20th September 2024
We’re not always curmudgeonly when it comes to investment trust governance: last week Daniel complimented the actions of the Board of Keystone Positive Change, and in recent weeks, we have been highlighting other positive developments in the sector since we wrote our “We Need to Talk About Investment Trusts” series (see here for the final recommendations part) in Summer 2023. But recent developments have left us decidedly grumpy and exasperated, specifically around the issue of charging management fees based on Net Asset Value (NAV).
We wrote in summer 2023 that the investment adviser (or “manager”) of an investment trust’s portfolio should be paid on market capitalisation not Net Asset Value (NAV). There has been no better evidence in support of this position than recent announcements from two trusts.
Calculating fees as a percentage of a valuation figure that is so clearly subjective is simply a nonsense and creates horrific alignment issues for shareholders. I’m sorry to pick on a few trusts, and those mentioned here are by no means the only guilty party (most of the sector is!). Gresham House is an asset management firm we hold in high regard; there are very good people there and we invest in their open-ended funds. In addition, the manager of the trust in question holds lots of shares. But the announcements from Gresham House Energy Storage (GRID) and Digital 9 Infrastructure (DGI9) should really be the nail in the coffin for any remaining arguments in favour of fees based on NAV.
On Monday 9th September, GRID announced a material write-down to its NAV. The main reason for this was the use of new more conservative “revenue curve” assumptions to calculate the NAV as a result of using a different third-party provider of these forecasts. These revenue assumptions – specifically the revenues batteries are expected to generate over coming years – inform a discounted cash flow model. The factors that influence such revenues are multifarious and as a result the “curves” can move around a great deal. In addition, the fact that GRID switched from one provider to another – both doing the same job, looking at the same information and yet coming up with different forecasts – shows how subjective this analysis of revenue forecasts is.
The main inputs into a DCF being both volatile and subjective is not a great starting point for a fee structure based on NAV! The answer is obvious: fees should be calculated as a percentage of market capitalisation. The scope for misalignment resulting from fees based on NAV are also obvious. In GRID’s case, the natural question for shareholders to ask is: have they been overcharged during the period when a more aggressive provider of revenue assumptions was used? We are not suggesting malintent or malpractice here – but by allowing this situation to happen, the Board have created a space for all sorts of accusations to be levelled.
The same is true of DGI9 but for different reasons. It should be stated immediately that the original Board have departed. We could write thousands of words on what has gone wrong with this trust……but for the purposes of this blog, we will laser in on one issue. NAVs for assets that rely on future capital investment to fund their expansion are problematic. A trust that trades on a large discount and that carries a large amount of debt will be capital-starved. It is ludicrous to place assets, whose valuation at purchase relies on continued future capital injections, into a structure where such follow-on capital is far from guaranteed. The valuation should only account for that growth if sufficient capital has been set aside at the point the valuation is conducted to meet the future capital requirements for growth that are being assumed.
On the 6th September, the Board of DGI9 felt compelled to issue an RNS giving an update on the unaudited portfolio valuation and NAV ahead of the interim results, which it was preparing for. Until we have the detail, we won’t know why the Board announced a provisional NAV of 45p/share – a 43.2% reduction from the last audited NAV as at the end of 2023. But one thing is clear: fees on a NAV that is subject to such a huge and sudden revaluation is just not acceptable. For nearly 2 years, shareholders have been feeling far more pain than the investment advisers, who have been paid on a NAV that was questionable.
For any asset where there is scope for subjectivity or sudden revision due to external factors, fees MUST be levied on market cap – especially when some companies only revalue their NAVs twice a year. In a structure such as an externally managed listed closed-ended investment company, the scope for misalignment between the investment adviser and the shareholder is too great for any other structure. In DGI9’s case, the Board announced that it “has made significant progress in its independent review of the Company’s investment management arrangements and will make a further announcement upon the conclusion of the process in the near future.” It’s a great shame that the horse has bolted but we look forward to that further announcement, nonetheless.
In addition, the market capitalisation is a reflection of the interaction between thousands of market participants and is arguably a much better reflection of what the NAV might be. We do not think the standard argument in favour of fees on NAV – that investment advisers have no control over the share price – holds any water when: a) they clearly have little control over the NAV of the assets either and / or b) they, as well as the Board, should be motivated to ensure that the share price is reflective of the NAV at all times. To the extent that it ever deviates from NAV (to the downside) they, along with the Board, should be incentivised to prove the veracity of the NAV to help the share price close any discount. As Charlie Munger said, “show me the incentive and I’ll show you the outcome.”
It is time for Boards (and shareholders via the Board) to be holding investment advisers and managers feet to the fire to a far greater extent than ever before. We must have greater alignment with shareholders.
Ben Conway – Head of Fund Management
For professional advisers only. This article is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. FPC24242.
