Opinion: Where does all the extra money come from?
Murray Weatherston asks a number of questions about the Waltus merger proposal and invites answers.
Saturday, September 2nd 2000, 2:58PM
by Murray Weatherston
The catalyst for "coming out" has been the series of 1/4-page advertisements run in the name of advisory firms advising the world that they are in favour of the amalgamation. In the interests of full disclosure, which is a slogan of our industry, I wonder whether those firms would be prepared to disclose who paid for those advertisements?
Let me also join Doug Somers-Edgar in asking those same advisers to disclose what ongoing remuneration do they presently receive from Waltus or the existing syndicates, and what ongoing remuneration are they in line to receive from the new entity?
I don't think there has been much serious debate about the merits or otherwise of the proposed amalgamation. The main thrust seems to be that investors will receive more income (please note the word is income and not return) from the new entity.
The rest is largely that it will be better to have a property fund to diversify the risk against an individual syndicate, to improve liquidity (at what price?), and so on. I wish I had kept all the earlier individual syndicate promotion material. I reckon most of it would have argued exactly the opposite case to the case now being promoted for amalgamating into one big fund.
Given the postponement of the meeting for two weeks, the adviser endorsement advertising and the 25 August "A Note from Your Independent Chairman", I reckon that Waltus have not yet got the support for the amalgamation - they are fighting a battle to the end to get enough support.
They are in an advantaged position to opponents. They have as I would expect managed the press releases, and I don't think they would be backward in coming forward to declare that they had 75% of the votes in favour.
I am against the amalgamation for all but the weakest of the existing syndicates. I should declare that I recommended a few clients invest in a few of the earlier syndicates, and I have taken over the advisory function for clients who had existing syndicate investments. I have always been worried about the loss of NAV against issue price - most syndicates when stamp duty was in place had a NAV around 85 cents in the dollar invested after issue. We could buy $1 worth of NAV in listed property companies for 90cents so it always seemed a no-brainer to me.
What are my key concerns about the amalgamation?
1. Increased income appears to be at the expense of capital.
One of the main benefits of the proposed amalgamation is that every investor is going to get a higher income return. That is agreed, and I have calculated that over the first 19-month period, the increased pretax income that is paid out to investors is some $7.4 million.
But where does this extra come from - is it a "free lunch"?
This issue was not covered in the Directors' reports. It was also excluded from discussion in the Deloittes report to the Directors, which is a fundamental flaw in that report. As an investor, I am as much interested in what happens to my capital as I am in what happens to my income.
The Independent Chairman states in his latest note that $500,000 comes from reduced interest costs. But that still leaves a lot unaccounted for.
My hypothesis is that the increased income comes at the expense of reduced capital.
Please note that my argument is not that the company is borrowing to pay income in the sense that the income payments will put the company into a loss situation on income account. It is not paying out more than its net income.
The reason why syndicate investors have been getting reduced income from some of the syndicates is that as the initial lease term comes up for renewal, the Directors cannot be certain that they will get a lease renewal or a new tenant immediately. However most syndicates will still be required to make interest payments on debt. They might also need cash for refurbishment, and they might have to give rent holidays as an inducement for the incoming tenant.
Therefore prudence dictates holding back some income from investors, and retaining the cash in the syndicate.
An individual syndicate's net worth is largely determined by the value of the property plus its cash less existing debt. The aggregate syndicate net worth is the sum of the individual syndicate net worths. This is the status quo position against which the amalgamation proposal should be measured.
In the proposed amalgamation, the same issue about lease incentives and development expenses will arise. They have to be funded somehow. The Directors explicitly state that these moneys will be borrowed. Deloittes report confirms that. But there is no subsequent mention of the effect of that debt on the balance sheet ratios.
Now I would have thought the syndicate properties would be worth the same after amalgamation as what they would have been if they remained as individual entities. So the gross asset value can't rise. But the amalgamated company's borrowings must be higher because they have borrowed for refurbishment and incentives.
Therefore the net worth must be lower.
Hence my conclusion that the increased income return comes at the expense of capital.
2. The expected valuation of the new shares and MCNs
I haven't seen anywhere the Directors' expectations of the value of the shares and MCNs after amalgamation? Nor have I seen any adviser speculation.
Much store has been placed on the fact that the syndicates are treated equally in terms of their net asset values. But no attention has been given to the likely market value of the shares and the MCNs after amalgamation.
I am not forecasting what the price will be after the amalgamation. Rather I am setting out what I believe is the theoretical way the securities should be valued. Market price is a different issue, and will depend also on supply and demand and sentiment, inter alia.
