“Foreign Investors Face Critical Test Over Chinese Bonds” Part 2

I bought US$10 Million in PUFG Bonds
And all I actually got back was this cheap T-shirt

Part 2:  More on the "Critical Test" facing PUFG bondholders. 

I’ll take a close look at the transaction structure quoting chapter and verse from the Offering Circular (prospectus).

I’ll break with what is sadly usual investment process by actually referring to the most important but usually least read section of the prospectus: Risk Factors. 

And in so doing “force” you to read along as well.

In this “exercise” I’m going to focus on structural/legal factors to the exclusion of other risk factors.

Why?

Because if the transaction structure is weak or the market has fundamental legal problems, you need to walk away.

Page 44 

It may be difficult to enforce any judgments obtained from non-PRC courts against the Group or its directors and senior management who reside in the PRC.

Page 48 

Additional procedures may be required to be taken to bring English law governed matters or disputes to the Hong Kong courts and the Bondholders would need to be subject to the exclusive jurisdiction of the Hong Kong courts. There is also no assurance that the PRC courts will recognise and enforce judgments of the Hong Kong courts in respect of English law governed matters or disputes.

These two items do not sound “promising”.

Page 45 

However, any claim by the Issuer, the Guarantor and/or the Trustee against the Company in relation to the Keepwell Deed or the Deed of Equity Interest Purchase Undertaking will be effectively subordinated to all existing and future obligations of the Company’s subsidiaries (which do not provide a guarantee in respect of the Bonds), particularly the Company’s subsidiaries in the PRC, and all claims by creditors of such subsidiaries in the PRC will have priority to the assets of such entities over the claims of the Issuer, the Guarantor and the Trustee under the Keepwell Deed and the Deed of Equity Interest Purchase Undertaking.

If you’ve read my earlier post about consolidated financials and what they mean, you realize that the holding company’s primary assets are equity in subsidiaries. Absent a guarantee from those operating entities, you’re already effectively in a “junior” position.

And, if by chance, you’re wondering about the PUFG guaranteed bonds, well the guarantee there is by the holding company only. There are no cross guarantees by subsidiaries. So it is limited to the assets of the holding company, which largely consist of stock in the subsidiaries.

Thus, while the PUFG “guarantee” is better than a keepwell deed of equity interest purchase undertaking, it still falls short of the sort of guarantee you would want. Another lesson from the tale of consolidated financials.

Here is the offering circular for the PUFG guaranteed US$250 million 7.875% 24 June 2021 bond if you’d like to check my analysis.

Page 46 

Performance by the Company of its undertaking under the Deed of Equity Interest Purchase Undertaking is subject to approvals of the PRC governmental authorities. (Five are listed)

No approval = legal bar to PUFG’s compliance.

Request for approval will come when the payment crisis has occurred. Not before. That seems a less than ideal situation. You don’t know if the Company is legally bound until default.

Page 47

Performance by the Company of its undertaking under the Deed of Equity Interest Purchase Undertaking may be subject to consent from third-party creditors and shareholders, and may also be restricted if any of the equity interests are secured in favour of third-party creditors.

That’s what we “professional” investors call “cold comfort”.

Page 47 

The Relevant Transferors have limited assets which can be sold to the Company pursuant to the Deed of Equity Interest Purchase Undertaking.

This sounds even less promising. If there’s nothing to purchase, the Company has nothing to buy.

Given all this, there seems little justification for bondholders’ complaints.

Or claiming there was a guarantee when there was not. 

Or even an “impression” of a guarantee as demonstrated by the quotes above.

They were warned in the prospectus.

As well, this isn’t foreign investors’ first “bad” rodeo in the PRC. 

If you’re planning to invest in a country, it’s probably a “smart” move to do a bit of due diligence on how other investors have fared with respect to laws, the legal system, legal structures, etc. 

However, on a positive note, this case does prove my version of the Efficient Markets Hypothesis.

The market is very efficient in separating the financially illiterate, the gullible, or the heedless from their money. And does not discriminate between the retail investor, the professional investor, and institutional investors.

