Chris Lee & Partners Ltd

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

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Taking Stock 5 June 2025

It seems reasonable for many investors who factor into their decisions the likelihood of political change to consider the probability of an imminent period when the two relevant political parties will be headed by Nicola Willis and Barbara Edmonds.

Both seem to be skilled at presenting their ideas and both seem to be motivated about the need to change our approach to spending; call it fiscal responsibility.

Many of us will be hoping that if they do inherit party leadership they both focus on changes to our national superannuation, recognising that it is unaffordable, and acknowledging that for many people 65 is no longer a relevant age at which to stop earning, and rely on welfare from the state.

Means testing and having variable ages at which to receive the pension would seem to be a topic on which the two logical, intelligent women might reach accord, removing the subject from political debate.

There are several other areas where they might find common ground.

One obvious area is banking.

For at least a decade, the cognescenti in the foyers of power have had on their dream list the creation of a large New Zealand bank, competing with the Australian banks, which collectively control around 85% of NZ banks.

I am not one to abuse the Australian owners. Strong resilient banks have regularly underwritten NZ living standards by negotiating us through disasters, often man-made disasters.

But a strong NZ banking entity would provide real pricing tension and might put an end to the often silly claim that bankers are "ripping off" New Zealanders.

Is now the time for Willis and Edmonds to meet over a green tea and a seaweed muffin to find common ground and agree to bring about change, when (or if) they become the leaders of out two major parties?

Kiwibank is currently owned by the Crown, having flirted with others like the ACC and the NZ Super Fund as a means of growing its capital.

It started out as a bank for low-value customers, the bank operating from bleak surroundings in NZ Post offices, probably more like a bank in Bratislava or Budapest than in Sydney or Melbourne.

Queues did not appeal to those with options to bank elsewhere.

Governance was sometimes of third-world standard, as were some of the bank’s policies, but gradually it matured, attracted some keen minds and is today a small but effective bank, with maybe 12% of the country’s banking business.

The Labour government bought back minor shareholdings from the other Crown entity owners and pledged that Kiwibank would remain in government ownership.

Willis and Edmonds might have the selling skills to persuade the country that there is a much wiser option for Kiwibank than being wholly-owned by a shareholder that has no desire to allocate more capital to fund growth.

The option is obvious, as it was ten years ago when NZ was locked into lazy leadership.

The answer is to merge with a listed bank (Heartland) and buyout three hamstrung unlisted banks, TSB, SBS and The Cooperative Bank, to form the Crown Bank of New Zealand.

The merged entity could remain majority-owned by the government, though if political leadership were wise the new entity would not be forced to have political appointments dominating board numbers.

The four new players would add only a few percent to the combined share of the banking market, but they would achieve for New Zealand a listed bank with access to capital and with the goal of competing with the Australian banks, making profits and providing dividends for all shareholders.

Furthermore, the transaction would greatly enhance the survivability of the likes of TSB, SBS and The Cooperative Bank, none of which can rely on access to new capital.

Of these banks, the TSB is community-owned, the ownership in a community trust structure.

TSB also owns a share of Fisher Funds, which has grown by buying the Kiwibank’s Wealth Management business, originally bought by Kiwibank from Gareth Morgan Investments. Fisher Funds is managed by the former MP Simon Power.

The other Fisher Funds owner (34%) is the American fund manager, TA Associates.

In effect, the TSB’s community trust, comprising directors hardly likely to be skilled in wealth management, have allowed TA to run Fisher Funds.

TSB Bank is a careful, low-risk, low-profit bank, its risk aversion acknowledging its lack of access to capital.

It focuses on unthreatening home mortgages at low margins.

Its profitability is thus constrained but it is highly regarded by its customers and rarely challenged, albeit now embroiled in an argument over responsibility for clients who lose money to scams.

SBS is smaller, a bank that was a building society, again without commercial shareholders, yet also trusted and stable, with a focus on low-risk, low-margin lending.

The Cooperative Bank has had a hairy history, saved from receivership by the good work of Bob Stannard in the 1970s when it had insurmountable liquidity problems.

At that time it was a cooperative, funded by its public service clients, lending to its public sector borrowers. It had no shareholder and thus no access to capital.

Known then as the Public Service Investment Society (PSIS), it was expected to return bonuses to its depositors, rather than accrue surpluses to build resilience.

Stannard did a remarkable job reconstructing the PSIS.

Like SBS, The Coop Bank profits are lean, its focus also on low-margin lending. Its capital access is zero.

So these three banks would collectively add billions of loans and deposits to Kiwibank, creating ample opportunity for savings through efficiencies.

But the real prize would be the link with Heartland Bank which, within another three years, is likely to be contributing nearer $200 million of surplus per year.

Heartland, itself an entity grown from multiple smaller companies including Marac Finance, now has ample capital and a shareholder strong enough to stave off any marauder looking to exploit its low share price as it transitions to an Australasian lender.

