Friday, July 29, 2016

1MDB Scandal: The Curious Case of PetroSaudi International

If You Were Owed $700 Million, What Would You Do?

Much has been written following the US Department of Justice’s 20 July 2016 filing of (at least) sixteen complaints to seize assets alleged to have been purchased with the proceeds of an alleged misappropriation of $3.5 billion from 1MDB, Malaysia’s state-owned strategic investment and development fund.
List of Cases:  CV 16-05362; CV 16-05363; CV 16-05364; CV 16-05366; CV 16-05367; CV 16-05368; CV 16-05369; CV 16-05370; CV 16-05371; CV 16-05374; CV 16-05375; CV 16-05376; CV 16-05377; CV 16-05378; CV 16-05379; CV 16-05380.
Not one to be left behind, I’ll be contributing my own thoughts.
Given the focus of this blog, my initial posts will deal with GCC entities that were involved in transactions with 1MDB and thus may have wittingly or unwittingly participated in the misappropriation.
Unless otherwise noted, the primary source document I’m using is the DOJ complaint against Red Granite, producers of The Wolf of Wall Street (the “Red Granite Complaint” or “Complaint”).  I will cite sources paragraph numbers rather than page numbers as “sourcing” for various points.
Before I begin one very important note.
The US DoJ has filed complaints.  The parties mentioned in the complaints have not been convicted of any crime, nor have they had a chance to neither respond to the charges made against them, nor have their responses and the original complaints tested by the judicial process.  At this stage all that can be said is that allegations have been made.  Please bear that in mind as you read this post.
Let’s start with PetroSaudi International (“PSI”), a privately owned Saudi company founded in 2005, its CEO and founder and a Saudi royal prince described as the “PSI Co-Founder” in the Complaint.  While their names were not disclosed in the Red Granite Complaint, enough information was supplied so that they could be separately identified. 
  • PSI’s website identifies Mr. Tarek Essam Ahmed Obaid as CEO and founder. 
  • Press reports identify Amir Turki Bin Abdallah Al Saud as the co-founder of PSI.  But note he is not mentioned on PSI’s website.  The second link contains copies of documents from a variety of sources that purport to confirm Amir Turki’s role in the company.
The Complaint alleges that the misappropriation of funds took place in three phases: the Good Star Phase ($1 billion); the Aabar BVI Phase ($1.367 billion) and the Tanore Phase ($1.2 billion).
While I want to focus on what appears to be curious behavior by PSI and its principals in this post, let’s start with some details about the alleged misappropriation to provide context.
The Good Star Phase - Overview
Para #8 - In the Good Star Phase (2009-2011) more than $1 billion was illegally transferred to an account in Switzerland belong to Good Star Limited, which is alleged to have been under the control of LOW Taek Jho instead of to accounts of PSI or the 1MDB/PSI JV.  The transfers were in two tranches: $700 million (2009) and then $330 million (2011) as detailed below.  
First Tranche - $770 Million
Paras #40-112 contain a detailed analysis of the Good Star Phase including the alleged diversion of funds and use of the funds for asset acquisitions and payments to parties involved.
Para #60 – On 30 September 2009 1MDB issued two payment orders to Deutsche Bank Malaysia to pay: (a) $700 million to RBS Coutts Switzerland for the account of Good Star (the alleged fraud) and (b) $300 million to JP Morgan Suisse for the account of 1MDB/PSI JV (the “JV”).  This latter payment appears to be in line with the JV agreement and so is not described as fraudulent in the Complaint.  Note that 1MDB’s instructions did not specify the names of the beneficiary accounts only their account numbers.   
Paras #60-77 detail the compliance questions that Deutsche raised with 1MDB and Malaysia’s central bank and those RBS Coutts raised with Deutsche.  Both banks request the names of the beneficiaries of the payments not just account numbers as identifiers.  As per standard payment protocols, any compliance questions that Coutts had would have to be routed to/through Deutsche, not directly to 1MDB.  1MDB advises the names and that Good Star is owned by PSI.
Paras #81-90 detail questions raised by 1MDB’s Board about the $700 million transaction’s conformity with the JVA, including an unacted upon request that the $700 million be returned and paid “through the originally agreed channel” (Para #85).  This request was apparently turned aside by a 1MDB officer’s statement that funds had been paid to PSI.
Second Tranche - $330 Million
Para#94 – Between 20 May 2011 through 25 October 2011, 1MDB made five payments totaling $330 million to Good Star’s account for drawdowns by the 1MDB/PSI JV under a loan facility provided by 1MDB to the JV in June 2010 (Para #92).  A 1MDB official told 1MDB’s board that the JV had instructed that the payments go to PSI.  Once again the payments went to Good Star.
Curious Behavior by PSI and the PSI Co-Founder
Without prejudging their eventual responses to the Complaint, AA found two incidents of “curious” behavior by PSI and the PSI Co-Founder.
