Is it News or an Advert?

Dr. Hilton with What Appears to Be Schroedinger's Cat

The National ran this rather remarkable piece yesterday, which sounds to my ears suspiciously like a transcription of marketing literature from Barclays.  

Not really news.  More like product placement in a movie.  Or outright touting.   Sorry, TN, but when you publish transparent advertizing like this, the natural question is:  Are your "news" columns for sale?  Or is this perhaps part of your transition to a new website and your staff are creating filler to see how it looks on the new "page"?

There's no real analysis of the product in the article.

Let's try and fill in that gap.

Before we start a very important caveat:  without seeing the marketing materials, I don't know the underlying structure.  

So what follows is a bit of speculation (note that word), hopefully informed based on structures I've seen before.  To hammer the point home:  this article does not necessarily provide a description of the underlying elements of Barclay's product but shows how such a product might be constructed.

Clearly this is no standard commercial banking fixed deposit product.  In the current market one doesn't get a 9% return on deposits.  And note right up front, it's not a promised return of 9%.  But a return up to 9%!  There is a difference.

Bankers are not very good on selecting earning assets (that's why a select group of distinguished banks, including those from The Developed West hold a disproportionate share of Dubai World debt) but they are generally fairly good at pricing deposits.  They usually are very careful to set the rate on deposits less than the rate they expect to earn on assets. (Note the word "expect".)

Compounding the earnings issue (what the banks will have to use to pay the depositors) is that the tenors are relatively short.  And it's a general rule that the shorter the tenor on a deposit instrument the lower the rate.  More risky assets (equity, etc) have of course higher returns.  One has to ask oneself just how high a return is needed to give the investor a high rate on his deposit/investment.  We'll look at that a bit later.

So how does a bank structure the transaction so it can make a tempting offer like this?

To be clear what follows is based on structures I'm familiar with - which are multi-year tenor instruments.

First, in order to "guarantee" the principal, the bank "buys" a zero coupon bond with a portion of the proceeds of the deposit.  This theory is that this "guarantees" the depositor his principal back at the end of the term.   At maturity the redemption value of the zero coupon equals the original principal.  If the bank or the investor wants a higher return, the amount of the zero can be reduced so that the depositor has this "guarantee" for some percentage less than 100% of his original principal, e.g. 90%, 85%, etc.

Sometimes when investors or depositors hear about the zero coupon, they think they have a guarantee of the return of principal.  Generally, they don't because the bank buys a "zero" coupon bond from itself.  So the depositor has a promise from the bank to pay him back secured by the bank's creditworthiness  In effect the exact same promise he gets if he places a conventional deposit.   In either case if the bank is in financial difficulty, it won't be able to pay back a straight deposit or a bond.

How could a depositor/investor get a real guarantee on his money?  Two steps.

1. The bank would buy a zero coupon government bond issued by the US, UK, UAE, or Indian governments, thus "guaranteeing" that at maturity the receipt of the face amount of the bond in  US$, Sterling, AED or Rupees respectively.  I'm assuming that each of these sovereigns would "print" enough money to satisfy its obligations if that would be required.
2. The bank would legally pledge these government bonds as collateral for the investment/deposit.  If they're not pledged, they are part of the estate of the issuer (the bank) in bankruptcy.  And the depositor/investor is an unsecured creditor of the bank.

Sometimes the transactions will be described as "guaranteed".  That occurs when a subsidiary of the bank issues the investment certificate or the deposit.  Then the parent guarantees its subsidiary's payment.  Again stripping away the form, the substance is that the same as if the depositor had placed a deposit with the parent (the bank).  There is no third party guarantee.  It is "all in the family" as I often like to say here at SAM.

Sometimes a minimum interest rate is "guaranteed".  This can be achieved very simply, by taking some of the remainder of the deposit after the zero is bought and putting it aside.  Say the bank wants to promise 1% interest.  It deducts $1,00 from the US$9.09 or the US$2.91 and puts it in a deposit.

The remainder of the principal of the deposit (what's left after the "zero" coupon security is bought and any minimum interest guarantee reserve funded) is then used to "punt" in the investments - equities, commodities,  options and derivatives, etc..  

Often with leverage where the bank lends additional funds secured by the additional assets purchased.  Generally with a mechanism to unwind leverage if volatility in the underlying instruments increases.  The bank will tout this as a "protective feature" to limit risk.  And it does.  However, volatility is a measure of the change of the value of an asset - whether the values are increasing or decreasing.  So some of the upside is given away.  But a fair trade to limit downside risk, I think.

Now to some numerical analysis.

 

With interest rates so low and the tenor so short, clearly a large part of the initial principal of the deposit would have to be used to purchase the zero coupon.

The remaining principal is likely to be very small.

