AITC Letter to Chairmen of Splits13
The AITC has been talking to the media, regulators,
IFAs and members of the public on the issues surrounding the difficulties
being experienced by a number of split capital investment trusts.
We have been explaining what splits are and how they work. The
Chairman's Committee has asked me to write to the Chairmen of
all split capital trusts and the Chief Executives of their respective
After some very negative initial coverage, we
are now seeing more balanced articles. But the situation is still
fragile. After extensive consultation, it is clear that there
are number of ways in which split capital investment trusts could
Although the principal problem is the rising
level of effective gearing in some trusts, caused by declining
asset values, an important first step would be to publish, on
a monthly basis, details of holdings in other investment companies,
cash holdings and debt positions. This would enable the market
to take a better view on fair value. It is currently assuming
the worst-case scenario for holdings of other splits. It would
also encourage liquidity, which, bar transactions between funds,
has all but dried up in many cases.
The current position, where the AITC publishes
portfolio spreads and where individual trusts and managers often
go further by publishing top ten holdings as well, is not sufficient.
The market recognises that two companies with identical overall
exposure to splits and even identical top ten holdings could have
radically different tails. I am attaching a schematic of the data
that we wish to collect and publish on our website.
Those trusts that are facing the greatest immediate
difficulty are those that have breached or are close to breaching
their banking covenants. Clearly, de-gearing by selling assets
at what is probably closer to the bottom of the market than the
top is unattractive expect as a last resort given how hard it
then becomes to get back to square one.
The better solution to banking covenant problems
would therefore involve balance sheet strengthening rather than
cash offsetting or selling the portfolio to repay debt wherever
possible. The AITC believes that there are two primary ways of
achieving this in present conditions.
One is for Boards to cut dividends and retain
cash in the company, thus reducing debt to asset ratios and providing
additional funds for investment in securities. This might be achieved
by adopting a more conservative accounting policy (and/or reducing
the portfolio yield). Whilst Boards might be nervous of taking
such a step, in the belief that the price of income shares is
held up by the prospective yield, an examination of the yields
on the income shares of those trusts which seem to be most stretched
will show that the market does not believe that these dividends
will be paid in any event.
A second is for mergers (rescues) of weaker
companies with (by) stronger trusts to reduce the overall level
of bank debt in the combined entity. These need to take place
widely and on an "extramual" basis (between companies
managed by different managers).
There is a third option, which is for recapitalisation
by new share issuance. This is particularly helpful if real cash
is raised, but if the new capital is arriving in the form of stock
swaps for more splits, it may prove to be a short-term palliative.
We are already seeing examples of trusts that have been to the
well only a few months ago approaching the point where they need
to do so again. Although this is better than nothing, it is a
long way from being as good as raising hard cash.
These corporate actions are underway in many
cases, but they are necessarily conducted behind closed doors.
Publishing the data on holdings as outlined would enable the AITC
to move onto the front foot and to explain that those companies
with the greatest difficulties are working hard behind the scenes
in a number of ways to protect the interests of shareholders and
that we can expect to see a steady stream of announcements in
the coming months, including recapitalisations, repayment of debt,
dividend suspensions, mergers and requests to shareholders for
the life of some trusts to be extended.
Following consultations with many of the managers
in the sector, the AITC is establishing a section of our website
that will carry a page for every split capital trust (including
non-Members) containing details of their holdings (above 0.5 per
cent of the Gross Assets of the company by value) in other investment
companies, among other things.
I hope your Board will be willing to support
this initiative. The AITC's statistics team will be in touch with
your Managers over the next few days to discuss the process for
submitting data. We hope to carry month-end figures, updated monthly,
and will be ready to go live at some point in December with end-November
Further AITC Letter to Chairmen of Splits7
The difficult circumstances still being experienced
by a number of split capital and certain other highly geared investment
companies has led the AITC to conduct a fact finding exercise
with a view to understanding the nature and extent of the risks
being faced by shareholders. A further objective has been to identify
possible courses of action for consideration by Boards.
