Investment trusts are in hot water.
The sector, beloved of private investors and the odd institutional activist, is one of the little-known casualties of the credit crisis.
The reason is not the widening gap between share prices and net asset values, nor the sharp drops in underlying asset prices that have wiped nearly £20bn off the value of the sector in the past year.
Investment trusts have been faced with a more pressing concern: the two banks that were the main providers of debt to the sector – Royal Bank of Scotland and HBOS – are no longer lending.
“I suspect they have different priorities now other than financing the investment trust industry – and that’s putting it mildly,” notes the chairman of one large investment trust.
Investment companies pride themselves on being able to borrow to gear up in a rising market, unlike other mutual funds available to private investors.
While few investment companies will actually go under if they cannot get a loan, an inability to borrow will affect performance. Many investment companies could find themselves unable to take full advantage of a rising market, just after they badly underperformed a falling one.
High-profile investment companies, including Monks, Bankers, Foreign & Colonial and Edinburgh, have all admitted to errors of judgment or disappointing returns in the past year.
Invesco English and International warned its shareholders in June that it had been unable to get new funding following the banking crisis, while Finsbury Worldwide Pharmaceutical was forced to turn to Goldman Sachs earlier this year for a replacement loan, after it was unable to renew its existing debt.
As a result, investment companies are going cap in hand to their shareholders, in some surprising ways.
The most unexpected has been the return in appetite for zero dividend preference shares.
Zeros, which pay no dividend but instead pay a fixed return at a fixed date in the future, were behind the split capital scandal of 2001.
But earlier this month Ecofin Water & Power Opps, a mid-sized utility specialist, managed to raise £60m through zeros – and people close to the company said the zeros had been 50 per cent oversubscribed.
More zeros are likely to follow. Private client brokers are keen to buy products that attract capital gains tax at 18 per cent rather than income tax, which is set to rise to 50 per cent. Some are even phoning up investment trust companies to ask for more.
However, although other investment companies watched the zero issuance with keen interest, the bigger trusts are unlikely to follow Ecofin’s example.
The Association of Investment Companies insists that any investment company that issues a zero will be classed as a split cap. That classification could be enough to deter many of the bigger names.
Convertible bonds are also proving to be an attractive way to raise money. Ecofin’s fundraising included £80m in convertible unsecured loan stock, which was £20m more than it had expected to raise.
BlackRock Latin American said this month it was considering launching $75m (£46m) of convertible bonds with a six-year life and a 3.5 per cent coupon.
Iain Scouller, an analyst at Oriel Securities, predicts that more investment companies will turn to debentures, which have traditionally been taken out by investment companies on very long time horizons and can be at very high rates – Edinburgh Investment Trust is paying about 12 per cent on its debt.
He thinks companies will be able to get loans on shorter time periods on lower rates, thanks to the UK’s low interest rates.
But despite all this innovation, some investment trusts will not make it through the storm.
Analysts believe that companies in the private equity sector are more likely than others to fold due to a lack of funding, as they tend to have more debt. Hedge fund and property sector companies have also been struggling.
But larger, more established investment trusts are looking more secure as they tend to have substantial cash reserves and will have the edge over rivals when it comes to securing funding.
All they have to worry about now is providing shareholders with a decent return.
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