Dealing with it

Advisers who are dubious about the merits of an investment company’s structure compared to that of an open-ended fund need look no further than the high-profile transactions recently concluded by the fund manager Neil Woodford. His open-ended Woodford Equity Income fund has just sold five holdings in unquoted companies to the Patient Capital Investment Trust he also manages, taking shares in the latter as payment.

It’s a deal that really speaks to the advantages of investment companies. Point one is that unquoted companies are illiquid investments that can be difficult to sell quickly at a fair price. That was problematic for Woodford Equity Income, which has needed cash to fund redemptions; in Patient Capital, by contrast, the closed-ended structure means inflows and outflows of funds from investors just aren’t an issue.

Point two is that Woodford Equity Income is set up, as the name suggests, at least in part to pay income to investors – but unquoted companies aren’t likely to pay dividends for many years to come. For Patient Capital, this is less of an issue: investment companies have the option of dipping into dividend reserves during less good years for earned income in order to fund pay-outs to shareholders.

The third point concerns governance. Woodford Equity Income has taken some criticism for this deal because shares in Patient Capital trade at a double-digit discount to the value of the underlying assets. This means the moment that the fund swapped its holdings for the investment company shares, it suffered a loss, albeit on paper.

Now, you can argue about the rights and wrongs of the deal, but there is a different governance structure for the open-ended fund. They have an authorised corporate director, who is responsible for the operation of the fund. By contrast, the investment company, like all closed-ended funds, has an independent board of directors responsible for shareholders’ interests; their job is to hold the fund manager to account. This is not to suggest that one fund has profited at the expense of the other here, but the deal will certainly have been scrutinised closely by Patient Capital’s board.

There’s a point four here too. One reason this transaction is receiving so much attention is Mr Woodford’s celebrity – as an asset manager with an enviable track record of outperformance, his recent record of what you might describe as more stuttering returns has raised eyebrows. Perfectly reasonably, Mr Woodford argues that investors must take the long view, but in his open-ended funds he is vulnerable to investors failing to do so.

When significant numbers of investors decide to run for the hills, managing an open-ended fund while coping with redemptions can be very challenging. In a closed-ended investment company, meanwhile, the issue simply does not arise. Investors may still decide to sell up en masse, prompting a dive in the shares, but this simply means their price trades at a wider discount to the value of the underlying assets, which remain intact. There’s no need to sell assets to meet redemptions – losses don’t have to be crystallised and in time the discount may narrow.

We should be careful here. Woodford Equity Income and Patient Capital have different mandates and, as such, aren’t directly comparable. Nevertheless, the events of the past month once again highlight the structural benefits that fans of investment companies so admire.