What are GFH’s Motives for Acquiring KHCB Shares?

لولا اختلاف النظر، لبارت السلع  

 Summary of key points in this post.

• 45% premium over market on 13.64% of shares from Shuaa and Goldilocks.

• Tender offer proposed for remaining 30.95% of shares

• Favorable Impact on GFH’s Consolidated Shareholders’ Equity

Background

On 6 June GFH announced it had increased its shareholding in KHCB from 55.41% to 69.05% as part of the “Group’s strategy to increase its ownership in KHCB.”

On 7 June GFH provided further details as follows:

With reference to GFH Financial Group’s announcement dated 6th June 2021 pertaining to the subject matter, GFH would like to announce that the increase of ownership in Khaleeji Commercial bank was pursuant to a sale and purchase agreement between GFH along with Shuaa Capital and Goldilocks Investment Company, to acquire their stake of 121,726,795 shares for a total of BD 8,764,329.240 equating to BD 0.072 per share.

On 8 June GFH announced that pursuant to Central Bank of Bahrain requirements regarding takeover and mergers, it had approached KHCB’s Board to make a proposed voluntary takeover offer for the remainder of KHCB’s shares.

Deal Analysis

According to the trading data from the Bahrain Bourse, during the period 4 January through 3 June 2021, the average price of a KHCB share was BD 0.050 (rounded to 3 decimal places). Typically the share trades at roughly 50% of book value.

The BD0.0720 acquisition price represents a 45% premium to the average trading price.

Since the GFH acquisition, the price has increased to just below BD 0.070 perhaps in anticipation of GFH offering the same BD 0.0720 price to remaining shareholders.

Apparently, KHCB is quite a valuable asset.

Though one might not have thought so from the fact that

• KHCB required an additional BD 60 million in capital to meet CBB requirements

• GFH had to buy the entire AT1 instrument

Or maybe you read Fitch Ratings comment on KHCB in their reaffirmation of GFH’s B credit rating. (That rating is below investment grade, if you didn’t know)

Following a balance sheet clean-up exercise in recent years KHCB's asset quality has been improving but is still weak and lags higher-rated peers'.

In any case I hope you are confident that the fact that Shuaa and Goldilocks are related parties had no effect on the 45% premium.

That being said, the size of the premium is perhaps perplexing. 

Neither Shuaa nor Goldilocks were inclined to participate in the AT1. That would seem to evidence a lack of faith in KHCB's future.

One might think of them as perhaps motivated sellers of KHCB. 

It is perhaps also difficult to imagine that there were other serious bidders interested in acquiring a minority stake in company where a single shareholder had control.

But then the ways of the market are mysterious and magical. Especially in the land of flying carpets.

Despite the premium, if you look at this earlier post on Goldilocks, you will see that Goldilocks acquired its stake in KHCB from Shuaa for BD0.096 a share. You will also note that KHCB didn’t pay any dividends since Goldilocks’ purchase.

So on this transaction Goldi has a roughly 25% loss from original cost.

No wonder Shuaa doesn’t publish data on Goldilocks’ performance, contrary to previous years.

In the post referenced above I also wondered if Shuaa had held on to its then 3.88% stake.

It certainly appears so because GFH says it bought shares from both Shuaa and Goldilocks and Goldilocks shareholding was 9.76% according to KHCB’s announcement.

Motives for the Transaction

So what is motivating GFH’s acquisition of KHCB?

Only GFH knows for sure but we can explore some possible rationales. 

I've selected two for discussion:

• Overlooked gem
• Increase in GFH equity beyond the purchase price

Other possible reasons for the transaction could be “civic duty”, etc. And more than one motive may be operative.

As you read, you can decide for yourself which, if either, is the more compelling one.

Overlooked Gem

The market has fundamentally undervalued KHCB.

The canny folks at GFH are about to get KHCB “on the cheap”.

Thereby reaping rich rewards long into the future.

