Select Committee on Treasury Minutes of Evidence

Memorandum submitted by the Association of Investment Trust Companies

  When the AITC appeared before your committee in the summer, I mentioned two initiatives that we were working on. I am in a position to update you on each of these.


  We have been engaged in a very significant project whereby we have collected the complete portfolio lists of almost every company in the universe of split capital or very highly geared closed ended investment companies. This includes all those funds that have invested in shares of other investment companies (often themselves split capital or otherwise highly geared). We collected this data at the end of March. As you can imagine this was a fairly laborious process and the fact is that data has not arrived in a standardised format making our data inputting a very time consuming task.

  Our primary ambition for this project was that it would enable us to "net out" the impact of the sectors cross holdings and identify the value of the "real" assets underpinning shareholder value. We expected that this would enable us to identify those funds most at risk of continuing falls. We also hoped that this project would help the market to arrive at better judgements about risk generally for splits.

  In the event, we have still not yet completed this project, although we hope that it will be a matter of days rather than weeks. The construction of the spreadsheet and the inputting of the last few funds have taken longer than expected. Furthermore, the continuing falls in stock markets, in general, and of split shares, in particular, has substantially reduced the quantum of possible future losses as, in effect the vast majority of the value that could be lost has already been lost.

  Nonetheless, the project will still provide valuable data and may well provide solutions to the provision of robust risk measurement standardisation for the industry.


  A second initiative being undertaken by the AITC is to seek to increase and improve the information available to investors. The objective being to ensure that investors gain a clear understanding of the risk:reward trade offs involved with any given share and are in a position to asses whether a share matches their performance aspirations and risk tolerance. Effectively, we wish to ensure that people are able to make intelligent decisions with appropriate information thus reducing the risk that investors could complain that they had been misled should catastrophic losses be experienced in the future.

  The basis of our initiative, which has been devised after a process of consultation, is that we would publish data on all splits on our website so that there would be a central source for investors. The data would include:

    1.  A list of all holdings in other splits and the value of those holdings.

    2.  An analysis of the split holdings, banding them by the amount of bank debt and also by the level of their own holdings in other splits.

    3.  Details of the company's borrowings and covenant arrangements.

    4.  A matrix showing the outcome for each class of share at the wind up date given a range of positive and negative returns form the underlying investment portfolio. Those returns would be broken down by sub-portfolio where appropriate.

    5.  A statement of the "hurdle rates" required to meet a range of outcomes depending on the class of share, eg:

    —  To return the initial subscription price.

    —  To return the current share price.

    —  To result in total loss.

    —  To return any promised entitlement (where appropriate).

  We hope to start publishing this data in February 2003.

  A copy of the letter that is being sent to Chairmen of Split Boards next week is enclosed at Annex.


  The AITC has conducted a research exercise to establish attitudes to corporate governance. The results of this research have been circulated to our Members and we have asked them for their comments by the end of the year. We then intend to produce a formal AITC guide or code regarding corporate governance. A copy of the research paper is enclosed.


Letter to the Chairman of Split Boards from the Association of Investment Trust Companies


  Further to the FSA's response to the industry's feedback regarding their discussion paper on splits, and the Treasury Select Committee's hearing on splits, we have been asked to develop ideas which could help to provide improved information to the market. In this process, we need the support of the Boards.

  One objective "illustrations of returns and portfolio information" is designed to provide advisers and prospective investors with better information to help them assess whether the risks involved in investing in a particular share are a good match for their objectives. We believe that this will stimulate demand and improve liquidity.

  To this end, we have proposals for illustrations of returns that we are putting forward today.

  Another objective (the "Data Project") was to provide Boards whose companies had significant holdings in other highly geared funds with information that would help them better understand the look-through position of their portfolio, the effective level of gearing and total expenses. This would help them to assess the likely outcome for various capital return and dividend flow scenarios.

  Since this project was conceived in March, the continuing fall in the values of holdings of splits by other splits has made the potential future impact of cross holdings less important as a further major collapse in split values has happened since then.


  We are proposing an additional regular publication for split capital and highly geared funds. One of the biggest difficulties in assessing the risk: reward dynamics of various share classes in companies with multiple sub-portfolios has been to work out how likely it is that the returns required to meet various hurdles are actually going to be delivered. This is probably one of the major factors behind the purchase by so many investors of shares whose risks they clearly did not understand.

