According to statistics published by the Association of Investment Companies (AIC), the UK trade association for closed-end investment companies, in 2015 net fundraising for closed-end investment companies, including investment trusts, was a record £5.24 billion, 56% higher than the previous record in 2007. £4.8 billion was raised in secondary issues, with 17 new launches raising £2.67 billion. Most of the new capital was raised by investment companies investing in high yielding sectors such as property and debt.
This article looks at the attractions for a manager in launching a UK investment trust as a vehicle to invest in credit.
A UK investment trust, notwithstanding its name, is not a trust; it is a public company the shares of which are admitted to trading on a stock exchange (most commonly the London Stock Exchange). It has a number of attractive features:
- The ability to give a manager wide investment discretion through flexible investment powers;
- The ability to “roll up” and reinvest capital profits, without these triggering a tax event for investors;
- Flexible borrowing powers;
- A flexible capital structure – English company law imposes few restraints on the terms on which, or manner in which, shares are issued;
- An advantageous tax treatment and access to the UK’s extensive network of double tax treaties, without the need for additional downstream structuring;
- A particularly helpful provision of the US/UK double tax treaty, and a relatively recent (2009) legislative change in relation to the treatment of interest income received by an investment trust (as described below) – with the result that the UK investment trust can be a particularly attractive vehicle for US-source interest payments that would otherwise be subject to US withholding tax; and
The ability to issue new shares, buy back shares and hold shares in “treasury”.
The flexibilities in capital structure and borrowing powers enable a manager to manage a stable portfolio of assets without the need to maintain a liquidity reserve for large redemptions, as is the case with an open-ended fund. Further, the stock exchange listing means that an investor should be able to realise its investment more readily than for a similar investment in a closed-end private fund – in the latter case, the ability to realise value is largely dependent on either waiting for the private fund to make distributions following its sale of assets, or finding a buyer who will typically acquire at a significant discount to both invested capital and net asset value. This means an investment trust is particularly well suited to investment in less-liquid assets.
An investment trust is exempt from tax on gains but pays tax (currently at 20%, falling to 17% by 2020) on income, at the same rate as a trading UK company. However, in the case of interest income, an investment trust can make a so-called “streaming” election – this effectively passes through some or all of the entity’s interest income as an interest distribution to its shareholders, which is then taxable in the hands of investors as interest and fully deductible for the investment trust. This means that interest income can be effectively tax-free in the hands of the investment trust and distributed to shareholders taxable as UK-source interest, and generally with no withholding taxes deducted at source in the UK.
The investment trust is a company for the purposes of double tax treaties and, for example, can generally benefit from double tax treaty benefits on interest income. In almost all cases, investment trusts also meet the “limitation on benefits” test in the UK/US double tax treaty – this would be more difficult for other types of fund. Thus, US-source interest that does not qualify for any other exemption (such as the portfolio interest exemption for bonds) – for example, from loans – can generally be received gross by the investment trust with no US withholding. Further, if a “streaming” election is made as discussed above, there also would not be UK tax payable at the level of the investment trust. With OECD action, following the culmination of the Base Erosion and Profits Shifting (BEPS) project, likely to tighten up the availability of relief under double tax treaties, the investment trust may be well-placed to benefit in relation to interest from other sources as well. While often there are ways to structure other types of funds to minimise tax leakage, these can add significantly to set-up and operating costs whereas the investment trust structure can often be simpler.
Nevertheless, the enhanced transparency of an investment trust structure can pose challenges for an investment manager, including ensuring that it can manage the “discount” at which shares of investment trusts typically trade relative to the net asset value of their underlying investments. While discounts in 2015 were significantly narrower than in previous years, and some trusts (especially those backed by yield) were able to command premiums, it is generally necessary to pursue an active discount control mechanism (which may include buying back shares) and to engage regularly with actual and potential shareholders to ensure that any discount does not become a problem.
The other challenge facing a manager seeking to launch a new investment trust is raising the capital. Existing investment trusts are already out there competing for the same capital and a new trust needs a reason to be successful. One reason for launching a new investment trust is to use it as a vehicle to restructure an existing private closed-end fund reaching the end of its investment period, by rolling investors into the new trust in return for the trust assuming the closed-end private fund’s investment portfolio. With significant assets already available to support the launch, this would provide greater certainty of capital raising for all parties while at the same time:
- Enabling the manager to raise further funds;
- Providing liquidity for investors; and
- Providing permanent capital for the manager.
Clearly, a manager considering such a restructuring would need to engage with investors in the existing private closed-end fund – to seek their consent to the restructuring, and also to determine whether tax, legal or regulatory issues would make the restructuring unattractive for the existing investor base. A new fee model that mirrors more closely that of a typical investment trust (which generally pays only a management fee, and no performance allocation) would also need to be adopted. While those issues are not insignificant, in a climate where holding periods for assets can be longer than originally envisaged, or where a manager otherwise wishes to take a longer-term view, the option of an investment trust may be an attractive alternative to existing end-of-life options..