Description

The S&P 500 Protected Equity Fund is a unique vehicle that offers equity-like returns with A-AA credit risk for those looking for short-term arbitrage profits. PEFX is a closed end fund that will liquidate in November 2007. I believe the return of capital will end up in a range of $10.35-$10.70 per share, depending on the value of the S&P 500 at the time of liquidation. The Fund was set up as a “guaranteed principal” investment at the heights of the S&P in 1999, offering a return of about 70% of the upside in the S&P with none of the downside. This was accomplished by the purchase of in-the-money European-style put options with a portion of the initial capital, while the securities making up the S&P 500 were purchased with the vast majority. Because European style options are not exercisable until expiration day and at the time the question was not IF the S&P 500 would go up over the next eight years but HOW MUCH, the pricing of these options turned out to be quite attractive. Additionally, because the S&P has done so poorly since inception, initial investors are focused on a return of capital, which in the documents speaks to a $10 per share liquidation value. From a buy-in price at recent levels around $10.07 per share, I see a potential IRR of 12%-25%, depending on where the S&P 500 ends up at liquidation date. This is comparable to many merger arbitrage situations, with one major difference – I believe the risk to be much lower. When one considers the risk inherent in the position, it would be difficult to conclude anything other than this security is mispriced. Unless Credit Suisse, whom I believe to be the counterparty to the put position goes bankrupt, this should be a safe vehicle.

The current opportunity exists because of the valuation of the European style options on the balance sheet. S&P European option valuation involves an imbedded discount because of the carrying cost of holding the put. American options receive a premium because they are exercisable at any time during the life of the contract. Additionally, it appears these puts are also being given a liquidity discount, as no market exists for these contracts.

As a result of the above, investors buying now will be taking advantage of a “double discount”. The discount inherent in most closed end funds (currently 2.5%) combined with the discount on the puts. As we approach liquidation day, it is likely the gap between liquidation value and the current price will close.

Here is a summary of where I see liquidation value at different S&P values using a November 15, 2007 liquidation date (all ultimate values per share are reduced by around $.04 per share to reflect net current liabilities):

S&P 500          Value of           Value of

at Expiration     S&P Equities    Put Options      Value/Sh          Investment IRR

1200                $7.60               $3.24               $10.80             34.6%

1300                $8.23               $2.50               $10.70             29.2%

1400                $8.87               $1.77               $10.59             23.9%

1500                $9.50               $1.03               $10.49             18.8%

1600                $10.13             $0.29               $10.38             13.8%

1700                $10.77             $0.00               $10.72             30.6%             

Quick Notes:

-         The expenses of the fund are covered by dividends from the S&P holdings and a small dividend (0.25%-0.5%) is paid annually to fund shareholders (this is not considered in the above analysis and provides incremental value to the IRR analysis).

-         Some of you may wonder if Blackrock will attempt to keep the fund open, rather than liquidate. This is a perfectly legitimate question as a fund management contract is rather valuable. I don’t think this will happen. Reason being, the Fund would need a 2/3 vote of all shares outstanding in order to pass a resolution that proposes to keep the fund alive.

-         One risk is that the put options are structured in some funky way that has not been disclosed. I am making the assumption that the put is a European put with a 1639.47 strike and no strange provisions that allow the counterparty to claw back money. In the original prospectus the fund discussed that the put options were structured to make up the difference between the fund’s value and $10 per share if the S&P was below the value at the fund’s inception (around 1350-1400). The fund has never published the actual put agreement so I don’t know if there is some odd clause in the agreement. I would think that the fund would have to publish it if there were, so I’ve been operating under the assumption that the put should be valued as it appears. But hey, even if there is something like this, your downside is to $10, so not too bad.

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