JZ Capital Partners and a disastrous shift of strategy
The grim tale of JZ Capital Partners, the UK’s worst-performing investment trust, presents a cautionary tale for all investors, writes David Stevenson.
Move over Neil Woodford – there’s a new challenger in town for the biggest single investment disaster in the investment trust market. That contender is JZ Capital Partners (listed in London under the ticker JZCP), whose recent market update reveals the grisly wreckage of a disastrous decision, made back in 2012, to appoint a co-manager comprising two partners not that long out of university with a grand total of 12 years’ experience between them, to build a $1bn real-estate portfolio.
At the centre of this tale is an echo of the Woodford affair – a decision by managers who were experienced in one sphere (in this case, private equity) to switch focus to a seemingly more exciting asset – in this case, real estate. However, by failing to stick to their core competency, the investment advisers have destroyed hundreds of millions of dollars in investor value – an error only slightly redeemed by the fact that the managers and related parties themselves are some of the biggest shareholders.
This slow-moving train crash has been a long time coming. In October, the market got wind that something wasn’t right when, in an unusual move, the trust postponed its results due to concerns over valuations. And since January, no monthly fact sheets have been forthcoming. But the full scale of the fiasco only emerged a few weeks ago in a market update. As analysts at Numis reported, the full-year results revealed that for the year to 29 February the net asset value (NAV – the estimated value of the underlying portfolio) “was down 38.8% mainly driven by the real-estate portfolio, detracting 42.5%, as well as the European micro-cap portfolio (-2.5%) and finance costs (-2.4%)”. Worse still, the trust scrapped a call with analysts and said there would be no more monthly NAV updates until “circumstances allow the company to make informed judgements as to value”.
A disastrous change of direction
How did we get here? Initially, JZ had a focus on US small-cap buyout companies. By the early part of the last decade that strategy had been tweaked to allow similar private equity-style investments in European buyouts. The traditional focus for the managers has been to invest in industrial services and testing businesses and at first their record was far from pedestrian. The investment adviser is Jordan/Zalaznick Advisers, Inc., which was founded in 1986 and is led by experienced industry veterans Jay Jordan and David Zalaznick, who have invested together for more than 35 years.
But anyone checking the company’s interim results from the end of August 2019 would have noticed something of a shift away from private equity – at that point the near-$1bn portfolio comprised legacy holdings in US micro caps, amounting to $425m, sitting alongside a hefty $427m exposure to US real estate. It’s this latter exposure to property that seems to have gone badly wrong.
Even before the Covid-19 crisis erupted, concerns were being voiced about the value of the properties in the portfolio provided by one independent appraiser. As a result, the managers brought in a different independent valuer for a second opinion. According to the recent market update, as a result of this new valuation, the managers have now written the value of two developments, Fulton Mall ($53.2m at 19 February) and Design District ($98.5m) down to zero. According to Numis, “the board note several factors, including the general decline of retail, and in New York regulations adversely affecting residential properties, leading to weakness in the Brooklyn and South Florida real-estate markets. In addition, there has been either an inability or a delay in executing strategic investment plans. High loan-to-value ratios at the property level have also exacerbated the effect of falling appraisals on the fund’s equity investments”.
Investors’ dissatisfaction with JZ has been a feature for some time. In 2015, for example, the fund ran a large placing at a 40% discount to NAV, antagonising many institutional investors. But as noted above, the root of today’s problems lies in that decision in 2012 by the private-equity managers behind the fund to take a punt on property developing. They formed a joint venture with a real-estate developer called RedSky Capital, which had been formed in 2006 by Ben Bernstein and Ben Stokes. The two Bens had established their business on graduating from Cornell University (also Zalaznick’s alma mater). On paper, RedSky looks professional. Its “asset management team of four boasts 25-plus years of collective experience, while the development and construction management team of five has a total of 30-plus years’ experience”. Its strategy was revealed in a lengthy video interview with one of the firm’s founders: “[we] go top down, we look at the market, the cycle, how the financial and lending markets are working, and come up with themes…. One of the things I’m most proud of is our hit rate is off the chart….when I go after a deal I pretty much know I’m going to win it”.
Many happy returns – for the managers
Alan Brierley, a funds analyst at Investec, has been doggedly digging into the JZ story for years now. According to the research he’s compiled, between 2012 and February 2019, RedSky put together a portfolio of 61 companies for JZCP, investing $394m. Initially the focus was on Brooklyn; it then broadened out to Miami in 2015. By February 2019, the split was 60% Brooklyn, 40% Miami. Brierley’s verdict on this investment spree is damning. It was, he says, an “unfathomable and cataclysmic decision to appoint RedSky Capital, effectively two partners just out of university with a grand total of 12 years’ aggregate experience, to build a $1bn real-estate portfolio”. This decision “has left a mark on both the credibility of the board and the investment adviser, and destroyed the performance record”.
Dig around inside the RedSky portfolio and one can sense the damage – the website contains no news updates since the end of 2018. The company’s CUBE project in Miami’s Wynwood district seems like a big bet – but there are obviously still plenty of vacant spaces available via the letting agents. With a total of 64,435 square feet to fill, the company’s website reports that office space is still available on floors four to eight. A recent newspaper article from the Miami Herald hints at the dismal wider context, observing that “office space development in Wynwood keeps growing, but some South Florida brokers are struggling to find tenants to fill the new inventory”. Indeed, the paper quotes an expert from real-estate advisory firm CBRE who reckons that “it will take five years for Wynwood to see its office market fully occupied”.
What investors can learn from this
In light of the dire trading update, the damage now seems complete for this huge property portfolio. The share price certainly tells its own story – at 95p a share (and falling), the fund is down by 80% over one year. According to Investec, JZCP ranks 747th out of 747 UK-listed open and closed-end funds over the last 20 years. And yet this hasn’t been reflected in the fees paid to the managers – in another note from February (entitled Peak Gravy?), Investec points out that the advisers have received base fees, capital incentive fees and income incentive fees of around $216m, although some of these have since been returned due to the dire performance. The chairman, meanwhile, “is paid one of the highest fees in the closed-end industry with cumulative fees paid approaching $2m” since 2006.
Those shareholders left standing must now reckon with concerns over accumulated debts. Impending loan repayments include a $150m loan, due 12 June 2021; convertible unsecured loan stock of £38.9m, due 30 July 2021; and zero dividend shares worth £57.6m, due 1 October 2022. If there is any small consolation, it’s that most of the shareholders seem to be US institutions, while the fund managers and related parties themselves are big holders – Zalaznick and affiliates plus Jordan and affiliates each hold about 13% of the ordinary shares, while an entity called Edgewater owns about 23%. I can’t see any big UK shareholders on the top ten investors’ list.
What are the lessons for investors from this fiasco? Stepping back, one can only wonder: what on earth possessed the managers and the board to make such a huge strategic shift from a core competence in small private businesses to high-profile, high-risk property development? At least Woodford could boast some success with his move from blue-chip income into investing in private (mostly tech-related) firms – he scored at least a few hits with university spin-outs. With this private-equity fund, by contrast, one is left wondering what competence the mandated fund managers – JZ – could boast in property? Why did no one on the board put a check on the huge level of fees paid out, or stop the strategic shift? And now that the mess needs to be sorted out, what chance do the managers have of selling their remaining private-equity assets for decent prices in such a hostile market environment? So the key lesson is simple. When a manager who has been successful in one field abruptly shifts strategy, be very wary indeed. That goes double if the new focus involves an illiquid asset class, where it’s harder to spot problems early.