Taking Stock 12 June 2025

DISCUSSION last week on the intended benefit of a grand merger of NZ banks generated some feedback.  The financial sector likes the thought.  To bring balance to the "dream" I should record some of the obvious hurdles to overcome.

The most obvious is the mutual structure of SBS and The Coop Bank, neither of which are large, and both of which might enjoy parochial support.

Kiwibank is the core of any plan, being a real bank with maturing bank systems. To gain political consent for a listing would require two political leaders who would work to gain the nation's blessing. My view is that the blue and red leaders might be women, Willis and Edmonds, who exhibit some commonsense.

TSB has an advantage in that it is a transaction bank, so has a low cost of funding, and a relatively low capital requirement because of its focus on home mortgages. Its access to free or low-cost money held in current accounts enables it to be a low-margin lender.

Again, parochialism may be an issue.

In any giant merger senior executives often will fight for their territory rather than look at the greater good.

Heartland in NZ is a potentially highly profitable bank but the margins it achieves in some areas of its lending have to endure high capital requirements, so its return on equity might reflect that.

It makes little sense to me that its reverse mortgage lending requires high levels of capital. Reverse mortgages (RM) have very little risk of collection problems. The average reverse mortgage today would have a loan to value ratio (LVR) of around 25%, less than half an LVR for a home mortgage. Obviously the LVR on a reverse mortgage rises each year, while the LVR on a home mortgage falls. But the bad debt ratio greatly favours reverse mortgages.

To force the banks together with a giant merger would create synergies, would lead to lower margins, and would generate NZX value.

A merger might force the Reserve Bank to review the capital requirements without threatening future bank failure.

If nothing is done, we could expect the Australian banks to enjoy nice margins here on very low-risk lending and see them maintain their focus on short-term, rate-review, mortgages.

Is this what NZ wants?

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NZ pension fund managers (KiwiSaver etc) are pleading with regulators, politicians and investors to be granted permission to invest much more money in private equity (PE).

The timing is dreadful, but these people subscribe to the theory that timing does not matter.

PE managers raise money from pension funds, insurance companies and those with extreme wealth.

The PE people then buy an asset — say a food manufacturer - using other people's money, perhaps some of their own, and usually add some bank or non-bank debt to take ownership (of the food manufacturer).

The PE manager may then sell off assets in the interest of balance sheet efficiency, or they provide capital to expand, or they cut costs to improve profitability, or perhaps they might buy another similar company seeking synergies and gains in productivity or annual profits.

When the acquisition has gained value, the PE company will either sell the improved company to a competitor in the food sector, or perhaps list the company on the stock exchange, cashing up and hoping to return cash and a nice gain to those who provided the equity.

That all sounds efficient.

The time from buy to sell may take a few years, the investors perhaps forgoing annual returns in a quest for capital gains when the eventual sale is arranged.

Occasionally, a PE company that can see long-term or high returns provided by the improvements may own the acquisition for many years, enjoying the growth and value enhancement.

NZ’s best PE company, Direct Capital, and other good performers like Rangatira, Pencarrow and Icehouse have good track records of adding value by being skilled, appropriately funded and patient.

Many others need a tailwind to survival.

Globally, the really big companies like BlackRock and Apollo have had more wins than losses.

The downside of PE investments is that they often lack liquidity, are always opaque in that the value enhancement is unknown until a final sale, and they usually richly reward the PE manager with bonuses of 15-25% of the final gain, as well as hefty annual management fees. In effect, the investors take all the risk, the manager does all the daily work, and the returns then highly reward the manager.

The concept works well when the targeted acquisition is bought at a cheap or fair price, in credible multiples of its historic earnings.

It works best when interest rates are stable, ensuring the multiple of earnings is a credible figure.

The concept rarely works when interest costs are artificially low, when valuations are at high multiples, and when economic conditions are highly volatile.

In 2020-21, the ground conditions were favourable. Covid had created fear, and interest rates were stupidly low.

By 2022 multiples were high, inflation was visible, interest rates were rising, and confidence was soaring.

All of this is my way of illustrating why the current plea for change to allow much greater investment in PE is dreadfully timed.

Sharemarket prices are extreme, the average US listed company priced at 21 times earnings, interest rates close to the bottom, bank lenders suspicious of global trading and fearful of surprises, and literally hundreds of PE deals unable to find a way to exit what are often cashflow negative deals.

Many exits are at a loss; banks are cautious about rolling loans to PE managers, and investors are vocal about wanting to exit, causing PE managers to make poor decisions.

So the timing to increase exposure to PE looks fraught.