Let's look at a simple example for a one year tenor.  Assume that interest rates are 10% (clearly they are not now.  This is our standard Panglossian best case.)  If they were, a zero maturing for $100 one year from now would cost US$90.91.   At 3% one year rates, the bond would cost US$97.09.  

This means that with the 10% scenario the bank would have US$9.10 of the investors' funds to punt with.  And US$2.91 at a 3% level of interest rates (closer to today's level).  As you notice, I am assuming there is no promised minimum interest.  And I'm assuming there are no upfront fees or ongoing operating expenses.  All of these would serve to make the economics even more difficult.

To get the 9% return on the total principal (i.e.,  US$9 in our example of the US$100 deposit), the bank would have to earn - without any leverage on the remainder (after buying the zero):

1. Roughly 100% if the remainder were US$9.09.  (Our highly unlikely 10% market rate scenario)
2. Roughly 309% if the remainder were US$2.91.  (Our still optimistic 3% market rate scenario).

Neither of these seem realistic returns for current market conditions.  And one might even consider that  if achieving these rates during the last bout of irrational exuberance was difficult, it might be even more so now.

Add some leverage and the required returns still remain very high.  

With total leverage of 3 times:

1. In the first case the required one year return is 33%.
2. In the second case, the required return is 103%.

With leverage, the lender always collects his principal and interest first.    If asset values decline, and trigger the leverage control, the lender will sell the additional assets and repay the loans (principal plus interest).  If the proceeds aren't enough to repay the loans, then he'll take money from the US$9.09 or US$2.91 "remainder" to cover any shortfall on principal and interest.  So employing leverage can cause an erosion of the "remainder" under certain market decline scenarios.

If the investing scheme breaks even, then the investor will get the market rate on his or her deposit.  The US$9..09 or US$2.91 in our two examples.  In effect the one year rates.

Up to 9% sounds great.  Getting it will be a little more difficult than reading a glossly brochure.  

To be very clear, am I saying it's impossible that this scheme could earn 9%?  No.  Rather that the probability of earning 9% is rather low.  Better I suppose than the odds of Paris Hilton winning the Nobel in Physics. But who knows what she's doing right now?

Emaar - Investment Opportunity of a Lifetime

I see on the DFM this morning that Emaar's Board has decided to sell its 200,000 treasury shares.  

You'd better jump quickly before this opportunity passes you by.

Unlike the postman, Opportunity only knocks once.

Update:  Shares sold 20 September at AED3.84 per share.

Shuaa Capital Turns the Corner or Does It?

Following the announcement of its 2Q10 financials, there have been several articles on Shuaa. From this one Shuaa Capital Improves Financial Stability Despite Downturn to more nuanced articles like this one over at The National Cautious Investors Leave Shuaa in Lurch.

The question on everyone's mind seems to be: Has Shuaa turned the corner?

SUMMARY

At this point, the simple fact is that it's not possible to say one way or another. One swallow does not a summer make. Nor six months' performance a turnaround, particularly after the last two dismal years. What has happened is that there has been material improvement in net income. But that was primarily due to improvement in a single line of business, proprietary investments. The LOB primarily responsible for Shuaa's past problems. The LOB that Shuaa is therefore de-emphasizing/exiting.

Most of Shuaa's other LOBs are underperforming. No surprise here. These are highly market sensitive. The markets in which the Company operates have been very, very difficult: significant reductions in trading volumes on local exchanges (down 45%) and declines in market indices.

Right now it appears that the current market slump is likely to be prolonged with a less than vigorous recovery. If that's the case, Shuaa with its high correlation to markets has a real problem. Can it staunch the bleeding, return to profitability (even if only modest) and generate sufficient cashflow from operations to meet its cash expenses? Doing this in the next two to three years is likely to be critical.  During that period, external sources of finance (for debt rollovers, expenses as well as expansion) are probably going to be very difficult to come by and very expensive if obtained. Expensive in terms of direct cost (margins and fees) as well as collateral requirements. 

At the worst, continued bleeding could be fatal. And if only modest profitability is achieved, the Company may slowly fade into irrelevance. On the other hand, with the distress at other regional firms, this might be the opportunity of a lifetime.

ANALYSIS

Let's take a close look at Shuaa's financials. The key documents for this excursion are Shuaa's Earnings Press Release and its 2Q10 Financials.

Income Statement

Net Income

Yes, there is a dramatic improvement in the bottom line. The AED37.2 million loss for 1H10 is roughly one-third of 1H09's AED113.7 million.

But the improvement is largely within one line of business.

The Net Loss Before (Losses)/Gains from Other Investments for the first six months of 2010 is AED 52.6 million almost spot on the AED52.9 million loss for 2009. The difference between the "bottom lines" (Net Income) of the two periods is Other Investments. An AED15.4 million gain in 2010 versus a loss of AED60.9 million in 2009.