H/T to AA's older wiser august and revered brother, expert in many things Asian, for the quote above as well as the T-Shirt picture.  "If you don't do stupid things, you won't end up in tragedy".

Market Commentary: Berkshire Hathaway, St. Augustine, and ESG

Patron Saint of Good Works,
But Primarily Those in the Future

 Analyst Disclosures:

• Oxford Commas provided by Eton College in return for this promotional mention. 
• AA holds no investment position (either short or long) in BH. Or more precisely BRK.

Berkshire Hathaway has made what I consider puzzling (at least on their face) responses to two shareholder introduced proposals for consideration at the 2021 annual general meeting. 

Readers are invited to make their own judgments as to the motives for these responses.

You’ll find BH’s proxy materials here. 

The first proposal is that “the Company publish an annual assessment addressing how the Company manages physical and transitional climate-related risks and opportunities.” This proposal contains suggested elements in that report but gives the board “discretion” on framing the report.

Berkshire replies that:

1. The Board recognizes the importance of responsibly managing climate-related risks to both shareholders and the future of Berkshire and its operating businesses.
2. The Board regularly receives reports on the major risks and opportunities of the operating companies, including those related to climate, and discusses those risks and opportunities. 
3. Berkshire manages its operating businesses on an unusually decentralized basis. There are few centralized or integrated business functions. (At the BH level).
4. We want our managers to do the right things and we give them enormous latitude to do that; consistent with our business model, each subsidiary is independently responsible for identifying and managing the risks and opportunities associated with their business, including those related to climate change. 

As I read this, BH admits it has the requested information in one form or the other (point #2) but pleads (point #3) that they don’t have the staff at the holding company level to compile such a report. 

Apparently, hiring a third party to compile such a report would be a large and extravagant expense. Note that is my assumption. BH did not say this.

Interestingly in arguing against adoption of this proposal BH then goes on to recite the climate related achievements of some subsidiaries in some detail. 

In light of the above comments about the small size of BH’s central staff, I wonder who prepared these. 

Could it possibly be the same folks who prepare information on financial performance at the subsidiary level? Note my assumption is that it is staff at those subsidiary companies.

In point #1 BH “recognizes” the “importance” of these issues and in point #4, it “wants” the managers of its subsidiaries to do the “right things”, but as also outlined in point #4 isn’t going to interfere with the discretion entrusted to the operating company managers.

BH's position on climate issues seems to AA to be similar to St. Augustine who reportedly recognized the danger of sin, and ardently wanted to do something about his own personal situation, but not today.

AA wonders at least rhetorically, and hope you do too, if the Board takes same approach on operating company financial performance. It “recognizes” the importance of good financial performance, “wants” good performance, but lets the operating companies “independently manage” financial performance.

The second shareholder proposal requested that “Berkshire Hathaway holding companies annually publish reports assessing their diversity and inclusion efforts, at reasonable expense and excluding proprietary information 

BH’s Board responded that:

1. Berkshire’s commitment to diversity, equity and inclusion and the effectiveness of our companies’ related programs starts with our leaders, including our Board of Directors on which three female and two ethnically diverse members serve. 
2. Mr. Buffett, Berkshire’s Chairman and CEO has set the “tone at the top” for Berkshire and its employees for over 50 years. During this period of time, Mr. Buffett has a record of opposing efforts, seen or unseen, to suppress diversity or religious inclusion. 
3. All of Berkshire’s leaders – whether in our operating businesses or on our Board – are extraordinarily qualified, committed to our culture and focused on ensuring long-term success for shareholders.
4. The proposal’s supporting statement indicates that “investors seek quantitative, comparable data to understand the effectiveness of the Berkshire Hathaway companies’ diversity, equity and inclusion programs,” improperly suggesting that there is a standardized technique for each of Berkshire’s more than 60 operating businesses to address diversity, equity and inclusion. 
5. Berkshire’s operating businesses represent dissimilar industries operating in multiple locations throughout the world. It would be unreasonable to ask for uniform, quantitative reporting for the purposes of comparing such dissimilar operations in different geographic locations. 

