Companies: ADU    AFN    EEN    EVS    MAP    NOI    ONL    PROV    REI   

Christopher Spink investigates a new breed of investment trust that will benefit fund managers, backers and promoters. But will they benefit investors?

Following recent disasters surrounding poorly-performing pensions, tumbling tech funds and moribund split-capital investment trusts, consumers' regard for the fund management industry must be at a low ebb. However this has not stopped those in the industry from dreaming up fresh products to attract subscribers. One of the latest is an investment trust that swaps its own shares with those of the companies it wishes to invest in. Risk-averse investors should give this new breed a wide berth.

This simple-sounding scheme has caught on with many smaller listed companies seeking fresh investment, even though they only receive the paper currency of trust shares rather than solid cash.

So far two have been launched: the Resources Investment Trust (RIT), in January, and the New Opportunities Investment Trust (NOIT), this September. But more are mooted to set up shop in coming months and the technique of share swapping, previously restricted to large institutions, looks likely to become more prevalent in the small cap market.

Established fund managers with pedigrees at investment houses such as M&G, AIB Govett and Axa Equity & Law have come together at MoneyGuru to develop both RIT and NOIT.

The manager of RIT is David Hutchins, who managed a mining fund at M&G, now owned by the Prudential. Meanwhile ex-Axa Equity & Law manager Keith Gilham looks after NOIT.

MoneyGuru itself is part of MG Capital, an Aim-listed enterprise half owned by Aussie mining shell Newland Resources. The main mover behind Newland is entrepreneurial financier Willie West, formerly of stockbroker Durlacher West.

MG executive chairman Charles Fowler, who has spent over 20 years in the investment industry – principally with AIB Govett, where he ended up as co-chairman – is also on the Newland board, as well as those of the trusts.

RIT originally hoped to raise £100 million by offering investors, mainly institutions, a method of getting rid of shares in mining companies and oil and gas concerns they were no longer interested in holding, in exchange for shares in itself.

The idea, according to MG, is that these trusts would then be easier to sell than the raw mining stock, thus realising cash for the investors. However the fundraising was scaled back to £15 million and it now appears that, rather than pulling in new cash, the trust has built up its assets by issuing shares to struggling small cap mining prospectors in exchange for them issuing new shares to RIT.

The same pattern has been followed with NOIT, with little physical exchange of cash actually transpiring between the trust and the companies it 'invests' in.

Institutional backing?

The only 'institutions' to have used the trusts for their original purpose of offloading unwanted stakes are Aim-listed corporate financier Cater Barnard, which exchanged most of its 29.9 per cent stake in fellow Aim telecoms outfit Envesta for NOIT shares, and struggling internet games developer Online, which offloaded a 12.5 per cent holding in subsidiary ADVFN.com, the financial information website.

Both exits hardly inspire confidence in the underlying investment. But maybe straight investment performance is not the first motive for these complicated manoeuvres. The fund managers and their backers will receive a percentage of the trust's net assets each year. Outside shareholders may have to wait longer for a positive return, which is by no means guaranteed.

James Carthew manages the £50 million Advance UK Investment Trust, whose aim is to back other trusts that trade at a significant discount to their assets. He bought a 3.8 per cent stake in RIT soon after the launch, picking up shares at a 40 per cent discount to the net asset value claimed at the time. 'We saw the trust was at a large discount to NAV. We also knew a new broker would shortly be appointed who might drum up interest in the trust, and this gave us confidence to invest,' explains Carthew, who coincidentally used to work with RIT fund manager David Hutchins at M&G.

Sure enough the shares rose back above the 100p mark in May, when HSBC was appointed broker. New buyers including 'arbitrageurs at Deutsche Bank' were found, enabling Carthew to 'trade out' of some of Advance's holding at a profit.

Explaining the idea behind share-swapping trusts, Carthew says his and Hutchins' former employer, M&G, used to run a scheme that allowed holders of popular shares, such as those in privatised companies like BT or British Gas, to exchange them for units in M&G funds in order to gain a more diverse investment profile.