The nice thing about write downs is that at some point they stop because one cannot write an asset below zero. But all this does is stop the bleeding. It doesn't generate new revenues. And unless it's accompanied by improvement in other LOBs' performance, the Company can "stabilize" at a loss or modest income. A bit later we'll take a look at Shuaa's other LOBs. For now let's concentrate on the macro picture.

Comprehensive Income

Comprehensive Income is more favorable: AED17.2 million loss in 1H10 versus AED88.2 million in 1H09 due to net revaluations of some AED20 million in 2010 and AED25.5 million in 2009. Both of these are non cash items – in a situation where cash generation is key. And largely related, it seems, to the business Shuaa will exit.

Cashflow

The gross operating cash flow is weak. AED18.4 million negative in 2010 versus AED10.6 million positive in 1H09. Also the Company is reducing/selling assets (chiefly Other Investments and Loans) to fund reductions in debt. A pattern they followed last year as well.

Deleveraging does improve the Company's risk profile. Usually the intent is to sell only the underperforming assets. But that doesn't always work especially in a down market. Often such assets can't be moved. Or if they can, only at fire sale prices leading to losses – which even if only paper losses  will erode market confidence and capital. As a result, the firm winds up selling good assets with a pernicious effect on future ongoing cashflow and earnings. Whatever the case, this is a limited strategy. Limited because there are only so many assets one can sell. At some point, if Shuaa doesn't have sufficient operating cashflow, it won't be able to continue.

Balance Sheet

Total Assets decreased from AED3.6 billion at 30 June 09 to AED2.4 billion at 30 June 10 due to a roughly AED710 million reduction in liabilities plus an AED469 million decline in equity (primarily 2H09 losses). The Company has also been able to improve its liability maturity profile via a secured (AED300 million of collateral versus an AED240 million facility) medium term loan from Abu Dhabi Commercial Bank. Quarterly repayments commence in December 2010 and end March 2013. The rate on this loan is not disclosed. Spreads on the Company's short term borrowings are at 3.5% to 4.0%.

From Macro to Micro

As mentioned above, we need to understand performance at the level of individual lines of business.

Let's turn to Note 17 in the 2Q10 Financials for Segmental Results.

One very important caveat, the allocation of revenues and expenses among segments is more an art than a science. Different definitions of LOB, different management assumptions on how best to allocate revenues and expenses can result in quite different allocations. Accounting and reporting system limitations are another factor. From Shuaa's description of its segments, it seems that there are significant management and administrative items (probably including shared or cross LOB revenues and expenses as well as Treasury functions) in its Corporate Segment which haven't been allocated to LOBs. As such, at the segmental reported net income level, we may be dealing more with gross operating margins than net operating margins. If the LOB numbers aren't fully allocated, and I don't think they are, this exercise is likely to be more "directional" than precise.

With that caveat let's begin with LOB revenues. LOB figures are based on Net Income and expressed in AED thousands.

LOB	1H10	1H09
Private Equity	8,571	21,885
Asset Management	7,280	16,835
Investment Banking	7,499	2,239
Brokerage	19,155	30,527
Finance	32,874	49,029
Corporate	18,848	34,662
Total	93,837	155,177

Revenues were down across the board except for Investment Banking. For many of the LOBs this isn't surprising as they are highly market sensitive and markets have been dismal. 

Asset Management revenues declined due to (a) an almost halving of fees and commissions which were down from AED10.1 million to AED5.37 million and (b) gains on Shuaa managed funds were down from AED6.8 million to AED1.9 million. You'll note that from the latter that asset management is not solely client related fees but includes gross performance on the portion of the funds that Shuaa owns.   In most firms I've worked in, holdings of own funds do not "belong" to Asset Management but to Treasury based on the idea that they do not fundamentally differ from holdings of other third party funds. On that basis Shuaa's Asset Management Revenues and Operating Margin are probably inflated. 

Next net profit (before Minority Interests) in AED thousands.

LOB	1H10	1H09
Private Equity	811	13,137
Asset Management	(491)	11,185
Investment Banking	(2,321)	(6,536)
Brokerage	2,038	12,378
Finance	16,071	14,332
Corporate	(53,289)	(158,219)
Total	(37,181)	(113,723)

The Corporate Segment (which seems to be the "warehouse" for the legacy assets) is allocated the lion's share of assets and expenses. Though it should be noted that as described above this LOB is also a central administrative and management unit as well. The amount of assets in Corporate indicate just how much "non strategic" business the Company developed. 

If we assume that this business is largely being wound down, there are two key conclusions: 

1. The future is in the other LOBs. 
2. The "new" Shuaa is likely to be a much slimmer (in balance sheet terms) entity with a more modest income stream than it was in its heyday. 

