Taking Stock

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Taking Stock 16 September, 2021

FOR about 65% of the population, any discussion on interest rates is about as riveting as new legislation in Germany on the fat content of pet food.

For about 25%, who have mortgages or business debt, the fear is of a chunky rise in the servicing cost of their borrowings.

But for 10%, any significant rise in interest rates is akin to a pay rise.

It is the latter group who will now be cheering, as the various factors that drive interest rates upwards begin to conflate:

- The Reserve Bank is itching to slow the increase of inflation, by raising the overnight cash rate;

- The Australian banks operating here are being bullied by the Reserve Bank into raising hybrid capital (debt dressed up as equity), totalling billions, to shore up bank reserves;

- Corporates are rightly fearful that changes in economic conditions, coinciding with constraints on banks, will lead to the Australian banks restricting their lending, and/or applying more rigid covenants on corporate loans. Logically, the cleverest, most indebted corporates, like Wellington International Airport, will want to raise retail debt to repay the banks, before market conditions react.

Conflate these three changing conditions and the most reasonable expectations will be a genuine rise in bank deposit rates and corporate bond yields, though this will be a view not necessarily accepted, some believing that Delta will lead to a prolonged recession.  However I expect a rate rise, soon.

If I am right, the 10% who manage their own savings would cheer loudest. Those whose savings are in Kiwisaver funds and other managed funds would need to mute their enthusiasm until the fund managers have fessed up to the losses when they mark to market their fixed-interest portfolios.

To convert this last observation to everyday English, the fund managers who have bought long-term, very low-yielding bonds and notes would need to report that these securities are worth much less than they were a few months ago, when yields were at an all-time low.

This would lead to write-downs, and some ugly negative influences on those funds' performances.

Some will argue that these write-downs would be a timely reminder of the dishonest marketing of such funds when they report a final annual return comprising real interest received and TEMPORARY paper gains, caused by the short-term increase in valuations when interest rates are falling.

When gains are reversed, the returns of previous years will be seen as misleading.

Yet eventually all investors in fixed interest will gain when rates rise.

Others will argue that the fund managers made a crass error when they invested other people's money into long-term bonds, at one stage some months ago at rates of around 0.6%. Those investing other people's money were probably reacting to the message that even NZ might succumb to the concept of negative interest rates.  The dopiest of fund managers provided long term mortgage finance at rates that now look silly.

From all of this, the smartest to emerge will be those who accepted pitifully low short-term rates – sometimes literally nothing – while they waited patiently for rates to revert to the 3.0%-4.0% range that we are now seeing.

A year at nil, followed by nine years at 3%, is immensely more rewarding than 10 years at 2%, if you can afford the first year of nil.

Patience is indeed a virtue.

Most who manage their own portfolios use banks for short-term rates (up to two years), as the fee involved in buying bonds for short terms destroys yields.

These investors then look to build a ladder of notes and bonds, gaining better returns and locking in the income on which they rely.

The smarter investors will use bonds that have any of the following features:

- The notes are issued by regulated banks with high capital levels and an established ability to raise equity in tough times;

- The notes are issued by profitable, dominant corporates with credibility gained by a history of success;

- The notes are secured by meaningful, easily-valued, tangible assets.

The securities most feared are those that are subordinated and issued by companies whose real assets are intangible, or by companies still striving to achieve stability.

In recent weeks, Oceania Healthcare, with bonds secured by property, ANZ, a well-capitalised bank, and Wellington International Airport, a dominant corporate, have announced new issues. The first two discovered ample appetite for their offers.  I expect WIAL to discover full demand for its $100 million offer.

Oceania paid 3.2%, ANZ paid 2.999% and Wellington Airport is offering a minimum of 3.25%.

Investors would be smiling if their brokers were allocating even a scaled-down amount to every applicant.

More issues will follow, the Australian banks certain to be following the ANZ, offering subordinated notes at fixed rates for many years, and probably a renewal formula should the banks be denied by the banking regulator the right in any particular future year to repay in cash.

Now is a much better time to be updating fixed-interest portfolios, than any time in the past 18 months.

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LAST week's Taking Stock gently chided the greed and incompetence of many receivers and liquidators, noting that the major accounting firms, like McGrathNicol and Grant Thornton, had behaved disgracefully with their tasks at South Canterbury Finance.

