Acorn Income Fund Limited — Time to act following wind-up proposals

In the FY20 annual report, AIF’s board announced that it had initiated a strategic review to determine the next steps for the fund ahead of the five-yearly discontinuation vote scheduled for the August 2021 AGM (since postponed). Shareholders had overwhelmingly backed continuation at the previous vote in 2016, but the period following the referendum on European Union membership had seen UK companies (and smaller ones in particular) fall out of favour with investors, leading to a widening discount to NAV for AIF’s shares even though NAV performance remained ahead of the blended benchmark (75% Numis Smaller Companies (excluding investment companies) Index and 25% ICE BofAML Sterling Non-Gilts Index). While the landslide Conservative election victory and the agreement of trade terms with the EU at the end of 2019 appeared to herald a more positive period for UK companies, the onset of the COVID-19 pandemic in early 2020 caused a severe shock in financial markets, with AIF’s portfolio selling off by more than its comparator index (Exhibit 2), compounded by a hit to its income as many companies cut or suspended dividend payments.

The strategic review sought to consider the appropriateness of the investment management structure and investment objectives, with the aim of addressing the discount, expanding the investor base and facilitating the future growth of the fund. With the previous level of dividends deemed unsustainable following COVID-related cuts, the board also sought to determine the appropriate level of sustainable yield, as well as the amount and structure of gearing and its impact on portfolio income.

In an update to the market in May 2021, AIF’s board said the strategic review had led to the conclusion that ‘the current arrangements will not deliver a product with wide appeal to investors and that maintaining the status quo will leave [AIF] facing the same problems of scale and liquidity that have challenged it in recent years’. Instead, it proposed a change in strategy and manager, with the new mandate to be a sustainable global equity income fund run by BMO Global Asset Management, ‘investing principally in a global portfolio of publicly listed companies that offer an attractive level of income and make a positive impact on society and the environment’. However, feedback from investors led the board to announce in August that ‘despite…continuing to believe that the BMO proposal is an attractive investment proposition…an alternative proposal…may represent a more suitable proposition for [AIF’s] shareholders’. This was then followed on 1 September by the announcement of a proposed scheme of liquidation with a rollover option into the Unicorn UK Income fund, set out in more detail below.

AIF’s ordinary shareholders may choose either to roll over their investment into the open-ended Unicorn UK Income Fund (which we consider in more detail below) or to take a cash exit. Those who make no election will be deemed to have chosen the rollover option. In either case, the value of the investment will be calculated after deducting the final capital entitlement of the ZDPs (c £35.5m) as well as setting aside a liquidation pool to cover the quantifiable costs of the scheme and a retention pool for any unforeseen administration costs (not expected to exceed £10,000). In total the costs are not expected to exceed £500,000, of which Unicorn Asset Management has agreed to contribute up to £100,000 (subject to a minimum of £50,000, the final level to be determined by the take-up of the rollover option). Taking a median contribution from Unicorn of £75,000 and applying these figures to AIF’s total assets at 1 October 2021 of c £102.2m would give residual assets of c £66.3m (after deducting the final capital entitlement of the ZDPs and the estimated liquidation and retention pools), which is c 1.5% below the 1 October net assets of c £67.3m. While AIF’s ordinary share discount to NAV has narrowed appreciably since the scheme’s announcement (from 18.6% at 31 August 2021 to 5.4% at 1 October), the estimated residual NAV per share (419.3p) would still represent a c 4.2% uplift on the 1 October share price of 402.5p, with shareholders on the register at 1 October also due to receive a dividend of 7.5p per share on 8 October. Furthermore, Unicorn has agreed to waive the management fee on shares in the Unicorn UK Income Fund for a period of 12 months for AIF shareholders who choose the rollover option.

The principal difference between AIF and the Unicorn UK Income Fund is of course that AIF has two portfolios (smaller companies and income), while the OEIC is a more straightforward equity fund. For this reason, we will consider only AIF’s smaller companies portfolio; fund manager Premier Miton has indicated that the income portfolio is currently being managed to maximise liquidity ahead of the overall mandate moving to Unicorn Asset Management on 13 October. (It is anticipated that Unicorn will oversee the portfolio as the fund is liquidated; however, the new management agreement will take effect even if the proposals are not passed by shareholders.)

The Unicorn UK Income Fund is a much larger vehicle than AIF, with more than £500m of assets under management. However, Unicorn has said that the two portfolios have roughly two-thirds of their holdings in common, which should give investors some comfort as to continuity of approach, as well as limiting the impact of dealing costs during the rollover. Looking at the two funds’ performance (Exhibit 4, right-hand chart), AIF’s NAV total returns have been similar to the total returns of the OEIC over three and five years, although the closed-end fund has outperformed markedly over more recent periods. While some of this may be attributable to differences between the two funds’ holdings, it is more likely to reflect the effect of AIF’s high level of gearing (currently c 52% of net assets, down from c 70% a year ago) in a rising market.

In Exhibits 5 and 6 we compare the two funds’ top 10 holdings at 31 August 2021 (the latest available data). Because this is prior to the announcement of the liquidation scheme, it will exclude any potential further alignment of the AIF smaller companies portfolio with the OEIC that may have occurred since 1 September. While there are five holdings in common, it is worth noting that the five smallest companies in AIF’s top 10 holdings (Warpaint London, Severfield, Somero Enterprises, Ocean Wilsons Holdings and Chesnara) do not appear in Unicorn UK Income Fund’s top 10, and only one of the OEIC’s top 10 holdings, Numis Corporation, has a market cap below that of any of these companies. This is understandable given the far greater size of the OEIC’s portfolio; while AIF can hold a meaningful 3.4% of its small-cap assets in the tiny (£135m) Warpaint London, a similar weighting in Unicorn UK Income Fund would represent c 12.5% of the company. So while the OEIC shares AIF’s bias towards smaller and mid-cap companies, the average market cap of its top 10 holdings is £1.7bn compared with £715m for AIF.

The dividend yield on Unicorn UK Income Fund is c 3.7%, with distributions made quarterly (as is the case with AIF currently). While AIF’s gearing (and to an extent its income portfolio) has historically allowed it to pay a higher dividend (total distributions of 23.0p in FY20 would represent a 5.7% yield on the current share price), the board had cautioned in the 2020 annual report that following the widespread UK dividend cuts as a result of the COVID-19 pandemic, ‘a return to a sustainable and covered dividend will necessitate a lower dividend payment in future years’.

The 7.5p dividend announced on 23 September is in effect a distribution of AIF’s remaining revenue reserves in anticipation of the fund’s liquidation, and brings total dividends for the year to 24.75p per share, a yield of 6.1% on the current share price.

While investors who wish to roll their AIF shareholding into the Unicorn UK Income Fund can in theory do so by taking no action, it is worth noting that the proposal is still subject to two votes: first, a vote in favour of discontinuation at the AGM on 12 October, and second, a vote in favour of the proposals at the EGM immediately following the AGM. Should both votes be passed by shareholders, those wishing to take a cash exit must elect do so in order to avoid defaulting to the rollover option. Key dates are as follows:

The full circular regarding the proposals can be accessed via AIF’s website.