FOOL'S EYE VIEW
Split Capital Shocker

By James Carlisle
March 18, 2002

Carburton Street, London -- Aberdeen Preferred Income (LSE: APR), the split-capital investment trust, has been in the dog-house ever since the Stock Market started falling in 2000. It first breached its banking covenants and missed its dividend payment late last year (not ideal for a 'Preferred Income' trust). Then, having been through a restructuring early this year, it announced last week that it had again breached its banking covenants and would be missing its new dividend. In all, the investment trust's ordinary shares have fallen from 150p to 1p since then to make technology investing look like a picnic (almost). Yet, from its name at any rate, you might have expected a rather safer investment.

Aberdeen Preferred Income Trust plc is a 'split-capital investment trust'. The way these work is to have different 'classes' of shares that share an investment trust's assets between them.

Let's say, for sake of argument, that there are three investors, Simon Security, Ian Income and Peter Punter. Each of them have £10,000 worth of shares and that they decide to pool them so that each of them can get what they want. So they set up a fund with £30,000 of shares and agree to sell the lot in ten years' time. They agree to share it out as follows:

- Simon Security gets none of the dividends from the shares, but gets the first £20,000 that's left in the pot when they sell up in 10 years. That means that he'll turn his £10,000 into £20,000 over ten years, a return equal to 7.2% per year, so long as the fund's assets don't fall by more than from £30,000 to £20,000 over the ten years (which would amount to an average fall of 4.0% per year). They decide to call Simon's shares 'Zero Dividend Preference Shares' or 'ZDPs' or 'Zeros' for short.

- Ian Income gets all the dividends, plus he's next in line to get his £10,000 back at the end of the ten years. Let's say the dividend yield on the shares is 2.9%, the same as for the UK stock market overall (that is, the FTSE All Share). So the rules are set for Ian to get £870 per year, equivalent to annual income of 8.7% on the money that he put in, as well as his £10,000 back at the end, so long as the assets of the fund at least hold their value over the ten-year period. Ian's shares get called 'Income Shares'.

- Finally, Peter Punter doesn't get any entitlement to dividends and he has no right to the first £30,000 left at the end (which is earmarked for the others, so long as its there of course). What he does get, however, is anything that's left, over and above the £30,000. So, if the value of the fund's assets doesn't increase over the 10 years, he'll get precisely nothing.

Above that, though, Peter's position improves rapidly. He only needs the fund to increase in value to £40,000 over the ten years, a return of 2.9% per year, to get his money back, and he only needs the fund to increase by 5.9% per year to be doing better, in terms of total return, than Simon and Ian. If, for sake of argument, the fund did really well and managed an increase in its capital value of 15% per year, then it would rise to a total value of  Peter Punter would get back a total of £91,000, equivalent to an annual return of nearly 25% on the £10,000 he originally staked. Peter's shares, by the way, get called 'Capital Shares' and, as you'll have spotted, they tend to be very risky.

Back to Aberdeen 'Preferred Income'

So that's the theoretical position and it doesn't sound that bad in the grand scheme of things. The reality, however, is a lot worse, because the agreements between the different classes of shareholder are generally much more complex. Instead of having a Simon, an Ian and a Peter, you might have, say, a Simon, plus another Simon (who's even more secure because he gets to take his money out sooner), plus a slice of debt, which has to be paid back to the bank, and then a sort of cross between Ian and Peter at the end who gets lots of income but who's position is 'highly geared' because of all those people that take their money out before him.

As far as I can piece it together (and it's not an easy task), that, roughly speaking, was the original position with Aberdeen Preferred Income at the end of February 2001. In its annual report, it had the following to say about its capital structure:

The Group has a capital structure comprising Ordinary shares and, through its subsidiary Aberdeen Preferred Securities PLC ("Securities"), 2003 Zero Dividend Preference shares ("2003 ZDP") and 2008 Zero Dividend Preference shares ("2008 ZDP"), all classes of share being listed on the London Stock Exchange. Additional gearing is provided by £18 1 /2 million (nominal) of 5 3 /8 per cent. RPI-linked Debenture Stock 2007, £19 1 /4 million (nominal) of 8.25 per cent. Subordinated Unsecured Loan Stock 2023 and £134 million of bank loans.

Work that one out! Perhaps I'm missing something, but the ordinary shares don't sound as though their income is very 'preferred'. A better name for the trust might have been 'Aberdeen Income, if you're lucky, Trust'. To make matters worse, a large part of the trust's investments were made in other split capital trusts. So, for each of these, you'd have to worry about a whole new range of Simon, Ian and Peter hybrids (not to mention the banks).

Anyway, the banking covenants were duly breached back in October and the trust went through a complex restructuring earlier this year. Essentially it appears to have involved the raising of £72m, about half of which went to the banks to keep them happy and about half of which went into the trust to restore its balance sheet. The people that put the £72m in were given 'stepped preference shares' (don't ask).

For all the world it looks like an exercise in 'doubling up'. It hasn't worked and last week the banking covenants were breached again and the restored dividend was suspended.

The moral of the tale

You'll probably have guessed the moral of this sad tale already. I haven't exactly been opaque about it (as you might have expected from one of these trusts - sorry, cheap shot I know). The simple fact is that neither you nor I or pretty much anyone else has a prayer of making a sensible assessment of this type of investment and...

If you don't understand it, don't invest in it!