Again, as I read points #1 and #2, BH both recognizes and supports diversity and inclusion. Though I’d guess that as outlined above in the discussion on climate, the Board really doesn’t do anything to interfere with the subsidiaries’ operations.

Also I'd like to call to your attention another demonstration of why many call Mr. Buffett the Oracle of Omaha: he apparently can see both the seen and the unseen.

Point #3 was puzzling.

AA wonders if it is designed to calm the potential worries that some shareholders might have after reading point #2. All that diversity. Is my money really safe? 

I’d also note that two of BH’s directors would qualify as senior citizens. So score a few more diversity points for the Company.

Points #4 and #5 raise a question about how BH is able to provide reporting on its financial performance. 

I mention this because BH’s 60 companies operate in “different geographic locations” and “different industries” in “multiple locations in the world”. 

As a consequence, it is highly likely they are using different languages, different accounting systems, to say nothing of accounting principles, and are subject to different laws. 

It sounds an impossible task, but if you take a look at BH’s 2020 Annual Report, you will see a rather extensive discussion on BNSF, BHE, and other of BH’s companies.

Were these prepared by the 26 central staff in Omaha who, if this is the case, might be the modern day equivalent of the 300 Spartans? 

Or were they prepared by the subsidiaries themselves?

Couldn’t that be a solution if only in part to the shareholder proposal? 

The subsidiaries prepare such reports. 

Who better prepared to put their efforts and results in the appropriate regional and industry context?

Perhaps, with the requirement that only a few of BH’s 60 subsidiaries report each year.

With the focus on the major subsidiaries.

Where there is a will there is a way or so AA was told by his parents.

On the wider topic of ESG itself, here’s a link to an interesting piece at Bloomberg from January 2020 which analyzes the differences between what investors profess and what they do.

Two salient points therein:

1. Berkshire tends to score low on ESG (even below Amazon) due to lack of reporting and its holdings of coal-fired utilities. Mr. Buffett’s Friedmanite skepticism dogmatism on ESG may also be a factor.
2. Most investors who claim that ESG is a key element in their investing philosophy do not practice what they preach. If an investment has a high return, ESG concerns vanish. Virtue is apparently not its own reward. Even more interesting those who claim they would shun an investment in Amazon because of concerns about workers’ rights, would definitely shop there. There are a lot of St. Augustines about, it would seem.

Manifest Signs of Irrational Exuberance in the Market

In December, Martin Wolf—for whom I have a lot of respect—wrote an article in the FT arguing that the stock market is not currently overvalued.

To be as fair, I’d note that his argument was based on two premises: corporate earnings would be strong and interest rates would remain ultra-low.

With the right assumptions, of course, just about any assertion can be supported.

I’d like to make a contrary case that financial markets—not just that for equities—are indeed in bubble territory.

Bubbles occur when providers of capital—lenders or investors—underestimate risk and overestimate return.

It’s relatively simple to diagnose contrary to what some “maestros” believe as I now propose to show.

Think of me as your financial Don Ho, but with a focus on larger events.

The size of the bubble is directly proportional to 

1. the acceptance of most outrageous investment theses and valuations and 
2. engagement in unsafe and unsound practices. 

For the last point, the “running with scissors” test is an apt tool.

First, signs in the equity market.

What better poster child for irrational exuberance in the equity markets than Tesla?

One does not have to be as smart as Jim Chanos to see that Tesla’s price is supported by multiple fanciful delusions about the future. “Fanciful” to distinguish these delusions from “normal” investor over optimism.

And Tesla is not the only case, but likely the most outrageous.

To measure the extent of the madness reflect on Tesla’s entry to the S&P 500.

That indicates the extent of the overvaluation of Tesla. 

It also thus suggests we have passed the frontier of “irrational exuberance” to “Brexit” level delusions.

Second, signs in the debt markets. 

Issuers with currently crippled businesses are issuing debt at record levels.

