8th October 2021
Footballers are well-known for their clichés. “Taking it one game at a time”, “A game of two halves”, “The next game is the most important”. But the one that winds me up is when they say “I gave it 110%”.
“It isn’t possible to give 110%”, I shout at the TV!
Whilst that may be true when it comes to human endeavour, it is possible with investment trusts thanks to the ability to use debt for gearing. This is one of the most important and distinguishing features when comparing them to their open-ended equivalents. Research has shown that because asset markets tend to go up in the long run, it is logical for investment trusts to incorporate gearing. This allows them to invest more in their asset class than would ordinarily be possible with just their equity and cash, in order to enhance returns.
Indeed, according to one piece of research I saw recently, almost every investment trust sector has outperformed their equivalent open-ended fund sector, with gearing the key reason (having a closed-ended structure, which allows a more concentrated portfolio and access to less liquid assets, are other obvious contributors to that outperformance).
The reason for discussing gearing in this note is that debt has become commonplace within many of the new breed of investment trusts we see today, particularly those trusts which invest in alternative asset classes (that is anything other than equities and bonds). We are becoming increasingly wary, remembering that too much debt was a major factor in the downfall of many investment trusts in the lead up to the Great Financial Crisis in 2008/09. We must therefore conduct another layer of research and due diligence when reviewing these trusts in order to assess a number of factors, including:
- whether the structure is appropriate;
- whether debt is purely being used to juice up otherwise mediocre prospective returns (as we felt was the case with the now doomed aircraft leasing sector);
- whether the managers are incentivised by applying debt to boost gross assets;
- what the limits or covenants are on that debt;
- whether the cost of the debt is cheap enough to create a suitable margin for returns;
- whether the debt is amortising (repayment) or interest only (requiring a final bullet payment in the future) etc.
Ultimately it comes down to applying our usual margin-of-safety checks to ensure the trust can survive a left-field event (like a global pandemic) before the bank asks for its loan back, and has a sustainable business model that works best for shareholders.
Debt can take different forms with some trusts using a Revolving Credit Facility (RCF) which is essentially a bank overdraft to draw down to invest in an immediate opportunity which then gets paid back by a subsequent equity issuance. This is sensible as it allows the manager to react quickly, but it does take shareholders for granted that they will support an equity raise on request. Others are applying simple bank debt for a period of a few years, knowing that the yield on the acquired assets, e.g. properties, songs or infrastructure, is comfortably higher than the cost of that debt. Lately boards and managers have taken advantage of record low interest rates to lock in long term fixed rate debt, with Scottish Mortgage a good case study of this having recently issued an unsecured private placement note of 2.0% for 15 years and another one at 2.3% for 25 years. It is hard to imagine a point in the future when that will not look like a cracking deal. More traditional investment trusts such as those investing in equities will use gearing on a tactical basis, adding leverage when the manager is most excited about the outlook for their respective opportunity set, thus avoiding the need to sell an existing holding before buying a new idea.
Currently, shareholders seem relaxed at most of the issuance coming to these new breed of investment trusts investing in alternative assets, judging by the scale of the equity raises. Many of which are over-subscribed, with the standard loan to value (LTV) ratio now approaching 40%. That the LTV figure has been creeping up over recent years from around 25% is typical for this late stage of a bull market – but is a signal for us to be more cautious. Investment trust IPOs and secondary placings are coming thick and fast and we need to look at each one on its own merits, i.e. taking it one game at a time. The presence of debt doesn’t necessarily increase the risk profile of an asset if it is used appropriately and proportionately, but if an asset class isn’t attractive without gearing then we will steer clear.
Daniel Lockyer – Senior Fund Manager
This financial promotion 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. HA4585.