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IT Insider: Forget the split-cap crisis - ZDPs still have a place in your portfolio
by James Carthew on Oct 12, 2011 at 00:01
JP Morgan Private Equity, the $600m private equity fund of funds, announced in August that it had acquired a £56.5 million portfolio of private equity funds in the secondary market and had decided to finance part of the transaction with an issue of zero dividend preference shares.
These have a life of about six and a quarter years and are well covered – over nine times at maturity (but see below). They are priced to give the vendor 8.25% per annum, but are being resold to new investors at price equivalent to a return of 7% per annum (the vendor gets the profit on this deal as part of their consideration). Crunching the numbers this means you will make roughly 50% on your money in six years.
JPEL has been one of the more prolific issuers of zeros in recent times. It already has two tranches of zeros in issue – one maturing in 2013 and the other in 2015 . Some have queried the usefulness of using zeros to finance relatively illiquid portfolios given the difficulty of raising funds from the portfolio to fund a bullet repayment.
JPEL is attempting to address this by asking holders of the 2013 zeros to roll over up to 40% of the issue into the new 2017 zeros. Potentially this would reduce the final level of asset cover on the 2017 zeros to 5.4x.
Given the level of final cover (which bolsters your confidence that the zero will be repaid in full), with inflation currently running at 4.4% in the UK and an equivalent gilt offering a gross redemption yield of 1.7%, this zero issue looks quite attractive. For equity holders though the attractions of the deal are more finely balanced.
JPEL states in the prospectus covering the new zero issue that is has returned 31.4% since launch in June 2005, equivalent to 4.7% per annum. Clearly if returns do not pick up between now and the end of 2017, equity holders will lose money on this deal.
The zero market has dwindled in recent years as the split capital market shrank following the collapse of 2001 / 2002. Many investors were put off splits for life and no wonder given the over leverage and the magic circle investing that left holders of many seemingly safe zeros getting back a fraction of the money they had invested. I think it is a shame that a few greedy fund managers and brokers destroyed the reputation of what should have been a great product.
The first thing to remember is that not all split capital structures are risky. Buying a package unit (usually one of each class of share) in an ungeared split capital trust or one geared only by zero dividend preference shares is little different to investing in a conventional trust.
The simplest split capital structures just have capital and income shares. The beauty of the structure is that separation of income and capital returns dramatically increases the potential shareholder base. Income is much in demand but capital returns attract much lower tax rates – now should be a boom time for these structures.
Zeros increase the gearing for both income and capital shareholders. Historically they have been priced relative to equivalent gilt yields but nowadays, even for well covered issues, zero investors seem to be demanding relatively high yields – I think this is a rare example of a sector where investors are being realistic about inflation.
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After a record year for inflows and market-leading performance in 2012, emerging market debt has taken a large step towards the mainstream. Our recent debate covers the outlook for the asset class this year and where opportunities can be found.
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J.P. Morgan Elect on investment growth, income and cash. More information on J.P. Morgan investment trusts.