The prospects for the UK and indeed the world economy have deteriorated dramatically over the past few months. Central banks have launched costly rescue plans and aggressively reduced interest rates. The price of oil, commodities and raw materials has fallen significantly, placing downwards pressure on inflation. Commentators suggest that many major economies (including the UK) face a deflationary spiral, where reductions in prices lead to lower production, which in turn leads to lower wages and demand and then on to further reductions in prices. This view is supported by a survey we have recently undertaken of major UK businesses where over 60 per cent of respondents considered that it was very likely or likely that the UK was heading for a deflationary environment.
Mind the Gap
The level of discount to net asset value (NAV) at which the shares of many investment companies trade has been widening over recent months. Funds across a number of Investment Management Association sectors are trading at double digit discounts, with average hedge fund discounts at over 20 per cent and many direct property funds having discounts of over 30 per cent. Discounts of these levels put increasing pressure on Boards and investment managers to propose corporate actions aimed at bringing share prices into closer alignment with NAVs.
Life’s ups and downs
Exacerbating this situation is the lack of general liquidity following the withdrawal from the market of brokers with access to balance sheets for purchasing stocks. This lack of liquidity not only increases discounts but also renders them more volatile, since relatively small trades can have a magnified effect on share price.
As asset values decline, total expense ratios (TERs) increase. This relative increase in the economic burden for shareholders may lead Boards and investment managers to consider consolidating similar pools of assets. Consolidation should reduce TERs through absolute reductions in costs based on synergies across the two pools and through increasing the pool of assets across which the costs are spread.
Key points - Deflation
- Falling asset values are likely to lead to poor performance and, consequently, poor shareholder returns.
- Geared funds will experience
- relatively greater reductions in net asset value (NAV)
- difficulties meeting loan to value and other financial covenants.
- Inbuilt discount control mechanisms, such as continuation votes or tender offers, will likely be triggered.
In the light of the above factors, Boards and investment managers may need to consider remedial action, including mechanisms to address the absence of liquidity, consolidation of funds, asset divestments and distributions in specie.
They are also likely to consider winding up investment companies (or modifying continuation vote dates and mechanisms) and, in some cases, capital deficiency will suggest the need for equity (or convertible) injections, capital market conditions permitting, and/or asset divestments.
This briefing focuses on liquidity mechanisms, routes to effect consolidation, distributions in specie and means of remedying breaches of loan to value covenants.
The current lack of market liquidity puts great pressure on investment companies and their advisers to offer alternative liquidity mechanisms. These can include share buy-backs, tender offers and regular redemption facilities (often triggered by discount levels). Some funds have been more creative, with a small number adopting quasi open-ended structures in recent years. Whilst all these measures may help to reduce the discount to NAV, it is important to consider the liquidity of the underlying portfolio and its ability to provide cash for any corporate action. Indeed, some may argue that the advantage of a closed-ended vehicle is that it does not face pressure to meet redemptions and can therefore take a long view regardless of market conditions.
When considering what, if any, liquidity mechanism to put in place, a Board must obtain advice in the fund’s jurisdiction of incorporation. In the UK the Companies Acts require that any share buy-back be made from distributable reserves. Where such reserves are insufficient, a Court approved reduction of capital or share premium to create further distributable reserves may be possible. These provisions are currently contained in Part 5 of the Companies Act 1985 (and will be contained in Parts 17 and 18 of the Companies Act 2006 when they come into force on 1 October 2009).
Overseas companies must bear in mind the tax consequences of putting in place regular redemptions. Whereas UK companies may buy back shares under Part 5 of the Companies Act 1985 (and Part 18 of the Companies Act 2006 when it comes into force) without the risk of being categorised as open-ended, this is not the case for overseas companies. If HMRC deems an overseas investment company to be open-ended, it can result in adverse tax consequences for its UK shareholders.
The tender offer is a well-trodden path for returning cash to shareholders. Typically a tender offer will allow all investors to tender a proportion of their shares for repurchase by the issuer (through its broker) at a narrower discount to NAV than that prevailing in the market.
Companies on the Official List are required by the Listing Rules to conduct any share buy-back over 15 per cent of their issued share capital via a tender offer made available to all shareholders, and most AIM companies follow this convention as well.
Tender offers by UK companies should always be carried out on-market, as off-market purchases of shares give rise to distributions by the company for tax purposes. It used to be common practice to apply for clearance from HMRC that it would not seek to apply certain anti-avoidance legislation (relating to tax advantages from transactions in securities) to these arrangements. Following such clearances being refused by HMRC in a few cases, it is now unusual for clearance to be sought. However, even though clearances have been refused in the past, we are not aware of HMRC actually applying these provisions to tender offers and it is considered that, in straightforward cases, those provisions should not be applicable.
