Description

Castle Alternative Invest (“Castle AI" or "CAI")

Bottom-line: Castle AI is a closed end fund of alternative asset managers trading at a discount to NAV of 25% and is buying back shares on a daily basis to close the discount to NAV. An investment in the shares is an opportunity to invest in a reputable fund of funds at a steep discount to NAV. 

Castle AI or Castle Alternative Invest is a Swiss investment company specializing in hedge fund investments. The company’s investment objective is to provide shareholders with a long-term capital growth through investments in well diversified and actively managed portfolio of hedge funds, managed accounts, and other investments vehicles. Castle AI charges a 1.5% management fee and 10% performance fee.

Castle AI was founded in 1996, listed on the SIX Swiss Exchange in April 1997 and on the London Stock Exchange in June 2009. The fund is listed in USD under the tickers CASND SW (SIX) and CAI LN (LSE), and under Swiss Francs under the ticker CASN SW (SIX).

The fund is managed by LGT Capital Partners ($22bn+ in HF and PE AUM), a global alternative investment manager whose focus is on hedge fund and private equity research and investing.

Strong Performance

The fund is up 148% since inception in 1997 vs. 51% for the MSCI World Price Hedged USD Index. CAI has annualized returns at just over 6% since inception. The fund has exhibited decent downside protection. In 2008, the fund was down 14.6% versus a nearly 40% decline for the MSCI World Index. The fund lost money in three years since inception in 1998 (-2.1%), 2008 (-14.6%), and 2011 (-6.4%).

Historical Performance (as of August 31, 2012)

YTD Performance: 5.06%
Cumulative net return: 154.43%
Annualized net return: 6.14%
Annualized standard deviation: 5.49%
Sharpe ratio: 0.48
Correlation to MSCI World Index: 0.49
Correlation to JPM Global Bond Index: -0.10

NAV performance in USD (from Jan 1997 to Aug 2012)

Source: company reports

http://www.castleai.com/uploads/media/August_2012.pdf

About LGT Capital Partners

LGT Capital Partners (“LGT CP”) is a leading alternative investment manager, based in Pfaeffikon, Switzerland with offices in New York, London, Dublin, Hong Kong, and Tokyo. The firm manages over $22bn in hedge fund and private equity assets and has an international team of over 180 professionals.

For over 15 years, LGT Capital Partners has invested in hedge funds and private equity funds on behalf of its global investor base of over 300 pension funds, insurance companies, banks, endowments and foundations. The firm provides alternative investment solutions to institutional investors through a broad range of fund of funds programs. LGT CP is a large proponent of eating its own cooking with a substantial proportion of its employees’ own investable assets in the same programs as clients.

http://www.lgt-capital-partners.com/en/index.html

The Discount to Net Asset Value

The fund currently trades at a discount to NAV of 25%. CAI traded at a maximum discount of 50.0% on November 21, 2008 and a median discount of 12.9% since the USD trading began in early 2002. If the fund returned to its median discount of 12.9%, we would have a 17.1% return plus whatever accretion we receive from buying back stock below NAV.

Premium/Discount

Source: company reports

http://www.castleai.com/uploads/media/prem_dis_USD_01.pdf

Share Buyback (The Second Trading Line Program)

CAI has been active in repurchasing shares nearly every day with purchases ranging from 5K to 20K shares. While it’s the right thing to do, it is also in the best interests of LGT CP if the asset manager ever intends to list a closed-end fund again or doesn't want this reflecting poorly on the company's abilities to be investor friendly. CAI purchased ~10% of shares outstanding per year for the past few years and has intentions to continue doing so given the significant discount to NAV.

A Second Trading Line program is mainly used in Switzerland with a few key nuances but this is neither here nor there for the thesis. For shares purchased on the second trading line, Swiss federal withholding tax of 35% of the difference between the repurchase price and the nominal value of the ordinary shares of CHF 5 is deducted from the repurchase price. The tax inefficiencies of CAI are one of the bigger pitfalls of the investment.

Mark White, co-head of listed investment companies at LGT: “The board of Castle AI believes in an active approach to managing the discount to net asset value and has implemented this program to support the price at which shares trade in the secondary market. The company has a long track record of delivering positive returns, proving an effective investment vehicle for investors wishing to enhance their portfolio diversification. The second trading line should help to tighten the discount, and should result in a share price which better reflects the value of the company and the quality of its underlying investments."

At the AGM held on May 18, 2010, the company approved a second trading line on the SIX Swiss Exchange to purchase up to 10% of issued share capital by December 10, 2010 at a discount to NAV as low as 5%. CAI completed the repurchase program on October 11, 2010 by repurchasing 11.29% of the shares on issue (post reorg) for 31.9mm Swiss francs and cancelled 2,225,464 shares at the 2011 AGM.

