Many associate gearing with bank debt, but it can also be achieved by adopting a split capital structure. A ‘split’ separates the capital structure into two or more different types of shares, hence the name. Often the objective in doing this is to enhance, gear up or leverage the return earned by ordinary shareholders.
Split capital companies try to take advantage of the flexibility of capital structures to create new opportunities for investors with different risk and reward characteristics than ordinary shares. The most common type of such a firm is one that includes zero-dividend preference shares (ZDPs) within its capital structure.
ZDPs are shares that will be redeemed at a fixed price at some defined point in the future – provided that sufficient assets are available. While they are not entitled to receive dividends themselves, the financing that they can provide to the ordinary shares boosts the overall dividends available.
Put another way, because a trust is able to generate income for its ordinary shares using the entire portfolio, and because the ZDP shares do not draw the vehicle’s income, the ordinary shares end up with a higher dividend. The quid pro quo for this is that the capital value of the ordinary shares is geared by the ZDPs, so moves in the value of the underlying portfolio are amplified.
Some advisers may be wary of split capital trusts, as excessive gearing, and indeed the wrong type of gearing, saw the sector suffer in 2000 when the market fell.
In addition, some of these vehicles were investing in each other. This led to allegations of a ‘magic circle’, which implied that this investing was in the interests of fund managers rather than investors, but amplified the damage caused by the fall in value of some trusts in 2000.
The wrong type of gearing meant that some of these split capital funds were gearing themselves with bank debt. In falling markets bank debt is much less forgiving than gearing using the capital structure, because bank debt comes with covenants.
Many funds found that as the value of their assets had fallen, the asset cover covenants – the ratio of assets to bank debt – were breached. These funds were forced to sell assets into the bear market to pay down or pay off their debt and some went bust.
As the sector has matured, and following the introduction of rules designed to prevent a recurrence of the problem, there are now few cross-holdings between splits. There is also much less bank debt in the split capital structure, which makes balance sheets more robust.
The flexibility of the closed-ended structure means that gearing can be changed to suit the market environment and the particular trust’s circumstances.
Premier Energy & Water’s (PEW) split capital structure, for example, worked in favour of ordinary shareholders in 2013, and also to a lesser extent in 2014, enhancing returns for investors. It worked against the trust in 2015 in a year where global emerging markets and utilities came under pressure as the gearing amplified the effect of falling markets on the net asset value of its ordinary shares.
The structure also boosts the income available to ordinary shareholders. PEW’s board expects to pay a dividend of at least 8p per year on the ordinary shares, a yield of 6.5 per cent on the current share price.
| EXPERT VIEW |
| Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC), says it is vital that investors understand the split capital trust structure: “The split capital trust structure is useful because the company has different share classes to accommodate different investment needs – namely income, capital or a combination of both – from just one portfolio. They were very popular until the structure was over-engineered, with considerable levels of bank debt being introduced and high levels of cross-investment, and a number collapsed. “Following this the listing rules were changed to prevent too much cross-investment and to stop this happening again. There was nothing wrong with the original split structure and splits now make up 5 per cent of the industry’s assets. “However, it’s clearly important to do your research and understand how the structure of a potential split investment works and the impact of bank debt if there is any. The AIC provides splits analytics data to help advisers do this.” The splits analytics can be found at www.aicstats.co.uk. |
Small Companies Dividend Trust (SDV) is another fund with a split capital structure. It invests in a portfolio of UK smaller companies – an asset class that is not renowned for producing much in the way of income. However, SDV is able to pay out a yield of 4 per cent and generate some impressive performance, its net asset value is up 78 per cent over three years thanks to its structure.
Looking at the trust sector as a whole, some well-known managers have been reducing gearing levels on the back of concerns about market volatility. The danger is that they miss the turn in markets. However, split capital funds with no bank debt can effectively keep their gearing in place permanently.
It is important to look underneath the bonnet of an investment trust, split capital or not, to understand and determine the factors that influence performance. The flexibility of trusts can be used by advisers to the advantage of generating returns for client portfolios.
Matthew Read is senior analyst at QuotedData
