O ver the past couple of years, many investment trusts have taken powers to buy back their own shares and increasingly they are using these powers.
Using cash on their balance sheet to buy them, these shares are then cancelled, thus reducing the number of shares in issue.
Assuming the shares are bought at a discount, this action results in an uplift in the net asset value per share. With the number of shares in issue falling, and the laws of supply and demand, this should also create a positive environment for managing dis- counts going forward.
It is important to consider why share buybacks have become so popular in recent years. This is primarily due to the abolition of advance corporation tax in April 1999. Before this, trusts buying back shares at a price greater than their issue price had to pay ACT on the difference. This was a major disincentive for trusts whose share prices were far higher than their issue price and, in particular, affected all the long-established international general trusts.
However, since the abolition of ACT, the majority of investment trusts have now obtained share buyback authority and many trusts have used their powers.
For existing shareholders of investment trusts that use share buyback facilities, there are many advantages. For example, the decision by an investment manager to buy in shares at a discount is guaranteed to enhance shareholder value for continuing shareholders. Not many investment decisions come with such a guarantee.
The volatility of the discount may also be reduced by ensuring that a significant source of demand for the trust is maintained. This allows the investment manager to be proactive in maintaining a balance of supply and demand for the shares.
Having the authority to buy in shares allows the company to absorb excess supply when sentiment towards the sector is less favourable.
This may help to smooth volatility in the discount of the trust. Share buybacks also provide a route through which shareholders wanting to exit the trust can do so without putting undue pressure on the balance of supply and demand.
In theory, this should lead to a happier, more stable shareholder base, which also should result in the discount being more stable.
Authority to buy in shares is now seen as standard good corporate governance practice – an essential tool in the armoury of shareholder-friendly trusts – and it may be that the market is giving poorer ratings – in the form of wider discounts – to those trusts which lack the share repurchase tool.
Research shows funds with active buyback policies have seen ratings improve relative to other investment trusts but the corollary may simply be that trusts without buyback powers are being penalised.
There is also an additional complication that discount narrowing may only take place if all trusts in a specific sector take and use powers to buy in shares.
If only some trusts in a sector buy in shares, then discounts may differ within the sector. This difference can only be so wide before an opportunity exists to arbitrage between the different discounts. The conclusion of all this is that a narrowing of the discount may follow an active share repurchase policy but is in no way guaranteed.
Despite the numerous advantages of share buybacks, there are issues to consider.
For example, the buyback could result in increased gearing. Share buybacks reduce the number of shares in issue, which, in turn, increases the trust's level of gearing if the absolute amounts of money borrowed remain unchanged.
However, shareholders and private investors can be reassured that trusts buying in shares have to ensure that borrowing covenants imposed by lenders are not breached through their actions.
Another issue is that the share buyback has to be funded and, while sometimes they will sell equities to do so, they will usually use cash on their balance sheets, which results in the liquidity of the portfolio being reduced.
On the premise that someone's gain is another's pain, who are the losers on buybacks?
On the face of it, the management groups, in that share buybacks shrink the size of investment trusts – the asset base on which fees are charged. But, it is in the management groups' best interests to be managing investment trusts where performance is good, discounts are stable and the shareholder base is satisfied and share buybacks can help achieve these objectives.
One thing is certain – investors in investment trusts with an active share buyback policy are backing boards and managers whose top priority is the enhancement of shareholder value.