By Simon Elliott, client director at J.P. Morgan Asset Management
The investment trust sector has been swept up in a wave of consolidation recently, with trusts merging at an unprecedented pace in their 156-year history. In 2024 alone, eleven consolidations have been announced so far, leaving many to wonder what is driving this activity, and if it a good thing for investors.
One key factor is the changing landscape of wealth management. As wealth managers grow into larger firms, they increasingly favour bigger investment trusts that can provide the liquidity they need. Some wealth managers struggle to recommend trust with a market capitalisation under £1bn – a threshold only 44 trusts currently meet.
But if bigger is better, why do some smaller trusts remain favourites in investor portfolios?
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There will always be a place for more specialist mandates that, by their nature, must remain limited in size. Trusts that focus on small-cap or even micro-cap companies, for example, require managers who can be flexible and agile. These portfolios tend to feature some of the nimblest companies – innovators and disruptors that can quickly adapt to changing market conditions.
With significant growth potential, many of these businesses are in the early stages of development, offering ample room for expansion as they grow market share and scale operations. Small-cap stocks are also less covered by analysts, making them potentially undervalued compared to larger firms and offering growth as the market recognises their worth.
These specialised mandates cater to niche investment strategies that larger trusts often struggle to replicate. As a result, investors with a strict size-based exclusion criteria risk missing out on some exceptional investment opportunities.
Additionally, smaller investment trusts tend to trade on wider discounts as larger institutional players may be reluctant or unable to invest effectively. Retail investors can therefore take advantage of such price dislocations, getting access to a top rate, well-managed but nimble portfolio at a significant discount to NAV.
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Nevertheless, it has become increasingly difficult to justify the existence of trusts with a market capitalisation below £200m. This is where consolidation comes in, offering several advantages to both professional and retail investors.
Larger investment trusts benefit from increased liquidity, which makes buying and selling shares easier and more cost-effective. For institutional investors, liquidity is a crucial consideration.
Another major benefit of consolidation is cost efficiency. As trusts grow, they can take advantage of economies of scale, leading to lower fees. Many trusts have adopted tiered fee structures, passing on these savings to shareholders. For investors, lower fees are always a win.
Historically, boards have been cautious about such corporate action, but recent experience shows that many boards are now more open to consolidation, recognising the need to grow in size to remain appealing to new investors. In some cases, trusts that didn’t necessarily need to merge have still chosen to bulk up, viewing size as a competitive advantage.
It seems reasonable to assume that consolidation will continue, despite positive developments in the sector such as changes to the cost disclosure regime and a boost from lower interest rates. However, there are also reasons why the number of consolidations is likely to remain modest.
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Merging trusts is a complicated and expensive process, often costing over £1m in professional fees. In many instances, the impact on shareholders has been alleviated by initiatives such as fee holidays. But it still means not every deal is viable or attractive. Sometimes, struggling smaller trusts are better off winding down rather than pursuing a merger.
Consolidation only makes sense when the merging trusts have similar investment strategies. If the portfolios differ too much, merging them can be difficult and unwelcome by shareholders, unless a liquidity event is included as part of the deal.
Recent consolidations have offered shareholders the option to take cash—sometimes up to 25% of the trust’s net assets—if they don’t wish to stay invested in the newly merged entity. While this adds cost to the transaction, it can smooth the process, especially when there’s a change in investment mandate.
It is important to note that shareholders must approve any consolidation, and while hostile takeovers are rare in the investment trust sector, boards can block unwanted bids by offering their shareholders a cash exit. Most consolidations, however, occur through friendly approaches, often following a strategic review.
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So, will the current wave of mergers continue? It’s likely many of the easier deals have already been completed, leaving more complex transactions for the future. But with investors increasingly demanding larger, more efficient trusts, boards may need to consider consolidation as a viable option to stay competitive.
While bigger isn’t necessarily always better, for many trusts, merging may be the key to survival in today’s investment landscape.