Accounting Magic

The key drivers of the appeal of this motive are two “facts”:

• KHCB’s book value per share exceeds the acquisition price

• GFH uses the book value—not the market or fair value—of KHCB’s assets and liabilities (and thus by the process of subtraction also KHCB’s equity) to prepare its consolidated financials.

As of 1Q 2021 KHCB’ s Book Value was roughly BD 0.160

By acquiring the shares GFH stands to benefit from the difference between book value (BD 0.16) and the purchase price (BD 0.072) and the happy application of rules for consolidated financial statements.

121,726,795 shares at BD 0.088 equals roughly BD 10.7 million or US$ 28.4 million.

Compare that to the BD 8.8 million purchase price. 

A not inconsiderable gain on purchase.

You might well ask:

“How can that be? The P/B ratio is well below one. This can’t make economic sense.”

As I’ve posted here before, accounting does not always reflect economic reality.

Here’s how it would work in detail.

Recall that in its consolidated financials GFH records 100% of KHCB’s assets and liabilities in its (GFH”s) balance sheet using the values appearing in KHCB’s balance sheet. Their book values.

Therefore, net assets (equity) are also reflected in GFH’s financials at book values.

As the final step GFH allocates those net assets between shareholders in the Group and Non Controlling Interests (NCI) in the Consolidated Statement of Changes in Shareholders’ Equity based on their respective ownership/voting rights.

With the acquisition of an additional 13.64% in KHCB shares, GFH’s share of the net assets (total assets minus total liabilities) in KHCB will increase.

This increase in equity attributable to shareholders of GFH will be accompanied by a corresponding decline in equity attributable to NCI in GFH's financials.

If its tender offer for the remaining shares is accepted and completed, an additional increase in Group shareholders’ equity will occur.

Depending on the percent take up on the take over offer, the component in NCI related to KHCB may disappear from GFH’s financials.

But there is indeed more!

You will recall (and if you don’t here’s the link to that post) that in connection with its 2020 purchase of KHCB’s AT1, GFH was required to reduce its consolidated equity attributable to shareholders of the Group by US$ 59.9 million in its FY 2020 financials.

The US$ 59.9 million reflects the excess (positive difference) between (a) GFH’s “contribution”--the amount of the AT1-- and (b) GFH’s share of KHCB’s net assets based on its percentage shareholding in KHCB.

Now that GFH owns 69.05% of KHCB, it is entitled to “recover” some of that amount.

Similarly, it will also have to absorb some of the US$ 14.3 million share of issuance costs levied against the NCI in 2020. Perhaps as much as US$ 4.4 million.

We should see the impact of the 13.64% KHCB share acquisition most likely in GFH’s 2Q2021 financials.

Keep your eye on GFH’s financials to see if my prediction comes true and how the related entries are handled.

Are they disclosed separately as in 2020?

Booked directly to equity?

Or perhaps to income?

Dubai Courts: Potential Conflict of Jurisdiction Between Onshore and DIFC Court

Bradley Hope over at The National reports on the case between Taleem versus Deyaar and National Bonds.  In September the DIFC ruled that the case could be heard in its system.  Earlier National Bonds had sued Taleem in Dubai Civil Courts. 


Justice Chadwick of the DIFCC wisely did not issue an order to the DCC to stay their proceedings preferring sensibly to wait until he sees their ruling.  At that point if it is contrary to the DIFCC's then it will be time no doubt to seek the intervention of a higher power.  And hopefully this case will lead to a mechanism for co-ordination between the two courts on future such situations.

It seems this is all about a failure in precision to specify the governing law and judicial forum.  And so I'd mark this down to a lapse in one of the most routine matters of contract drafting.  As the episode of Shuaa's convertible securities, those of Citi Group, and those of  National Bank of Umm AlQaiwain show, it really does pay to pay attention.

And as with the examples cited above, the amount involved is no small beer -- AED236.6 million.  

Hard to understand this.  The parties to the examples mentioned above consider themselves sophisticated firms.  The amounts are substantial.  Yet they fall down on rookie mistakes?

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.

Walid Shihabi Rejoins Shuaa Securities as CEO

As per an announcement on the DFM.

