Part 3: Alignment and Structure
14th July 2023
We believe there needs to be significantly better alignment in the investment trust universe between Boards of Directors, Investment Managers, and brokers with shareholder interests. This requirement becomes increasingly obvious when discounts to net asset values (NAVs) are persistent as there is no motivation to do something about it due to poor incentive structures.
Board of Directors
The job of the Board of Directors is to ensure that shareholder interests are always looked after. This is a wide-ranging remit including making sure the investment advisor is managing the vehicle to the best of their abilities and in line with the objectives of the trust, to ensuring that the trust structure is relevant, and shareholder returns are closely aligned with NAV returns. One of the big positives of the investment trust structure for investors is the additional layer of scrutiny on the investment manager that having an independent board brings. Although sometimes the external managed structure of an investment management agreement can make it hard to effect changes.
Whilst there are some good Boards in place today, there are far too many examples of poor governance from Boards of Directors across the investment trust universe, with many of the issues stemming from poor alignment of interests between Boards and the shareholders they are employed to represent.
This lack of alignment is particularly noticeable when it comes to addressing investment trust discounts. Remuneration in general is poorly structured and does not incentivise Boards to do all they can to close the discount, especially the option of winding-up trusts that persistently trade on discounts. Today, most directors are paid a fixed fee each year regardless of the shareholder experience or manager’s performance.
The investment companies’ team at the broker Investec publish an excellent annual “Skin in the Game” report, which shows the annual fees for the directors of all investment trusts compared to the amount they have invested in the trust. What always stands out is that the annual fees that most directors receive from their role on the board is higher than the amount they have invested in the vehicle. This immediately creates a conflict of interest with shareholders: boards are more incentivised to keep the vehicle running and collect their annual fees than drive a good return on their shareholding and are especially disincentivised to wind up a trust even if it would result in the best outcome for shareholders. Turkeys don’t vote for Christmas.
Ultimately, shareholders have the power to remove directors if they are not acting in the shareholders’ best wishes – but this can be a complicated, long, and messy affair: many investors do not have the time or resources to pursue this. Therefore, we believe a better alignment from the start for all directors will have hugely positive repercussions for the whole sector.
The job of investment managers is to achieve the investment objectives of the trust, and successfully market the vehicle to help keep demand for shares elevated and help with the trust’s rating relative to the NAV. Very rarely do we see investment management fee structures that ensure close alignment with shareholders.
Today, only around 10% of investment trusts have fee structures that see the investment manager paid on the lower of net asset value or market capitalisation. Most investment management agreements have fee structures that are paid on NAV. We believe this results in poor alignment with shareholders:
- If the shares trade at a discount to NAV, the investment manager does not experience the same pain as shareholders as their fees continue to be paid on NAV. This is especially the case if there are also performance fees based on NAV.
- Investment managers can be overpaid based on stale NAVs. Many investment trusts only publish NAVs on a quarterly or semi-annual basis. As a result, NAVs are often stale and not reflecting current market conditions. In the event market conditions deteriorate and a discount opens, investment management fees do not reflect that until the NAV is lower, potentially a full 6 months later. We do accept this works both ways with a rising NAV, which would result in higher fees for the investment manager, also coming with a lag.
When it comes to investment trusts, the job of brokers is varied from launching new vehicles, including appointing the initial board members, providing ongoing advice to the board, and market making.
Brokers are well incentivised to launch new vehicles and over the past decade have taken advantage of buoyant markets to help raise billions of pounds for new investment trust IPOs. When it comes to advising on M&A and wind ups however, brokers are not nearly as well incentivised. Once they have made a large one-off sum from launching a new vehicle, they are quickly onto the next thing. As we covered last week in the IPO process, this fee structure for the IPO process could be staggered over the first few years post launch and even linked to the rating of the trust during that period to ensure better alignment with shareholders.
Brokers should speak the truth to Boards and provide sound advice. However, this can be clouded by the fact that brokers want to retain their brokership and as a result there is a danger of telling the board what they want to hear rather than what they need to hear.
It is common that the investment manager is involved in the selection of the independent board during the IPO process. This should not happen and brings into question the independence of some Boards, with the risk they are more aligned with the investment manager than shareholders.
Shareholders have their part to play too. Too many owners of investment trusts are not engaged enough with the sector and do not speak to the Boards that represent them. This amplifies the alignment issues that comes from poor structures because it makes it difficult to effect change. If shareholders don’t talk to their Boards, their Boards cannot know what is in their best interests and so the easy default position is stick with the status quo and continue to collect their annual fees and brush issues under the carpet, including persistent discounts. For a healthy, thriving investment trust sector we need engaged participation from all shareholders. After all, most institutional investors boast of their ESG credentials yet fail to deliver on the ‘G’. We worry that the trend of industry consolidation, creating ever larger wealth managers with centralised buy lists run by analysts lacking the time, resources or skill set to effectively engage with Boards is at the heart of this lack of shareholder activism.
Investment trust structure
We recognise that when it comes to addressing discounts on investment trusts that hold illiquid assets, there are often limited options in the short term. It can take some time to sell assets to gain the liquidity required to help manage a discount either through returns of capital at close to NAV or through accretive share buyback programs (buying shares at a discount increases NAV per share). Within private equity, there is often ongoing funding requirements for companies, which at times will need to come before discount control mechanisms as failing to provide additional capital could result in material NAV falls. Many trusts employ gearing, and in more difficult times when discounts widen and as NAVs come down gearing increases and needs to be addressed ahead of issues like discounts to NAV.
Ultimately, we need to recognise that while the investment trust is a fantastic vehicle to access less liquid assets, it is not perfect. This imperfection is amplified by poor incentive structures. A discount can become entrenched for many reasons, so incentive structures need to exist to protect shareholders. Boards, brokers and investment advisers must always remember the day one shareholder who paid a 2% premium. That shareholder MUST be protected with corrective mechanisms in place to realise value, triggered by stakeholders who are incentivised to do so.
The limitations of the structure need to be addressed as part of the IPO process as outlined in “Part 2: The IPO Process”, but also through reviews of existing investment trust structures.
From left to right: Ben Mackie, Ben Conway, Daniel Lockyer, Dan Cartridge
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