Select Committee on Treasury Minutes of Evidence

Annex E

AITC Letter to Chairmen of Splits—13 November 2001

  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 management groups.

  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 help themselves.

  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 figures.

Daniel Godfrey

Further AITC Letter to Chairmen of Splits—7 March 2002

  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 consider immediately.

  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 more attainable.

  A second step could stem from a review of the allocation of expenses and interest costs between capital and income.

  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 to revenue.

  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 companies.

  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 consent.

  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.

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