James Carthew: ‘Investment companies’ and the dividends versus buybacks debate

Oakley Capital Investments (OCI ) has just announced that it will drop its dividend in favour of share buybacks. I thought it might be worth exploring the thinking behind this move and whether other investment companies should follow suit.

To maintain its investment trust status and benefit from the various advantages this brings, a UK investment trust is required to distribute at least 85% of the income it receives to its shareholders. But this does not apply to OCI as it is a Bermudan-domiciled investment company and so is not subject to this rule. The same is true of other investment companies that are domiciled in places like Guernsey and Jersey; there are just shy of 100 London-listed investment companies that are not UK investment trusts.

In addition, like many investment companies investing in private equity, OCI does not receive much dividend or interest income from its underlying investments. Its primary objective is to beat the FTSE All-Share index over the long term, but most of OCI’s returns come in the form of capital gains. We do not get to see the split between revenue and capital returns in OCI’s accounts – again, its structure means that it is not required to produce accounts in that format. However, it seems likely that most of the dividends that it has been paying are actually distributions of capital profits.

OCI introduced a 4.5p per share dividend in 2016 ‘based on the consistent income generated from co-investments and increased cash returns from exits’, but that was also perhaps an attempt to stimulate new interest in the shares, which were trading on a 29% discount. At the time, 4.5p represented a 2.7% yield. The dividend has not been raised since, but the share price is up more than 180% since 2016. Therefore, today 4.5p is equivalent to a yield of less than 1%, and that is based on a share price that is trading at a 32.8% discount to net asset value (NAV).

It is impossible to say whether some investors came to OCI for the dividend in 2016 and will now be disappointed to see it scrapped, but it is clear that introducing the dividend did not close the discount in the way that was hoped.

If regulations permit, as a way of returning capital to shareholders, buybacks make much more sense for companies trading at meaningful discounts than dividends do. OCI will replace a dividend that was costing it just over £7.9m each year with buybacks of at least £20m annually. These will be accretive to the NAV for remaining shareholders and provide some additional liquidity to those that are exiting.

On their own, the new buybacks will not fix the discount either, but other measures that OCI has planned – in particular the potential shift of its listing from the specialist funds segment to the London Stock Exchange’s main market, increasing the pool of potential investors – should make a difference. I have long thought that if it were easier for retail investors to buy OCI, it would trade at a rating closer to HgCapital Trust (HGT ), which is currently on an 8% discount.

A pickup in NAV returns after a quieter period for exits would help too. Over the past year or so, when the pace of realisations has slowed, the managers have been busy adding new investments to the portfolio. Underlying earnings growth remains strong, and, if the past is a guide, once realisations pick up, so will NAV returns (investments tend to be held at conservative valuations up until the point of exit).

Should others follow OCI?

Many other investment companies focused on private equity have been paying dividends out of capital. Again, it does not appear to have helped their ratings. The question is, should they be following OCI down the route of switching to buybacks instead?

Two other investment companies focused on private equity – Apax Global Alpha (APAX ) and Partners Group Private Equity (PEY ) – trade on yields above 6% (over 9% in APAX’s case). Yet, they trade on wide discounts of 41.7% and 30.1%, respectively. They cannot boast the same impressive long-term returns as OCI or HGT, which is likely reflected in their ratings. This is particularly true for APAX.

APAX is targeting NAV returns of 12-15% per annum and was paying out 5% of NAV each year as dividends. Unfortunately, over the past three years its NAV returns have been negative, and so the dividend has been eating into its NAV.

In June 2024, APAX set out a new capital allocation framework whereby it will pay a fixed 11p dividend each year, and create a distribution pool to fund share buybacks. An initial €30m distribution pool is being topped up with cash left over after dividends have been paid and is capped at 5% of NAV. The discount trigger for buybacks being considered is 23%.

APAX’s discount has widened since it introduced the framework, but then, nine months in, it has only spent about €6m of the €30m pot – its shares are not very liquid. Therefore, perhaps there is not much point in increasing the size of the pot by scrapping the dividend. Perhaps more drastic action is needed, such as using the money to fund a tender offer.

PEY’s NAV has moved sideways for the last four years but its share price took a big tumble over 2022. In March 2024, it introduced a new capital allocation policy which applies a percentage of its free cash flow (the percentage varies depending on how wide its discount is) to fund share buybacks. Again, free cash flow is measured after it has paid a 5% dividend on NAV (about €50m, or £42m per annum, which compares to a market cap of £730m). The unfortunate thing is that there was no free cash flow available for buybacks over the course of 2024. Nevertheless, the board has just said that it is sticking with the policy.

My instinct is that PEY should think about tweaking its policy and cutting the dividend so that it is easier to come up with cash to fund buybacks. However, as APAX shows, these are not a panacea.

James Carthew is head of investment company research at QuotedData

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