Select Committee on Treasury Minutes of Evidence


Annex C

EXPLANATION OF HOW SPLITS WORK AND OF COMMON TERMS

  Different split trusts have different combinations of share classes and this is explained and illustrated by two examples below which illustrates two typical examples of splits. A closer examination is now taken of the main types of different classes of splits' shares in issue.

  1.  Zero Dividend Preference Shares (zeros or ZDPs) as their name indicates, have no entitlement to income. They offer a capital return in the form of a predetermined redemption value at a fixed wind-up date, expressed as a compounded percentage return eg 7 per cent per annum gross redemption yield. They are not guaranteed as any redemption value is dependent on sufficient assets being available but normally rank before the other classes of shares, but after bank debt. As they pay no income they are not subject to income tax and their returns are treated as a capital gain.

  2.  Income Shares offera a range of entitlements to income combined with various pre-determined entitlements to capital at the wind-up date. The entitlements often depend on the type of split structure. Income may range from a fixed dividend to the entitlement to receive all the distributable income generated by the trust. The redemption value can vary from a very low amount (somewhat like an annuity) to the issue price or a share in the capital growth as well. At wind-up income shares typically rank after zeros but again any redemption value is not guaranteed and is dependent on sufficient assets being available.

  3.  Ordinary Income Shares (Income & Residual Capital Shares or IRCs) offer a high income with prospects for capital growth. They are typically entitled to all the income after any prior ranking entitlements. They have no predetermined redemption value but are entitled to all surplus assets after payment to any prior ranking share classes or lenders. They are often issued in combination with ZDPs.

  4.  Capital Shares pay no dividends. They do not have a predetermined redemption value but are entitled to any assets remaining at the winding up date after the prior ranking charges (such as bank loans) and other classes of shares have received their entitlements. If there are substantial prior ranking charges and share classes ahead of them, they are highly geared.

  As well as the structural gearing that is achieved by having different classes of share, additional financial gearing can be taken on by bank borrowing, either short term or longer term, floating rate or fixed.

  There are many different types of splits. Financial engineering has meant that some no longer have fixed lives with one or more classes of share being issued by a 100 per cent owned, limited life, subsidiary of the parent company that itself is undated.

  There are also some very highly geared investment trusts (through bank debt) that have only one class of share but which exhibit many of the characteristics of splits. There are also some funds that are domiciled offshore but listed in the UK that are not technically investment trusts at all. For the purposes of this exercise and throughout this paper, we will refer to them all as splits.

  The universe of split capital trusts numbers some 136 companies with £12.6 billion of gross assets as at 31 May 2002. A number of useful statistics about the sector are included as Annex A.[25]

Number of investment trusts
397
Number of split capital investment trusts
136
Split capital trusts as a per cent of total by number
34%
Value of all investment trusts
£64.2 billion
Value of all split capital investment trusts
£12.6 billion
Split capital trusts as a per cent of total by value
20


  Split trusts are launched with portfolio and structures that accommodate market conditions at the time of issuance. There are many variations in terms of capital structure but many fit within the two broad categories described below:

Example 1—simpler structures of the 1960s and 1970s

  Income shares and capital shares. This was a period of distorted tax rates for investment—higher rate income tax at 98 per cent and CGT at 30 per cent—with an environment of increasing inflation. This is, however, the basic structure of many splits launched from the mid-1960s until the late 1980s. The renaissance of splits in the mid-1960s came through change of the tax rules, which have often acted as a driver for splits' innovation in the past.

  The income shares receive all the income and the capital shares all the capital growth. Suppose £50 million is raised at launch for capital shares and another £50 million for income shares, £100 million in total. Suppose the income shares are promised all the income of the portfolio and first call on their initial investment back in ten years' time provided there are sufficient assets in the company at the time.

  Let us say the £100 million is invested in a portfolio of higher yielding UK stocks yielding 4 per cent and that all expenses are charged to income and amount to 1 per cent. Income available for distribution is £3 million. This provides the income shareholders with a 6 per cent yield (£3 million on a £50 million investment) without taking on the portfolio risk normally associated with moving up the yield curve and buying a portfolio of shares that themselves yield 6 per cent.

  Even if there is no growth in the annual income received by the company over the next 10 years, the income shareholders would have received a total of 60 per cent of their investment back as income. Provided that the value of the portfolio does not drop by more than 50 per cent over the 10 years they will get back their full £50 million at wind up. Whilst not impossible, most investors would consider it extremely unlikely for a well-balanced portfolio of blue-chip UK shares to drop by 50 per cent over 10 years, so shareholders would regard the return of their £50 million as being extremely likely.

  The net effect for the income shareholders is that their income is enhanced (a 6 per cent yield from a portfolio generating 4 per cent) and their capital is capped and degeared (they cannot get back more than £50 million and a 40 per cent fall in the portfolio leads to no loss for them; even an 80 per cent fall would lead to a lower 60 per cent loss).

  The capital shares could be described as "structurally" geared. They receive no income at all, but in 10 years, they receive all the assets of the company on wind-up, less the first £50 million that is due to the income shareholders. If the portfolio falls by 50 per cent or more over the 10 years, they are wiped out. If it falls by 30 per cent to £70 million they will receive only £20 million after the income shareholders are paid out, thus suffering a 60 per cent fall themselves. If the assets rise by 50 per cent over the 10 years to £150 million, the capital shareholders double their money; if the portfolio doubles, they treble their money and so on. These examples assume no liquidation costs.

