Pinetree Capital – Possibly the worst closed-end fund, ever

This article is about Pinetree Capital (TSX: PNP), which came across my radar a few months ago when doing some casual screens of the market.  I’ve analyzed this one many, many years ago and dismissed the idea for obvious reasons.  Nothing much has changed since then other than that management has blown about half a billion dollars – this is an accomplishment that very few non-fraud artists can claim.  The firm itself is quite easy to analyze.

The company functionally operates as a closed-end fund that invests in extremely risky microcap ventures in the mining sector. They were lucky enough to catch the uranium boom half a decade ago, but judging by their subsequent performance it was likely due to luck more than anything else. Their existing investment portfolio is full of unrealized losses in failed ventures:

With a whopping 378 investments, this company is a functional proxy for the TSX Venture exchange index.  And as investors might know, the Venture exchange has taken a serious beating over the past year, especially as most gold ventures have cratered (the TSX Venture is down 24% year to date, while you can see Pinetree capital’s portfolio is down about 45% in a year where there is a raging bull market in practically everything else than what Pinetree is invested in).

It is kind of amazing to see the $494 million unrealized loss row on the financial statements as this type of prowess in investment picking should be carefully harvested in a hedge fund designed to mirror 180 degrees exactly whatever the Pinetree investment committee chooses to engage in.  Investors would have made a fortune.

On the balance sheet side, the asset portfolio is primarily capitalized with $388 million equity from generous investors and the usage of convertible debentures (TSX: PNP.DB) of which $61 million is currently outstanding.  Strictly in terms of assets and liabilities, the debentures are the only major liabilities on the book and they are currently the only debt on the books (aside from some broker margin loans that arise from time to time):

There are a couple comments I will make on asset quality (or lack thereof):

1) Fortunately, most of them ($124 million) are level 1 assets, which means that there is some external methodology (market quotations) that can be attributable to how management values them.  The level  2 and 3 assets I would mentally write off.  Even the level 1 assets will likely have questionable amounts of liquidity (given that the history of the corporation is to purchase minority stakes in various junk firms) and should be mentally discounted for this reason.

2) The company is likely to exclude the $23 million in deferred tax assets when they release their year-end audited report as it will be a very, very long time before they’ll be able to use it all.  In fact, one of the likely liquidation scenarios for the entire firm is to sell the whole thing to somebody that knows what they are doing, and will recapitalize the firm and utilize all the capital losses the company will be booking – indeed, if you journal the half billion in losses, the company does have about $65-70 million in a reasonable capital tax shield to a potential acquirer.

This tax asset does have hidden value, but you have to get by the fact that management has a heavy severance penalty.

So when doing some mental adjustments on these assets (eliminating the deferred tax asset, eliminate level 2 and level 3 assets, and taking a 20% haircut off the level 1 assets) you have about $100 million, offset by about $61 million in convertible debentures.  The residual $39 million is reasonably close to the current market cap of the company ($42 million at present).

Management is entrenched in the company and they make a pretty profit from simply being there.  I will let this chart speak for itself:

Suffice to say, pulling a cool million a year out of this train wreck is rivaling what Robert Mugabe has done to Zaire Zimbabwe over the past few decades.

So what is the thesis on this train wreck? The answer is in the debentures.  They are trading at around 2/3rds of par value for obvious reasons – they mature in May 2016 and investors are wondering whether the level 1 assets are going to have any hope of recovery or not.  That said, there was a covenant in the debentures that required the company’s liability to asset ratio to not be greater than 33%, which they breached earlier this year (mainly due to losses on their investment portfolio).  They had to arrange a special meeting to obtain a partial cure (where the liability to asset ratio would be 50%) for 9 months, and endeavour to buy back some debentures and raise a little more equity capital on a best efforts basis.  They were able to obtain this by giving out a 6% sweetener and increasing the coupon from 8% to 10%, effective at the end of this month.

If the company didn’t broker this deal, debenture holders could have foreclosed on the entire firm and then there would be a firesale to make the debtholders whole.  Indeed, the salaries of top management could be used to pay for bankruptcy trustees.

In addition, the following terms and conditions were agreed upon:

It is clear that there is some large holder out there of the debenture that is dictating terms to the company.  Notwithstanding the external pressures being applied by the major debenture holder, management still has firm control of the company and it is clear that nobody rational would ever want to own the common shares of the business.

Management has a clear incentive to seeing that this train wreck continues as long as possible – it is a million dollar per year vehicle to extract capital out of unwitting investors and this incentive should make it possible for them to get rid of the pesky debenture holders by just selling enough assets and getting rid of them.

Of course, the scenario of destruction is that management will continue to bleed away their asset base.  At the rate they have been going, they will hit zero at 2014.  I think the value of the gravy train is more of a powerful force for management than trying to screw over debtholders, however.

The debentures can be redeemed at maturity for shares of common stock at 95% of the market value at a pre-defined time before maturity.  This is the ultimate nuclear button for management, but it would virtually ensure they would lose control of the firm at this point.

There is the additional catalyst of the 9 month deadline for the company to once again be compliant with the 33% liability-to-asset ceiling.  This is June 12, 2014.  By then, the company should have bought back $20 million in debentures and raised $5 million in equity.

The risk/reward dynamic here is obvious – if the Venture index does not plummet any further, debtholders should come out whole and also receive some very healthy-sized coupon payments along the way as compensation for holding onto the train wreck.  The risk is the aforementioned market risk with the index-like exposure the company has to the penny stock market.

Anyhow, I took a position in this early July before some other insightful writer identified this opportunity and it became public on Seeking Alpha.  It received a temporary boost-up in value then, but it has recently sunk to values that made me want to write about this in case if somebody wanted to hold their nose and purchase some of this stinker – the debentures, not the equity.