An apparent lack of follow-up on the $700 million shortfall initial JV payment due in September 2009.
Two payments made from the PSI Co-Founder’s account to a high ranking Malaysian official’s account at a Malaysian bank.
Apparent Lack of PSI Follow-Up on the $700 Million JV Payment
Para #52 – As per the JV Agreement 1MDB was to contribute $1 billion to the JV.  As per the Complaint the JV only received $300 million.  I didn’t see anything in the Complaint that PSI, its CEO, or any other PSI official ever contacted 1MDB about the shortfall.  AA finds it rather remarkable (hence this remark) that PSI did not press for the funds, perhaps contacting 1MDB’s Board or as a last resort going public.   A seventy percent shortfall and no apparent complaint.  AA will be mighty interested to read PSI’s response to learn what he’s missing.
Para #96 – In May 2011, the CEO of PSI requested that 1MDB inform Coutts that the first two payments (totaling $95 million) made to Good Star earlier that month were for Good Star and not PSI.  However did the CEO learn about these transfers to an account over which he had no control or ownership?  Even more remarkable at this juncture is that still short a “cool” $700 million from the initial JV payment, he apparently did not ask about the missing funds.  Or perhaps he did. Could it be that the DoJ didn’t consider that relevant to its case?  That seems unlikely because that would provide the DoJ another argument that the $700 million was “misappropriated”.
For the sake of completeness there is perhaps another reason why there was no complaint. Alleged internal PSI documents that were leaked/sold to a Malaysian website opposed to the current Malaysian Prime Minister purport to show the project had zero value. 
See the section below about blackmail.
Alleged Payments from PSI Co-Founder to Private Bank Customer in Malaysia
Para #101 on 18 February 2011 Good Star transferred $12.5 million to the account of the PSI Co-Founder at Riyad Bank.  On 23 February 2011, the Co-Founder’s account transferred $10 million to a private banking account at AM Bank Malaysia for Malaysian Official 1.  On 10 June 2011 Good Star transferred $12 million to the PSI Co-Founder’s same account.  On 13 June 2011 that account made a similar transfer to AM Bank Malaysia.  This formulation is meant to cover the possibility that another party was operating the account under a POA and that the PSI Co-Founder was unaware of and did not approve the transfers.
Para #102 the holder of the account at AM Bank is identified by the DoJ as Malaysian Official 1 who the Complaint alleges was the recipient of a $681 million transfer from Saudi Arabia in 2013.   That would appear to identify the holder as the current Prime Minister of Malaysia.  The Wall Street Journal
The reason for the payments from the PSI Co-Founder’s account is not specified in the Complaint.  Perhaps they were gifts as Malaysia’s Attorney General said was the case with the 2013 $681 million. 
Saudi royals would appear to be quite a generous lot.  Perhaps, this as well explains the apparent lack of follow-up by PSI on the “missing” $700 million JV payment.  AA definitely should cultivate more Saudi royal clients, though it would be just my luck that their innate generosity has been tempered by recent and no doubt unwarranted accusations of unethical behavior.
Perhaps like the famous Devonia transaction, the Saudi shaykh bought something from the holder of the AM private bank account and sold it to Good Star.  Shares in Sibneft?
For the sake of considering all the possibilities and not because AA has a suspicious mind, perhaps, it was a kickback of some sort.  Seems a rather meager commission on such a large amount.   Also it seems rather strange to one’s kickback payment transferred to an account in one’s own country easily identifiable.
If indeed it was a kickback, then the roughly 20% “commission” for making the payment is in line with Devonia precedent for the use of “shaykhly” accounts. 
Not Relevant But Too “Good” to Omit:  The Independent article claims that at a meeting among Shaykh Sultan, Mr Abramovich and Mr Berezovsky a bank compliance officer asked the good shaykh for a copy of his passport and proof of residence, the shaykh handed him some UAE dirhams and said “my face in on these”.  The article notes a hearty burst of laughter by the participants but is silent on whether other KYC documents were produced.    
Blackmail by Former PSI Employee
Just about one year ago (17 July to be precise), Singapore’s Straits Times reported on the apprehension of a former PSI employee who was arrested by the Royal Thai Police and charged with attempted blackmail of his former employer and the sale of PSI documents to opposition figures in Malaysia. Apparently the individual had secured an earlier payment from PSI.  The payments don’t necessarily prove any wrongdoing by PSI. The earlier payment may have been made for other reasons, e.g., to avoid a scandal that would tarnish one’s name and business opportunities even if it’s not true.
These would appear to be some of the alleged PSI documents sold by the former PSI employee.  Note the SR is part of the opposition in Malaysia.

