Splitting headache

On April 6, when rowers from the Universities of Oxford and Cambridge embark upon their 149th annual Varsity Boat Race on the River Thames, all 16 oarsmen will be sporting the logo of Aberdeen Asset Management on their blue jerseys.

On April 6, when rowers from the Universities of Oxford and Cambridge embark upon their 149th annual Varsity Boat Race on the River Thames, all 16 oarsmen will be sporting the logo of Aberdeen Asset Management on their blue jerseys. The sartorial display will mark a rare moment of glory for a deeply troubled firm.

As the symbol of an industrywide scandal involving split capital investment trusts -- closed-end funds with different classes of shares -- Aberdeen, the largest split cap manager in the U.K., has attracted the opprobrium of the press, politicians and, increasingly, its market regulator, the Financial Services Authority. The FSA is investigating how split capital trusts were marketed and whether Aberdeen and its industry cohorts colluded in managing them.

As part of its investigation, the regulator is looking into about ten companies that were involved in the sale of split cap trusts. The list probably includes BFS Investments, Exeter Asset Management and Gartmore Investment Management, as well as brokerages Brewin Dolphin Securities and Collins Stewart.

Facing a fine from the FSA and a barrage of lawsuits from investors wiped out by the split capital scheme, and weakened by £247 million ($388 million) in debt taken on to finance an acquisition spree in the late 1990s, Aberdeen was forced in January to sell off its crown jewels -- contracts to manage six of its most popular unit trusts, with combined assets of about $3 billion. The buyer was Aberdeen’s upstart rival, New Star Asset Management, which paid £92.5 million for the right to manage the trusts.

To further pare its debt load, Aberdeen will soon sell off Aberdeen Property Investors, which manages £6.6 billion in real estate holdings. Some ten buyers are said to be interested, and the final price should exceed £100 million, far above the £44 million it cost Aberdeen to put API together in the late 1990s. When the deal closes, Aberdeen will be left with just £15 billion in assets under management, well below its peak of £34 billion in 2000. One silver lining: Aberdeen will have far less debt -- £65 million, down from £247 million.

Aberdeen shares, which rose as high as 700 pence in 2000, giving the money manager a market capitalization of nearly £1.3 billion, began falling in 2001 as the bear market kicked in. The stock collapsed in 2002 as the split cap debacle played out. Aberdeen shares traded recently at 61p.

Exeter Asset Management has suffered a similar fate. Its share price is languishing at 65p, down from a 12-month high of 475p. One of its split cap trusts, Exeter Enhanced Income, has collapsed, while another, Exeter High Income, saw a 66 percent decline in the value of its shares in 2002.

To be sure, many money managers are struggling to cope with three years of dismal market conditions. Aberdeen’s troubles, however, date back to the late 1990s, when many money managers aggressively marketed split capital investment trusts to retail investors. In all, 138 trusts were sold in the U.K. Called split capital because they carry different classes of shares -- in the simplest form, offering either regular income or capital gains -- these investment trusts are publicly traded companies. Significantly, and unlike ordinary mutual funds, they are allowed to borrow unlimited amounts of money, by taking on bank debt or issuing loan stock or debentures, in an effort to enhance returns.

The trusts used the borrowed money to leverage the assets of the funds. Aberdeen Preferred Income, one of the largest split cap trusts currently in receivership, had nearly £133 million in bank debt and £38 million in other forms of debt at the end of February 2001. This was separate from the debt of Aberdeen Asset Management. Christopher Fishwick, the architect of Aberdeen’s dalliance with split caps, managed the fund. In the bull market leverage worked for both the management company and shareholders. Aberdeen was paid 45 basis points on the assets managed, and shareholders benefited as Aberdeen Preferred Income shares rose from 80p in 1997 to a peak of nearly 180p in 1998, fueled by leverage and strong returns. Early in 2000 the shares were still worth 150p, but they were subsequently suspended and are now virtually worthless.