For the pension fund manager battling to invest in PE the motivation seems to be a mix of higher fees for the pension fund, a willingness to bet against the house, a desire to reduce visibility (and accountability) OR a belief that the world is on the cusp of a new long-term rise in prosperity.

To recap, private equity made hay when interest rates were improbably low, leading to high valuations when the PE firms were selling in trade deals, or listed the companies they had been nesting.

The corporate and high-worth funders of PE had a large bucket of easily earned money. Those PE managers who sold or listed had done well until 2022.

Rising rates at the time when valuations were still high have led to a long hiatus, the risks rising, leaving the investors in PE depending on another fall in interest rates.

Clearly that has not happened. High debt servicing costs on overpriced, over-leveraged assets has led to a bulging problem.

Yet it was in this troublesome part of the cycle that here in NZ we have some fairly lightweight pension fund managers imploring some fairly uninformed politicians and regulators to make new settings, allowing the pension fund managers to rapidly increase exposure to PE, funded, of course, by Other People’s Money (long term savers).

Many PE managers are not succeeding in selling their acquired company and are finding mainstream banks reluctant to rollover loans on assets that have lost value.

The observation of this problem perhaps led to the cynical advice never to buy into a new listing being sold off by a private equity manager, certainly not to buy in current conditions.

Without access to funding, or a sale, some PE managers have made the classic mistake of raising private credit (PC) funds with the plan of obtaining funding without any need to use the risk-averse banks. Private credit also is funded by pension funds, insurers and wealthy individuals.

Private credit has now raised more than US$1 trillion from pension funds and wealthy individuals, much of it used to lend to the PE assets that cannot be sold, or to obtain refinance packages from banks.

Here is where the clue appears that a major problem is looming.

To encourage funding, the private credit funds seek a credit-rating for the loans they make or propose to make.

Read on. This is important.

The major credit raters (I will not over praise them by describing them as the “credible” credit raters) are Standard and Poors, Fitch and Moodys.

They are the top tier, regulated and (mostly), respected raters whose methodology is seen as (mostly) sound.

Recall their nonsensical ratings in 2006/7/8 led to liar loans being rated AAA, culminating in the disasters of the Global Financial Crisis of 2008, when “AAA” securities became worthless (as liar loans are wont to do).

But let’s call S&P, Fitch and Moodys the “A” team.

Here is the point.

Eighty percent of credit ratings for PC loans are now performed by tiny credit raters whose methodology is “hairy” in the eyes of many.

One tiny USA rating firm is claiming it is the most prolific rater of private credit. That firm, Egan-Jones Ratings Company, rated 3000 different loans in 2024, employing just 20 analysts, meaning each analyst knocked out a full rating every second day. Many believe a full process takes a week or more. Hmm.

While the big successful private credit issuers, like BlackRock, exclude Egan-Jones, as does the UK monster Apollo Global, Egan-Jones is in full flight.

Whereas ratings are usually paid for by the potential buyer (like a pension fund) Egan-Jones is almost exclusively paid by the PC issuer. Hmm.

The industry believes the tiny rating firms on average provide a rating three grades higher than would be the conclusion of the big three.

The small credit raters rarely offer a rating of sub investment grade. There are cases where their rating is SIX grades higher than the Big Three. Hmm.

They are busy.

In 2019 there were 3000 PC loans seeking a credit rating. In 2023 that number was 8000.

Problems are surfacing with recent loan defaults arising just a few weeks after an investment grade rating was assigned.

For two years Taking Stock has been watching the growth in the faith in PE, and with it the growing dependency on PC, supported by what I have regarded as ambitious credit ratings.

If I used a pension fund manager to manage my savings, I would exclude any who uses PE or PC for those savings.

My guess is that PE and PC are approaching the part of the cycle that smells a bit like 2007.

If Egan-Jones is the biggest rater of PC and on average offers ratings higher than others, that would perhaps be a possible cause of the odour. Hmm.

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Bond issues

Infratil confirmed that its 7-year senior bond, will have a fixed interest rate of 6.16% per annum. This was set slightly higher than the minimum interest rate, with Infratil covering the transaction costs (resulting in no brokerage payable by clients).

Clients who would like this bond should urgently contact us for an allocation.

Payment will be due no later than Friday, 13 June. 

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Travel

Wellington – 18 June – Edward LeeChristchurch – 23/24 June – Chris Lee (FULL)Ashburton – 24 June (pm) – Chris LeeTimaru – 25 June – Chris LeeAuckland (North Shore) – 25 June – Edward LeeAuckland (Ellerslie) – 26 June – Edward LeeAuckland (CBD) – 27 June – Edward Lee

Please contact us if you would like to make an appointment to see any of our advisers.

Chris Lee & Partners