Central Bank of Bahrain Compliance Enforcement Reports

In case you missed it, I certainly had until just recently, the CBB is publishing annual “Compliance Enforcement Reports” which provide information on actions taken by the CBB to enforce regulations.  

This is a good source of information on the types of violations that occur as well as trends year to year.  Of interest—AA certainly hopes—is the section that names violators and provides a generic description of the violation.  But this is only for some violations.  You’ll see some of the firms that have appeared on this blog as repeat offenders in the CBB’s  reports. 

Reports for 2018, 2017, and 2016 have been posted.  The 2016 report has some data on 2015.  If the past is any guide, reports for this year will be issued in January 2020. 

AA was particularly gratified by two items in the 2018 report both appearing on Page 9.  

First, the CBB levied a fine (which was upheld on appeal) on a BSE listed company that had provided a clarification to an overseas exchange, where it is cross-listed, regarding the content of a news article published in that overseas jurisdiction about the listed company’s operations.  This clarification was disseminated on the overseas exchange’s website without the same on Bahrain Bourse’s website, which was only published by the listed company, a day after, in response to the CBB’s instructions.   

Faithful readers of this blog (that would be AA) will recall a characteristic AA rant about a failure by GFH to provide the same information on its 3Q10 financials on the BSE as it did in the UAE.  

And AA’s appeal to the CBB to change disclosure rules to require the same. 

As outlined in the CBB’s  2018 report, this requirement exists as per Section OFS-5.1.19 of Rulebook Volume 6 Capital Markets.  It appears to have been imposed in January 2014, though it may have existed elsewhere in another rulebook.  

Here’s chapter and verse of OFS-5.1.19.  

For Bahraini issuers who made an offer or listed their securities outside Bahrain, and for overseas issuers who made an offer or listed their securities in Bahrain, all information of importance to shareholders made public about the issuer in other markets must be made public in Bahrain, whether or not disclosure of such information would otherwise be required by the CBB.    

Note that this requirement includes the "making of an offer" and not just listing on the BSE.

Second, the CBB sanctioned an unnamed individual investor for market manipulation during 2018. 

Mystery US Navy Ship Spotted in Yokohama Harbour

Special to Suqalmal BlogSpot

The internet has been abuzz with speculation about the identity of a mystery ship recently spotted in Yokohama Harbour.

Without looking under the tarp, AA can now report that he has confirmed that the ship in question is definitely not the USS Cadet Bone Spurs nor the USS Richard Hersey.

Dana Gas: FYE 2018 and 1Q2019 Financial Performance - A Brighter Picture But Not by Much

A 5 Watt Bulb is Brighter than 2 Watts

Last December I made a bold prediction based on DG’s 3Q18 financials that the company would have a break-even year or at best case perhaps earn a 4.5% ROAE.  

DG’s 2018 financials  (but not its glossy annual report) have been released. 

Let’s take a look and see how prescient AA’s prediction was.  

Net income for 2018 is what might charitably be described as “disappointing”, a net loss of USD 186 million driven by impairment provisions of USD 250 million.  USD 187 million for the write-off of the Zora field and USD 59 million for certain Egyptian assets (or perhaps uncertain Egyptian assets).  

Pretty far off from AA’s less than less than "prescient" prediction a scant five months ago.  

In the MD&A section of the report DG’s Directors emphasize that the 2018 impairment provisions were “non-cash items” and that “On a like for like basis, excluding one off impairments, profit from core operations increased to USD 64 million (AED 234 million) as compared with USD 5 million (AED 18 million) in 2017".  

On that basis, DG earned an ROAE of some 2.35% using total shareholders’ equity as reported on the balance sheet.  If we adjust 2018 equity for the non-cash impairment that year (add it back) then ROAE is 2.27%. 

In the Directors’ “best” case, a dismal return.  

Certainly well below the risk-adjusted return DG should be earning given its business concentration in risky markets.  Equally well below the return it should be earning ignoring risk.  

However, the picture in 1Q19 is brighter, but only marginally in an absolute sense.  

Net income of USD 35 million, largely driven by a USD 10 million reduction in interest expense.   If this pattern continues, projected ROAE for 2019 is some 5.3% much better than 2018.  