The 1MDB Scandal - An Overview

Happier Days

This post is based upon the 20 July 2016 complaint filed by the US Department of Justice (DoJ) against Red Granite pictures. (the “Red Granite Complaint” or the “Complaint”), producers of The Wolf of Wall Street.    I will cite sources paragraph numbers rather than page numbers as “sourcing” for various points.

The Red Granite Complaint is one of at least fifteen other complaints filed to secure the civil seizure and forfeiture of assets alleged to have been purchased with the proceeds of an alleged misappropriation of approximately US$3.5 billion from Malaysia’s state-owned strategic investment and development fund, 1MDB.
The DoJ is making the individual complaints available at this website.   Also note the powerpoint with pictures of some of the assets.  Link here. 

This post will set the stage for subsequent posts here at Suq Al Mal.  Because SAM focuses on the GCC banking sector, those posts will look at GCC parties involved in transactions with 1MDB where those parties’ behavior raises questions –at least to AA.  Of course, if past is prologue, then you know that AA will not be able to resist the urge to venture beyond the GCC if something interesting catches his eye.
Before I begin one very important note.

The US DoJ has filed complaints.  The parties mentioned in the complaints have not been convicted of any crime, nor have they had a chance to neither respond to the charges made against them, nor have their responses and the original complaints tested by the judicial process.  At this stage all that can be said is that allegations have been made.  Please bear that in mind as you read this post.
According to the Complaint, the misappropriation of funds from 1MDB took place from 2009 through 2013.  The DOJ identifies three phases named for the vehicles purported to have been used in the theft.
  1. The Good Star Phase (2009-2011)                US$1 billion 
  2. The Aabar Investments BVI Phase (2012)     US$1.367 billion
  3. The Tanore Phase (2013)                               US$1.2 billion   
The Good Star Phase (Para #8 and Paras 40-112)

In 2009 1MDB signed a joint venture agreement (JVA) with PetroSaudi International, a privately owned Saudi-registered firm, to develop properties in Argentina and Turkmenistan. 

According to the JVA, 1MDB was to contribute US$1 billion in equity to the JV. 
The Complaint alleges that in late September the Malaysian fund made payments totaling US$1 billion, but that US$700 million were transferred to an the Swiss account of Good Star, a company actually controlled by Malaysian LOW Taek Jho. 
In May 2011 and October 2011 an additional US$330 million was transferred to Good Star, ostensibly advances under a murabaha facility extended by 1MDB to the JV.
The Aabar Investments PSJ BVI Phase (Paras #9-10 and 112-226)

During 2012, 1MDB raised US$3.5 billion in bonds (arranged and underwritten by Goldman Sachs) and guaranteed by 1MDB as well as IPIC, an Abu Dhabi state-owned investment fund. 