In this regard Mr. Shihabi was quoted as saying:

“It is with great excitement that I look ahead towards taking responsibility for one of the truly outstanding brands in the region’s securities trading market. I believe there remain tremendous avenues for growth  available to the company, and I am truly privileged to be in this position to help guide the company to further success, after having participated in building it into one of the largest and most respected investment banks in our region.”

Personally I would have hoped that the new CEO would have shown a bit more enthusiasm for his new role and a bit more faith in his new employer.

Shuaa Capital Gulfinvest Kuwait and Ahlia Investment Company

You've probably seen the press reports that Gulfinvest had defaulted on a AED 200 million loan extended to it by Abu Dhabi Commercial Bank which Shuaa Capital had guaranteed. The loan was to partially finance Gulfinvest's purchase of  19.2% of Ahlia Investment Company (since 2007 Ahlia Holding Company) from Shuaa.  As a result of the default, Shuaa is now obligated to pay ADCB AED 200 million.

How did Shuaa get in this situation and what are the consequences?

Sixty second summary:

1. Shuaa has already taken an AED156.6 million provision (in its 2009 annual report) so the financial pain is already felt.
2. Recovery prospects are probably best characterized as difficult given that Ahlia represents roughly 73% of Gulfinvest's assets. 
3. The story of the sale is complicated.  Shuaa seems to have been motivated to provide the guarantee so that it could close the sale.  The profit on which was 26% of 2006 net income.
4. Gulfinvest appears to have paid a significant premium over "market" price for the acquisition.  Almost twice market!

Now the details.

Those with long memories will recall that Shuaa's 2005 acquisition of Ahlia had been controversial in some quarters.  As far as I know, no regulatory action was taken against Shuaa for the transaction.  Here's one article about the ESCA.  And there is nothing on file against Shuaa at the DFSA for this transaction.

In 2006 it sold all of its shares in Ahlia to Gulfinvest, in whom Ahlia was a significant shareholder.

As the below press release from the KSE 29 July 2006 discloses Gulfinvest bought 100% of Emirates Company for Opportunities Ltd #3 which owned 115,730 shares of Ahlia for KD51.9 million.   This is what the press release states but it's clear from Ahlia's 2006 financials that the purchase must have been for 115.73 million shares. As an unrelated (to this story) comment, you might find Note 27 (Related Party Transactions) and 32  (Regulatory Violations)  in Ahlia's report interesting reading.

Here's Gulfinvest's 29 July 2006 press release on the transaction.

[7/29/2006-7:58:14]  ِ(غلف انفست) تشتري "شركة الامارات للفرص المحدودة 3" بمبلغ 51,9 مليون د.ك

يعلن سوق الكويت للأوراق المالية أن الشركة الخليجية الدولية للاستثمار
ِ(غلف انفست) قد قامت بشراء "شركة الامارات للفرص المحدودة 3" بالكامل،
وذلك بمبلغ قدره 51,9 مليون د.ك (واحد وخمسون مليونا وتسعمائة ألف
دينار كويتي).‏
علما بأن "شركة الامارات للفرص المحدودة" تمتلك عدد 115,370 سهم
من أسهم الشركة الأهلية للاستثمار.‏
وعليه، تصبح ملكية (غلف انفست) في الشركة الأهلية للاستثمار 30,17%‏
بشكل مباشر وغير مباشر، وذلك بدل ملكيتها السابقة البالغة 11,03%.‏

If we look at the 2006 annual audited 2006 financials for Shuaa Capital Note 8, we get more details. The sale price was AED 656.744 million and Shuaa recognized a gain of AED 67.821 million.  This represents roughly 26% of Shuaa's 2006 net income of AED 262,43 million.   Strong incentive to "close the deal"!  And maybe take a bit of credit risk.  And maybe in retrospect a bit too much.

What motivated Gulfinvest is less clear.  In the period around the end of July 2006, Ahlia was trading at KD0.240 or so.  A glance above shows that Gulfinvest paid almost twice market price for the shares!!!