My hypothesis is that the shares should trade at a reasonable discount to issue price. Accordingly most of the MCNs should also trade at a discount to par, the exceptions being those with the highest coupons and the longer terms. Why?
On issue, the shares will have a fixed dividend of 9% per annum. (Over time as MCNs are converted, the dividend will be able to be increased. Ditto when rentals are increased.) How much a rational investor should pay for this dividend income depends on their required rate of return. If they require 10%, then the price should fall to 90 cents (nine cents divided by 10%). If they require 11%, as I believe was suggested at the Auckland meeting at Ellerslie, then the theoretical share price would be only 81.8 cents (nine cents divided by 11%).
What about the MCNs? The MCNs are not bonds - which have a fixed coupon but are repaid at par on maturity. Rather, they convert to shares, so their maturity value depends on the share price at the time.
One of the features of the amalgamation is that whereas an existing investor has a stapled security, the shares and the MCNs will be unstapled - this means that they will trade separately. This means their relative value will be arbitrageable, assuming there actually will be liquidity for the amalgamated Waltus issues.
Sharebrokers value the convertible notes of a listed property company as the value of share plus the NPV of the extra return the convertible note gets until they convert.
If we carry this analysis over to the Waltus MCNs, then the value of any issue of MCN should be the value of the share plus the NPV of the extra return on the MCN compared with the share. For the shorter term MCNs, we can approximate this margin by multiplying the return per MCN in excess of 9% (the share dividend) by the term to conversion.
There are only three syndicates that would have a margin of 18 cents or more (that would mean they would trade at or better than par if the share price was 82 cents) - these are Regalia, Trafalgar, Senate and Storecool. Over half the separate MCN issues would not reach 90 cents on this measure.
Following this analysis, are investors who vote in favour of the amalgamation going to be disappointed in the post amalgamation marketplace?
3. Treatment of minority dissenters
I am not in favour of the tyranny of the minority. Nor am I in favour of the tyranny of the majority.
There are two ways of amalgamation under the Companies Act. The first is s221, which is a voluntary one, but which provides rights for the dissenting minority to ask to be bought out at "fair market value". This is the same provision that Infratil is invoking in the Natural Gas takeover of Transalta, which isn't an amalgamation but a major transaction but the rules are the same.
Waltus has chosen the alternative s236 route. The subject companies apply to the Court for permission to hold a meeting to consider an amalgamation, and the result has to go back to the Court for sign-off. There is no automatic buyout provision for the dissenters under this route, but the Court has the power to decide what the amalgamated company has to offer dissenting minorities.
The s236 application was made quite legally ex parte - i.e. no one else was required to be present at the hearing, and I doubt whether most investors would have known the application was being made.
It will be very important for dissenters who feel sufficiently aggrieved about a successful vote for amalgamation to ensure they are represented at the subsequent Court hearing to get the Judge to consider making a minority buyout ruling.
4. Loss of security
Four syndicates have no debt. Two other syndicates have only minor debt that does not rank ahead of the investors who have a first mortgage security.
In the proposed amalgamated company, these investors lose this preferential position. They do not seem to receive any extra compensation for this lessening of position.
5. Individual Syndicates ability to borrow
Are investors being seriously told that the banks have indicated that they will not lend to individual syndicates? By my calculations, only one syndicate has a debt to NAV plus debt ratio of significantly over 50% (Storecool, which I calculate at 60.4%).
In my experience, the lending institutions are flush with cash and will fall over each other for a good deal. Are the syndicators saying that the properties they have packaged are not good deals that stack up in their own right?
6. Tax losses
In the amalgamation, the syndicates collectively lose about $17million of tax losses. These have arisen largely because of depreciation. These are worth about $3 million at 19.5 cents and $6 million at 33 cents.
I can't see that it is beyond the wit of man to have figured out a way to use these.
If the syndicates remain as is, then these tax losses would be a partial shield against depreciation recovered on the sale of the properties.
If Directors wanted to use them earlier, couldn't they withhold a similar amount of interest payment from the investors, and then pay the gross amount out to investors as a partial repayment of their bonds? This would be tax-free in the hands of the bondholder.
If the only reason preventing this route is the issue terms of the bonds, then why not use the next AGM to ask bondholders to change the terms of the bonds. Who would vote against such a resolution? Only someone who preferred to pay tax rather than not paying tax!
Invitation
I would invite those in favour of the amalgamation to respond, especially to the disclosure issues in my introduction and to the questions in items 1 and 2, namely
1. Where do the extra returns come from?
2. What do you expect the market prices of the shares and MCNs be after amalgamation?
Murray Weatherston is an Auckland based financial planner
Murray Weatherston is the principal of Auckland-based financial planning firm Financial Focus.
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