The Red Granite Complaint alleges that US$1.367 billion of the bond proceeds were diverted to a Swiss bank for the account of Aabar Investments PSJ in the British Virgin Islands.  
Despite the similarity to an IPIC subsidiary Aabar Investments and Aabar Investments PSJ, the company in the BVI was not owned by IPIC or Aabar.  Curiously, according to Para #115 of the Complaint, the directors of the BVI were H.E. Khadem Abdulla al Qubaisi (Managing Director of IPIC) and Mohamed Ahmed Badawy Al Husseiny (CEO of Aabar).
Funds were later allegedly transferred from the BVI account to an account controlled by TAN Kim Loong, described by the Complaint as an associate of Mr. LOW.  Funds were used to acquire assets and transfers were made for the personal benefit of officials at 1MDB, IPIC, and Aabar.
The Tanore Phase (Para #11 and Paras #227-290)

The Complaint alleges that US$1.2 billion was diverted from a US$3.0 billion third Goldman Sachs arranged bond issue in 2013, which in part was to fund investments with Abu Dhabi in the Abu Dhabi Malaysian Investment Company (ADMIC). 
The US$1.2 is alleged to have been transferred to an account in Singapore for Tanore Finance Corporation, a company alleged to be ultimately controlled by Mr. LOW.  This amount inter alia is alleged to have provided funding to Red Granite for the production of The Wolf of Wall Street.
What Were They Thinking

For the sake of making a few comments, I will assume that the Complaint is accurate.  That is, that roughly $3.567 billion was misappropriated from 1MDB.    
As of 31 March 2014, 1MDB’s financials show roughly MR51.4 billion in total assets or approximately US$15.7 billion.

US$3.5 billion represents almost twenty-three percent of total assets. The size of the fraud is immense not only in dollar terms but as a percentage of assets. 
How did the perpetrators think a fraud of this size would go undetected?

In the future, assets booked to disguise the defalcation would prove worthless and have to be written down or written off.   This would have been very visible not only because of the amounts of the write-downs/write-offs but perhaps more importantly by their relation to the fund’s equity.
As of 31 March 2014, 1MDB had equity a shade over MR 2.4 billion (US$747 million), roughly twenty percent of the US$3.5 billion that is alleged to have been stolen.  Thus, even a partial write down would wipe out equity.

Often in such “operations” the proceeds of new misappropriations are used to partially cover the previous ones.  That is, for example, funds from the Aabar Phase would have been used to cover the Good Star Phase misappropriations, justified by a statement that the PSI/1MDB JV projects were not proceeding according to plan and to prevent further losses “prudent” management was terminating the JVA.  An amount could be written off ostensibly as costs incurred without necessarily ringing alarm bells. 
Or was there something else at play here besides simple greed and less than adept defalcation skills?

Global Investment House: The Future is Now and Likely to Remain So

For Some Now May Be the Only Future They Have
As promised in my first postsome thoughts on Global’s future.

As detailed below, Global faces a variety of very real constraints to growth—the primary one being control by its creditors. If it doesn’t or can’t grow, Global’s net income will remain modest, likely be volatile, and its ROE subpar. These obstacles are formidable and AA has a hard time seeing Global finding a way out of this challenge.
First a recap to set the scene.

Recap
In my previous post I identified a structural problem with Global’s revenues and expenses.  The latter (adjusted to exclude impairment and loan loss provisions) average roughly KD 14 million a year – 140% of the revenues from its core Assets Under Management (AUM) business.  Other lines of business (LOBs) then have to generate enough revenue to cover remaining expenses and produce a profit.