Key points - Tender Price
- The tender price is usually the NAV per share on the calculation date, less a specified percentage to allow for costs and, potentially, a small uplift in NAV for continuing shareholders.
- Some companies have used an auction to calculate the tender price. Under this structure, shareholders specify the discount to NAV at which they are prepared to tender their shares (for example the Templeton Emerging Markets tender offer in 2008).
- The auction method ensures that the tender price is at the widest discount acceptable to shareholders wishing to cash out, thus providing the greatest enhancement to NAV for continuing shareholders.
Consolidation - Schemes of reconstruction
The most common way of achieving consolidation in the investment company sector is a scheme of reconstruction under section 110 Insolvency Act 1986 (a 110 Scheme). In a 110 Scheme, the subject company enters into solvent liquidation and its assets are acquired by one or more other companies (which may be an existing fund or a new company promoted by the existing manager). As consideration, the acquiring company or “rollover vehicle” allots its shares to the liquidator of the subject company, who then renounces the allotment in favour of those shareholders of the subject company who have elected to roll over their interest.
Key points - 110 Schemes
- Shareholders in the subject company may be offered a cash exit, often through an open-ended money market fund.
- Shareholder approval is required for the subject company by the passing of a special resolution. Shareholders who do not vote in favour of the resolution can dissent from the 110 Scheme and then have the right be bought out at a price agreed with the liquidators or determined by arbitration. However, dissenting shareholders have been known to cause a 110 Scheme to be derailed, as in the case of F&C Emerging Markets in 2005 where the holders of over 13 per cent of the shares dissented. Scheme documents often contain a provision stating that if shareholders with holdings of more than, say, 5 per cent dissent then the directors may refuse to implement the Scheme at their discretion.
- The rollover vehicle may need shareholder authority to issue the consideration shares but pre-emption rights will not apply since the shares are not issued for cash consideration. Shareholder approval for the acquisition of the assets will not be required provided the assets fall within the acquiring company’s investment policy.
- The rollover vehicle will have to publish a prospectus in relation to the consideration shares. A prospectus is no longer required in order to list the “temporary” reclassified shares that arise during the process in order to preserve investment trust status.
- Stamp duty will be payable on the transfer of any shares in UK incorporated companies held in the portfolio at the rate of 0.5 per cent.
- Shareholders who elect to roll over their shares should not be liable to a charge for UK capital gains tax on the disposal of their shares in the subject company and their base cost in their original holding should be attributed to their new shareholding (in the case of shareholders holding 5 per cent or more of any class of share, this is subject to an applicable tax clearance being obtained by either the roll-over vehicle or the subject company from HMRC).
Consolidation - Takeover offers
Less common means of consolidation are the takeover offer and the scheme of arrangement (now contained in Part 26 of the Companies Act 2006).
A takeover offer is a simple contractual arrangement the mechanics of which may be governed by the City Code on Takeovers and Mergers (Takeover Code). A scheme of arrangement is a court sanctioned process, the operation of which may also be subject to the Takeover Code.
Most investment companies admitted to listing on the Official List of the UK Listing Authority (UKLA) will be subject to the Takeover Code. AIM companies domiciled outside the UK, Channel Islands and the Isle of Man are likely to be outside the Takeover Code’s jurisdiction.
As in the case of 110 Schemes, roll-over relief should be available for UK shareholders for tax purposes, subject to clearance in the case of shareholders holding more than 5 per cent of any class of share.
Where the target company is an investment trust, careful planning is required to ensure that the assets of the target can be transferred to the acquiring company prior to the target losing its investment trust status (and therefore not being liable to tax on capital gains).
Appendix 2 to the Takeover Code has special requirements in the case of offers and schemes where the consideration offered is calculated by reference to a formula related to the net asset value of the offeror or the offeree (the formula asset value). Rules 6, 9 and 11 of the Takeover Code, which govern mandatory offers, minimum levels of consideration and cash alternatives, apply equally to formula asset value offers and care must be taken not to inadvertently trigger an obligation under these rules.
Key points - Takeovers v. Schemes of Arrangement
- On a takeover offer, the offeror controls the process and it is easier to alter the terms of the offer, once it has been made, to combat any competing offer. On a scheme of arrangement, the scheme is the target company’s, it tends to control the process and the scheme remains more vulnerable to a competing offer. However, more recently, “deal protection packages” entered into as part of the implementation of schemes of arrangement have sought to mitigate these risks.
