Split Capital Investment Trusts

June 20, 2013

Different investors have different objectives for their money. Some will require an income while other look to capital growth. Other investors may want to know the amount of money they will receive back at a given future date. Some investors have a mix of these investment objectives at the same time.

Split Capital Investment Trusts were developed to cater for a variety of investors within a single investment vehicle. They do this by offering different forms of shares, and when the split capital investment trust is first established, with its shares sold to investors, it will do so with a date of maturity. On this date the trust will wind itself up and divide any residual value amongst qualifying shareholders. This date of maturity is commonly known as the wind-up date.

Types of Shares

To be considered a split capital investment trust, the trust must be issued with at least two forms of shares (called share classes). The risks of each class of share will be different, as will the investment objectives that they satisfy.

This list of the different share classes offered by split cap trusts runs in the order of priority of payment at the wind-up date and also the inherent risk of each class of share:

Zero Dividend Preference Shares

These shares will not pay any dividends to shareholders. The return is by way of a fixed payment to shareholders on the wind-up date. These shareholders will be the first to be paid out when the trust winds-up, providing there are sufficient assets held within the trust.

Income Shares

For investors requiring an income, split cap trusts issue income shares. These often come with some capital protection and most (sometimes all) of the trust’s income that it generates will be paid to the holders of income shares through to its wind-up date.

Annuity Income Shares

Less common than income shares, annuity income shares pay a high yield which rises through to the wind-up date. Because of this high yield, annuity income shares are issued with little to no capital protection.

Ordinary Income Shares

This class of shares is also known as income and residual capital shares, and benefit the shareholder with a high income and a slice of the residual assets of the trust when it is wound-up and other liabilities and shareholders’ right shave been satisfied.

Capital Shares

These shares pay out pure capital upon wind-up, the amount of which is determined by the value of assets/ cash remaining once all other liabilities and shareholders have been satisfied.

Returns on Split Capital Investment Trust Shares

When markets are rising, income shareholders receive their income and dividends and at the wind-up date the assets are paid out to shareholders in the predetermined order as laid out above. Before any asset value can be divided between shareholders payments to shareholders, all creditors and other liabilities of the company would need to be satisfied.

However, problems arise when the market is falling. If the value of assets held by the trust is lower than the original value of the shares, then shareholders will not receive what they thought they had been entitled to.

The Split Cap Trust Crisis

Split cap trusts grew rapidly in popularity during the 1990’s, when the market was rising strongly, but then when stock market values plummeted in the early 2000’s many shareholders of split cap trusts found themselves deeply out of pocket. Those split cap trusts due to wind-up when the market was low found themselves with little or no value left (after paying debts and loans) with which to pay any returns to shareholders: even those with capital protection or the promise of fixed payments were left out-of-the-money.

The problem had been compounded by the fact that many split cap trusts had invested in other trusts, the fall in values snowballing across the sector.

In summary

As vehicles for satisfying a number of investment needs, split cap trusts should be considered by investors. However the crisis of the early 2000’s highlighted the potential high risks involved – particularly with owning capital shares and high income shares – and complaints to the financial ombudsman ballooned overnight.

This led to a review of the sector by the financial regulatory authorities, with compensation schemes put in place and the number of complaints received has subsequently dropped sharply.

Nonetheless, for those investors considering buying shares in split cap trusts, it is important to be fully aware of the risks of investment. While an investment trust’s gains can be multiplied several times by their ability to borrow money to invest, a downturn in the market could produce severe losses. Most borrowings will be linked to the value of investment, and if this falls below a certain level it could trigger sales of investments to repay the loan, or the terms of the loan be renegotiated.

While there are now new regulations to more fully protect investors, and a compensation scheme to do the same, it has to be remembered that creditors and other liabilities have to be satisfied before any payments to shareholders can be made at the time of the winding-up of the split cap trust.