BSTZ: Why This CEF Is Outperforming The Sector (NYSE:BSTZ)

What is the BlackRock Science and Technology Term Trust?

The BlackRock Science and Technology Term Trust (NYSE:BSTZ) is an equity closed end fund that invests in the technology sector. The fund was launched during the summer of 2019 as a follow up to the extraordinarily successful BlackRock Science and Technology Trust (BST), which we recently covered. Managed by BlackRock (BLK), the world’s largest asset manager by AUM, BSTZ has been a top performer in the technology closed end fund sector alongside BST. Since inception, BSTZ has notably trailed BST and the broader technology sector despite similar sector focus.

The devil lies in the details for BSTZ. Simply put, the fund launched during an exuberant period when demand for technology-oriented investments including semiconductors and software peaked. The slowdown impacted BSTZ more significantly than sister fund BST or indexed technology funds such as the Vanguard Information Technology Index Fund ETF (VGT). As the IPO markets begins to defrost and private equity activity ramps up, BSTZ has begun to outperform.

Nearly three years ago, we discussed BSTZ in depth. The fund has been reshaped since our previous coverage including changes to the portfolio and a restructure of the monthly distribution. Today, we are going to revisit the fund and explore the turnaround that is beginning to take shape.

The Fund

BSTZ invests in the largest and most successful companies across the technology sector. BSTZ enhances portfolio returns with a yield generating covered call strategy. Covered calls are a conservative derivative strategy designed to generate additional income. This strategy is most successful during flat markets and may underperform during significant market runs. For shareholders of BSTZ, the options strategy provides additional income to support the fund’s monthly distribution.

Looking in the portfolio, the largest holding is Nvidia Corporation (NVDA) at nearly 8% which continues to lead the technology sector with AI innovation. NVDA alone has powered a significant portion of return across indices including the S&P 500. Most of the portfolio is invested in large capitalization companies.

The remainder of the portfolio is a critical differentiator between BSTZ and other technology oriented funds including BST. Most closed end funds and index funds invest in publicly traded equities. As a result, their portfolios are generally similar to large funds including VGT or the Invesco QQQ Trust ETF (QQQ). A significant portion of BSTZ’s portfolio is invested in private, venture funded investments. Within the top ten holdings, we’ll note that most of the investments are privately funded including Project Debussy (7.53%), Project Picasso (4.29%), and Project Sibelius (2.82%). We will explore this side of the portfolio in depth.

BSTZ is currently trading in an attractive valuation. Following changes to the distribution policy and a stabilizing market, BSTZ has begun rebuilding net asset value or NAV. Even still, the fund continues to trade at a meaningful discount to NAV of over 16%.

However, the discount is even more valuable to BSTZ. Closed end funds have a variety of financial maneuvers to generate value for their investors. One such mechanism is a share repurchase program. Over the past two years, BLK has initiated significant share repurchase programs for their closed end funds, focusing on those trading at significant discounts to net asset value. BSTZ is one such fund, repurchasing a total of 2,467,361 shares as of year end. The impact of these repurchases have been significant. The average discount to NAV on days repurchased has been (16.7%) corresponding to $8,535,673 in net asset value accretion.

BSTZ is also a reasonably priced fund. The fund does not use any form of leverage, so internal expenses are limited predominately to the management fee charged by BLK. The gross expense ratio on net assets is 1.35% composed of a management fee of 1.25% and administrative fees totaling 0.09%. This management fee is cheap, especially for a fund operating in the private space. The fund does not charge an incentive fee like many private equity funds.

Dividend

BSTZ launched prior to the pandemic, when the technology sector was hot. The immediate success propelled BSTZ’s share price and distribution, increasing dramatically. For early adopters of BSTZ, the fund’s success was extraordinary, essentially leading the closed end fund universe in terms of performance. However, the success was short lived. BSTZ quickly fell into the chaos of the rising interest rate era. During 2022, the fund underperformed competitor BST significantly, predominantly due to the allocation to private investments which suffered from illiquidity and valuation compression.

BSTZ ran into trouble quickly and the fund’s fixed distribution began to quickly erode net asset value. The cycle was visibly unsustainable and BSTZ’s management team decided to cut the dividend in March 2023.

However, even the distribution cut was insufficient to alleviate the pressure of a tightening market. BSTZ continued to erode with negative total returns despite a double digit distribution. At this point, management decided to act decisively. BSTZ and BST both initially launched with managed distribution policies meaning a flat monthly dividend supported by a year end supplement, if necessary. In October 2023, BSTZ announced the implementation of a floating payment managed distribution plan. The dividend is now calculated as 6% of the fund’s trailing net asset value over the previous 12 month period.

The distribution policy update resulted in a significant cut to the dividend in the near term. However, the policy is not uncommon and is more aligned with the long term health of the fund. The distribution policy is similar to that of the Liberty All-Star Equity fund (USA). BSTZ’s net asset value declines during periods of market stress. Considering the fund’s illiquid holdings, the reduction in distribution during these periods is welcome and preserves the fund’s assets. In contrast, valuations expand and NAV appreciates during strong periods allowing the fund to pay out a higher portion as a dividend to BSTZ shareholders. The updated policy has already corresponded to a recovery in BSTZ’s net asset value.

Private Investments

BSTZ’s structure as a closed end fund is an appropriate setup for a fund that invests in the venture capital space. A primary area of concern is the opacity of BSTZ’s private holdings. The private portion of the portfolio is either a key point of attraction for bullish investors or a disqualifier for skeptics who value transparency above all else. Both parties can agree that BSTZ’s value proposition is rare with few other funds operating in a similar space.