But still subpar for the risk.  No longer pitch dark.  But a 5 watt bulb is cold comfort.  

There was other good news.  

Continued reasonably good collection of receivables from Kurdistan.  

A less favorable 70% collection rate in Egypt, including some receipts in Egyptian pounds.  A less than happy approximate USD 9 million increase in Egyptian receivables.  Both factors –accepting funny money (Egyptian) and increasing receivables --something to keep an eye on.  

DG also reported that it and Pearl had prevailed in their arbitration (LCIA) with MOL over the KRIG settlement. 

So is DG out of the woods?  

Not quite yet.  

While better than 2018, the projected ROAE is still not at a level that a company with this risk pattern should be earning.  

One quarter does not a turnaround make.   

More importantly the factor driving the turnaround is financial not operational.  The current interest charge is based on a non-market rate.  Once the company has to borrow at market rates again, this financing advantage will disappear.  And financing will be important if DG is to materially grow its business.  

With an approximate 5% ROAE, there will also be little opportunity to use financial leverage to increase shareholders returns materially.  And, if lenders demand more than the ROAE, leverage will actually diminish ROAE.

There's a real negative on the operational side: the write-off of Zora.  It was DG's one revenue stream from a creditworthy country. Admittedly small, but perhaps with a potential to grow.

There's also another cloud on the horizon.  

DG is looking at a roughly USD 400 million principal payment on the sukuk in October 2020 some 17 months from now.  

With USD 442 million in cash as of 1Q19, an almost certain USD 95.5 million dividend this year and one next year which is likely to be approved and paid prior to repayment date, there’s little margin for error. 

The sukuk lenders/investors did not or could not impose any real control on DG's payment of dividends.  They agreed that DG could pay dividends equal to 5.5% of paid-in- equity on the condition that after such payment, DG would have cash of at least USD 100 million.  And they did this knowing the repayment due in October next year was going to be a multiple of USD 100 million.  Roughly 4 times.

If DG is able to honor the repayment obligation in full, and that’s not certain, it could be left with little cash for its business.  

In such a case it’s hard to imagine investors and lenders rushing to support DG, but then they (lenders and investors) routinely demonstrate little common sense in their underwriting. 

So the future while brighter (5 watts instead of 2 watts) isn't bright enough to lift DG from the dog investment category.

Dana Gas 3Q 2018 Earnings: "Woof, Woof"

Earlier this year, I took a look at DG’s 1Q18 earnings and made some predictions for the full year.  A best case 4.5% ROE or worst case a break-even year.  As you’ll note, the best case falls well short of what would be an adequate return given the risk profile of DG.  

So how does AA’s prescient prediction look with a full three quarters of data?  

Frankly, not so good.                  

DG reported USD 41 million in net income for the first nine months of the year.  Pro-forming this for the full year, would result in roughly USD 55 million for the full year or an ROE of 1.9%.  

But to get a sense of the return from ongoing operations, we need to exclude two special items.  Those are USD 8 mm in 2Q18 sukuk restructuring expenses and a 1Q18 reversal of 13 million in previously accrued expenses.  If we exclude both amounts—a net of negative USD 5 million--, DG earned some USD 36 million over the first nine months of the year.  Pro-forming this over 12 months results in projected full year net income of USD 48 million or an ROE of 1.7%.  

Inadequate when one considers what would be a normal ROE for a stock investment.  

Dismal indeed when considers the higher ROE that that a risky stock like DG should deliver. 

To boot DG’s ROE remains well below its current roughly 4% cost of borrowing which is artificially depressed from the appropriate risk adjusted cost by the restructuring.  

Of course, there could be a miracle in 4Q18. 

The hoped for settlement with NIOC could materialize.  The US Government could graciously facilitate Iran's payment of the settlement proceeds to DG and, perhaps, as well give DG a license exempting its transactions from newly re-imposed US sanctions on Iran.  

At this point, it appears that the best value creation opportunity DG has is to repay its debt in full.  That will result in a net "benefit" of some 2.1% per annum to shareholders.  Dividends are another option - as it might be expected that shareholders could find other investments to return more than 1.9% a year.

