27th April 2023
Here’s the deal. You give me £1 in cash. I’ll immediately give 2p of that away, never to be seen by you again. I’ll try to spend the remaining 98p on assets that are meant to generate a return for you. To do that for you, I will set up a business to manage those assets and charge you 1% a year. There is no guarantee I will be successful – either in buying the assets or in generating the return. Even if I am successful, it is likely the share price (what you own) may deviate from the valuation of the assets (what I buy for you in the portfolio and what I earn fees on) and trade at a discount to that value. I will be given a contract to manage those assets by a Board, for an initial term of 5 years. I will have to really mess up not to be managing the assets for a lot longer. Of course, there will be plenty of additional costs to come out of that 98p to buy those initial assets too (especially if I’m buying property), so you’ll end up with 93p-98p of assets from your £1. Does this sound like a good deal to anyone? It is for me, but not for you!
What I have described here is the proposition potential investors in investment trust IPOs face. It is also why we so rarely back IPOs! The most common rebuttal to our position is that if everyone took our attitude, then investment trusts (offering access to wonderful diversifying alternative assets and providing much-needed capital to productive areas of our economy) wouldn’t exist. Nonsense. What should happen is that the chief initial beneficiaries of investment trust IPOs – the investment advisers earning the fees to manage the portfolios – bear the costs of the IPO. Why it costs 2% is a mystery to me, but it is in large part a fee to the brokers for all the work they put into launching it (which is substantial and essential). For the investment advisor managing the portfolio of the new investment trust, the business case for paying those fees is rock solid. Invest 2% up front, and in return gain a revenue stream of 1% per year for the minimum term of the initial investment contract (e.g. 5 years). I don’t need a CFA to know that 2% up front to earn 1% for the next 5 years is pretty good. And not to forget that the contract will almost certainly be renewed as long as the adviser doesn’t do a terrible job. If the investment adviser can’t afford to stump up the cash needed to ensure investors get £1 of assets for £1, surely innovative lenders could structure a loan secured against future fees?
If the investment adviser won’t pay the costs, there are so many other ways to give day one investors a better deal. Giving them subscription shares (essentially options to buy the shares at a future date at a fixed price) is an obvious way to do it. The subscription shares would obviously be dilutive (if in-the-money) but other investors shouldn’t grumble – day one investors launched the thing after all! The subscriptions shares could be structured so that day one investors’ costs (2%) would be reimbursed (and then some) should the portfolio perform in the way the investment adviser guides investors to expect. This should be standard in my eyes – and the cost of these subscription shares at launch is way less than 2% (they are hard to value, but a bit of Black-Scholes and some conservative volatility assumptions will get you a cost of far less than 1%) – and the bearer of these costs are investors who buy in the secondary market subsequent to issue, rather than the broker or investment adviser.
At Hawksmoor we do, of course, give this sort of feedback. Indeed, we’ve been consistent on this for years. Some brokers even privately agree with us. But the feedback is that next to none of our fellow investment trust investors are bothered. This is extraordinary to me. I wonder if it’s because it’s not their own money they are investing? Or is it because the institutions are so large they need the liquidity that an IPO gives them to buy the required number of shares to get positioned? Both are terrible reasons. I have also heard feedback that some of our peers don’t like subscription shares as they are too complicated or look messy on valuations. We despair!
In any case, we are now in a world where almost the entire alternative investment trust universe trades on a discount to NAV. We’ve seen barely any launches for the better part of 18 months. Launches that do get away will, we suspect, have to be innovative with fee structures and the way they handle costs (and thankfully we are seeing some that offer value to day one investors).
Underlying this all is alignment and recognising who is creating value for whom. When an investment trust is created, it is the day one investors that are literally creating a business for the investment adviser and one that potentially benefits from semi-permanent capital. Once that trust has launched, we all know how rare it is for that business (the investment management contract) to be taken away from the investment adviser. In addition, the open-ended fund world is completely opposite. Day one investors are often rewarded with better economics than subsequent investors through the availability of discounted founder share classes (the good ones of which apply in perpetuity). Day one investment trust investors usually get worse economics. They not only pay the 2% costs, but then bear execution risk (the investment adviser has to deploy the cash and buy the assets at the expected price mentioned in the IPO roadshow) and then the shares have to trade at a 2% premium (at least) in the secondary market to justify participation at IPO (opportunity cost). Our experience has taught us that the risk of having to pay a premium post-IPO in the secondary market is unequivocally worth taking on. Just look at the sector today.
IPO economics need to be addressed. Until they are, we will remain extremely reluctant to back investment trusts at launch – which is a tremendous shame and gives us no joy. But our stance is justified, we believe, by putting our own clients first.
Ben Conway – Head of Fund Management
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