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Return of the split cap

Most readers will know of or have experienced the debacle of the split-capital crisis in the early part of this decade. But after a time in the wilderness, recent events now mean the sector could be due a renaissance.

To recap, a split-capital trust has two or three types of share classes, each linked to a pool of underlying assets. Zero dividend preference shares (zeros) entitle holders to no future income but a predetermined amount of capital at the end of the life of the trust. Income shareholders are only entitled to receive their initial capital back at the end of the life of the trust but do enjoy all the income generated during that time.

Splits are a simple concept which continue to meet a need – school fee planning being a commonly quoted example. So why did around 50,000 investors lose most of their money, with the industry forced to create a fund of around £194m to compensate shareholders?

The short answer is that they were marketed very badly and often managed very badly. In good times such as the late 1990s, rising asset prices led to hubris. An incestuous relationship also contributed as many split-capital funds owned shares in each other and there were also dedicated “funds of split-capital trusts”. Add in unhealthy amounts of leverage to the mix (the zeros act as gearing to the returns of the other share classes) and the willingness by the industry to promote these as “guaranteed’ returns (they are not) and the mess that occurred after the 2000-03 bear market is, with hindsight, not surprising.

Many of these trusts are small, due to wind-up in the near term, and there is significantly less attention paid to trusts than to the wider market. But we are lucky to enjoy the skill and experience of a number of experts in splits who continue to follow the sector closely and invest wisely and profitably for new and existing clients.

Advisers with clients subject to the 50 per cent marginal income tax rate do not really want them to give away half of their investment income to the taxman. Equally, those who require an ongoing income may not want to pay tax on their capital gains. This is where splits can play a leading role in personal financial planning.

New rules due to be in place from September after being announced in the Budget this year aim to address a tax anomaly that currently disadvantages investment trusts versus the open-ended sector. Interest income earned by an investment trust is liable for corporation tax whereas franked dividends paid by UK companies are not.

Trusts may now elect to “stream” interest-bearing income, meaning that the income previously subject to corporation tax is now tax-free within the company.

This change in rules, together with the tax situation, means that a whole new opportunity has arisen within the UK closed-ended fund market. That is a new, well managed, conservatively run and cautiously geared split-capital sector which includes fixed-interest investments.

It will come as no surprise that the splits’ market has declined dramatically since the bad days. At their peak, the sector was worth £14bn, today it is worth around £2bn, with 19 trusts today compared with 104 at the height of the boom. Many of the split-capital trusts remaining are very different to those around 10 years ago.

Some, such as the Aberforth geared capital & income trust, Ecofin Global water & power or JP Morgan private equity are run by very good managers in asset classes of interest to the ordinary investor.

Ecofin enjoys the likes of Invesco Perpetual and Artemis as long-term shareholders, indicating that well regarded investors will put money in a sector where they recognise a quality product. The Ecofin and JP Morgan trusts have also been raising new capital in recent months. This is a sign there is both nascent growth in the sector, and recognition that raising traditional finance via issuing ordinary shares or bank debt remains difficult and expensive.

We expect to see bigger trusts issuing zeros well covered by total assets as a replacement for traditional bank debt over the coming years, as banks are reluctant to lend to the sector at present.

The split-capital sector has extremely negative connotations for many investors due to the well noted problems but within the wider investment community we believe the sector deserves a second look, albeit with a cautious and critical eye.


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