To end on a rare (for AA) positive note,   all things are relative.   

DG may be a “mutt” investment, but AA suspects that investors in Gulf One Investment Bank Bahrain might find it quite attractive. 

Gulf1 has not reported a profit since FY 2013 and appears poised to continue that "run" in FY 2018.  Over the period FY 2014 through FY 2017 Gulf1 “lost” (that doesn’t mean “misplaced”) some 57% of its total equity:  from USD 133 million at FYE2013 to USD 57 million at FYE 2017.  

It’s hard to say how FY 2018 will turn out, though the loss this year for nine months is larger than for the comparable period last year.  But as is well known providing an opinion on fiscal year audited financials generally concentrates the minds of auditors more sharply than the  signing off on interim unaudited financials.  In 2017, the bulk of G1's USD 27 million loss was booked in 4Q.

On another somewhat positive note:  Gulf1 is equity funded so there are no lenders with significant exposure and thus in significant danger.

Brexit: Bishops Pray for Politicians' Integrity Amid Brexit Turmoil

"Father" Ethan Rushes to Join Prayers

According to The Guardian, Church of England bishops have said they are praying for “courage, integrity and clarity for our politicians” after a week of turmoil over Brexit.

According to the Bible, "With God all things are possible".

However, as you'll note, while the Bible speaks about "possibility", it is silent on "probability".  No doubt to cover situations like this.

How to Mitigate Against PE GP “Sharp Practice”

Fait ou fiction?

Ahmed Badreldin, Former Head of MENA for The Abraaj Group, has written an interesting article on the above topic for Private Equity International.  

He emphasizes enhanced controls over the GP by LPs and proper due diligence.  

A lot of good common sense suggestions. 

Some quotes that particularly resonated with AA:  

1. “A key element of diligence is maintaining skepticism until the very end.”  
2. “Furthermore, funds shouldn’t have large positive cash balances and alarms should go off if there are drawdown requests from funds that already have large cash balances.“ 

What I found particularly interesting was his focus on a three specific examples of GP “sharp practices”.   

Do you wonder if he witnessed these “sharp practices” first-hand during his career at one of his previous employers? Or is he just applying his theoretical knowledge to identify key risks?  

AA has his own opinion, but what’s yours? 

In his own words:

“A recent case involved a fund that had externalized fund administration, but where drawdowns were made despite the fund having large cash balances.  Monies ultimately went to a bidco SPV where the bank accounts and the SPV were controlled by the GP without external oversight by independent directors or fund administration (despite the actual fund having fully externalized its fund administration).”

“Funds should not have large cash balances for multiple quarters, especially given the risk of fund bank account balances with “quarter end window dressing”, where the cash balances of the fund can be temporarily shored up from external funding sources, which can be difficult to detect, resulting in reported cash in the GP reports not actually existing for the reporting period.”  

He also focused in on valuation of portfolio companies.  Suggesting that these be audited by independent third parties with perhaps the inclusion “simple” metrics such as EV/EBITDA versus comparables as a way of providing a check on the GP's valuation.  

AA would note that selection of “comparables” can allow the GP a great deal of discretion to achieve a desired result.  And there is always the possibility of manipulation.  

Bahrain International Bank valued its investment in Burger King franchises it owned in the Carolinas using a multiple based on an unconsummated offer to buy the Burger King company. Note that is comparing the value of a franchise (part of the chain) to the main company (ex the franchised outlets).  

That’s not to say the DCF produces a more accurate result.  Small changes to assumptions (discount rate, growth rate) can result in big changes to valuation.  

As he notes, valuation is an art not a science.  When the intended result is known, the artist can employ all of his talents to achieve that result.  Or just enough.  One hopes though that the arts employed are not the "black" arts.

Американский Е́льцин (America’s Yeltsin)

слава россии!

слава США! 

слава олигархам!

Скорее всего, в США сделают то, что сделал Борис в России.

Dubai and L'Affaire Abraaj - Realism Amid Emotion and Financial Fairy Tales

Perhaps Better to Wait Till the Dust Settles to Get a Clearer Picture?

As you might expect, in the wake of the Abraaj scandal, financial journalists are examining the impact on GCC markets and in particular Dubai. 