As we stand today, it seems likely that there
are a number of companies whose problems are sufficiently severe
that they would require quite strong rises in markets in order
to avoid further erosion in their asset base.
To avoid such an outcome, it might be worthwhile
to examine measures that should strengthen balance sheets and
improve debt to asset ratios. The AITC has identified two possible
measures that we have concluded might be helpful for Boards to
The first measure that Boards could take in
an effort to improve the financial strength of their company in
these exceptional circumstances is to look at all costs of the
company, including fees paid to investment bankers for reconstructions
to see if they can be reduced. Further, they could ask the manager
to waive fees on that part of the portfolio that is invested in
other investment companies and on the company's bank debt.
These fees could be replaced by a performance
fee that would be paid out at the end of the life of the company
(or the winding up of the zero if the company is undated). It
might be paid if the zeros receive their full entitlement and
if the NAV for other shareholders has risen subsequent to the
change in fee arrangements.
In some cases, eliminating the impact of charges
on charges and charges on gearing could have a significant impact
on how fast the assets have to grow for NAVs to stand still. It
could easily cut the TER by 80 per cent and thus make hurdle rates
A second step could stem from a review of the
allocation of expenses and interest costs between capital and
If such an exercise were to conclude that the
current allocation policy of expenses to capital was no longer
a fair reflection of the likely long-term source of total return,
given the current portfolio of the company, it might be appropriate
to rebalance the allocation of expenses such that a greater portion
(or in some cases perhaps even 100 per cent) of expenses are taken
This should have the effect of retaining cash
in the company, strengthening the balance sheet and reducing gearing
ratios, but it would also result in a reduction in the level of
dividend that could be paid. One can see however that the market
is already expecting dividends on some companies to be cut substantially.
Yields on some shares are now so high as to indicate that expectations
are for no more than eighteen months' dividends to be paid.
Of course, no two trusts are identical and Boards
will need to consider whether either or both of these measures
would be beneficial for their shareholders in their own circumstances.
Many of those who we have consulted have stressed
that Boards need to be very careful to ensure that any reconstructions
are in the interests of all shareholders. We recognise that a
reconstruction involving the issuance of new paper in exchange
for shares in other highly geared funds may be acceptable in the
last resort, but it is likely to prove a short-term fix. Boards
need to be sure that the impact will not be to erode value for
one or more classes of shareholder and that a repayment of debt
is not a better option.
Finally, we believe it is necesary to build
a complete picture of the entire holdings and cash and debt positions
of all the companies in this sector at a common date. If this
can be done, it will be possible to analyse the true impact of
investment on other investment companies and leverage. We would
then be able to analyse the outcomes of various projections in
terms of dividend performance and market growth. This will enable
us to understand better the extent of the risks being faced by
shareholders and to consider whether there are any further measures
that can be suggested to Boards.
In October, we asked all Boards of split capital
investment companies and certain other highly geared companies
to supply us with details of all their holdings in other investment
Over 70 per cent of those companies approached
are now supplying this data, which is published on our website.
To enable us to build the total picture of the
sector's position and that of each individual company, we are
asking every company to supply us, in confidence, with
details of their complete portfolio, cash and debt arrangements
as the close of business at the end of March 2002. This will enable
us to drill down through all the holdings in other funds on a
look through basis and to build a complete picture of the real
underlying assets that are supporting each fund.
We would ask that this data be provided by Monday
15 April 2002.
Whilst this data will be kept in confidence,
it will be used to develop a risk rating system, as suggested
in submissions to the FSA's discussion paper. The rating system
is to be developed by the AITC in association with leading analysts
and other experts. Ratings would not be published without your
We will also conduct a review of the efficacy
of our current disclosure methodology and when this is complete,
we will revert to you to ask for your permission to disclose such
data that best meets the needs of the market to determine fair
value and improve liquidity.
I very much hope that you will agree to provide
us with full details of your portfolio holdings as I cannot over-emphasise
just how important it is for us to build a complete picture of
the sector. With this information we will, for the first time,
be able to understand and quantify the true impact of multiple
levels of gearing and charges that arises from the element of
the portfolio that is invested in other investment companies.