Many split cap trusts also invested their assets in the shares of other trust fund managers. This was perfectly legal, but the FSA is investigating whether the trusts illegally colluded to prop up each other’s shares in what has been widely dubbed a “magic circle” of mutual share support.

For example, four of the top five holdings of Aberdeen Preferred Income were other Aberdeen split cap trusts, according to the 2002 Crédit Lyonnais Securities Investment Trust Yearbook. The trust’s largest holding was in Aberdeen High Income, which was also managed by Fishwick and is now in receivership. Shareholder lawsuits allege that by buying the shares of other members of the magic circle, fund managers contrived to boost not only their share prices but also their management fees and personal compensation. Fishwick, who resigned from Aberdeen last October, was paid £930,000 in 1999 and £1.7 million in 2000. In 2001 he received £1.8 million plus £1.45 million in deferred benefits.

As markets fell, trusts were forced to sell shares to pay down debt, and the value of these holdings declined precipitously. Aberdeen High Income and Preferred Income are two of the 18 trusts that have suspended their shares. Of the 138 split cap trusts sold in the U.K., one third have such high levels of debt that they are under threat.

The trust debacle compels Aberdeen, which has been a major player in the U.K. retail fund market for the past decade, to reinvent itself as an institutional money manager. After Aberdeen Property Investors is unloaded, some £12 billion of Aberdeen’s £21 billion in assets will come from institutions, mostly life insurers. The problem: Powerful pension consultants view Aberdeen as a bit player in this game, especially as the firm is burdened with a weak track record in the most important institutional asset class, U.K. equities.

“It is true that we are not perceived as an institutional house,” says Gary Marshall, head of sales and marketing at Aberdeen. “We have to get out there and change that perception because it will be an important focus of the business in the future. In retail it is fair to say we have made a tactical withdrawal.”

Not all of Aberdeen is struggling. Its Asian business is doing very well in both the retail and institutional markets. Standard & Poor’s rates all Aberdeen Asian equity funds AA or higher.

The firm’s Asian group, headed by Hugh Young in Singapore, “is a super team,” says Meera Patel, senior fund analyst at Bristol-based Hargreaves Landsdown, a leading independent financial adviser. “They’re well worth supporting so long as clients aren’t completely put off by the Aberdeen name.”

On the retail front, the unit trusts sold to New Star suffered £300 million in outflows from September through January. Figures seen by Institutional Investor show that Aberdeen was facing redemptions at a rate of up to 20 percent last year -- four times the industry average.

Patel, for one, recommends that clients sell Aberdeen funds, with the exception of the firm’s Asia portfolios, whose assets total £3.5 billion of £15 billion that will be left after the sale of API. “I can see little reason to stay with Aberdeen when there are many other good funds around that don’t have the same uncertainty at the corporate level,” she says.

While Aberdeen struggles, New Star shines in the universe of U.K. retail managers. Launched in July 2001 by John Duffield, who helped make Jupiter the U.K.'s best-known retail fund brand in the mid- to late 1990s, New Star has grown to more than £1 billion in assets in the teeth of the bear market. It also boasts a market share of about 10 percent of net new retail money raised in the U.K. last year. Credit superior performance: Five of New Star’s six retail funds have been in the top quartile of their peer group since their inception, reports Standard & Poor’s.

New Star had been looking at various potential acquisitions before it made its deal with Aberdeen. Says Howard Covington, New Star’s CEO: “We have been looking to boost our retail business. The Aberdeen deal gives us 400,000 new customers. We’re not acquiring a business with overhead, and we don’t have to worry about integration.”

New Star’s purchase price, 5 percent of funds, sounds high in depressed market conditions -- the industry average is between 1 and 2 percent -- but it will probably prove to be a good deal for New Star. One source estimates that Aberdeen’s acquired assets come with about £30 million in revenues and £15 million in costs. Aftertax this equates to £10 million in profits, or a price of 9.25 times earnings.

Stock markets will eventually recover. When that day finally arrives, New Star could expect to float shares at a multiple of between 15 and 20 times earnings. At that point, the Aberdeen trusts acquisition will look like a bargain.