- A takeover offer can be declared unconditional in all respects once the offeror has received acceptances which take it over 50 per cent of the voting rights. In contrast, a scheme requires approval by a majority in number representing 75 per cent of the votes cast, and so it can be blocked by a determined minority.
- A scheme of arrangement, if approved by the requisite majority, will ensure that 100 per cent of the target will be acquired. Under a takeover offer the compulsory squeeze out provisions will only be triggered if acceptances in respect of 90 per cent of the shares to which the offer relates are obtained and accordingly there is no certainty that 100 per cent of the target will be acquired.
- It should be possible to structure a scheme of arrangement so that no stamp duty is payable (through use of a cancellation scheme, as opposed to a transfer scheme) whereas stamp duty at the rate of 0.5 per cent will be payable in respect of all shares acquired under a takeover offer.
Illiquid portfolios - distribution in specie
In current markets, and for particular asset classes, the ability to realise assets for close to their book value (or bid price) cannot be taken for granted. Where realisation may be problematic, a Board may wish to consider distributing some of the more troublesome assets in specie - for example as consideration under a tender offer or share buyback. Certain shareholders may prefer an in specie distribution as it will allow them to reflect the market price of the underlying assets in their own NAV without any discount.
However, attractive as it may appear, this route may prove difficult to achieve in practice.
Key points - in specie distributions
- The UK Listing Rules require equality of treatment of shareholders of the same class. This is one of the six listing principles that apply to companies on the Official List.
- If an in specie alternative is being considered by a company careful thought should be given as to which shareholders are offered the chance to participate. Any qualifications for participants may have to be justified to the UK Listing Authority.
- In addition, the UKLA may treat the distribution of securities in portfolio companies to a large number of investors as an offer to the public of those securities for the purposes of the Prospectus Rules. Unless an exemption is available (such as the offer being made to less than 100 persons per EEA state), this may require the production of a prospectus in respect of each underlying portfolio company, which would render the proposal impractical and expensive.
- Specie distributions will normally be treated as income in the hands of UK shareholders for tax purposes (in the same way as normal dividends). Also, where the distributing company is an investment trust, care needs to be taken to ensure that the company complies with the requirement that it does not retain more than 15 per cent of its income (and does not breach the requirement that it may not pay dividends out of realised gains).
Remedying LTV covenant breaches and rectifying capital deficiencies
Investment companies with exposure to gearing, as is typically the case with property investment companies, will be considering ways of avoiding breaching covenants in their bank facilities regarding the value of the company’s assets versus the value of its loans (loan to value or LTV covenants).
One course of action open to such companies is the disposal of certain assets. The sale of particular investments should create cash that can be used to pay down debt, thus reducing the loan to value ratio of the relevant debt facility. In order for this course of action to work, however, there must be a willing buyer for the assets concerned. The danger for investment companies seeking to dispose of assets is that they become forced sellers, committed to realising assets at almost any price. This can significantly reduce the benefits of a disposal programme as the proceeds of any sale could be much lower than the value at which the relevant assets were previously carried in the investment company's books.
Alternatively, investment companies at risk of breaching LTV covenants may seek to raise fresh capital. The most straightforward route would appear to be the issue of new ordinary shares, although current market conditions make this somewhat challenging.
Assuming that a cash injection is possible, it is important to consider on what terms potential investors will agree to invest. If it is likely that the net asset value of the investment company will continue to fall, investors may seek to negotiate discounts, potentially quite steep, to attempt to protect themselves from further falls. One way for investors to reduce this risk is to invest through a convertible instrument rather than directly via equity. A convertible with the strike price tied to net asset value per share as at a certain date would give investors some certainty that their investment will not be immediately devalued in NAV terms, although any further declines following the conversion date would have an impact. The downside to a convertible instrument is that the potential dilution to existing equity holders increases. The investment company's advisers will have to consider these competing interests when structuring any potential injection of fresh funds.
Key points - avoiding breaches of LTV covenants
- Closed-ended companies listed under Chapter 15 of the Listing Rules do not have to consider the class test requirements of Chapter 10 when disposing of assets, provided the disposal is in accordance with their published investment policy.
- Disposals to related parties (including any investment manager), however, must still comply with the related party rules.
- Many investment companies are prohibited from issuing shares at a discount to net asset value (the Listing Rules prohibit such issues unless prior shareholder approval is obtained or the shares are offered by way of rights). With most listed closed-ended investment companies trading at a discount, this effectively rules out an issue of ordinary shares without prior shareholder approval. The same considerations would apply to private closed-ended funds, whose constitutional documents should be examined closely before any proposal to issue fresh equity is made.