Let's go a bit deeper.

In Gulfinvest's 2006 Annual Report Note 2, we see that it actually only paid cash of KD37.9 million.  It financed the remaining KD 14 million by using KD1.7 million in dividends from AIC to pay Shuaa and KD12.3 million though a note payable (presumably to Shuaa) which carried interest of 7.75% p.a.   It also recognized some KD15 million in goodwill on the purchase.

In its 2007 Annual Report, Gulfinvest disclosed in Note 8 that this receivable was settled during 2007 by utilizing a portion of the term loan "availed from a bank in the UAE".  The term loan is for KD14.96 million.  The term loan appears to be some KD2.697 million larger than required.  

Could the difference be interest?  And how can we put a boundary on the interest calculation?  The convenient thing is that Shuaa's fiscal year 2006 ended  31 March 2007.  At that point as per  Note  33 in its 2006 annual financials it is showing an AED 207 million guarantee.   It's a safe bet that this is this loan.  So the maximum period for interest is from August 2006 through March 2007 or 8 months.  At 7.75% that's KD0.634 million.  In rough numbers leaving KD2 million or AED 26 million of apparently extra  (note the qualifier "apparently") debt which Shuaa has guaranteed.

The press reports that Shuaa helped Gulfinvest get the loan from Abu Dhabi Commerical Bank.  The loan was secured by  the pledge of the 19.2% stake in  Ahlia bought by Gulfinvest.  But ADCB also wanted and got Shuaa Capital's guarantee.  Perhaps a sign to Shuaa that it was taking on more credit risk that it bargained for.

With the default and the legal obligation of Shuaa to pay ADCB, some press articles have remarked that this is yet another headache for Samir Ansari, Shuaa's CEO.  However, a glance at Note 33 in Shuaa's 2009 financials (now a December Fiscal year end) shows that it already took an AED 156.643 million provision.   So the headache was recognized long ago and preparations made.  The financial pain has been taken.  Or largely taken.  If the provision proves later to be insufficient, the likely additional amount seems clearly manageable - and not life threatening to Shuaa.

Once it pays off the ADCB loan, Shuaa will step into the shoes of ADCB  with Gulfinvest's  other creditors  to negotiate the debt rescheduling.  

From a quick glance, recovery looks difficult.

As per Gulfinvest's 30 September 2009 financials (the latest I can find) Gulfinvest has KD63.4 million of assets.  Of this total KD46.1 million is represented by Ahlia.   It's now trading at roughly one-tenth of its value on 29 July 2006.  And roughly KD20 million of that now belong to Shuaa.  Other creditors (excluding Shuaa) are some KD34.6 million.

Shuaa Capital 2009 Audited Annual Report

Shuaa released its 2009 audited annual report on the DFM today.

You can read the details about performance (they had a net loss of AED538 million versus a net loss of AED965 million in 2008), two things are worthy of comment:

1. The Board of Directors report is pretty straightforward.  Unpleasant news is not avoided, buried or sugar coated.  Admittedly, there's a bit of puffery in the press release but nothing too egregious.  One does not expect self flaggelation.
2. The annual report is very good in terms of disclosure.  My only quibble (and AA always must have a quibble) is Note 10.  I would have liked to see details of the values for each individual investment.

Also if you're interested in hearing the company speak for itself, here is a link to their press conference on their preliminary results. Their CEO, Sameer AlAnsari, about SC's expectation for the market and its business and its strategy.  And what more comforting that to hear what sounds like a good Scots burr talking about financials.

Orion Holdings Overseas - "Unauthorized" Trading and Corporate Governance "Shortcomings" Led to Collapse

A bit more information has come to light about the causes of the meltdown at OHO via an article in The National: at least US$20 million of unauthorized trades in gold and other commodities including oil.

That sounds familiar.

"It's hard to understand how this happened.  If OHO's main lines of activities were brokerage, fund management and technology, that is a great deal to lose in this period, even given the economic meltdown.  Was OHO taking proprietary positions that turned against it?  Was it trading in oil?  Or other commodities?  OHO was a member of the Dubai Mercantile Exchange."

