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.

Update on GFH Treasury Share Trading – Another USD 40 Million to USD 69 Millon of Equity Up in Smoke

This is what I suppose one might from a shareholder’s perspective call adding insult to injury.  Or more accurately “insults” to “injuries”.  For details of the "original" insult look here.

At its FY 2018 EGM, GFH shareholders accepted the Board of Directors’ proposal to cancel some 207,547,170 of Treasury Shares. According to the published minutes, there was no discussion on this topic.  A fool and his money … 

Now you may be wondering why AA thinks this is an “insult” to shareholders.  

After all, the Treasury Shares have already been deducted from shareholders’ equity and so canceling them will not affect shareholders’ equity.  

There will just be a set of accounting entries within shareholders’ equity to remove these shares from the Treasury Shares account in shareholders equity to other accounts within shareholders’ equity.  The net accounting effect is zero.  

AA agrees. 

But, and there’s always a “but” with AA.  It will also involve the legal cancellation of these shares.  They will no longer exist. 

GFH did not conjure these shares out of air.  It paid hard cash—shareholder cash—to acquire them.  

And, thus, there is a real economic effect to canceling them.  

One thing AA learned in business school was that if you have to choose between economic and accounting effects, choose the former.  Unless, of course, you’re part of management and your bonus depends on the accounting.   “If you can’t fix the business, fix the accounting”.  

If GFH retained the shares, it could sell them in the market or use them as compensation in a transaction with a third party in lieu of cash or other assets sometime in the future.  

So by cancelling the shares what are GFH’s shareholders “losing”?  They’re losing those future potential uses of Treasury Shares. 

But you object GFH’s Board are prudent stewards of shareholders’ interests.  It’s probably a de minims amount.  

At FYE 2018 GFH held 255,455,953 in Treasury Shares valued at USD 85.424 million, giving an average cost of a T/S at roughly USD 0.33.  

GFH and through SICO its market maker have been busily buying and selling Treasury Shares since then, but we don’t have the data to compute an average price per share for a more recent date.  So we’ll use the USD 0.33 FYE 2018 average price per Treasury Share with the knowledge that the average price may be lower, particularly as GFH shares are now in the USD 0.20 range.  

The 207,547,170 in T/S--that GFH most likely canceled in May or June this year—are (or more precisely “were”) therefore worth some USD 68.5 million using USD 0.33 per share.   

At USD 0.20 per share average price the pain is less but still a considerable USD 41.5 million.   

Think of either of these amounts as a percent of reported net income  

Unless we assume that GFH could have only sold these shares for zero in the future and that no one would have assigned them any value in a transaction, GFH has just thrown as much as USD 68.5 million down the proverbial drain.   

Suppose, for example, that it could have sold the shares for roughly one-third of their FYE 2018 price.  That would be very roughly USD 23 million for the shareholders.  If it sold them at current prices, somewhere in the USD0.20 range, that would be USD 46 million. It would have incurred a loss on the transaction but nothing near the loss from cancelling the shares. 

You’ll remember that GFH’s excellent 2018 and 1Q19 misadventure in share trading cost its shareholders some USD 37.4 million. And if you don't, here's the link to an earlier post.  Add the cost of cancellation and that number together and you have an amount almost equal to FY 2018 reported income.  USD 68.5+USD37.4= USD 105.9 million.  Or, if we assume the average price per Treasury Share in May this year was around USD 0.22, a total of USD 78.9 million. 

But there’s more.  

GFH appears to have continued its Treasury Share transactions in 2019 past 1Q19.  Here are the links to the disclosures for April and May.   

There’s little need for AA to  detail this topic.  

Dr. Sabah Al Binali has already done so with an excellent analysis in Zawaya on this activity.  He notes that the activity is not consistent with “making a market”.    A market maker provides temporary liquidity to bridge gaps between supply and demand in the market.  Thus, a real market maker should be running a roughly balanced position with some inventory on hand in case there is excess “buy” demand.  

AA thinks it is highly likely that in the case of GFH such inventory need be only minimal.  It seems from the trading numbers that “supply” far outweighs "demand".   To add another insult, despite all this spending, GFH’s price has continued to drift downward. 

Now having incurred the losses of FY2018 and 1Q19 what business logic would then decide cancelling Treasury Shares with a value of USD 68.5 million was a good idea?  

And having proposed the cancellation of these Treasury Shares, what sort of logic (if we may use that term in this connection) would have continued Treasury Share transactions? 

It’s hard for AA to think of a sound business reason.  

Those more suspicious than AA might surmise that GFH is desperately trying to maintain its share price because someone important to it has used GFH stock as security for a loan or has created a fund which contains GFH stock.  And GFH needs to clear out the “old” Treasury Shares so it can continue buying its shares and still remain within the 7% limit in what appears to be losing effort to prop up its share price. 

Those same people would probably think that only something like that could persuade the Board that piling more losses on top of USD 105.9 million was an “idea” much less one that should be considered.  There is a logic here because according to the CBB approval SICO, GFH’s “market maker”, is limited to holding not more than 3% of GFH stock.  And GFH restricted to holding 7%.  

One other point.  In its FY18 annual report, GFH touted the use of its Treasury Shares as follows:  

“To manage the liquidity risk arising from financial liabilities, the Group aims to hold liquid assets comprising cash and cash equivalents, investment in managed funds and treasury shares for which there is an active and liquid market.” 

Some observations:  

1. GFH Treasury Share transactions in 4Q18 which were roughly 39.7% of all transactions in its shares on the Kuwait, Bahrain, and DFM during that period and ended the period holding more of its shares. That’s clearly not an “active and liquid” market, but rather an artificial market.  
2. Investors are generally advised to carefully consider the liquidity of the securities they purchase before they purchase.  Getting in to an investment is generally remarkably easy.  Getting out may be another matter entirely. Also investing in securities whose price is being artificially supported is a recipe for losses.   
3. On a positive note GFH’s liquidity position apparently has remarkably improved as it no longer needs to use its Treasury Shares to provide liquidity.  It can therefore cancel some 207 million of them.  
4. Not only that but GFH’s liquidity allowed it to spend between USD 78.9 million (USD0.20 per share) to USD 105.9 million (USD 0.33 per share) on the cancellation and Treasury Shares trading during FY 2018 and 1Q19.   
5. Kudos to GFH’s management for strengthening GFH’s liquidity!  
6. Based on just these two achievements, I’m certain that very few will argue with AA’s assertion that USD 3. 5 million in 2018 compensation for GFH’s Board just isn’t fair when all they have done for (or is that “to”)  shareholders is considered.  

Amidst this gloom, there is perhaps hope on the regulatory front.

Sometime in 2019, the Central Bank of Bahrain mandated that market making transactions be disclosed. 

AA thinks, but doesn’t know, that his was likely the CBB’s reaction to GFH’s 2018 Treasury Share transactions.  If AA’s conjecture is correct, then hopefully the CBB is aware of the situation and taking whatever action it deems appropriate.  

As for GFH’s poor and as each day passes apparently poorer shareholders,   الله يوفقهم

Though as AA learned in school, it’s best to tie one’s camel first ….