Are investment trust discounts getting out of hand?

Risk-off sentiment has pushed investment trust discounts to historically wide levels and many boards have been proactively trying to address the issue.

This year will be a record for share buybacks with almost £3.5 billion of investment trust share buybacks in the first 11 months, data compiled by the Association of Investment Companies (AIC) shows.

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That is almost 30% more than a full-year figure of £2.7 billion for 2022 and continues a clear trend towards buybacks in recent years.

Source: Winterflood and Morningstar, figures rounded to the nearest £m.

Below, we take a closer look at buybacks, how effective they are and other measures being taken by boards to try to keep a lid on discounts.

What are share buybacks?

An investment trust can use cash on its balance sheet to buy its own shares, which it thencancels to reduce the number of shares in circulation.

Buybacks are one of the key tools used by boards to narrow the trust’s share price discount to net asset value (NAV). This is especially true for trusts that have discount control mechanisms, which aim to stop a discount going over a certain percentage. Some have a “zero discount” policy and strive to ensure the shares trade close to their underlying NAV in normal market conditions. Only funds with highly liquid portfolios can contemplate such a policy, however.

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Generally speaking, buybacks support the share price and improve investor sentiment. “A commitment to undertake buybacks can be a message from a board that it feels the shares are too cheap and it’s taking action to address that,” says Matthew Read, a senior analyst at QuotedData. “It’s also a strong indication that it believes in the accuracy of the NAV – both should be good for sentiment.”

Who’s buying back what?

Analysis by Peel Hunt shows that equity strategies continue to dominate buyback activity, but there has also been an uptick among alternative asset trusts.

In pursuit of its zero-discount policy, Troy Income & Growth (LSE:TIGT)has bought back the greatest amount of shares as a proportion of shares in issue during 2023 at a total of £30 million or 16% of issued share capital.

Based on the total spent on buybacks, Worldwide Healthcare (LSE:WWH) tops the table with more than £200 million of shares repurchased. Another nine trusts have bought back more than £100 million of shares, including three in the AIC Flexible Investment sector – RIT Capital Partners (LSE:RCP) with more than £150 million, Capital Gearing (LSE:CGT) at more than £140 million and Personal Assets  (LSE:PNL) at more than £120 million, according to Peel Hunt.

Top 10 buyback programmes in 2023 (% of issued share capital (ISC)

Source: Morningstar, Peel Hunt. Data for 2023 to 3 November 2023. 

Top 10 buyback programmes in 2023 (£m spent)

Source: Morningstar, Peel Hunt. Data for 2023 to 3 November 2023. 

Boards of infrastructure trusts have also been active in buying back shares. “A key feature of 2023 has been the introduction of buyback programmes across several real asset strategies where discounts have widened considerably in response to the rising interest rate environment,” says Peel Hunt analyst Thomas Pocock.

Some have made more progress than others. Several have hit or exceeded their original commitments. Aquila European Renewables Ord (LSE:AERI) and Foresight Solar (LSE:FSFL) continued buybacks beyond their original target. SDCL Energy Efficiency Income Ord (LSE:SEIT)completed its £20 million buyback programme on 11 September but has been inactive since.

Others have made limited progress. Cordiant Digital Infrastructure (LSE:CORD) and Downing Renewables & Infrastructure Ord (LSE:DORE) have each repurchased around £2 million since starting buybacks in February and March respectively.

More recently, Greencoat UK Wind (LSE:UKW) committed to a £100 million share buyback programme – by far the largest planned by alternative strategies.

Other than ongoing buyback programmes, investment trusts can repurchase their own shares through a tender offer where all shareholders are given the option to redeem some or all their holding at either a set price or auction determined price.

Private equity trust Pantheon International (LSE:PIN) is the largest example of this, having completed a £150 million tender in September.

Are there limits on buybacks?

David Liddell, a director at IpsoFacto Investor, points to three constraints on buying back shares for UK registered companies: shareholder permission, available “distributable reserves” and cash or liquid assets that can be turned into cash.

“The biggest constraint on companies is likely to be the availability of cash, hence it’s more difficult for companies that are fully invested in illiquid sectors – property, infrastructure, private equity and illiquid bonds – to buy back shares. These, of course, are precisely the sectors where the discounts are highest,” he says.