That’s a problem because Global’s other LOBs lack the scale to consistently generate enough revenue to do this –either in absolute or ROE terms.
Profitability is cobbled together from these “hobby” businesses plus one off items such as FX translation gains from a depreciating dinar or loan loss provision reversals—items whose persistence is unlikely.  
By way of example, if these latter two items had not been present in 2015, Global’s net income would be 10 percent of the reported KD 6.5 million.  Additionally, the non-AUM fee-generating LOBs (chiefly brokerage and investment banking) are market sensitive and thus add unwelcome volatility to earnings.
Strategic Options

In the face of this structural problem, Global can either: 
  1. Accept its current position. 
    • Live with the volatility. 
    • Or rationalize its expense base to reduce the volatility. Without detailed information it’s not possible to determine if cutting what appear to be “hobby” operations – Bahrain and Oman brokerage, for example—would result in significant cost reductions without disturbing the AUM business.  
  2. Seek to materially change its fate by significantly growing revenues as a way of eliminating volatility, increasing ROE, and making itself a more credible partner for clients and a more compelling opportunity for equity investors.
As my framing of options indicates, I think growth is the preferable path. 

Shrinking oneself to greatness is not really a business strategy.  Growth will also facilitate the sale of the creditors’ 70 percent stake which as argued below is the major current constraint on the firm’s development.
One caveat about growth.

FGB/NBAD is unlikely to challenge ICBC 'sor JPMorgan’s position.  Nor will Global rival the likes of Blackrock.  That’s fine.  There’s nothing wrong with being a fish in a small pond.  But even a fish in a small pond needs to grow to keep up with the other fish in the same pond. 
There is a third option: a sale to another institution that can fold Global’s business into its own, cut costs, and reap the benefits of scale. 

Two things would be required.  
  1. A sale price that would satisfy the creditors.  This probably would be the main sticking point to this scenario.  This early in the life of the debt settlement there probably would be creditor price resistance to a “bargain” sale.  
  2. A transaction that does not disturb the current client relationships, i.e., that maintains the KD 1.1 billion in AUM.  That is perhaps easier to achieve if current legacy management and board representation is retained.
If Global doesn’t increase revenues, net income is likely to be volatile, remain relatively modest, and ROE subpar.  As outlined below, Global faces some very real growth constraints. It’s hard for AA to see a way forward for the firm out of this conundrum.

Constraints on Growth
Current Majority Shareholders (Creditors)

The primary current constraint on growth is the majority shareholder (Global’s creditors) who by virtue of their 70 percent equity stake control the firm.  Their self-interest is directly at odds with a pro-growth strategy.    
In the best of times, bank creditors like other “bond” investors focus on return of capital and not like “equity” investors on growth and increasing return on capital.

A debt restructuring typically intensifies this tendency.  Cash extraction from the debtor becomes even more urgent and is imposed through aggressive repayment schedules and rescheduling covenants that severely constrain spending and business development.   
But Global wasn’t a typical restructuring.  Creditors normally don’t take assets to settle debts because they know that their track record in realizing assets is much worse than in underwriting loans.   

The fact that creditors demanded 70% of the rump firm’s equity and existing shareholders gave it is a very clear sign that a serious shortfall from asset sales was expected. That deficit and the need to maximize recovery have no doubt exacerbated the impulse for cash extraction.   
When equity in the borrower is taken, creditors cash out by selling the firm to investors or collecting dividends.  When a sale at an acceptable price is not possible, then dividends become “favorite”. 

At this time, price expectations of seller and buyer are probably far apart.
Since we are only three years into the settlement, an acceptable price for creditors is probably one that is no less than the value ascribed to the equity when the “expected” loss on the settlement was calculated.  To sell for a lower price would require booking a loss.  Over a longer period, the creditors’ price discipline could wane, if earnings prove volatile and that volatility requires a revaluation of the carrying value of the equity.

Given its current condition, Global is not a particularly exciting investment prospect for new investors.  Legacy shareholders probably haven’t changed their minds from 2012/2013 when they turned down an opportunity to infuse new cash.      
If creditors won’t let Global spend “precious cash” to build the business, what other ways could they help grow revenues?

