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Activist Track: Korea Equity With a Twist

The action around the Korea Equity Fund could signal a seachange in country-specific closed-end funds.

This column was originally published on RealMoney on Aug. 2 at 12:46 p.m. EDT. It's being republished as a bonus for readers.


Korea Equity Fund


is facing a battle between its two largest shareholders, as well as the fund's management that could potentially create a buying opportunity in the next few weeks.

All of the parties involved agree on one thing: There are reasons to be bullish on Korea. In the past few years I've been a


on Korea. The country is experiencing massive growth, its market has traded at single-digit P/Es for years, and the market has experienced a largely artificial selloff due to worries about either North Korea or potential slowdowns in China. Neither of these worries has done much to slow down the growth in GDP in South Korea.

But that raises the question of how best to invest in that premise. An examination of the battle taking place on KEF provides a clear idea on how to play that fund, which is one tool investors have used to access the Korean market, and could lead to ideas on other closed-end funds as activists stretch their muscles and aim for more liquidations.

Over the past year, KEF has gone through an activist battle involving Harvard College, which owns 29% of the fund, and the Nierenberg family of funds, which owns 7% of the shares. Within the past week, this battle has taken another interesting twist.

Last July, I wrote

A Primer on Closed-End Fund Arbitrage

and explained why closed-end funds often trade at discounts to their net asset value. These discounts could range anywhere from 0% to 30% and usually reflect the cost of liquidating the portfolio, taking in a discount for taxable gains as well as reflecting a discount for illiquid securities or lack of trust for the managers. Often activists will accumulate shares of a closed-end fund if it's trading at a larger-than-normal discount to its NAV and then pressure the fund to become an open-end fund, which would immediately eliminate the discount.

In March 2005, Harvard filed a 13D stating that it felt KEF should be turned into an open-end fund and be liquidated, eliminating the discount to NAV. It felt that KEF was too small to be cost effective and too small to amortize the fixed costs of managing the fund. David Nierenberg, manager of the Nierenberg Family of funds, also filed a 13D supporting Harvard's move. In May, Harvard called for a vote at the annual meeting, scheduled for next week on Aug. 10, to vote to liquidate the fund.

Harvard, the largest shareholder of KEF, has successfully applied this strategy to other funds. From 2000 to 2002, Harvard had accumulated 23% of

The Asia Tigers Fund

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, which was trading at a 25% discount to its NAV when Harvard first began buying. Harvard pressured the fund into periodically buying back its shares in order to reduce the discount. By the time Harvard had sold its shares in November 2003, the discount had been reduced to 7% and the stock had risen 45% since they had first begun buying shares.

Activism With a Twist

In a surprising reversal, on June 30, Nierenberg filed a 13D filing stating that he was now supporting the management of KEF and not supporting Harvard's request for liquidation. Specifically, he wrote:

"We have continued buying shares of KEF because we view it as an attractive long-term investment, rather than a short-term arbitrage. Korea is home to some of the world's leading companies, such as Samsung and Hyundai. Korea's long term economic growth rate is approximately 50% higher than ours in the U.S. Yet the average forward price-earnings ratio in Korea is less than half of ours. We have changed our minds about how we will be voting ourshares and intend to support the continued independent existence of the company."

When I spoke to David Nierenberg two weeks ago he mentioned that he felt the discount had narrowed sufficiently and there was no more need to go for a liquidation and that the costs of liquidating might exceed the current 3.5% discount to NAV that currently exists.

In fact, looking at the chart of KEF's discount to NAV since its inception in 1993 shows that KEF is trading at its smallest discount to NAV since 1999.

Korea Equity Fund
The current discount to NAV negates any advantage to liquidation


With a discount of only 3.5%, according to Nierenberg, it's unlikely that the costs of liquidation will save any money compared with just keeping the closed-end fund intact.

Making it all the more confusing, Nierenberg told me that Harvard called him directly telling him that if he did not buy its shares they could end up hurting the stock if they sold following the Aug. 10 vote if that vote went against Harvard. "Why are they so eager to get rid of their shares?" Nierenberg asked.

Harvard's position in KEF is represented by Sowood Capital Management, run by Jeffrey Larson, who formerly worked at Harvard before starting up Sowood. For the 12-plus years Larson was at Harvard, his portfolio of foreign equities returned 15.3% a year. He left Harvard with about $700 million in seed funding for his new firm.

I called Sowood and spoke with Megan Kelleher, Sowood's general counsel. Her view is that shareholders will still get value in a liquidation and that the costs of liquidating should not exceed the current discount to NAV. Also, she feels there are better vehicles out there for making a bet on Korea and it's impossible for Harvard to get out of its position without the fund liquidating since, although many of the underlying positions of the fund are very liquid, the fund itself is not very liquid.

Yesterday, Institutional Shareholder Services (ISS) released an opinion favoring the Harvard position. The firm recommended that shareholders vote on the dissident proxy card and in favor of a liquidation of the fund. It points out that for the one-, three- and five-year periods, the fund's NAV performance has lagged the KOSPI Composite Index, which tracks the Korean Stock Exchange, by substantial amounts.

ISS also points out, however, that any liquidation of the fund would prevent the fund from using a substantial capital loss carryforward that could've been used to offset future gains, and further sees that shareholders would face tax consequences in a liquidation. That said, its final recommendation is to vote for termination of the fund's management agreement and to vote for a liquidation of the fund.

In terms of KEF, I don't have a specific play at this point. Perhaps the best thing to do is wait for the vote on Aug. 10. If the vote goes against Harvard and it decides to liquidate its position, the discount to NAV will widen significantly and the share price will drop. At that point there will probably be a buying opportunity.

Interestingly, ISS also noted that the "emergence of ETFs have increase the supply of investment vehicles covering South Korea and therefore may have systematically undermined the market performance of closed-end country funds." Given that, the firm wrote that "the fund many find it more difficult to return its share price to NAV."

This trend toward country-specific ETFs extends to every country and could signal the potential demise of many country closed-end funds. Other funds that Sowood has large positions in but has not been as active with are the

Korea Fund

(KF) - Get The Korea Fund Inc. Report

and the

Brazil Fund


. These funds may bear following so as to see if similar battles result.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Korea Equity Fund and The Asia Tigers Fund to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of

Trade Like a Hedge Fund


Trade Like Warren Buffett. At the time of publication, neither Altucher nor his fund had a position in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback;

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