Turning to the remaining, LOBs, in absolute income terms, the most profitable LOB is "Finance".  The Press Release describes this as "vehicle finance", though the FYE2009 financials  identify it as primarily "construction equipment finance". The lending focus makes a critical difference in terms of future prospects – at least over the next 3 to 5 critical years.  Renting construction equipment probably doesn't have a bright future in the near term. While not investment banking or broking, lending (assuming the right economic segment) could deliver an annuity cashflow to offset Shuaa's more volatile market sensitive revenue streams. It is one, however, that is asset intensive and requires leverage to generate the ROE that investors require. 

Brokerage depends on the tone of markets as well as the perception of market participants about Shuaa's longevity. With other brokers shuttering their doors, Shuaa may have an opportunity for growth. The trick here will be driving volumes – largely dependent on market recovery -- to offset what appears to be a rather high (perhaps somewhat fixed) expense base of roughly AED17 million in annual G&A. Further extension of the platform would make business sense though the capital to fund might be difficult to attract. Thinking ambitiously, a single firm able to offer its own brokerage services in more than one GCC market (as opposed to working through local firms) might be a compelling value proposition.

Asset Management could be another promising venture. Success will depend on Shuaa's reputation (largely based on its performance and favorable market perceptions of firm longevity) as well as like Brokerage the all important market tone. This is another volume business given generally modest margins. For a comparable, Global earns about 1% in gross fees and commissions (excluding performance related compensation) on its KD1.5 billion in AUM.

Investment Banking and Private Equity are perhaps more "long shots". Despite higher gross margins, these are likely to be even more hit and miss than Asset Management or Brokerage because of the uneven timing of transactions. Investment Banking requires deal flow – a function of markets, the firm's reputation, and pricing. Private Equity is more equity intensive (on a risk basis) with highly volatile cashflow and income. With this LOB there's always the danger of becoming the "lender of last resort" to a failing investment under the sunk cost fallacy: investing just a few more dirhams to protect all the ones you've already invested. 

Clearly there are opportunities for Shuaa.

But to make a success of its business, Shuaa needs to convince lenders and shareholders that it is viable. To a large extent that means having a reasonable prospect of delivering a meaningful ongoing revenue stream as well as an attractive ROE. It needs both. A 50% ROE on AED100 is unlikely to excite anyone. AED100 million of net income with a 0.5% ROE is likely to be similarly unattractive.

At this point, logically, an ROE analysis of Shuaa's individual LOBs makes sense. Unfortunately, the Segmental Results really don't contain the data I think is necessary for such an analysis. Revenue and expense do not appear to be fully allocated. Determining LOB equity is similarly troublesome. Shuaa's own data has some seems too volatile for Private Equity. Allocated assets don't seem to have a logical pattern. They were AED123 million at FYE2008, AED155 million at 1H09, AED93 million at FYE09 and AED172 at 1H10. Determining required equity for Shuaa's Asset Management and Investment Banking is more than just a matter of the very slim amount of assets these LOBs carry. One needs to consider the equity required to cover operations and risk absorption. While it's possible to construct models to calculate all these, that would require a lot of work and be well beyond the intended remit for this blog.

So we'll end with some general observations.

1. The road in front of Shuaa is difficult. 
2. By their nature its major LOBs are market sensitive and/or volatile. 
3. Markets are difficult and may remain so for some time. 
4. LOBs offering good prospects (Asset Management and Brokerage) are generally low margin requiring significant sustainable volumes to deliver acceptable ROEs.
5. External financing - debt or equity capital - is likely to be difficult to obtain and when obtained costly.

While this analysis does not definitively answer the question about Shuaa's future, it provides some insight into the key challenges and as well some key milestones to watch for progress. 

The exercise of determining whether they can realistically develop the ROE and quantum of earnings to be a meaningful player has been left to the student.

Towers Watson on Pension Fund "Alternative" Asset Allocations

A very interesting report from Towers Watson on pension fund Alternative Assets' AUM by asset class, geography, top managers (by volume, no performance numbers given), etc.

And this very delightful quote from the press release accompanying the release.

Carl Hess said: “Infrastructure and commodities managers have significantly increased their pension fund assets under management during the past year, as investors have become more comfortable with these asset classes and while others have continued to opportunistically add to their allocations. However, investors should be very wary of the structure of some of these mandates with careful attention being paid to the ‘net of fees’ proposition, in particular for infrastructure.”

Wise advice indeed.  "Net of fees" is an important concept to perceptive investors in all asset classes.  I presume Carl mentioned it here because some fee "propositions" in the infrastructure class were in his opinion a bit "rich".  Which just goes to show that "conventional" firms can charge fees like so-called "religious" ones.  Doing God's work, indeed!