Creditors could shift AUM from their own firms to Global.  They could solicit new AUM for Global.  But if they did, they would share the resulting profit with other creditors and the 30 percent “legacy” shareholders in the firm.  Little economic sense in that, particularly because relatively large amounts would be required and creditors have already taken a “hit” on the debt settlement, no doubt exhausting whatever minute amounts of generosity they may once have had.    
Global’s strategy confirms this analysis. It’s clear that the firm is being managed not for ROE or growth, but for cash extraction.   That involves retaining the “cash cow” KD 1.1 billion in AUM, keeping a firm control on costs, and following a conservative risk acceptance policy. 

“Souk legend” (the Gulf equivalent of urban legend) is that GIH’s KD 1.1 billion in AUM-the main driver of current revenue—is largely (almost all?) comprised of KIA funds that Ms. Maha played a key role in obtaining.  The creditors are smart enough to recognize that they need legacy management to keep current customers in place and perhaps incrementally add to AUM. This probably explains her continued presence in the board and in executive management as well as the retention of other “key” legacy managers.
As regards expenses, a glance at note 16 (2015 annual report) shows no evidence of significant investment in new assets, including computer equipment which would involve relatively small amounts.   Assets are almost fully depreciated.  While accounting useful life is not the same as economically useful life, this does suggest some replacement is likely needed.  That it has not occurred at any measurable level is revealing. Directors’ fees are also being kept at modest levels.  Usually, in the old boy (and in this case one girl) world of boards, cost control is not an urgent imperative.  The amounts are not just that large.  Clearly expense control is a key business focus.

In terms of risk aversion, the overconcentration in cash and cash equivalents is a very clear sign of heightened risk control and husbanding cash for dividends.  With 50% of assets in low ROA banks and cash despite there being no material debt obligations, it is clear the firm is being managed for cash not ROE.
Other Actors – Private Clients

Could other parties step up to deliver needed growth?
Retail investors aren’t going to provide the revenue required.  Too many small ticket transactions and portfolios would be required to change Global’s fortunes.  Many new retail customers would increase operational costs offsetting some of the revenue gain.

Large institutions and HNWIs could drive material change at GIH.   But what is their incentive to shift their portfolios? Global doesn’t appear to have any compelling investment product or products that differentiate it from its competitors and make it a “must have” for such an investor.  Why would such an investor select Global over NBK or another major regional or international firm?  
Global also still carries some remaining baggage from its 2008 difficulties, particularly in the treatment of investors in AlThouraia/Mazaya Saudi and Global MENA Financial Assets. This probably exacerbates non Kuwaiti GCC nationals’ general concerns about Kuwaiti business practices as well as the appetite of those Kuwaitis who invested in these funds.

But there’s another constraint. Assuming there are private institutional and HNW investors (and these are likely to be Kuwaiti rather than other GCC investors) willing to do business with Global, where would the funds come from?
As discussed in my post about the NBAD/FGB merger, the GCC is a minor financial market when measured in terms of assets and earnings and is highly likely to remain so for a variety of reasons (demographics, the nature and size of local economies, etc.). 

With GCC asset managers this is even more the case.  Major world firms have AUM in the trillions (Blackrock at $4.6 trillion) and net income is measured in billions (Blackrock north of $3 billion) or hundreds of millions. 
Currently, Global is mid-tier behind NBK Capital and KAMCO each of who have at least 3.5 times Global’s AUM.  A significant shift in Global’s fortunes would require a major shift away from these other firms.  Something that doesn’t seem highly probable to AA.  “Losing” 10% of your clients is a rare occurrence.  “Losing” 30% or more even less probable.     

Other Actors-Official Institutions
What would motivate a government-related entity to place investments with Global when 70% of the profit on the relationship will go into the hands of creditors, who include foreign banks?  And very likely include some investors who have acquired their positions at a discount.  Few like to feed vultures.

Another constraint is that non-Kuwaiti official institutions are unlikely to shift business to Global.  They have their own national firms to support and sad to say many in the GCC have a dim view of Kuwaiti business practices.
All in all a rather bleak strategic cul-de-sac.