Nicholas Parasie at the WSJ took a look at Dubai earlier this week.  “Once Billed as a Financial Haven in the Middle East, Dubai Turns Investors Wary”   

As usual, I have a slightly contrarian view which I’d like to convey by responding to quotes from his article. The point of this exercise is not to cast doubt on the article, but use several of the points mentioned to highlight areas of difference. 

“Investors are questioning whether Dubai’s young financial center can police itself as the meltdown of its marquee private-equity firm highlights broader concerns about placing money in the region.”

That’s a perfectly natural human reaction.  I’ve got a problem so first let’s identify all the people who let me down and are responsible for my misfortune.  Perhaps, but perhaps not, I’ll eventually get around to examining my own behaviour. 

There’s another element.  Realistically, where is that well-policed market that Dubai should measure up to? That sought after “haven”? 

The Bernie Madoff scandal, the dot.com bust, the almost a Second Great Depression, Lehman, Libor all occurred in what are generally described as the “mature” “well regulated” markets in the OECD.  These scandals are widely attributed to regulatory and corporate governance failures which is the central “charge” against Dubai in L' Affaire Abraaj. 

Given the dollar magnitude and number of these scandals relative to those in Dubai, shouldn’t investors be questioning the ability of these “Western” markets to police themselves much more than questioning Dubai? If not, why not?  

Should Dubai be held to a higher standard?  If so, why?  

“Dubai was supposed to be a rules-based haven in the Middle East’s opaque financial world, but fears about corporate governance and conflicts of interest are rising."

I suppose if one didn’t look too closely but rather relied on the promotional advertising alone one might have imagined that Dubai was a “rules-based haven”.  But one would have had to be pretty oblivious.  It's like reading "The Art of the Deal" and thinking that the chap on the cover is America's #1 DealMeister.  In both cases your credulity would have gotten the better of the facts. 

I know that for some—usually bankers and investors--ten or fifteen years in the past is an age unknown probably before recorded time.  

But back in 2004 Ian Hay Davison, Chairman, and Philip Thorpe, CEO, both of the DFSA were summarily sacked. Ian by mobile phone.  Philip was "escorted" from the DFSA’s offices.  Both “lost” their jobs because they had the temerity to suggest that the real estate transaction for the Gate was freighted with conflicts of interest among certain high “personalities”.   Read it here.  If you read it in the Torygraph, you know it must be true. 

After the Dubacle--which in itself might have suggested causes more than just irrational real estate exuberance--, a number of high ranking officials were relieved of their positions.  One chap, the former head of the DIFC, was “encouraged” to return “bonuses” that were alleged to have been improperly obtained. There is of course more but those are two rather glaring examples.  A good rule of thumb is that if you suspect there are ethical issues at a regulator or in government departments or corporations, you should be wary of ascribing high standards to the jurisdiction.  Focus like this can simplify your due diligence greatly.  

“Unlike in the West, where corporate executives are often held accountable by supervisory boards, “there are no checks and balances in the Middle East in some companies,” she said.”  The “she” in this quote is Alissa Amico, a Paris-based former executive at the Organization for Economic Cooperation and Development.

Quite!  As to the “developed” Western markets, there are “checks and balances” indeed but mostly on paper. Rarely do independent board members take action to prevent corporate malfeasance.   In some cases, they appear to aid and abet it. See Hollinger. See Enron whose board composition on its face ticked every box in good corporate governance.  See Volkswagen and dieselgate.  For more on supervisory board failures in Germany read this article from Handelsblatt. 

The clear lesson here is that corporate structures and rules while a necessary condition are not sufficient to prevent malfeasance. People are the critical variable that make these structures and rules effective. If they are wanting, the entire structure fails.     

“The longer it waits, the more Dubai’s ability to attract foreign capital could be at risk, said Oliver Schutzmann, chief executive of Iridium Advisors, an investor-relations firm.” The “it” in this quote is the DFSA.

No doubt immediate action might satisfy investors who no doubt are looking for vengeance. 

But a proper investigation needs to be conducted to determine the extent of the malfeasance, if any, and the parties involved.  