  The income shares require the "terminal" value of the company to be at least £50 million for them to get their money back. Above that level, there is no additional payback to the income shareholders. Since the company starts off with £100 million there are twice as many assets as needed on day one and, whilst this remains the case, the income shares are described as having "cover" of 2x the final entitlement. The "hurdle" rate is described as minus 6.5 per cent per annum This is the rate by which the value of the assets can fall each year and still be sufficient to meet the final entitlement of £50 million.

The capital shares need the portfolio to maintain a value of at least £100 million, so they have a "hurdle" rate to return their original investment of 0 per cent.

  
Amount
Income shares
£50 million
Capital shares
£50 million
Total raised
£100 million
Income pa
£4 million
Expenses pa
£1 million
Distributable to income shares
£3 million 6 per cent of
£50 million
Income shares entitlement at wind-up
£50 million
Day one assets
£100 million
Cover
2x
Loss pa to produce £50 million at wind-up
6.5 per cent pa
Hurdle rate for income shares to produce £50 million final entitlement
-6.5 per cent pa
Final asset value
£200 million a 100 per cent gain
Income shares entitlement
£50 million
Capital Shares entitlement
£150 million a 200 per cent gain
Final asset value
£50 million
Income share entitlement
£50 million
Capital share entitlement
£0 a 100 per cent loss



Example 2—newer structures of the 1980s and 1990s

  Ordinary income shares (Income and Residual Capital shares or IRCs) and zero dividend preference shares (ZDPs). In the 1990s, the tax and investment environment changed, with the advent of popular capitalism, growing stockmarkets and lower tax rates for higher rate payers.

  Again, let us suppose that the company raises £100 million, this time £60 million in ordinary income shares and £40 million in ZDPs. This is the structure of many split capital trusts that were devised after ZDPs were invented in 1987 and with the expectation of stockmarket growth. The portfolio is still invested in higher yielding UK shares with a portfolio yield of 4 per cent and total expenses of 1 per cent all charged against revenue and a 10-year life.

  The ZDPs have no entitlement to any income but a final entitlement of £2 per share roughly equivalent to a return of 7 per cent per annum compound on the initial £1 subscription price. So the first £80 million of assets will be due to the ZDP holders at wind-up. On day one the portfolio is worth £100 million so the ZDPs are fully covered and will receive their final entitlement so long as the portfolio does not fall in value by 20 per cent over the 10 years. The "cover" rate is 1.25 times the requirement (1.25x) and the "hurdle rate" required for the ZDP holders to achieve the final entitlement is minus 2.2 per cent per annum.

  The ordinary income shareholders receive all the income and any captial left over once the ZDPs have been repaid. This time the ordinary income shares are entitled to the full net income of £3 million or 5 per cent of their £60 million, again without the normal portfolio risks of such a high yield.

  The ZDPs exchange investment risk for a capped but relatively safe return in a potentially tax efficient manner as all gains are treated as capital. They are degeared whilst their final entitlement is covered. The ordinary income shares are geared as to capital and their income is enhanced.

  If the portfolio falls by more than 20 per cent or £20 million over 10 ten years, the ordinary income shares will get no capital back at all and the ZDPs will get back less than their full entitlement. A 40 per cent fall in the Company's assets to £60 million over 10 years wipes out the ordinary income shares and produces a 50 per cent gain for the ZDPs who receive the full £60 million against the expected 100 per cent.

  A 40 per cent rise over 10 years gives the ZDPs their full entitlement and returns the intial investment to the ordinary income shares on top of the 5 per cent yield they have enjoyed. A 100 per cent rise over 10 years gives the ZDPs their full entitlement and doubles the ordinary income shareholders' capital on top of the 5 per cent per annum income they have received on their initial subscription price.

  
Amount
Zero dividend preference shares
£40 million
Ordinary income (IRC) shares
£60 million
Total raised
£100 million
Income pa
£4 million
Expenses pa
£1 million
Distributable to ordinary income shares
£3 million—5 per cent of £60 million pa
ZDP shares entitlement at wind-up
£80 million
Day one assets
£100 million
Cover
1.2x
Loss pa to produce £80 million at wind-up
2.2 per cent pa
Hurdle rate for ZDPs to produce £80 million final entitlement
-2.2 per cent pa
Ordinary income shares are wiped out
  
Growth pa to produce £140 million at wind-up
3.4 per cent pa
Entitlement for ZDPs
£80 million—full entitlement
Ordinary income shares entitlement
£60 million—money back
Hurdle rate for ordinary income shares to Return capital
3.4 per cent pa
Final asset value
£80 million—20 per cent loss
ZDP shares
£80 million—full entitlement 100 per cent gain
Ordinary income shares
£0—100 per cent loss
Final asset value
£50 million—50 per cent loss
ZDP shares
£50 million—25 per cent gain
Ordinary income shares
£0—100 per cent loss
Final asset value
£200 million—100 per cent gain
ZDP shares
£80 million—full entitlement 100 per cent gain
Ordinary income shares
£120 million—100 per cent gain
Final asset value
£300 million—200 per cent gain
ZDP shares
£80 million—full entitlement 100 per cent gain
Ordinary income shares
£220 million—266 per cent gain







25   Ev 35. Back


 
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