Friday, July 22, 2016

Global Investment House - 2015 Financial Performance Reveals Structural Problems with Earnings

It's a small world after all, and for some even smaller

It’s been five years since Global signed its first restructuring agreement and three years since its final settlement with creditors.

How is Global doing?   What are its prospects for the future?   
The first question is the subject of this post.  I’ll cover the second in a companion post.
Catching Up with Global
 
When last I posted, Ms. Maha was Chairman, GIH had published financials showing about KD 1 billion in assets, and the firm was touting its first rescheduling deal with its creditors.
At that point, commenting on the deal’s principal repayment terms—10 percent the first year, 20% the second year and a whopping 70% the third year—I noted that:
“It's highly unlikely that Global is going to be able to meet the repayment schedule even with one or two small miracles coming its way.   With the short fuse and the extensive trip wires (by way of covenants below), the spectre of a second default has to be haunting Global's management and shareholders.”
Not surprisingly in mid-2013 GIH negotiated a second rescheduling deal that gutted the firm: almost all of GIH’s “fine” assets were transferred to creditors in settlement of the debt.  Because the assets weren’t that “fine”, the creditors took a 70 percent stake in the “rump” GIH.  For a variety of reasons, the firm focused its business strategy on fee-based not balance sheet intensive business.  Ms. Maha was replaced as Chairman, though she remains on the Board as Vice Chairman and retains a role in management.
Review of 2015 Performance and Financials
Overview
The structure of GIH’s revenues and expenses indicates a high probability of future earnings volatility. Normalized expenses are 140% of AUM related revenues.  Non AUM LOBs can’t consistently generate enough revenue to cover the remaining expenses and generate a meaningful profit. They are market sensitive (volatile) themselves and more importantly lack scale.  They are more “hobbies” than substantial LOBs.
Besides these structural earnings problems, I noticed a few things in the loan portfolio and murabaha receivables worthy of comment.  Nothing that is life threatening.
Income and Expense
Net Income:
Global earned KD6.5 million in 2015 versus KD6.4 million the year before.  However, 2015 net income was bolstered by a (non-cash) write back of KD4.3 million of loan provisions.   Without this “timely” reversal, net income would have been a much lower KD2.2 million.
Revenues:
Fees and Commission Income accounted for 89% of total revenues in 2015 and 66% in 2014.   Within this category, AUM related fees account for some 80% of revenues, and represent a relatively stable revenue stream.  The other key fee-generating LOBs-- brokerage and investment banking-- each generate about one tenth of the AUM fees but are more volatile.
In 2015 Global benefited from KD 1.8 million in FX translation gains (KD 2.2 million in 2014) due to depreciation of the KD against the US dollar.  Not a stable core revenue source.
Net interest income contributed KD 1.6 million.
Fair Value Through Profit and Loss a loss this year of KD1.5 million vice KD0.8 million in positive revenue the year before.
Expenses:
Excluding loan provisions and impairment losses, Global’s average expenses are about KD 14 million a year – 140% of its stable AUM related earnings.
Structural “Problem” with Earnings
That’s a problem because Global’s other fee-generating LOBs (chiefly brokerage and investment banking) are market sensitive and more importantly lack the scale to  consistently generate significant revenue  to both cover expenses and generate a profit.   Growing earnings by growing assets is constrained by policy and no doubt as well by limited market access. 
Global then is forced to rely on one-offs such as continued depreciation of the KD or provision write backs to turn a reasonable profit.  Note that if there had been no FX translation gain in 2015 and no write back of the provision, Global would have had a modest profit.   
Balance Sheet
As mentioned above, a couple things caught my eye in the loan portfolio and murabaha receivables.
Loan Loss Provision Write Back
According to GIH’s 2015 annual report note 13, the write back provision for credit losses “for the year include KD 3,292 thousand (2014: KD 130 thousand) written back as a result of settlement agreement with a borrower.” 
