Part 4: Capital Allocation and Corporate Activity
21st July 2023
The de-rating of the investment trust sector and the fact that many now trade on wide and entrenched discounts poses important questions of Boards regarding capital allocation and strategy.
All too often when questioned about wide discounts Boards and management teams shrug their shoulders and say there’s not a lot they can do about the share price and that measures like buying back shares does little to drive a re-rating. This is perhaps true but that doesn’t negate the importance of share buy-backs as a tool in the armoury of all trusts trading below net asset value (NAV). Buying back shares on a wide discount can be highly accretive and should be regarded as a capital allocation decision to be considered alongside reinvestment, debt reduction and other forms of returning capital to shareholders when looking to deploy cash. Buying one’s existing portfolio at a discount should also be a lower risk, better informed investment than making a brand-new acquisition which on a risk-adjusted basis suggests a higher hurdle rate for the latter. From an IRR perspective the correct decision only becomes apparent after the event of course, but it would still be nice to see more boards and advisors giving greater thought to the capital allocation decision and perhaps even providing ex-post analysis of the outcome. Ultimately the burden of proof should be on the Board to outline why buy backs are NOT happening.
As previously discussed, we believe certain investment trusts in the alternative real assets space trade on wide discounts because investors don’t have faith in the stated valuation of the underlying assets. NAVs for assets like infrastructure, renewables and royalties are inherently opaque with lots of moving parts and assumptions around revenue forecasts, inflation and discount rates to name but a few. With this in mind we believe judicious recycling of capital is key. Asset disposals provide investors with transactional evidence helping to validate NAVs with the amount a third party is willing to pay the ultimate arbiter of value. Prevailing discounts also mean real asset investment trusts can no longer pursue the old strategy of buying assets with debt and then raising fresh equity to pay down their revolving credit facilities. In this new world, selling steady state projects or investments where asset management has already borne fruit provides capital to be deployed into new investments with potentially higher return prospects. Selling assets can also free up capital for accretive buybacks and whilst we accept prescriptive discount control policies are less appropriate for trusts investing in less liquid assets, we still believe buy-backs should be a permanent consideration. There are plenty of examples of alternative trusts buying back shares at the moment and we think its important more follow suit, particularly in the context of the pre-2022 rush to issue fresh equity at often debatable premiums to live NAVs. Doing something to try and address the divergence between relatively stable NAVs and prevailing elevated share price volatility is particularly important in this space given the embedded diversification qualities of the underlying assets (low economic sensitivity, defined cash flows etc.).
We’re also aware that some Boards and investment advisors are reluctant to engage in buybacks for fear of shrinking the trust and impairing liquidity. The cynics amongst you might suggest that this is particularly true of investment advisors who tend to be paid on net assets as opposed to NAV per share, but ultimately boards should be independent and embrace the fact that sometimes it’s necessary to shrink to grow. Ironically, the common knowledge that a Board is committed to efficient capital allocation may prevent a discount from emerging in the first place.
Whilst buy-backs can be a useful capital allocation tool, the persistence or otherwise of a discount is largely a reflection of prevailing market sentiment which a buy-back program has only limited ability to influence. The fact that many discounts have become entrenched means that other provisions should be in place to protect shareholder interests. For more liquid investment trusts these might include features like tender offers and annual redemption facilities at NAV less costs, for less liquid ones read continuation votes and redemption pools. We believe all new trusts should include these features but also think existing trusts should embrace them as a matter of course.
There are certain instances where more drastic strategic decisions are required. Trusts trading on entrenched discounts often lack relevance, scale and liquidity and should consider returning capital to shareholders or other corporate activity to address the aforementioned issues. For investment trusts with liquid underlying portfolios, discounts are ultimately a choice with the realisation of shareholder value via an orderly liquidation a fairly straight forward and easy to execute process. Managed wind-downs are also a viable option for investment trusts investing in less liquid assets. Intransigent Boards clipping their annual salaries are an obstacle to be surmounted (turkeys don’t vote for Christmas) in what would be a cathartic and cleansing process with the resulting reduced supply having benefits for the sector as a whole. Strong Boards are also required in representing shareholder interests and in making investment advisors aware there is no such thing as permanent capital. Brokers have an important role to play in this regard, offering Boards the right advice even if it’s not the sort of news the respective parties want to deliver or hear. Similar principles apply to consolidation where the merging of two trusts doing similar things to one another helps boost scale and liquidity and reduce costs. Against a backdrop of centralised buy lists, wealth manager consolidation and an unrelenting focus on costs, remaining relevant is more important than ever. A weak market for corporate control and poison pills in the form of external management contracts adds further barriers but pleasingly we have started to see a pickup in consolidation and Boards embarking on strategic reviews.
Whilst this is good news, the path ahead is likely to be long and winding with a successful conclusion to the journey reliant on all stakeholders taking a more proactive stance over the key capital allocation and strategic decisions which are required to put the investment trust sector back on a firmer footing. Underlying everything must be the recognition that success (defined as an investment trust trading at a premium for at least some of the time) is only possible if Boards are willing to contemplate shrinking or even fully-liquidating. If not, the sector is in danger of becoming a place where the only stakeholders not riding the gravy train are the shareholders.
From left to right: Ben Mackie, Ben Conway, Daniel Lockyer, Dan Cartridge
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