However, a "mere" US$20 million in losses should not have caused the collapse of a company which  was valued at some US$263 million in February 2008.  The losses would have had to been more, a lot more.  Or it would have to be that the company had a lot of assets whose ultimate value proved to be much less than their carrying value. Or some combination of these and perhaps other factors.

That's not the only thing in the article that I'm having difficulty getting my head around.

1.  Shareholders' Blame Game - This seems to contradict the statement that "management was gambling with the firms' money".  Unless of course some shareholders felt that management was acting on the instructions or with the acquiescence of some of the other shareholders.  And were therefore asserting that that shareholder had a liability to make them whole.  Otherwise, it would seem the shareholders would have a very compelling shared interest to protect their dwindling investment by cleaning house of the culprits in management.  There is also the "testimony" from Shuaa that it was not involved in the management of the company.   Was no other shareholder?  Not even the largest? If so, what then is the basis for Shuaa's legal action against  the Chairman and Petra? 
   
2. Risk Management Report - The article seems to question whether the Board saw the report.  The Chairman says that he resigned in protest of the Board's failure to respond to the report.   It seems plausible that before resigning he would have raised the topic with the Board.   And then it would seem equally plausible that they would have asked to see the report if they had not.  One might also wonder if Sami Boujelben wouldn't have "rung up" the board members as part of the professional discharge of his duties.  Now, if at his resignation, the old Chairman did not agree to allow other parties to select his replacement, his resignation did not diminish his company's control over the number of seats on the Board and thus over OHO. It was then only a matter of changing a face.  Another set of questions regarding corporate governance and risk management focuses on the losses themselves.  Once they occurred, did the Board not receive and review financial reports?  Did the CEO or CFO brief the Board on the financials, including the losses?  If the Board wasn't getting periodic copies of and verbal reports on the financials, then there are some rather potentially difficult questions for the Board about how it implemented corporate governance.
   

What is presented raises more questions than it answers - at least for me.

The shareholders of OHO are primarily institutional investors.  They are not small unsophisticated retail investors hoping to turn a quick buck on their shares so they can buy a refrigerator (as one punter on the Dana Gas IPO told the press in Bahrain).  Thy had placed serious money on the table.  It was evaporating.  They did nothing? 

It seems there must be something more to the story.  Just as the US$20 million loss doesn't fully account for the financial distress the company now finds itself in, the corporate governance  related comments here don't seem to as well.

Another interesting bit from the article and that is the assessment that Shuaa over reached in its private equity investments and will be retrenching to focus on more core business of brokerage.

Finally, other investments as well as the general market trend are responsible as well for the decline in Shuaa's share price. It's not just OHO. When Shuaa issues its year end detailed audited financials, it will  hopefully be possible to quantify in part the relative contribution of each investment to the provisions and the loss.  No doubt,  the debacle involving the convertible and Dubai Group also played a role. 

Orion Holdings Overseas - Involuntary Liquidation at DIFC

You've probably seen the press reports that OHO has been put into involuntary liquidation.  Here's one from The National  Here's another from Business 24/7.

Often a closer look at news items is quite revealing.  Here's a bit more of the story.  Since OHO's financials do not appear to be available on the Internet, we'll use Shuaa Capital's and some other information to reconstruct the story.

Here's the link to OHO's registration at the DIFC.  While the DIFC says it was incorporated in 2008, the company seems to go back at least several years earlier.   It owns Orion Capital, also registered in the DIFC.   OHO's shareholders as per the DIFC are Petra Invest Ltd, Shuaa Capital, Primavera Holdings (Cayman) Ltd., MHK Investments LTD, AJ Capital Limited, and Shihab Ahmad Khalil.  Petra is identified as the majority shareholder, though The National article says it owns 32%.  Manara Capital, a Lebanese related investment company, is mentioned in Shuaa's press release as a shareholder.  It acquired an interest in OHO in September 2007.  It's unclear which of the entities above represents it - MHK, AJ Capital, etc.