  The principle behind this proposal is that we would collect from managers and publish on a regular basis:

    —  A breakdown of the portfolio spread. Also a detailed list of all holdings in other investment companies by value, and top ten holdings for each sub-portfolio, updated monthly. We will then publish that list together with a breakdown of those holdings showing the extent to which they themselves have bank debt shown in bands by ratio of debt to assets and/or holdings in other investment companies. We would also show a breakdown of any other sub-portfolios. This will enable investors to take their own view on the potential returns of the investment company's sub-portfolios. From these views, they would then be able to derive their own assumptions for income and capital returns for the whole portfolio. These could be applied to the matrix of final NAVs and redemption yields (see below) thus enabling investors and advisers to gain a proper understanding as to whether a particular share offers risk:reward characteristics that meet their own objectives, needs and appetite for risk.

    —  Details of the overall portfolio yield and the breakdown of the portfolio yield for each sub-portfolio, updated monthly.

    —  Details of all borrowings, their amounts, repayment dates and covenants applying.

  With this data and using our existing data source, Fundamental Data, we will also publish:

    —  Hurdle rates, updated daily, for each class of share to achieve a range of outcomes. This would provide investors with a clear idea of how demanding the performance requirements are upon the underlying portfolio, if the shares are to achieve the investors' objectives. The hurdle rates would be published to show the capital returns required from the portfolio to result in (depending on the share class):

      —  Total loss.

      —  Current share price.

      —  Initial subscription price.

    —  Final entitlement

      —  Final NAVs and redemption yields, updated daily, for each class of share based on a matrix of performance scenarios (say from ¸10 per cent per annum to +10 per cent per annum). This would enable investors to understand more easily how sensitive their potential returns may be to relatively small changes in the performance of the underlying portfolio. There may be cases where the existence of sub-portfolios makes it desirable to show each sub-portfolio's performance separately in a more complex matrix. This would help investsor take an intelligent view on the likely outcomes for themselves.

  The sector clearly wants to avoid the danger of investors buying shares without a proper appreciation of the risks involved. If the data as suggested above were to be published on the AITC's website, we believe that the opportunity would exist for investors, analysts and their advisers to ensure that purchases are made with eyes wide open. This would eliminate or at least substantially reduce the risk of the sector being accused of misselling or worse if substantial losses were subsequently sustained.

  We will follow up this letter with your company secretary to discuss the detail of the proposed intended data collection. We hope that the information will first be published in this format in February for end-January data.


  Our data project collected the full portfolio lists and gearing details as at the end of March of virtually every split capital trust and certain other highly geared funds. With this information, we have been building a complex model with help from BFS who have sponsored a break-up valuation model for cross holdings. We expect the model to be able to deliver a number of conclusions at the macro level. However, the market has clearly moved substantially since then and the value of holdings by splits in other splits has, in most cases, been very seriously reduced. If updated, the model will show:

      —  The true level of assets (after cancelling our cross holdings) underpinning the sector—the sector's break-up NAV—which can then be compared to the sector's market cap.

      —  The sector's true level of gearing.

      —  The sector's true level of expenses.

  At the micro level, we expected to be able to determine for each share class:

      —  The NAV on a break up basis of all the underlying holdings.

      —  The effective gearing for each company.

      —  The effective expenses for each share class.

      —  Scenario planning for various capital returns.

      —  Scenario planning for various revenue returns

      —  Further, we would expect to be able to use the data to provide ratings for each share class, customised for individual analsysts and managers. If this were achieveable, we would want to gain agreement to a generally accepted rating system for public dissemination.

  We hope to complete the initial stages of this project over the next 6 weeks and we will then revert to each Board with a sample customised invididual analysis of each company and share class based on data as at the end of March.

  Of course, this exercise will show only the type of data that will be available. The gap between March and now means that the world has moved on considerably and we shall have to decide at that point whether it is worthwhile collecting the data on a regular basis in order to be able to re-run the figures.

  If, when Boards and market participants have examined this data, it were deemed to be useful, we would then make proposals on those parts of that data that we wanted to publish publicly and for a continuation of the project by refreshing the data on a monthly basis.

  I hope that your Board will agree to the release of the portfolio information as indicated. That is a list of all investment company holdings, by absolute value and by value as a percentage of your total assets, a breakdown of the portfolio spreads, sub-portfolio yields and details of debt.

  We expect the Treasury Select Committee to hold a further hearing into the split capital sector before the end of the year. In the meantime, we are doing everything we can to explain the fact that split captial trusts have a valid role, that they have enormous potential and that a majority of the sector does not have the scale of difficulties being faced by a minority.

  I would be delighted to meet with your Board, if you would like to talk about these proposals or any other issue you may wish to discuss.

October 2002

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