However, I should have richly praised Robert Walker, the clever, dogged, brave insolvency practitioner given the task of untangling the messes of David Henderson's contrived business failure at Property Ventures Group (PVG).

Henderson, it should be recalled, was the tax evader and serial bankrupt who claimed a victory against the Inland Revenue Department, decades ago.

In doing so, he could be likened to a sniper whose rifle managed to shatter a window before he was blown to pieces by armoured tanks, his subsequent battles with the tax department suggesting his initial one-shot hit was of no significance at all, if judged by the ultimate outcome.

Henderson had spent decades creating an illusion of creditworthiness that sucked in multiple finance companies, guided by a clever solicitor and aided by the oddball politician Rodney Hide, who has often praised Henderson, and sometimes invested in Henderson's structures.

Henderson's extreme use of debt, his almost total blacking out of transparency, his serial defaults, his back street cunning and the followers of his ZAP (Zenith Applied Philosophy) Scientology teachings, created a labyrinth that few insolvency practitioners could penetrate.

Unbelievably, a now-retired PwC accounting partner, Maurice Noone, then colloquially nicknamed the South Island Rainman for PwC, arranged for PwC to audit the Property Ventures Group mess, in return for 20, or maybe 30 pieces of silver.  Or maybe 10.

The failings of PwC in this audit process were blamed by the unpaid creditors when PVG was shown to have no ability to repay its $100 million (plus) creditors.  The audit process had been amateurish.

PwC's insurance policy, probably aided by the contributions of PwC partners, stumped up many tens of millions with an out-of-court settlement arranged by the insolvency expert Walker, whose case was part-funded by a litigation funder, LPF.

Whether the out-of-court, out-of-sight settlement was $30million or $60million has never been revealed.

Whatever, PwC's capitulation was a great victory for Walker, whose task was similar to searching for wedding rings in a myriad of blocked sewerage pipes, housing a resident crocodile.

Walker was a hero.

The PVG creditors had a return that must have been tens of cents of each dollar lost, thanks to him and his litigation funder.

So here is the punchline.

Walker, having successfully attacked a Big Four accountancy firm (PWC), is now dependent on a  licensing process determined by the accountants' institute. It is seeking to ban him from practising his craft.

After his monumental effort in dealing with a Machiavelli as a bankrupt, Walker's health was depleted. He has, at least temporarily, retired. His health may become a debating point seized by the panel which judges him.

Whether or not he is banned from practising, he should be honoured as one of the most courageous and persistent pursuers of a just outcome for creditors that New Zealand has ever seen.

Do you wonder why none of the big firms took on the task of tackling Henderson's mess?

Do the initials OBN ring any bells?

Do we really want accountants to be their own regulator, with the power to preserve an OBN that has served New Zealand poorly?

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Johnny Lee writes:

The demerger of Fabric Property Group, an off-shoot from listed property trust Stride Property Group, will introduce a new listing on our exchange in early October.

An important point necessary to preface this article is to note that Stride - SPG listed on the NZX - is a stapled security and as such confers ownership of a group including Stride Property Group, which owns and leases property around the country, and Stride Investment Management Group, which manages property for various entities, including listed property trusts Stride Property Group and Investore.

A demerger occurs when a company ''spins off'', or structurally separates part of its business to create an independent, stand-alone entity. This is usually done when the objectives of the subsidiary no longer align with the overarching entity, in this case giving Fabric the opportunity to pursue growth in an avenue external to Stride's own objectives.

Other examples of demergers include Tilt Renewables' demerger from Trustpower, or South32's demerger from BHP Billiton in Australia.

Stride established Fabric late last year as a subsidiary created to own commercial property in the ''Office Building'' sector. Following the listing, Fabric will have a value (market capitalisation) of about $600 million, or a fifth of the size of Precinct Properties, another major listed property trust specialising in office space.

As part of the demerger, shareholders of Stride will receive shares in Fabric at no cost. Stride shares will fall in value, theoretically matched by the value of the Fabric shares themselves. In practice, market forces will determine the exact outcome.

The demerger allows Stride investors to either pursue an exposure to office property (buying Fabric shares) or ''town centre assets'' and property trust management (buying Stride shares).

Stride will retain a large minority (roughly 30%) shareholding in Fabric. While Stride has not entered into an escrow agreement, it has committed to hold the shares until May 2023.

Fabric has also elected to employ Stride Investment Management Group to act as its external manager.

