a 31.5% discount, the gain percentage is 1.00/0.685 or approximately 46%. Thus, the alpha generated by the 9.1% distribution is calculated as follows:

(0.091)*(0.46)=0.0419 or approximately 4.19% per year.

Note that this is considerably more than the base expense ratio of 1.67%.

Institutions hold about 35% of the shares.

Here are some activist investors who held shares of HFRO as of June 30, 2022.

Activist	#Actions
Thomas J. Herzfeld	2,487,502
Bulldog Investors, LLP	397,753
Holdings Group Advisor	844 116
Matisse Capital	52,262

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What’s the latest update on the Credit Suisse lawsuit?

On June 28, 2021, a $121 million judgment was entered against Credit Suisse to Claymore Holdings LLC. This is an entity formed to pursue class claims on behalf of HFRO and NXDT.

On July 23, 2021, Credit Suisse filed a notice of appeal against the judgment. The case was heard by the Dallas Court of Appeals, which previously ruled unanimously in favor of Claymore in the final round of appeals.

The total aggregate award consists of damages and prejudgment interest. The reward will continue to earn interest until the appeals process is exhausted. Any final judgment amount would be reduced by attorneys’ fees and other litigation-related expenses.

The net proceeds would then be allocated to the Funds based on the respective damages (approximately 82% to HFRO and 18% to NXDT). On October 11, 2022, oral arguments were presented at the Texas Fifth District Court of Appeals in Dallas.

Highland Income Fund

• Total investment exposure: $1,151 million
• Total common assets: $1,011 million
• Annual distribution yield (market) = 9.02%
• Last regular quarterly distribution = $0.077 (Annual = $0.924)
• Base fund expense ratio: 1.67%
• Discount on NAV= -31.09%
• Effective leverage: 12%
• 3-month average daily volume (stocks) = 199,175 (Source: Yahoo Finance)
• Average daily dollar trading volume = $2,000,000

HFRO ​​is a fairly liquid stock and typically trades with a bid-ask spread of around three cents. There is often a limited size available on both the bid and the ask, so care should be taken when trading HFRO. If you use a market order, you will usually get price improvement and receive a price somewhere between the bid price and the ask price.

I believe HFRO is a good buy now for opportunistic investors.

If HFRO receives a large reward from the lawsuit, there should be a significant “pop” in NAV, which could reach $0.75 per share.

Even if HFRO ultimately loses the case and receives nothing, I think the current 31% discount and high payout yield make the fund a decent buy in any case. If you look at the graph below showing the NAV and market price performance for HFRO year to date, you can see that volatility has been quite low and performance has been quite good during the bear market of 2022.

HFRO ​​- Net Asset Value and Year-to-Date Market Price