Recently, both Troy Income & Growth Trust and Capital Gearing Trust have come up against restrictions. TIGT was forced to suspend its discount control mechanism as the number of shares bought back had depleted its shareholder authority (around 15% per annum) and distributable reserves.

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And since the end of October, CGT has not been able to complete its usual share buybacks due to having limited distributable reserves. At a general meeting on 5 December the trust attained shareholder approval to create more distributable reserves and is also pursuing court-sanctioned accounting changes to solve the problem.

“If any investment trusts were at risk of depleting their distributable reserves, the issues flagged by CGT and TIGT should have served as a useful reminder to ensure the appropriate accounting measures are taken in a timely manner and we would hope not to see a repeat in the near future,” says Pocock.

In other jurisdictions, the distributable reserves restriction does not apply. “All the company needs to show is that it’s solvent, hence companies like Guernsey-domiciled Fair Oaks Income is constantly buying back shares,” says Liddell.

He adds: “A further twist is that unrealised losses can be ignored in the calculation of distributable reserves, so although it’s showing negative revenue reserves Petershill Partners (LSE:PHLL) is able to buy back shares regularly.

Do buybacks work?

Discounts remain stubbornly high despite the significant increase in buybacks. Does it therefore follow that buybacks are ineffective?

On the contrary, Peel Hunt’s analysis gives at least some indication that trusts whose boards have been buying back shares have not suffered the same extent of discount widening as peers that have not been repurchasing shares.

Among conventional equity trusts, those that have bought back at least 5% of shares in issue and £25 million by value (excluding those with zero discount policies) have experienced two percentage point less severe discount widening than their respective peers.

“Indeed, within this subset, we note a meaningful (circa 50%) correlation between the proportion of shares bought back and how well the relative rating has held up,” says Pocock.

Discounts among infrastructure trusts that have initiated buyback programmes this year are on average four percentage points better than the peer group weighted average. AERI and SEIT, which seemingly paused their buybacks on 11 October and 11 September respectively, have since seen their discounts widen by eight and five percentage points more peers.

While recognising that regular buybacks can have the desired effect, Liddell emphasises the need for other factors to support the share price, such as a distinct investment proposition and good access to private client investors.

“Personal Assets Trust is a good example of this. Without good investment performance share buybacks are unlikely to do the trick,” he says.

What else can boards do?

It may not always be practical or reasonable to narrow a discount through share buybacks.

“We think that the main reason that investment companies outperform is that they can operate with a fixed pool of capital,” says Read. “Share buybacks make the fund smaller and more expensive to run as the costs are spread over a reduced asset base.”

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Boards have been proactive in other ways, such as completing strategic reviews and proposing mergers and wind ups.

“The trend to merge investment trusts to create bigger, more liquid and potentially more cost-effective trusts has continued with four mergers already completed this year and an additional four proposed for early 2024,” says Annabel Brodie Smith, communications director at the AIC.

For example, having suspended its share buybacks, the board of TIGT has since proposed a merger with STS Global Income & Growth Trust Ord (LSE:STS).

Asset disposals at uplifted values can also help to improve investor sentiment. “For example, in August, the Renewables Infrastructure Grp (LSE:TRIG)sold three wind farms in the Republic of Ireland for 26% more than it had them valued for, and NextEnergy Solar Ord (LSE:NESF) just sold its 60MW Hatherden ready-to-build solar project for double its holding value,” says Read at QuotedData.

Could boards do more?

“Almost certainly,” says Liddell at IpsoFacto. Communication and engagement are highlighted as key areas for improvement.

“There’s no magic bullet,” says Ben Yearsley, investment director at Plymouth-based Shore Financial Planning. “But ultimately, boards need to do more to proactively promote the benefits of their trust.”

Read agrees. “Money well spent by a board on marketing the trust’s story, where the market is not properly understanding its true value, can go a long way: funds that are good at engaging with the market in both good and bad times tend to have tighter discounts.”

Shareholders have a responsibility too though. “Although boards are responsible to shareholders, we have seen instances where shareholders have not used the opportunities for engagement,” says Andrew Rees, an investment manager at EQ Investors.

“Each investment trust is different, and this is why it’s important for shareholders to engage with boards directly. Most boards we have met are very agreeable to hearing from shareholders.”