Now I am not advocating refusing loans to all companies in distress. But rather being selective.

And when doing so applying time tested practices.

One should wear a helmet when riding a motorcycle and drive at a sensible speed.

When the road is wet, it’s daylight madness not to wear a helmet and not to drive slower.

But exactly the opposite is happening.

Much of this debt is “secured” by assets that the borrowers currently cannot profitably employ.

There is also a surfeit of such unemployed assets at present.

Additionally, it is unclear what returns these assets may afford in the future. Or when that “future” may be.

The collateral value of an asset that has limited value in use is roughly equivalent to the sound of one hand clapping.

Think of planes and cruise ships.

To that add the wanton abandonment by “investors” of basic common sense credit and legal structuring.

Debt is repaid by cashflow not assets. History suggests that primary reliance on collateral for repayment is likely to be an unhappy affair.

Covenant “lite” structures offer limited legal protection and limited means to pressurize debtors. And will be of limited utility when clouds gather.

Third, signs in private equity. 

Also in December Kate Wiggins wrote an article on how canny private equity General Partners had found a solution to blocked “exits”. 

If there’s no suitable opportunity for a trade sale or an IPO, why not sell a portfolio company to yourself? Or more precisely to a so-called continuation fund.

A suitable “opportunity” is one where one doesn’t have to sell at a loss. Or face the subsequent valuation consequences of failure to sell a duff asset that there was no perceptible demand for.

But sales essentially to oneself can be “structured” to

1. deliver sufficient “return” to LPs to keep them happy
2. generate carried interest for the “deserving” GP, and
3. create the appearance of a suitable return on the selling Fund that will persuade a “sophisticated” investor to sign up for the buying Fund (the continuation fund).

One hopes that LPs from the selling fund are not the major cohort in the buying fund.

But then AA has seen some rather incredible behaviour by so-called sophisticated investors.

Fourth, signs in the retail market. 

Increased activity by the financially illiterate: the rise in the price of Bitcoin, day trading, etc. 

The past suggests that all this is not going to lead to a happy outcome. Though as you know past performance is no guarantee of future results.

Creditor on Creditor Violence

Annual Leveraged Loan Investors Conference

Over the millennia our ancestors have passed down important life lessons to us in the forms of proverbs and other sayings.

Sometimes the author’s name is known. Most often not.

“Measure twice cut once”. Or in one country measure seven times before cutting.

“Don’t run with scissors” (ascribed, I believe, to Plato by Aristotle).

“Tie your camel first, then trust in God. (اعقلها وتوكّل)” ascribed to the Prophet Muhammad (SAWS) by Anas Ibn Malik via Al-Tirmidhi. (2517)

A recent article by Alicia McElhaney in Institutional Investor under the above title reminded me these and other similar sayings.

She describes how some members of leveraged loan syndicates are suing other syndicate members charging that when the obligor became distressed those lenders converted their “old” loans (those under the syndicate agreement) to “new” loans (outside the syndicate). 

In the process making the old loans subordinate to the new ones.

What those lenders did was take advantage of apparent deficiencies in the loan agreements.

AA finds it hard to have much sympathy for lenders stupid enough to sign syndicated loan agreements with inadequate protective covenants.

In the case at hand failing to insist that the loan agreement contain what were once standard covenants requiring:

1. 100% lender agreement to allow material changes to the loan conditions (rate, repayment, maturity, collateral)
2. pro-rata sharing of any repayments received by one or more syndicate member among all syndicate creditors 
3. limitations on market purchases of debt, along with a careful definition of what constitutes a “market purchase” etc.

While not the case here, this failure to “tie one’s camel” is similar to covenant lite loans that impose no real controls on the borrower. That is, no real triggers for creditors to call a default and accelerate the loan.

Both are “sins” in every kind of loan.

But more so for much riskier leveraged loans.

This asset class is supposedly where sophisticated investors—those able to analyze and bear the risks--”play”.

One might forgive a retail investor on the Robin Hood platform a “wise” investment in Tesla as a rookie mistake.