MF Global collapsed in late 2011.  In 2013 the US CFTC filed charges against the former Chairman and CEO that involved allegations of “misuse” of client funds similar to allegations against officers of Abraaj.  

There are risks to too-quick action.  

1. Failure to punish all those, if any, who should be punished.  
2. Failure to punish for all offenses.  The DFSA would look rather incompetent if it later turned out that there were transgressions more serious than “borrowing” client funds at Abraaj and that it failed to punish these. 
3. Or if in the rush to take action, it inadequately prepared its case and wrongdoers, if any, were subsequently acquitted.  

As well, while vengeance may be  satisfying, it won’t result in investors being made whole.  Rather cold comfort for Mr. Jaffar: I’ll get a jail sentence against Brother Arif, but I still won’t get my US$300 million.  

It’s perfectly natural for investors who have suffered a loss or think they have to get quite emotional and thus irrational.  

Sadly, there’s often a tendency for others to get caught up in these emotions of the moment. Cooler heads are needed, but few are found. 

1. False comparisons are made.  Dubai compared with the mythical conflict-of-interest free well-policed Western markets.  
2. Double standards are applied. Dubai must be purer than Caesar’s wife.  
3. Dire end of the world or end of the market predictions are made. No one will invest here anymore.  But why didn’t that happen after Hay/Thorpe, Bin Sulaiman, et al.? Or after the Dubacle?  Or in Bahrain after TIBC, Awal, GFH?  Or in Kuwait after TID and Global?  Or in KSA, after the typical SAMA response to prefer local banks over foreign in the TIBC and Awal affair? Or in the USA after the Almost a Second Great Depression? 
4. Fundamental issues can be missed.  Nuances lost.  What really makes a market investable?  A fancy building, some imported be-wigged English-law judges, an impressive rule book? Or are other things more important?  
5. Remedies are prescribed before there's enough information for a thorough diagnosis.  We really don’t know exactly the extent and type of malfeasance in L'Affaire Abraaj.  Is it equivalent to MF Global or Bernie Madoff?  Who was involved?  Yet, hobby horses are trotted out from the stable and vigorously ridden.  Sometimes very specific prescriptions given.
6. Sometimes meaningless platitudes are given.  Meaningless because they are not specific.  “Regulators and boards need to step up their game.”  Or perhaps “work smarter not harder”.  Indeed, if only the UK had “stepped up its game” in the World Cup, they would have won.  If Abraaj had “stepped up its game”, no doubt it would have realized the sale of K-El and there wouldn’t have been a cashflow problem.  
7. Can we be that far away from a suggestion to use Blockchain to “disrupt” old patterns of corporate governance? In some places it promises the disruption of courts. Why not corporate governance?  Let's step boldly forward together to the “bleeding edge of leveraging the Blockchain space to disrupt the existing paradigm of corporate governance”.

In Some Parts Apparently Scarier Than President Putin!

Extremely Scary Highschool Graduate (The Girl not the Man)

في بعض الأماكن على ما يبدو أكثر مخافة من الرئيس بوتين

в некоторых местах явно страшнее, чем президент Путин !!

If you're not prone to excessive fear, you can check out this scary story here.

On to law school!

Storm Signals in Private Equity

A Severe Warning Flag Given the Amounts Involved

Chris Schelling’s article in Institutional Investor flashes some very clear warning signals about PE.  

“Private equity sponsor-to-sponsor transactions are on the rise. But lately, some firms have begun selling companies to other funds in their stable — a far more worrying development.”  

Chris outlines the risks of both sorts of transactions:  

1. a private equity firm selling a fine investment to another PE firm and 
2. the more worrying one a private equity firm selling a fine investment from one of its own funds to another of its own funds. 

When "exits" aren't via trade sales or IPOs are they really exits?  Or are they symptoms of real problems?  When they represent a large percentage of declared but perhaps not real "exits", are the problems severe?

Let's look at these in order.

First inter sponsor sales.

One-third of all private equity “exits” in 2017 were the first type:  one sponsor selling to another sponsor.  Data for 1 H 2018 show a similar trend. 

There probably are some situations when these transactions can be economically justified in terms of value creation for the limited partner not just for the fund manager/sponsor.  