Advance applied this principle when setting up the Advance Value Realisation Company (ADVARC) in July 2000, allowing fund managers to swap stakes in unwanted small caps for ADVARC shares. The idea spurred 26 institutions to offload shares in 113 separate companies, worth a combined £52.7 million. Most of these stakes have since been sold, leaving the group with just 14 holdings.

Trading difficulties

This model was the original plan for MG Capital's two trusts, but RIT has not worked quite as intended. Rather than offering shareholders an exit, the vehicle has attracted cash-strapped companies desperate for money to keep going in the current harsh climate.

Thus these strugglers issue new shares to the trust in exchange for fresh paper from it. This paper can then be sold to bring proceeds into the specific company. However RIT shareholders might be concerned about holding a motley collection of shares that people want to sell. This should in theory push the value of the trust's assets lower.

Carthew accepts the adverse affect it might have on the trust's NAV. Another problem is that the companies which deal with RIT dilute their existing shareholders by issuing these fresh shares to the trust. This immediately means RIT's assets may fall in value, in turn pushing down its overall value. This massive issuance of paper could lead to a 'reverse pyramid' situation, with values continually spiralling down.

The example of Emerald Energy is pertinent. In March the oil explorer firm agreed to swap 9 per cent of its shares at 1.5p for a slug of RIT shares at a NAV of 123.5p. The deal was worth £1.17 million. Just two months later Emerald was keen to sell these shares but could only get a price of 91.75p – a 26 per cent discount to the level at which it had bought RIT shares. This fundraising exercise shows how determined Emerald was to bring in new money, even at the expense of diluting existing shareholders by 9 per cent.

Share-swapping trusts are not alone in doing deals at arbitrary valuations. Aim-listed technology developer Flintstone, which owns stakes in four private fledgling enterprises developing Russian technologies, recently increased its stake in one company, Hardide, from 31 to 55 per cent by swapping some of its shares for Flintstone paper, which Hardide's Russian founders preferred to accept rather than cash, according to chief executive David Chestnut.

The price at which the deal was concluded theoretically valued Hardide at £4.3 million, more than double the £2 million valuation it boasted at the beginning of the year, when the Oxford Technology 2 VCT invested in the venture.

This then lifts the overall value of Flintstone's portfolio which, if reflected in the shares, would benefit executives, including Chestnutt, who have substantial stakes and generous option schemes exercisable at the flotation price of 33p a share.

Management incentives

It is also in the interest of managers of the share-swapping trusts to boost the NAV of their portfolios since they get paid a percentage of this figure, which they can influence as they agree the terms on the initial share-swap deal.

RIT is managed by RSL, a private company that has MG Capital chairman Charles Fowler as a co-director, along with the trust's fund managers, including Hutchins. NSL is a similar structure set up to manage NOIT, with the same MG Capital connections.

Both management companies receive an annual fee of 1.5 per cent of the respective trust's NAV. Some 1.1 per cent goes to MG Capital. The management companies will also get a performance fee of 10 per cent of any annual rise in the NAV above 6 per cent for NOIT, and 20 per cent of any uplift in NAV each year for RIT.

No wonder then that Fowler stated in MG Capital's latest interim statement, when speaking of the set up of RIT, that: 'The size of the fees duly received from this exercise have been very satisfactory,' adding, 'We believe that there is a considerable opportunity for us now to get involved in helping launch other specialised, closed-ended investment vehicles.'

One problem that RIT has is how to pay fees to RSL, since it has raised no cash from investors. One method is to sell the equity holdings it picks up. Indeed it has already sold some of the shares it had in Celtic Resources, raising £65,000.

However the trust has also arranged a placing of £2.23 million of loan stock, repayable in 2006, with the Royal Bank of Canada Trust Corporation. RIT has to pay 6 per cent interest on these instruments, but the cash raised should more than cover the requirements of running the trust and servicing the debt, and allow it to pay management fees, before it has to sell its investments.

Others in the investment world have witnessed this lucrative exercise and are waiting to launch similar share-swapping trusts. Harry Pearl, son of north London wheeler-dealer David Pearl, is understood to be seeking up to £100 million in equities through the launch of the Jubilee Investment Trust. Jubilee will exchange its own shares with those of other companies in transport, hi-tech and other sectors.

But it is hard to see how individual investors could benefit from backing such vehicles, even if those running them can.