But “sophisticated” institutional investors with access to high-priced “elite strike force” legal teams?

I think not.

This is yet another cautionary tale--like that of Golden Belt Sukuk, Bernie Madoff, Abraaj, Wirecard, etc--for those who cling to unfounded myths about the innate wisdom of markets.

Great Moments in Capitalism: Tesla – He Built It All by Himself or Did He?

"Daddy, read me the story about how the Power Ponies saved the Job Creators"

There are many stirring yarns of dogged entrepreneurs who by dint of their prodigious intellects, hard work, and business smarts built businesses all by themselves.  Giants of the business world.

Secular saints for our national—and dare I say international--religion:  Steve Jobs, Henry Ford, even according to some, Papa John.  Visionaries, pioneers, rugged self-reliant individuals.  The kind that disdain handouts.

According to these tales, more often than not these hardy individuals have had to struggle against the heavy “dead hand” of governments that seem more interested in crushing their visions than stepping out of the way to allow them to succeed.  Men like Hank Rearden.

In today’s installment, we look at but one slim chapter from the storied career of Elon Musk—visionary technology investor, entrepreneur, engineer, and product architect.  

An  immigrant to these shores and to Canada in more tolerant times, he’s built many businesses all by himself demonstrating, though no demonstration is really required, that a hard working smart individual can succeed on his own without government handouts.

But would you be surprised if I told you that Musk like many other of our secular saints had a silent partner who helped make his dreams reality?

An unsung hero.  One that AA will now reveal.

To set that stage some information from Tesla’s financials. They say that numbers never lie, though they rarely ascribe that virtue to all accountants.

TESLA REGULATORY CREDIT SALES (RCS)
Millions of US Dollars
Year	RCS	Net Loss	RCS/NL	NL-RCS
2009	$8	($557)	1.5%	($565)
2010	$3	($154)	1.8%	($157)
2011	$4	($254)	1.5%	($258)
2012	$41	($396)	10.2%	($437)
2013	$194	($74)	262.7%	($268)
2014	$216	($294)	73.6%	($510)
2015	$169	($889)	19.0%	($1,057)
2016	$302	($773)	39.1%	($1,075)
2017	$360	($2,241)	16.1%	($2,601)
2018	$419	($1,063)	39.4%	($1,481)
TOTAL	$1,716	($6,695)	25.6%	($8,411)

Regulatory Credit Sales are from Zero Emission Vehicle Credits (ZEV), Green House Gas (GHG), and since 2016 credits associated with Solar City.  You can read about it here on page 11 of Tesla’s 2018 Annual Report.  Data above is from that AR and earlier ARs.

Tesla has also indirectly benefited from the USD 7,500 tax rebate given purchasers of its cars by the Federal Government.  To be fair Tesla is not the only company that has benefited.  That tax rebate is not reflected above as it accrues to the purchasers not directly to Tesla.

However, without Uncle Sugar’s discount, Tesla cars would cost more and sales would be less.

Tesla has reached the 200,000 car sales milestone at which point the credit halves and then haves again this year.  Unless Tesla and other electronic vehicle manufacturers are successful in their efforts to “save the environment” by having a usually compassionate Congress extend the rebate program, an important support for sales will be lost.

At this moment prospects don’t appear good for the “Driving American Forward” Bill.  Senate Bill.  House Version.

Let’s assume that this noble effort falters.

Ignoring the reductions in 2019 in the rebate, and assuming that anyone who buys a Tesla has at least a USD 7,500 Federal tax bill, then Uncle Sugar has supported Tesla’s business to the tune of at least an additional USD 1.5 billion.  Or USD 3.2 billion in total.

Beyond that Tesla benefited from a US Government Guaranteed  USD 465 million loan under the ATVM program.  Tesla repaid the loan prior to its maturity.

Tesla also benefits from various state incentives.

There are a lot of Sugar Daddies out there for struggling corporations and the deserving rich who can afford to buy Tesla’s product.

With partners like these it’s hard to see how Tesla can fail, unless you look closely at the financials.