As far as Shuaa Capital is concerned the saga began in February 2008 when it acquired 20% of OHO  and controlling stakes in 5 Orion brokerages initially for AED 193 million (US$ 52.5 million).  If you look closely at the press release you'll notice it's dateline is 11 January 2008, though it was released 12 February.

In October 2008, Shuaa announced its preliminary results for 3Q08, including that it had taken a one time charge of AED 45.8 million for OHO.

There's a bit more detail in Shuaa's 3Q08 financials.  Note #7 discloses that Shuaa booked the investment at AED 277.1 million.  There's no explanation for the AED 84 million increase.  The Note discloses that AED 137.7 of the carrying value of OHO has been reversed.  This amount represented a contingent payment due upon OHO meeting certain financial performance targets which it was clear it would not given its year to date results.   The offset was probably a reduction in Payables and Other Credit Balances, though no details were provided. 

Based on OHO's results Shuaa  also booked a provision of AED 36.7 million.  Initially I thought that the difference between the two provisions was due to refinement of Shuaa's numbers from the October press release until the issuance of the financials on 3 November.  However, in the 3 November press release Shuaa repeats the same AED 45.6 million provision number.  No explanation is given for the AED 8.9 million difference.  At this point, the carrying value of OHO on Shuaa's balance sheet was AED 93.7 million.  At year end it was AED 92.2 million, perhaps due to FX movements and/or share of losses.  Since Shuaa  accounts for OHO on an equity basis, this may explain both the AED 8.9 million provision difference and this change.

In its 1Q09 financials, Note 6, Shuaa disclosed a further provision for AED 59.2 million resulting  in a carrying value of AED 23 million.  As you'll notice there is a further AED 10 million in decline in carrying value which is not explained.  More equity earning accounting?

In its 2Q09 financials, Note 6, there is no change in carrying value but legal action by Shuaa is noted.  Apparently, this is related to the July press release discussed in the next paragraph.  Shuaa's 2Q09 financials were released 2 August and the news of the 8 July lawsuit is included within but not specified as a "post balance sheet event". 

On 8 July 2009, Shuaa announced that it had filed a legal claim at the Dubai International Arbitration Centre against Mohamed Abdel-Khaleq Mohamed Abu Al Haj and Orion Holdings Overseas Limited (“OHO”) for breach of obligations in respect of the Company’s investment in OHO.  At that point Shuaa claimed it had lost AED115.9 million on OHO.  The press release states that a full write off of OHO was in Shuaa's 31 March accounts.  As noted above, as of both 31 March 2009 and 30 June 2009, Shuaa showed AED 23 million in carrying value for OHO.  It is unclear what this represents, perhaps the carrying value of controlling interest in the five Orion brokerage firms that were part of the initial purchase?  Also at this time, AlHaj and Petra Invest (a related company) filed a counterclaim against Shuaa.

Unfortunately, in its  September 2009 financials, Shuaa no longer provides a breakdown of its various investments in associates.  See Note #6.   Two interesting bits of information though are contained.  First, that Shuaa took impairment charges of some AED 225 million (note as per information from earlier reports during 2009, the total provision for OHO was AED 59.2 million).  Second, that Shuaa is in discussions "to sell its shareholdings in a number of associates".  

Note 6 also contains: "Orion Holdings Overseas has ceased to trade. The Group owns 20% of this company. The Directors of the entity have voted to liquidate the company but a resolution to liquidate failed to achieve the necessary majority in a vote by the shareholders. It is anticipated that the shareholders who favor liquidation will soon petition the DIFC Court and that thereafter this entity will be placed in insolvency. In these circumstances the Group has written off this investment. The Group has a legal case ongoing in connection with the Orion Holdings Overseas acquisition. It is management's view that the likelihood of the Group incurring a material liability as a consequence of these legal cases is remote."

In November the DIFC Court froze OHO's assets after former employees lodged claims that they had not been paid and that the company was engaged in asset sales.

