NOTE BY CAZENOVE ON SPLITS
UNITED KINGDOM: INVESTMENT COMPANIES THEMATIC
25 JULY 2001
"We remain nervous about some of the barbell
portfolios underlying [split capital and highly geared] funds.
The growth portfolio is often highly volatile, while the income
portfolio has more capital risk than many investors think. Not
only could the proportion invested in other splits fall sharply
if the underlying hurdle rates are not met, but the high yielding
bonds that are popular in some structures are quasi equity. The
worst case scenario for investors is therefore a growth portfolio
that does not grow and an income portfolio that suffers defaults
and capital loss. In this instance high headline yields do little
to mitigate the overall losses that will be suffered."
Cazenove Investment Companies Annual Review,
10 January 2001.
The sharp correction in markets has hit many
investment trusts hard, but few more so than a number of the so
called "barbell" trusts, whose highly geared capital
structures have come under severe pressure. Barbell trusts are
designed at issue to offer their shareholders the growth prospects
of a popular sector (or market) together with a very high income.
The 32 barbell trusts in our sample account
for £4.6 billion or 50 per cent of the £9.2 billion
of total assets raised by highly geared and split IPOs since the
beginning of 1999. More significantly, during 2000 and 2001, of
the £7.1 billion of total assets raised, barbells accounted
for £4.2 billion, or 59 per cent.
Despite this high level of issuance and their
apparent popularity, there are serious structural issues with
barbell trusts and perhaps most importantly the risk of a systemic
A systemic collapse could result from the high
degree of investment by these trusts in other geared funds. A
sale of these assets by trusts breaching their banking convenants
could cause a collapse in market prices, and as a result other
funds investing in this area to breach their own covenants. If
they then have to sell, it is easy to see how a downward spiral
might develop, exacerbated by high gearing. Cross shareholdings
which result in a trust effectively owning its own shares add
to the gearing of a geared trust, but should not in themselves
lead to a downward NAV spiral in the event of a fall in the underlying
Fees and financing costs as a percentage of
shareholders' equity are magnified by the existence of high levels
of debt, and this is exacerbated as gearing increases in a falling
market. These vehicles were costly at issue and many have now
become even more so.
The high headline yields attract investors,
but are achieved partly through an accounting sleight of hand,
by charging most of their expenses and financing costs to the
capital account, which transfers value from capital to income.
There are a number of practical problems when
a highly geared trust nears or breaks its banking covenant levels.
The fund at this point is being controlled by the bank, not the
shareholders, or the manager. Any forced rebalancing may be sub-optimal,
and poorly timedassets may have to be sold in a falling
market, negating the benefits of the closed end structure. Furthermore,
if the trusts degear after having fallen sharply, they are not
so well placed to capture any upside. In addition there may be
penalties to pay for early repayment of the loan, particularly
if interest rates have changed since inception. New equity is
expensive to raise if the managers are reluctant or unable to
sell the existing portfolio and, if similar trusts are trading
on discounts, it may be impossible. These problems do not exist
where the gearing is provided by prior ranking share capital,
although such finance is more expensive and is therefore less
attractive to lower ranking shareholders.
In flat markets with no dividend growth, the
charges to capital (which enable a larger dividend to be paid)
necessitate the sale of assets, and everything else being equal
a fall in the level of income. So even if dividends generally
are maintained, there is pressure on the revenue account. Underlying
dividend cuts simply exacerbate this situation, and the market
prices of many high yielding trusts would collapse if their yield
prop was removed. Whenever ultra high yields are on offer it is
always in return for high levels of risk.
Hurdle rates can be difficult to interpret and
can look deceptively easy to achieve. Investors should study carefully
the basis on which they have been calculated and, just as importantly,
whether in a low inflation environment they are achievable. The
capital downside for many of these vehicles is greater than the
upside for a given annual percentage change in total assets. An
apparently low risk income portfolio invested in splits and bonds
could decline substantially in capital value if the amount invested
in other splits fails to meet its underlying hurdle, and/or where
there are risky bonds that default.
Providers of lower risk capital, such as zeros,
should be wary about financing trusts backed by volatile assets
they have limited upside but full downside.
High profile losses in these funds for the smaller
investor could ruin the good name of the whole investment trust
sector. IPO documents, particularly those aimed at retail investors,
should spell out more clearly the risks of these vehicles, and
show a wider range of possible returns. Reporting by issued trusts
is not always very informative, and too many funds operate as
Despite their popularity, we have shown that
there are some serious problems with the barbell structure. Our
biggest concern is the risk of a systemic collapse. Even if this
rather gloomy scenario does not materialise, many barbells have
stretched capital charges to the limit in order to produce high
headline yields and have invested in lower quality assets for
income. This means that the growth and income portfolios will
have to work hard to maintain the value of investors' initial
capital. If current market conditions continue there will be further
financial distress. Even if long term total returns from equities
are in line with our expectations of about 8 per cent per annum,
many funds will struggle to meet their hurdles.
We are not against high gearing, or splits per
se. We have shown in previous research that gearing has added
value for trusts, while splits enable trusts to offer different
types of securities to different types of investor, and can be
used to increased demand for the underlying fund. The recent restructuring
of Investors Capital is a good example of a sensibly structured
fund. However, we believe that many of the more recent structures
required unsustainable portfolio returns to avoid total capital
An over-dependence on easy and "cheap"
bank finance has exposed the inflexibility of the barbell structure
in more challenging market conditions. The underlying portfolio
strategy should drive the structure rather than the structure
drive the underlying portfolio strategy.