Can Aberdeen survive the split capital crisis?

Fund manager's chief executive and the director responsible for the trusts face a grilling from the Treasury Select Committee

Today is not a day Aberdeen Asset Management has been looking forward to. This morning two of its most senior directors are up before the influential Treasury Select Committee to explain why some of the company's clients who put money into split capital investment trusts are set to loose all of their investment.

Martin Gilbert, Aberdeen's chief executive, and Chris Fishwick, until two weeks ago the director in charge of Aberdeen's splits, will also try to persuade the public hearing before MPs that Aberdeen was innocent of the practice allegedly common among a "magic circle" of fund managers in the investment trust industry; the group allegedly inflated the price of each others' funds in an effort to encourage investors to pile in and to boost their own management fees.

As scandals go, the failure of many of the UK's split capital trusts is not huge. At the end of August, there were 383 investment trusts in Britain, with 110 constituted as split caps. Even when private investors were ploughing cash into the stock market in their droves in 2000, there were only 50,000 investors in split caps.

Many of these people's investments have now suffered badly, but the problem is minor compared with the thousands who suffered in the pensions mis-selling scandal in the early 1990s or the millions who are likely to see their endowment mortgage fail to pay off their home loan.

Yet the fall out from the once-obscure split cap sector is threatening to bring down Aberdeen, a one-hundred-year-old company which, fuelled by the dot.com boom, saw its shares trade at 664.75p.

Yesterday Aberdeen's shares closed up 4p at 35.5p. They have fallen from 400p just from the beginning of this year, as many investors in the market fear an implosion of the company. It is one of a number of fund managers being investigated by the Financial Services Authority over "magic circle" allegations and is also likely to be pursued through the courts by solicitors acting for hundreds of angry investors.

If found liable of that as well as producing misleading marketing material, Aberdeen could have to pay out as much as £270m in compensation to investors. If the FSA or the courts did force Aberdeen to do this, it would drown the company, which now only has a market capitalisation of £50m and is already saddled with net debts of £260m.

Even if Aberdeen escapes a massive compensation bill, some in the market think that Aberdeen's brand has been so tarnished by the split cap fiasco that it is only a matter of time before other strong lines of business, such as unit trusts or bonds, will also be fatally undermined.

Jason Hollands, deputy managing director of the brokerage BestInvest, said: "There are very, very serious problems at Aberdeen. It now has such a battered brand that the rumours are rife that its able fund managers are leaving. Why should they stay?"

Setting up split capital trusts seemed like a good idea to a number of fund managers when the stock markets were spiralling upwards in the 1990s. They took advantage of the bull run in equities by introducing funds with more and more gearing. These trusts also largely had increasing amounts of cross holdings with other split caps because, managers felt, it made sense to invest in vehicles with the same structures.

The boom in split caps, so called because they include different types of shares, came not long before its bust. By this time last year some of the highly geared vehicles were struggling to keep their levels of debt within the level stipulated by banking covenants and by this summer about a third of the entire sector were in financial distress and nearly 20 had gone into receivership.

While a number of fund managers have been hit by the spectacular fall out of split caps, Aberdeen has been sent reeling. This is because when other fund managers such as Jupiter or Gartmore set up a handful of split caps, Aberdeen launched 19, making it by far the largest player in the sector. It managed four of the trusts which are now in the hands of receivers.

Aberdeen claims to be looking arguing its case, but privately it fears a repeat of the last time it was hauled before the group of MPs in July, when the committee members did not mince their words.

Then it was the only fund manager to be forced to account for what has gone wrong with split caps in the last year. Aberdeen's management, at that meeting represented by Mr Gilbert and another director, Piers Currie, was accused of acting like a group of "snake oils salesmen" who bamboozled investors into taking up split caps. When the MPs did not accept the two's explanations, they said they were being "selective and evasive".

Mr Gilbert knows that today he will be fighting for his company's future and probably his own future as the head of Aberdeen. His colleague, Mr Fishwick, has lost his own battle to remain a director of Aberdeen, after the board accepted his resignation two weeks ago. He is only appearing before the MPs today because he was key to so many of them being set up by Aberdeen.

Aberdeen yesterday was keeping its battle plans for today's Treasury Select Committee under wraps. But many in the City believe that there is nothing Mr Gilbert could say today which would give investors confidence that Aberdeen, once one of the strongest of the many fund management houses to originate in Scotland, has a viable future.

Martin Cross, an analyst at Teather & Greenwood, said: "Is Aberdeen going to survive? In its present configuration it is open to doubt."

The surgery Aberdeen might need could be as mild as a change in leadership, Mr Cross suggests. This relies on Aberdeen not having to pay out large amounts of compensation to investors who have lost money on split caps.

Mr Cross said: "It will be very difficult to prove that investors that they have lost money because of what Aberdeen has done rather than because the markets have fallen. And even if they do prove this, it would require the wisdom of Solomon to work out exactly how much they have lost due to Aberdeen and to levy a fine accordingly."

Aberdeen is understandably very unwilling to agree to a general compensation package, but it has already agreed to make sure that more than 3,000 investors in its Progressive Unit Trust do not lose the basic investment they put into the trust.

Aberdeen felt it had to do this because it was found to have marketed the fund as the "one year old that lets you sleep at night". Unfortunately the trust was invested heavily in splits and has lost more than half of its value.

The cost of this compensation package, to be paid in 2005, depends on what happens to the stock market until that point, but it is likely that Aberdeen will have to find about £50m to fund it.

Aberdeen maintains it is "totally committed" to paying out the money but it is thought to have not been able to make a provision to pay it. This has led to speculation that the company will have to renege.

Most observers believe Aberdeen will in the end have to fall back on a course of action that other struggling financial services companies have had to accept recently: selling off bits of its business. Aberdeen is already understood to have received approaches about its well-respected property investment arm and fixed income business likely to be the first to go.

But just as MPs are watching Aberdeen carefully, so is the FSA. One observer said: "There have already been discussions between the FSA and Aberdeen on this point. One thing the FSA won't allow is Aberdeen to sell off the good bits and leave a rump with all the toxic liabilities. That would not be seen as an acceptable solution."