Some diligence and digging as investors can yield helpful information about BSTZ’s investments. For example, Project Debussy is an investment in a software company called Databricks. Databricks is an emergent software firm founded over a decade ago. The company describes itself as a global analytics and artificial intelligence company. Databricks pioneered their “Lakehouse” platform, a cloud data platform that allows for abstract querying against large data sets. That is the limit of my expertise into the software space, but the firm provides additional color on their business:

Today, more than 9,000 organizations worldwide — including ABN AMRO, Condé Nast, Regeneron and Shell — rely on Databricks to enable massive-scale data engineering, collaborative data science, full-lifecycle machine learning and business analytics.

Headquartered in San Francisco, with offices around the world and hundreds of global partners, including Microsoft, Amazon, Tableau, Informatica, Capgemini and Booz Allen Hamilton, Databricks is on a mission to simplify and democratize data and AI, helping data teams solve the world’s toughest problems.

Another large private investment in BSTZ’s portfolio is Project Picasso, also known as PsiQuantum Corp. PsiQuantum is working to build a next generation computing platform based on processing enormous and abstract data sets. Their website describes their mission in greater detail:

PsiQuantum’s mission is to build and deploy the world’s first useful quantum computer. The company was founded on the premise that commercially valuable quantum computing will require error correction, and therefore very large-scale systems. We believe that we have a fast and feasible path to large-scale fault-tolerant systems, based largely on leverage of existing technology – including high-volume semiconductor manufacturing, packaging, and high-power cryogenic systems.

Our advanced society – and by extension a large fraction of industry – is built on a foundation of chemistry, physics, and information. Quantum computing has the potential to categorically advance our mastery of the physical world and of information, with widespread impact across science and technology. We are engaged with customers and partners to evaluate and optimize applications spanning climate, healthcare, finance, energy, agriculture, transportation, communications, and beyond. We are building a means to solve impossible problems and are engaged in partnerships and licensing of our technology through PsiQuantum licensing services.

Project Debussy and Project Picasso are the fund’s two largest private holdings. These investments are in sophisticated technology firms who are leading the development of emergent technologies. For the fund, these positons are major drivers of performance, despite their illiquidity. In the annual report, BLK notes that both of these investments were major detractors of fund level performance.

Further on, a private off-benchmark position in Databricks also detracted from relative returns. After an additional funding round was raised in September, Databricks agreed to acquire Arcion, an enterprise data company, in October 20233. As a result, the valuation increased but underperformed technology equities in the benchmark.

A private off-benchmark position in PsiQuantum also dragged on relative performance. The quantum computer developer underperformed tech stocks over the quarter due to the long duration nature of the firm’s endeavor.

The negative performance of the fund’s private investments relative to the broader success in the technology sector is not surprising. Success in the publicly traded portion of the sector has been evident in players like NVDA. However, venture capital funded companies remain locked up as elevated interest rates continue to suppress the private markets. Funding remains materially more expensive for these small players and lack of M&A activity has weighed on valuations.

However, there are signs that the worst may be behind us. The outlook is brightening as encouraging signs from across the market point towards a brighter future.

Outlook

The private equity markets have slowed significantly over the past two years. Deal flow remains limited relative to the post-pandemic era of cheap capital. For a fund with major private holdings, this meant trailing performance relative to peers. However, BSTZ has outperformed BST year to date, with the major differentiator being the weight of the private holdings.

As interest rates appear to level and the economy remains heated, there is a healthy momentum building across the private markets and IPOs. PWC recently put out a report discussing the health of private equity.

In 2023, private equity (PE) activity remained sharply down from its pandemic peak, reflecting stubbornly high inflation and correspondingly elevated interest rates and capital costs. Despite sitting on unprecedented capital, investors remained cautious, awaiting reductions in asset valuations to reflect cooler demand and tighter financing. Vendors, for their part, are willing to wait for the right suitor, extending hold periods to maximize exit value.

This year is taking shape differently. Year to date, there have been noteworthy IPO filings of large players in the technology sector including Reddit (RDDT). Additionally, acquisition activity is beginning to ramp up across other sectors with Blackstone (BX) showing interest across sectors. BX recently announced they are nearing the buyout of L’Occitane International SA (OTCPK:LCCTF). Additionally, BX recently returned to an acquisitive position in the real estate sector with the acquisition of Apartment Income REIT (AIRC).

As private players begin putting capital to use, the winds are beginning to change for BSTZ. Valuation of the private holdings have stabilized and their liquidity may improve as more investors return to the space.

Conclusion

As the IPO market continues to defrost, BSTZ’s redesigned distribution has resulted in appreciating net asset value offering value to shareholders. The fund’s management prudently cut the distribution during a tumultuous period when the fund’s holdings were undervalued. As the landscape begins to improve, BSTZ is outperforming peers and publicly traded competitors. The outperformance is likely to continue should the economy remain strong. A rate cut would serve as an even more significant catalyst for near term performance.

BSTZ is a unique fund offering significant value for shareholders. The opportunity to hold private, illiquid investments in a publicly traded vehicle is significant. As a result, BSTZ offers a meaningful complement to large index funds including QQQ which are technology oriented. BSTZ offers diversification and additional tax efficient yield due to the closed end fund structure. The fund is a strong buy as it demonstrated the ability to weather a significant period of disruption and capitalize through a share repurchase program and solid dividend design.