At the AGM held on May 17, 2011, the company approved a second trading line on the SIX Swiss Exchange to purchase up to 10% of issued share capital by June 5, 2012 at a discount to NAV as low as 5%. CAI completed the repurchase program on June 5, 2011 by repurchasing 9.74% of the shares on issue for 19.5mm Swiss francs and cancelled 1,128,779 shares at the 2012 AGM.

At the AGM held on May 15, 2012, the company approved a second trading line on the SIX Swiss Exchange to purchase up to 10% of issued share capital by June 5, 2013 at a discount to NAV as low as 5%. The board announced it intends to do whatever it takes to narrow the discount to NAV at the board meeting: “The board reiterated its commitment to moderate the volatility of the share price discount to NAV through share buybacks and such other techniques as may be permitted within existing regulations and are tax efficient to investors.”

There is a potential for more discount to NAV narrowing actions. Tim Steel, the Chairman of Castle AI, stated in the 2011 Annual Report: “The board remains convinced that a well-diversified portfolio of hedge funds can deliver attractive risk adjusted returns but this must be associated with only a modest degree of discount volatility and with stronger share price performance. We will continue our efforts to achieve this in the coming year, not only through share buybacks as we have done in the past but also using such other techniques as may be permitted within existing regulations and which are tax efficient to investors.” Something else other than buybacks could be in the works if the discount remains at 25%.

Management Team

While the fund is only $240mm, the fund sports a strong roster of investment professionals, at least on paper, leveraging the $20bn platform of LGT Capital Partners. Thomas Weber, LGT CP’s Chief Investment Officer Hedge Funds, has been lead portfolio manager since launch and personally owns 34,150 shares as of December 2011.

http://www.castleai.com/uploads/media/CAI_Investor_presentation_April_May_2012.pdf

Investment Objective

To provide shareholders with long-term capital growth through investment in a well diversified and actively managed portfolio of hedge funds, managed accounts, and other investment vehicles.

Access to Managers

A major value driver is represented by the investment manager’s experience and access to excellent hedge fund managers around the world. Castle AI is able to provide access to hedge funds that are currently closed to new investors. The majority of the assets are invested with managers that have achieved a consistent and superior investment track record in their market segment, while a minority may be made with younger managers.

The annual report has a good breakdown of the investment managers:

http://www.castleai.com/uploads/media/CastleAI_annual_report_2011.pdf

Largest Portfolio Holdings (Funds Over 2%+ of NAV) at 2Q12

Source: company reports

Breakdown of the Top 5 Managers

The fund’s largest position is a 12.4% stake in a Crown Managed Futures Segregated Portfolio, which is a diversified program of managed accounts with systematic CTAs and macro traders. LGT is the manager of the fund, which is up over 150% since inception in October 2000.

“Launched in October 2000, CMF is one of the world’s oldest CTA/macro multi-manager managed account programs. With $1.5bn of allocated assets it is also one of the world’s largest. CMF investors benefit from the program’s proprietary managed account platform, which enables full transparency on the more than 450 instruments held by its 15 managers. In addition, CMF is able to respond quickly to changing market conditions through the daily liquidity it has with underlying managers, while investors enjoy weekly liquidity on their CMF investment.”

http://www.lgt-capital-partners.com/_news/en/Crown_Managed_Futures_celebrates_10th_anniversary_en?DCSext.nav_type=1

One of my initial concerns with CAI was the self-dealing but the investment manager (or any of its affiliates) waves or compensates CAI for any additional fees above and beyond the initial management and performance fee CAI charges. One might even argue that CAI is providing (or attempting to provide) a value-added service that large pension funds and endowments typically receive with large SMAs. (http://www.bloomberg.com/news/2011-11-04/texas-teacher-fund-hires-kkr-apollo-to-oversee-6-of-assets-2-.html)

Crown Managed Futures Performance

Sources: Company reports

Discovery Global Opportunities Fund (6% of NAV) invests in emerging market economies in equities, debt, and currency and is run by Robert Citrone, who came out of Tiger. Discovery employs a combination of top-down analysis and bottom-up security selection, centered on specific themes within an economic region or individual country, sector within a country, or sector in an economic region.

Discovery Global Opportunities Fund Performance

Sources: Company reports

HBK Offshore Fund (5.0% of NAV) is a global multi-strategy fund with a focus on relative value and event driven (distressed and risk arbitrage) and is run by Jamiel Akhtar.

HBK Offshore Fund Performance

Sources: Company reports

Zebedee Focus Fund (4.9% of NAV) is a long/short fund which combines bottom-up stock-picking with top–down macro views and market timing. It was founded by Julian Edwards and has annualized 18.9% since it launched in February 2008. The $800mm strategy, which is hard-closed, runs a concentrated portfolio of around 15 positions, favoring low net exposure and no leverage.