One of the major issues with this structure is the obvious conflicts of interest that exist for the external manager. These are not hidden – in fact they are clearly highlighted on Page 47 of the 103-page Product Disclosure Statement – and the company will be very careful to ensure a robust policy is in place to minimise any perception of acting in conflict.

This conflict exists because Stride Investment Management Limited also manages assets for Investore and, more importantly, Stride Property Group. The Product Disclosure Statement cites the example of a central Wellington office building currently owned by Stride Property Group being sold to Fabric.

While the actual management of these conflicts is achievable, the perception is ultimately more relevant. For example, if said Wellington office building encounters problems after its development and sale to Fabric, Fabric shareholders would rightfully question whether their company is being treated as ''second-class citizens'' by the overarching management group. Stride will be aware of this and will be at pains to ensure that any process which concludes with a transfer of assets from one managed group to another is completely transparent and in the interests of both groups of shareholders.

Another issue with the proposed offer is the fees accrued to the manager. The fees are expected to equal about 16% of total revenue. These fees exist partly ''to incentivise the Manager to ensure transactions generate value for the Fabric portfolio'', a turn of phrase that is unworthy of anyone's vernacular, least of all a listed company. Imagine if Stride were to claim that they were not motivated or incentivised to manage Fabric in an optimal way.

These external management contracts have largely fallen out of favour among investors, due to the imbalance of risk and reward that inevitably occurs. Precinct was the most recent listed property trust to exit its management contract, buying out AMP Haumi Management Limited for $215m in order to manage its own buildings. Vital Healthcare's ongoing dispute with its external manager (Northwest) is well-known, and led to efforts from major shareholders to rein in the eye-watering fees charged by Northwest, presumably charged to incentivise them to ensure they added value as opposed to, say, not adding value.

Ironically, Stride itself is an evolution of DNZ Property Fund, which gained notoriety a decade ago following a dispute with its external management team, and had to pay more than $30 million to rid itself of an unwanted management contract.

Fees charged by Stride Investment Management Limited to Fabric include asset management fees, transaction fees, leasing fees, debt capital raising fees, property services fees, accounting services fees and, of course, performance fees. The offer specifically states that the fees cannot be changed by Fabric or Stride Investment Management Limited.

One must assume that, as part of its process of selecting Stride Investment Management Limited to the role of external manager, Fabric conducted a thorough and transparent tender process to ensure Fabric's new shareholders maximised the value of an external manager.

For Stride, the divestment is absolutely logical. The group was able to raise capital last November to purchase new assets, before selling them to investors a year later while maintaining an undeniably lucrative management contract. If Stride is to continue this path of incubating property assets before divesting on market, then shareholders of Stride will be pleased to see the accompanying growth in management fee income accruing to the group.

For potential investors in Fabric, the question one would ask is: why invest in Fabric over other, larger, more established owners of commercial office space? The company and its lead managers will now be pitching their argument for why Fabric is the superior choice.

Precinct Properties, while not necessarily a comparable peer, is an example of a listed property trust that invests in the prime commercial office space. Depending on how Fabric is priced, it intends to offer a dividend yield of between 3.6% to 3.8%, forecasted to lift slightly in future years to about 4.3%. Precinct pays a similar dividend yield (3.9% at time of writing) that is also growing, and has a market capitalisation about five times larger than Fabric. Obviously, other factors form part of the investment decision, but potential Fabric investors will logically be seeking a competitive advantage offered by Fabric over other alternatives.

Overall, the transaction is good news for investors wanting additional options to consider for investing in office property or property trusts. It is also good news for shareholders of Stride Stapled Securities, as it enjoys yet another lucrative management contract for its book.

Advised clients considering investing into Fabric, or those holding Stride and are about to receive shares in Fabric, are welcome to contact us to discuss further if they wish. We will also display our view on our client-only research page.

TRAVEL

Chris plans to be in Christchurch on Tuesday October 26 and Wednesday (am) October 27. Any client wishing to arrange a meeting is welcome to contact the office.

If Covid allows, he intends to be in Auckland in early October and to conduct seminars in November, in North Shore, Auckland, Tauranga, Napier, Palmerston North, Kapiti, Wellington, Nelson, Christchurch and Timaru, and elsewhere if feasible.

Chris Lee

Managing Director

Chris Lee & Partners Limited

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