Note the term “settlement agreement”.  GIH did not restructure the loan. The amount was not repaid in cash. Rather the bank took securities to settle the loan as is clear from an analysis of the firm’s cashflow statement and note 11.  The absolute increase in assets in note 11 is much more than the amount shown on the cashflow statement.
A single customer was responsible for 77% of the write-back.   A quick scan of annual reports back to 2012 suggests--but does not prove--that GIH has held this provision since at least 2011. 
The same note states:  “Loans are granted to GCC companies and individuals and are secured against investments in the funds and securities held in fiduciary portfolios by the Group on behalf of the borrowers.”
Why didn’t GIH seize and realize the collateral long ago?  Why hasn’t done the same with the borrowers representing the KD 5.9 million in unused provisions?
One explanation might be that legal processes in Kuwait are painfully slow.  Thus, GIH was legally unable to seize the collateral and extinguish the loan, but rather forced into prolonged negotiations with the borrower. 
That the reversal came at just the “right” time to protect earnings is certainly a remarkable coincidence.  Perhaps difficulties in 2015 caused management to redouble its efforts to collect.  Perhaps a long period of negotiation finally came to a close.  From the financials, it does not appear that GIH gave the borrower a discount on the asset swap.
Loan Portfolio:
Is there room for more earnings positive settlements with borrowers?
Net loans are KD 1.6 million = gross loans KD 7.5 million less provisions of KD 5.9 million (note 13). 
That KD 5.9 million would appear to be able to fund a few “timely reversals”.  
Particularly because Global holds KD17.8 million (fair value) collateral as per note 25.2.2 page 57.  That’s 240 percent coverage of the gross amount of the portfolio.  One might argue and AA certainly would that there doesn’t appear to be a compelling reason to hold a loss reserve when collateral coverage is so high.   
But there’s more.
Global is accruing interest on the gross portfolio because KD 490K in accrued interest in 2015 equates to a whopping 21% per annum yield on the average net loan portfolio. (Simple average of 31 December 2015 and 2014 amounts).  It’s a more reasonable 4.8% on the average gross portfolio. 
To accrue interest, Global would either have to be receiving cash or have almost certain assurance of payment of the interest. 
The cashflow statement shows that Global did not receive cash payments in 2015 for about KD 500 million of interest accrued that year, an amount very close to the interest accrued on these loans.  Of course, the KD 500 difference could well relate to other interest bearing assets.  It could relate primarily to the loans but be due to timing difference:  the interest payment was received after 31 December 2015.  If cash is being received and Global holds such an excess of collateral, how does it justify maintaining the reserve to its auditors? 
On the other hand, if Global is accruing interest—but not receiving cash—, its justification is likely based on asserting that collection of interest is almost certain given the collateral it holds. If the interest is secure and again the collateral so much larger than the principal, then it would seem the principal is also secure and no provision is needed.
All this suggests to AA that Global has some “dry powder” for future contingencies.
Murabaha Transactions
Global is earning a princely 5.28% per annum on these one year transactions (note 12).  Not many good investments offer such a return for a one year tenor.  Kudos to GIH for finding this consistently attractive opportunity—5.24% in 2014, 5.3% in 2013, and 5.45% in 2012.
One would think that such rates would come at the cost of higher risk, but the provision is a modest KD 123K on some KD 3.1 million. 
One thing did catch my eye.  Note 25.2.2 page 57.   The murabaha receivables were more than 180 days past due (but not classified as impaired) as of 31 December 2015 and as well at 31 December 2014.  I didn’t see a reference to collateral for these transactions.  Of course, AA has been around the block a few times on “Islamic” banking transactions and knows that in addition to careful structuring (technically حيل) “Islamic” finance is one area of the faith where miracles occur with a dazzling regularity.
Notwithstanding the above, perhaps a provision of some sort would be warranted.  And could be accomplished by a simultaneous reversal of some of the loan provisions and booking of an equivalent amount as provision for the receivables.  But of course الله اعلم

Sunday, July 17, 2016

In Memoriam Abdo Jeffi




 6 March 2016

Il n'est pas un banquier ordinaire.

Il n'est pas un homme ordinaire.