Zebedee Focus Fund Performance

Sources: Company reports

Amiya Global Emerging Opportunities Fund Ltd (4.3% of NAV) is a long/short fund which combines a top down and bottom up approach investing primarily in global emerging market equities. The fund employs a strong bias to liquid/large cap equities and inherently BRIC markets. The currency exposure is hedged and the leverage limited to 50% of NAV. The exposure management is flexible and regionally the fund aims to be diversified, investing maximum 25% in a single country. It is managed by Ian Mukherjee.

Amiya Global Emerging Opportunities Fund Performance

Sources: Company reports

The breakdown of investment styles is 27% in long/short, 24% in event driven, 19% in macro, 18% in relative value, and 12% in CTA.

Style Allocation at 2Q12

Source: company reports

The fund is primarily in global managers (64% of NAV). The rest is in Europe (15%), North American (14%), and Asia (7%).

Geographical Focus at 4Q11

Source: company reports

Surprisingly, CAI has good liquidity when it comes to its portfolio of funds. 75.6% of the fund’s assets can become cash in 6 months or less. It would take over a year to liquidate 6% of the NAV.

Liquidity of Investment at 4Q11

Source: company reports

Restructuring Event in 2009 with the Largest Shareholder

Swiss Life (49% shareholder at the time) approached the independent directors in 2010 to “seek an orderly exit from the Company by disposing over time its shareholding of 18,793,940 shares” largely driven by regulation for financial companies (increased capital requirements). Castle AI entered into an agreement with Swiss Life to cancel the shares and transfer Swiss Life’s holding to CAI Ireland, an open-ended investment company. This was an overhang at the time but is behind the company now. The only negative I can see from this is the fixed costs spread over fewer assets and the 0.18% hit to NAV from the expenses from the restructuring.

Risk Management

• 15% investment limit in any single manager and no more than 10% of assets in any single investment.
• Borrowings shall not exceed 30% of NAV at time the borrowings are made.

Peer Analysis

There are a number of publicly traded fund of funds that all trade at discount’s to NAV. CAI stacks up as one of the most attractive with a discount to NAV of 25% versus the median peer median discount of 10.8% and average of 13.9%.

Comparable Funds

Note: As of 10/12/2012. Source: Bloomberg

Potential Liquidation

The liquidation of CAI is definitely a possibility given peers are liquidating left and right. Listed FoFs in wind-down according to Jefferies are Acencia Debt, Blackrock Absolute Return, Goldman Sachs Dynamic Opportunities, and Signet Global Fixed Income. CAI's sister fund, Castle Private Equity, with $671mm in assets as of September 2012, was engaged in a proxy fight by Abrams Capital, run by David Abrams. The fund agreed to begin a harvesting strategy and reduce the management fee to 1% from 2% (http://www.castlepe.com/en/cpe/news/news-details/article/39/board-recomm.html?no_cache=1). The fund’s discount to NAV has since narrowed to 17% from 25%. This is a great example of what can happen to a very similar fund.

Tim Steel, the Chairman of Castle AI, stated in the 2011 Annual Report: “The board remains convinced that a well-diversified portfolio of hedge funds can deliver attractive risk adjusted returns but this must be associated with only a modest degree of discount volatility and with stronger share price performance. We will continue our efforts to achieve this in the coming year, not only through share buybacks as we have done in the past but also using such other techniques as may be permitted within existing regulations and which are tax efficient to investors.” Something else other than buybacks could be in the works if the discount remains at 25%.

A good example of a FoF in liquidation is the Absolute Return Trust Ltd. Shareholders approved on September 7th for the Absolute Return Trust Ltd (ABR LN) to liquidate and return assets of $335m to investors. The discount to NAV was 15% over the past year and now the fund is trading at a 6% discount.

“After extensive shareholder consultation, the board of Absolute Return Trust Limited has resolved not to seek continuation of the Company.

Notwithstanding a compound increase in the NAV of some 4% per annum since inception, the discount of the Company's share price has steadily widened over recent years. This has occurred despite persistent share buybacks and capital returns at NAV via the operation of the redemption facility. In discussions with shareholders the persistence of the discount was identified as a key investor concern. The Board has explored a variety of ways to address the discount for the benefit of all shareholders and has concluded that in current market conditions there is insufficient demand for a closed ended company that invests in a multi-manager portfolio of hedge funds to warrant continuation.”

Negatives

• Tax inefficiencies
• Illiquidity
• It should go without saying that if you have a generally bearish market view over an intermediate time frame, the discount could widen in a market selloff but this can clearly be hedged. Plus, I believe CAI is built to outperform in a downturn.

Additional Details About Castle AI

Investment manager  
LGT Swiss Life Non Traditional Advisers

Investment adviser
LGT Capital Partners

Administrators
LGT Bank in Liechtenstein
Credit Suisse Administration Services (Ireland)

Sponsor and Broker
RBS Hoare Govett

Auditor and reporting accountants
PricewaterhouseCoopers

Swiss legal counsel
Niederer Kraft & Frey
UK legal counsel
SJ Berwin

Fees
1.5% management fee and 10% performance fee.

Catalyst