5th May 2023
It is generally accepted wisdom that recycling is a good thing. Asking ChatGPT what it thinks about recycling, it highlights environmental benefits (such as reducing the amount of waste going to landfill), economic benefits (creating new jobs in recycling industry), conservation of resources (like timber, water, and minerals), and energy conservation (recycling uses less energy than producing new products from raw materials). We think it is missing something: the benefits of recycling assets held in investment trusts – duh!
For much of the past decade, investment trusts that focused on alternative assets like solar farms, wind turbines, property and infrastructure have had an easy ride. With bond yields relentlessly declining each and every year towards zero, investors had to look elsewhere when it came to getting an attractive level of income without taking on too much risk. This resulted in burgeoning demand for investment trusts invested in real assets which typically offered yields of 5-7%. Due to this demand, much of the past decade has seen these trusts trade on premiums to their net asset values (NAVs). As a result of these premiums, when opportunities have presented themselves that are more attractive than the existing portfolio, rather than selling assets they simply raised more capital to deploy into their pipelines. Alternatively, as debt was so cheap to access, they were able to use cheap leverage to further bolster return profiles.
Unfortunately for these trusts, that easy ride is now over.
The past 18 months has seen the 10-year government bond yield rise from sub-1% to over 3.7% as I type. Credit spreads have widened from all time tight levels back towards long term averages. The combination means investors can move away from alternative investment trusts and back into bonds for yield. This has resulted in premiums to NAVs rapidly evaporating, with most trusts now trading on discounts (in some cases very substantial discounts). Trusts cannot raise additional capital if trading at a discount. Debt is also no longer cheap for them to raise either, and in some cases isn’t accretive to use and needs to be paid down.
A change in approach is required. Investment managers of alternative trusts should no longer just sit on their accumulated assets and collect the cash flows; they need to earn their fees and be genuinely active. We would like to see managers embracing recycling to maximise returns for shareholders.
There are several benefits to recycling assets, including:
- Proving the current net asset value and installing confidence in the investor base that a discount to net asset value is not warranted. The way net asset values of alternative assets are calculated can often come across as a bit of a black box. Lots of assumptions (including discount rates, inflation, revenue, and cost projections) go into the calculation, but ultimately an asset is only worth as much as someone else is willing to pay for it. Sell an asset, and you know exactly what someone else would pay for it.
- Provides ammunition to the managers to reinvest capital into higher return pipeline opportunities.
- Provides ammunition to pay down debt at a time when debt costs are elevated.
- Provides ammunition to buy back shares if trading at a discount.
Unfortunately, so far there has been very little evidence that these benefits are being recognised by investment managers of trusts, who appear unwilling to accept that we are now in a new world where they will not be able to easily raise new money.
Last week, we were therefore very pleased to read the news from Next Energy Solar (not held in our Funds) announcing a capital recycling programme. The trust intends to dispose of 236MW of assets from its subsidy-free UK solar assets. Proceeds are to be used to repay its drawn revolving credit facility, invest in long-term opportunities (such as battery energy storage systems which it wants to have greater exposure to) and to buy back shares which trade on a 10%+ discount to net asset value. This is great news for shareholders, and ticks all of benefits listed above. Broker comments suggest confidence that the sale will be done at a premium to carrying value – thus proving the NAV. The shares have already begun re-rating highlighting that investor confidence has improved. The debt is expensive, so paying it down makes sense. Finally, we know from our investments in battery storage that the return profile from battery assets should be higher than those available from the existing portfolio of solar assets. It’s a win-win-win for the trust and for investors.
Within our Funds, there are other examples of high-quality management teams that have been recycling capital into new opportunities, to fund buybacks and to pay down debt. Within shipping, Tufton Oceanic and Taylor Maritime are great examples of this discipline, and within property LXi REIT is another. Our hope is that these examples will encourage other trusts to follow suit, particularly given the very wide discounts to net asset value that most investment trusts now trade on. It is time for the managers to prove their active credentials and start recycling.
Dan Cartridge – Assistant Fund Manager
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