MF3d
The BlackRock Health Sciences Trust II (NYSE:BMEZ) is an interesting fund concept that combines ‘next generation’ healthcare-stocks with high-risk/high-return private investments and a high distribution yield. During bull markets, the BMEZ allows investors to participate in the speculative frenzy that can develop in risky biotech stocks while earning a healthy distribution. However, during bear markets, investors can suffer from capital writedowns and a distribution funded from return of their own principal.
Currently, the private markets appear frozen, as companies are reluctant to go public with poor risk sentiment and valuations. I would be hesitant to invest in the BMEZ fund until the market environment improves and the private-to-IPO path re-opens.
Fund Overview
The BlackRock Health Sciences Trust II is a closed-end fund (“CEF”) that aims to deliver total returns through a combination of current income and capital gains. The fund has over $2 billion in net assets and charges a 1.30% gross expense ratio.
BMEZ takes a unique approach to investing in the healthcare sector. It blends together ‘next generation’ stocks with pre-IPO private investments and tactical option writing strategies to generate income. BMEZ’s CEF structure allows it to take riskier private bets, as the fund is not susceptible to redemptions (CEFs can trade below NAV if there is more supply than demand for its shares, but the assets cannot be ‘redeemed’ like a mutual fund or ETF). The BMEZ fund aims to invest up to 25% of the portfolio in private investments.
Portfolio Holdings
Figure 1 shows BMEZ’s sector allocation. The fund is primarily invested in pharma / biotech companies (64.5%) and healthcare equipment and services companies (30.0%).
Figure 1 – BMEZ sector allocation (blackrock.com)
Figure 2 shows the fund’s top 10 holdings, which account for 21.5% of the fund’s assets.
Figure 2 – BMEZ top 10 holdings (blackrock.com)
Since inception, the BMEZ fund has deployed $539 million into private companies, or ~25% of the original funds raised. As of September 30, 2022, BMEZ continues to hold investments in 18 privates comprising 8.6% of the fund’s assets, or ~$170 million. In addition, the fund invested 2.4% of its NAV across 5 SPACs. Figure 2 details the fund’s private investments to September 30, 2022.
Figure 3 – BMEZ private investments (BMEZ Q3/2022 report)
From the fund’s disclosure, it appears many of the fund’s initial private investments have gone public. Furthermore, it appears the fund has not made any private investments in 2022 (up to the latest September quarterly report).
Private Investments Are High Risk/High Reward
In bull markets, pre-IPO private investments can offer extraordinary returns. For example, the BMEZ fund initially invested $5.4 million in Acumen Pharmaceuticals (ABOS) in Q4/2020 for 1.4 million shares. By the time Acumen went public in 2021 at $16 / share, BMEZ’s position had quadrupled in value to $22.4 million.
However, biotech stocks are very sensitive to risk sentiment. The bull market for biotech stocks peaked in early 2021, as shown by the price peak in the SPDR S&P Biotech ETF (XBI) shown in Figure 4.
Figure 4 – Biotech stocks peaked in Q1/2021 (stockcharts.com)
By the end of 2021, BMEZ’s position in Acumen had fallen in value to only $9.6 million (Figure 5).
Figure 5 – BMEZ’s position in Acumen Pharmaceuticals (BMEZ 2021 annual report)
Returns
The BMEZ fund has had a rocky start since its inception in early 2020. The fund had a phenomenal stub year in 2020 with returns of 59.6%. However, it lost 8.6% in 2021 and 22.6% in 2022 (Figure 6).
Figure 6 – BMEZ annual returns (morningstar.com)
In comparison, the Health Care Select Sector SPDR ETF (XLV) returned 13.3% in 2020, 25.9% in 2021, and -2.0% in 2022 (Figure 7).
Figure 7 – XLV annual returns (morningstar.com)
Distribution & Yield
BMEZ pays a high monthly distribution of $0.145, which annualizes to 10.9% of current price or 9.2% of NAV.
However, investors should note that as BMEZ’s ‘next generation’ stocks typically do not pay dividends, BMEZ’s distribution has been funded from selling options and return of capital (Figure 8).
Figure 8 – BMEZ’s distribution has been funded from capital gains and return of capital (BMEZ December 2022 19a notice)
Paying a high distribution rate could be problematic for the BMEZ fund if it consistently earns less than the 9.2% of NAV distribution. Under-earnings will be funded through return of investors’ principal, which shrinks the NAV over time, creating a vicious loop.
So far in its short operating history, BMEZ had a strong stub year in 2020, and poor performance in 2021 and 2022. It is too soon to place judgment on whether BMEZ can fund its distribution over a cycle.
Risk
The biggest risk I see for the BMEZ fund is that its investments are mostly high-risk / high-reward bets (biotech stocks and privates). However, its high yielding structure may attract investors who seek the safety of income and dividends.
When times are good, such as in 2020, investors are happy to collect BMEZ’s distribution while enjoying unrealized capital gains in risky healthcare stocks. However, when times are tough, like they were in 2021 and 2022, BMEZ investors may find out they own a basket of high beta biotech stocks and privates wrapped in a high yielding vehicle.
In fact, wary investors have marked down BMEZ’s market price to a 15.5% discount to NAV (Figure 9).
Figure 9 – BMEZ trades at a steep discount to NAV (cefconnect.com)
Since CEF units cannot be ‘redeemed’, when a CEF trades at a steep discount, it is indicative that investors have grown disillusioned with the fund and / or are wary of the calculated NAV.
Conclusion
The BlackRock Health Sciences Trust II is an interesting fund concept combining ‘next generation’ healthcare stocks and exposure to pre-IPO investments unavailable to most retail investors. It also pays an attractive 10.9% current yield that is funded from realized gains and return of capital.
During bull markets, pre-IPO investments can add significant torque to a portfolio, as private companies can get a large valuation lift from going public. Unfortunately, the private / IPO market is currently frozen due to poor risk sentiment. I would be hesitant to invest in the BMEZ fund until the market environment improves and the private-to-IPO path re-opens.
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