And finally just recently, the DIFC Court has ordered an involuntary liquidation of OHO.

With that background, some further thoughts:

1. Shuaa made its investment in OHO in 1Q08.  By 3Q08 it was clear that that OHO was not performing.  Ignoring the contingent payment, on a cash basis at 3Q08, Shuaa had lost some 33% of its investment.  By 1Q09, that is within one year of its investment, Shuaa had lost 84%.  It's hard to understand how this happened.  If OHO's main lines of activities were brokerage, fund management and technology, that is a great deal to lose in this period, even given the economic meltdown.  Was OHO taking proprietary positions that turned against it?  Was it trading in oil?  Or other commodities?  OHO was a member of the Dubai Mercantile Exchange.  Were original values overstated?  
2. Also as noted above, Shuaa seems to be selling its other associates - which appear to be focused on industrial activities.  AlKout Industrial Projects (listed on KSE, water projects);  Taghleef Industries LLC (Dubai registered plastics manufacturer),  City Engineering  (a Sharjah construction company) and Septech Holding (a Sharjah company in the waste water and water infrastructure business).  OHO, City Engineering and Septech were acquired during 2008.
   

Resignation of Deputy CE at Shu'a Capital

Karim Mitri has resigned.  It seems to pursue other interests.  Announcement thanked him for his many contributions.

The One Billion Dirham "Camel"

"Tie your camel first, then trust in God."

SRA

(Jami'y al-Tirmidhi)

Given the anniversary, a belated postmortem of the AED 1.5 billion convertible bond deal beween Dubai Banking Group ("DBG") and Shuaa Capital ("SC") and DBG's resulting AED 1.016 billion (US$277 million) loss - slightly more than the cost of the average camel.

On 31 October 2007, DBG and SC sign an agreement for a one-year convertible bond.  The bond has a quarterly 6% coupon and is convertible into 250 million SC shares.  The stated conversion price is AED 6.000 per share.  However, since as part of the deal DBG advanced SC another AED 176 million (so SC could terminate its stock option program), the effective strike price per share is AED 6.704 - approximately SC's market price at signing.

Fast forward to the maturity date one year later.  SC shares are trading at AED 2.71.

Not surprisingly, DBG has no interest in converting.  To do so would result in an immediate loss of AED 998.50 (US$272 million) - roughly 60% of the initial investment.

However, SC issues a conversion notice, advising DBG that the bond has been converted to shares.

What?  How could that happen?

Clause 6 in the Note Certificate allows both parties - SC and DBG - the right to force conversion.

DBG refuses, threatens litigation to force repayment.  The parties embark on a very public drawn out dispute.

On 25 June 2009 they announce a settlement:  the bond will be converted into 515 million SC shares.  The resulting strike price is billed at AED 2.91 per share - though when the extra AED 176 million is factored in, the strike price is actually AED 3.25 per share.  At this point SC's shares are trading at AED 1.28.

Using market value, DBG has just paid AED 1.676 billion for AED 659 million in shares - a loss of AED 1.017 billion (US$277 million) - 60% of its initial investment.   One heck of a "control" premium.  DBG's one consolation is that it owns a lot more of SC than it would have under the original conversion terms.  Somehow I'm suspecting that may be cold comfort.

Of course, markets move.  Anyone with a stock portfolio in October 2007 has seen some wide and painful movements.

But the whole point of a convertible bond is the structure is designed to give downside protection.   To combine the "safety" of a bond with an option to capture  potential price appreciation.   One only converts if the stock price is favorable.  If not, one cashes in the bond.

But for this to work,  one can't give the issuer of the bond the right to convert because as shown by the above example, the issuer has an incentive to convert when the market price of its stock is below the strike price. 

I'm at a loss to explain this transaction from any banking or finance principle I know.

If anyone out there can, please post.

To rephrase the hadith quote above:  "First, tie down you deal terms firmly, then trust in God".

For those interested in more background, additional documents and information can be found here as part of shareholder information for SC's March 2009 EGM.