Description

We are recommending a hedged position in BB Biotech.  BB Biotech is a closed-end fund trading in Switzerland, Germany, and Italy in Swiss franks and in Euros.  It currently trades at a ~20-21% discount to NAV  (CHF share price of 107.80 and NAV of 135.30… and Euro share price of 87.20 and NAV of 110.15).  There are few important differences between BB biotech and many other closed-end funds trading at discount to NAV.   These differences make it easier to hedge the investment by shorting the underlying assets and make the reduction in the discount more likely.  BB Biotech has: 1) relatively low fees/friction 2) relatively concentrated and stable underlying portfolio of liquid positions that are easy and cheap to short and 3) the fund has a clear mandate to close the discount through a set of rules on open market purchases of own stock as a function of the discount.  

1)   The fund fees and expenses:

The remuneration paid to the asset manager is based upon a 1.2% all-in fee model without any additional fixed or performance-based elements of compensation. The fee is applicable up to an average annual market capitalization of CHF 1 bn. It will not apply to the market capitalization exceeding this threshold.   BB biotech is slightly over the market cap threshold with X market cap.

2)   The underlying portfolio:

The fund has a fairly low turnover and is relatively concentrated.   The top 5 positions represent >50% of NAV; top 10 positions represent almost 75% of NAV.  The top 5 positions are Celgene (15.30% of NAV), Actelion (12.00%), Gilead (11.20%), Isis Pharmaceuticals (7.60%), and Incyte (7.20%).

The borrow availability is good on all core positions and borrow rates are all sub 1% with the exception of Actelion which is still very reasonable 1.18%.

These are the borrow rates on Interactive Brokers:

Celgene:  0.15%

Actelion: 1.18%

Gilead: 0.15%

Isis Pharmaceuticals: 0.15%

Incyte: 0.99%

Most of the remaining investments are in other listed companies; investments into private equity are formally capped at 10% of the net asset value and are currently close to zero.

3)   Mechanism of action for closing the discount to NAV. 

Few years ago, the fund used to pay dividend that was a function of the discount to NAV;  the larger the discount the higher the dividend payout.  In 2011 the rule was changed and now the mechanism is even more favorable/tax efficient for shareholders.  On March 21, 2011, BB Biotech initiated an extensive program to reduce the discount:

“The persistently high discount between the Net Asset Value and the share price of BB Biotech AG, currently 21%, has prompted the Board of Directors to take concerted action to remedy the situation with the objective of bringing the discount towards the targeted range of 10% to 15% within the next 12 to 18 months. A steady reduction of the discount will be achieved by firmly reducing the number of shares through a series of share buyback programs.”

At the same time the dividend payments have been discontinued as the board decided that the company’s capital can be more effectively deployed through the accretive strategy.  

Currently the Group can purchase up to 10% of the issued shares. In addition, the AGM approved a share-buy back program of another 10% for the purpose of capital reduction.

Effectively, Bion is selling the underlying asset on the open market at NAV and buying back its own shares at 75-80 cents on a dollar of NAV.  We believe, over time, this is a strong mechanism for narrowing down of the discount.  

For some historical context the discount has averaged 14% over the past 5 years with a peak of 33% (during the '08 financial panic) and a low discount of around 10%.  Going further back, this company has been publicly traded since 1993 and at times as even traded at a premium to NAV.  The chart below outlines the NAV discount since 1993 through 2012.

https://dl.dropboxusercontent.com/u/659242/BB%20biotech%20discount%20to%20NAV%20since%20inception.png 

Finally, we believe that some degree of discount may always remain due to management fees and a liquidity discount.  However we believe the discount will likely close at least partially from the current level of nearly 20-25%.

Risks:

Discount gets wider.  It has been a little wider in the past and could certainly get even wider if the panic in Europe continues.  We would view any widening as a temporary thing, but have no views on timing of when this may happen and how long it may last.  

NAV declines in the non-hedged part of the portfolio.   We realize it may not be practical to hedge/short the entire portfolio.  To the extent the non-core positions decline dramatically, a partially hedged investment  in Bion will suffer. 

Catalyst