It bought Challenge Bank in Australia to access the Australian Government Deposit Guarantee, enabling Heartland Bank to reduce the cost of its funding because of that guarantee, which makes all banks “equal” for retail depositors.

Unlike New Zealand, the Australian guarantee was not available for non-banks, so the acquisition was in effect a payout to the Challenge owners in return for a long-term reduction in funding cost, thanks to the guarantee.

It will not be until 2028 that the last of the more expensive deposits have been cleared out but the nett result by 2028 will be a funding saving of around 1.75% on what by then might be a $3 billion loan book.

This saving would equate with an interest-rate saving of around $52 million a year.

Other synergies, growth in its Australian and NZ lending, and a fine tuning of its unwise matrix lending in NZ should enable Heartland to achieve the level of profit that its directors have forecast for 2008 — $200 million, with an implied dividend of perhaps 12 cents.

If Kiwibank merged with Heartland, used Heartland’s listing, acquired three hamstrung but tidy regional banks and cut banking duplications, it would not be hard to envisage a NZ Bank majority crown-owned, earning more than $500 million after tax per year, perhaps nearer $750 million in its second year.

The new merged entity would be one of the most profitable companies on the NZX, most certainly in the top ten by that criterion, and would attract strong fund manager support.

It would be a source of revenue to the Crown and would add a tension to the pricing of many bank products, yet still be required to have some sensible social policies.

To get there would require political support from the two major parties, to overcome the opposition from uncommercial ideologues who the MMP system delivers to the Beehive.

That might seem awkward given the leadership today but if there were tacit respect between Willis and Edmonds, and if it takes two smart women to display genuine care for the betterment of NZ, there may be a chance!

If they could concurrently reshape national super, and bring to an end to idiotic subsidies for the well off, a much stronger NZ balance sheet could be achieved, without adopting any shades of communism.

The required political cooperation could start tomorrow, with Willis and Edmonds displaying the necessary maturity to put New Zealand’s welfare ahead of blue or red nonsense.

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Fixed interest investors will have become well accustomed to the retail funding strategies of Infratil, the highly successful investment company which was created by the late Lloyd Morrison and listed on the NZX in 1994.

As an admirer of Morrison, I supported his listed company from the outset and have been well rewarded both by share price growth and by a consistent flow of bonds. Infratil is the company most supported by our clients.

Infratil by now will be approaching $2 billion of bond issuance, putting it up the top end of all NZ bond issuers.

Having learnt through his failed company, Omnicorp, how banks panic in tough times, Lloyd Morrison determined that Infratil would escape future bank panic by funding largely from a retail base, thus avoiding the sort of covenants that are brutal during bad times.

He appointed a money market-trained young man (at that time), Tim Brown, to manage the funding of Infratil’s required debt. (Brown, now in his mid-60s, has retired.)

Brown did a great job in most cases, accepting that the pricing of the bonds (the coupon rate) would have to be set at a level that acknowledged Infratil’s lack of a credit rating.

Morrison had always been cynical about the methodology and therefore value of credit ratings.

Curiously thirty years later, we are again learning a lesson about credit raters as Taking Stock will discuss in the near future.

The problem now for Infratil is that many of its faithful borrowers are just about replete with Infratil bonds , some like me, probably over-indulging with exposure that borders on the highest level allowed by any normal diversification guideline.

Rules can be flexible but are sane reminders of the value of diversification.

Infratil in 30 years has never caused any alarm for its followers and remains one of New Zealand’s best public companies, likely to be our biggest in terms of market capitalisation, given that the Australian banks are a secondary listing.

As a result, its bond issues are always fully bid, its latest issue this week being overbid by a level that forced Infratil to scale all broker requests.

What this means is that many retail investors will obtain less than they bid, scaling often occurring at extreme levels, despite Infratil not being considered by those fund managers who pledge to buy only those bonds subjected to a credit rater’s investigation.

The bidding was lopsided for a reason.

Those brokers with client permission to invest as the brokers see fit, sometimes bid for the whole of an issue, knowing that if by some miraculous event they were allotted the whole issue, they could simply stuff the bonds into the accounts of those clients who have handed over the investment decisions to their broker.

If a broker really wanted, say, $30m of bonds but bid the whole $75 million of an issue, it would create a scaling exercise that means all the honest bids became swamped. If the “bids” total $225 million, including the false bids, all brokers would receive 33% of the sum allocated.

Years ago I pestered the Financial Markets Authority and the NZX to consider quite how a broker could dump excess stock on those clients the broker did not have to consult.

However was such behaviour in the best interests of the client? Was not the broker abusing the privilege of using other people’s money to manipulate the scaling process?

That issue was never addressed.

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Bond issuesInfratil confirmed yesterday 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.

_ _ _ _ _ _ _ _ _ _

Travel

Whanganui – 11 June – David ColmanWellington – 18 June – Edward 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

Chris Lee & Partners

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