But such instances are clearly not one-third of all exits.   More likely to be for a fraction of that percentage.  3%? 

Essentially what the fund manager who sells is saying is that he can no longer increase the value of the investment.  What the fund manager who buys is saying is that he can.  

There could be special situations where this is true, e.g., a further increase in value of an investment requires that it be integrated with other companies that the selling fund manager doesn’t own and is unable to buy.  The buying fund manager may own those companies.  

But if the buying fund manager has no special advantage like that and is relying on making traditional operating or financial improvements to generate IRR, then:  

1. The buying fund manager believes he has the skills to make a PE like return on the investment at his higher entry price 
2. If the selling fund manager is realizing a profit that triggers carried interest, then the ultimate return on the investment must be such that two managers will separately and independently be able to generate PE like returns. That would be some investment! 

AA has a hard time believing that the probability of this happening is significant enough to justify one-third of all exits as sponsor to sponsor deals.  

As an aside, through this transaction, one or both of the fund managers may be displaying reasons why they are likely not to be good stewards of your money.

1. If the first manager can't use traditional methods to enhance value but the second can, then an LP might wonder if it's particularly wise to be investing in the first manager's funds
2. If the second manager is wrong and can't generate additional PE-like returns, then he's probably not a wise choice for LPs.

Naturally suspicious folks like AA would want to know if there are reciprocal deals.  Fund managers are helping each other out "exit" less than ideal investments.  Fund Manager A sells “fine” investment #1 to Fund Manager B.  Fund Manager B sells “fine” investment #2 to Fund Manager A.  Each generates an IRR which allows them to sell future funds, to earn carried interest, quiet current investor unease at lack of exits. Hopefully, the purchased investment turns out to generate a decent return or can be buried among other returns if it’s not so decent. 

In other words, are GPs passing around less than stellar investments among themselves?  Investments that they cannot place with a trade buyer or IPO?  That the volume of inter sponsor transactions is at one-third of all "exits" suggests something is not right.  When one factors in the rise intra sponsor sales, the red flag gets even bigger.

Or is the explanation the need to use so-called “dry powder” (uninvested funds) now perhaps as much as some US$1.5 trillion? LPs can't be happy seeing their univested funds earning cash returns that likely don't even cover the 2% management fee.

Fund managers are merrily raising more money.  One might question why any additional money needs to be raised, other than to increase GP's management fees—which as you know or should are independent of fund performance.  I

Interested in more on the topic of “dry powder”?  Check out this article by Melissa Mittleman from Bloomberg.  

An ocean of money looking for investments is more likely than not to be on average an ocean of particularly dumb money.  Overpayment and poor underwriting choices will be the result.  Limited partners’ future returns will be diminished. 

But even if firms have discipline to avoid these mistakes, they will generate lower returns for their LPs because of the earnings drag on the overall portfolio from cash holdings.  

So here's another worry for LPs to add to worries about asset quality, lower returns for a long-term commitment.

Second, intra sponsor sales.

But all this pales when one considers the even more troubling intra-sponsor sales. A sponsor sells a “fine” asset from one of its own funds to another of its own funds.   This is a major red flag.  

As before, there are no doubt excellent reasons why this should be done sometimes, but the incidence of these “sometimes” is likely to be less than observed demonstrations of probity by the political class.  That would take this to much less than the 3% for sales of “fine” investments from one sponsor to another sponsor.  

I’ve mentioned before that we were once approached by a prominent PE firm pitching us on their new fund and touting the return on a predecessor fund.  A closer look at that fund disclosed that its return was almost all generated by a single deal.  A sale of a “fine” investment from that fund to another managed by the same GP.  We, of course, declined the opportunity to invest and struck that firm off our list of “serious” firms.  No further due diligence needed.  When you don’t trust the people, due diligence really isn’t needed at all.  

And finally a shout out to Chris’s first comment:   

“A well-known GP in our portfolio has been known to say that PE performance “isn’t a return until you can buy a beer with it.”

Quite!   

But if your GP is generating beer rather than champagne returns, you might consider interviewing additional fund managers.  "Beer and pretzels" is the lowest stage of FY money among investment bankers.