“Foreign Investors Face Critical Test Over Chinese Bonds” Peking University Founder Group Part 1

Failure is Most Often Preceded by Failure to Prepare Adequately 

The 9 April edition of the FT had an article about the “critical” test facing foreign holders of USD bonds supported by a “keepwell” from Peking University Founder Group and by extension other similar "Chinese" bonds.

It is indeed a sad story.

So sad that I'll have to discuss it in two posts.

A few quotes to set the stage for my commentary.

A “person” quoted in the article made two comments worthy of note.

Will a Chinese parent recognise its contractual obligations under a keep-well deed, which literally gave the impression to offshore bond holders the deeds are equivalent to a guarantee?

The person added:

The Chinese parent actually took the majority of subscription proceeds back to China for its own use.

And Simmons and Simmons:

The administrator’s decision has cast significant doubts concerning the validity and enforceability of keepwell agreements, at least under [mainland China’s] restructuring process,” the law firm said in a January report

Now to my commentary.

I think the real issue here is that the bondholders failed an earlier “critical thinking test” that got them into this fix.

This is similar to the case of not knowing “insurance” from a “guarantee”. Or a “promise” from a legally binding “obligation”. Or consolidated from legal entity financials. 

The equivalent of running with scissors and wondering why you got hurt.

What in the investment world might be characterized as a “rookie” mistakes, though sadly it’s not just rookies who make this mistake. At least as they are typically defined. 

If they are looking for someone to blame, a mirror would be handy

Background

I found six outstanding bonds issued by subsidiaries of PUFG listed on the HK Exchange.

As you will notice, four of them are guaranteed by PUFG (indicated by “G” in the table below).

Only two have the keepwell and deed of equity interest purchase undertaking (indicated by “K”).

If you had looked at this time last year, most of PUFG’s outstanding bonds were ‘”supported” by keepwells / deeds of equity interest purchase undertaking.

We turn now to AA’s elder wiser brother, expert in many things Asian, for an explanation.

As is often the case, regulatory avoidance “influences” PRC financing and investing structures. There are many regulators in the PRC, but usually avoidance of SAFE (State Administration of Foreign Exchange) requirements is the primary driver. Cross border foreign currency guarantees must be registered with SAFE. A process that can be time consuming, result in requests for disclosure of all sorts of information that one would prefer not to disclose, as well as refusal to register the guarantee. Keepwells do not fall under this regulation

According to press reports, this structure is used with only 16% of outstanding Chinese offshore bonds. But note that represents some US$96 billion. 

The FT article above refers to bondholder concerns about those with keepwell structures.

This is the group of bonds that I focus on this commentary.

It’s a sad but common fact that most investment problems begin prior to the actual purchase of the investment. 

That is, before the “wise” investor plunks down his or her cash.

The first mistake so often made is a failure to read the offering documents.

Here’s a link to the Offering Circular (prospectus) for the Nuoxi Capital US$400 million 5.35% 24 Jan 2023. To which I'll refer in this and a following post. 

I am presuming that the prospectuses for other keepwell issues are similar.

The first thing to notice is that this issue is for “professional” investors.

There’s a reason for that.

The issue contains risks beyond those considered normally acceptable for retail investors.

Even if you are a professional investor (or more likely imagine you are), that should cause you to think very very carefully.

Structure

The Issuer: Nuoxi Capital, is a special purpose company set up for the “special purpose” of borrowing money.

It has no assets of its own. It conducts no operation other than borrowing funds and upstreaming them to its parent.

The Guarantor: HK JHC Company, is an actual company with assets and operations.

According to the prospectus page 17, as of June 2017 the Guarantor had (drum roll) US$28.5 million in equity capital and US$856.2 million in total assets.

You may also have noticed and I certainly hope you did that the Guarantor has some rather “large” gearing (leverage) and some rather “small” equity.

At this point you should be wondering about the capacity of the Guarantor to guarantee some US$600 million in bonds. The Offering Circular is for two bond issues: US$200 million and US$400 million..

And perhaps what it is going to use the $600 million for.

Not to worry we learn on page 55, it is going to use the funds for “general corporate purposes”.

Well actually to worry.

First, this is a rather “large” amount. One might be forgiven for wanting a bit more detail as to what "good works" this money might be put to.

One might also think that the borrower would have concrete plans and be able to supply some details. 

After all, if you borrow money, you generally borrow only as much as you need. So before you borrow, you need to know the amount so you don't wind up with too little or too much money.  

Unless of course your borrowing is motivated by negative cashflow in your business.  

Second, if you know your PRC company behaviour, you know there is classic PRC MO: borrow money outside the PRC (HK is a favorite) and funnel it to China.

If you’re a serious international investor, you should know this.

If you don’t, you probably should stay in your home marker where you could buy today's Carillon, Thomas Cook, Tesla or Gamestock.

The Parent Company: PUFG, a PRC company, was founded in 1986. Its consolidated financials as of 30 September 2017 are prepared according to Chinese GAAP. 

If you’re not familiar with Chinese GAAP, you might want to pause to ask yourself if you should proceed with this investment. Can you evaluate PUFG's financial position?

The financials shows some CNY 56.7 billion in shareholders equity composed of NCI of CNY 35.8 billion (!) and CNY 20.8 billion to shareholders of PUFG.

If you’re wondering, the fine banks that prepared the prospectus had a very high opinion of readers’ ability to convert CNY to USD. 

Or perhaps thought we should all getting used to thinking in terms of CNY. 

So they didn’t provide conversion to USD.

As per my calculation using IMF data as of the financial statement date, those numbers are in sequence US$8.5 billion, US$5.4 billion, and US$3.1 billion.

Usually in consolidated financials the NCI have a smaller share of total equity than the shareholders of the Group.  That's why they are typically called "minority interests".

That might be another sign to take a deep breath and close the prospectus unless of course you are already sleep walking your way to a “wise” investment.

What the financial position of the three above parties indicates is that the “credit” rests on PUFG, assuming of course that we assess that PUFG is sufficient credit support. 

Otherwise, you should find another “prime” asset to invest in.

What’s key then is the ability to go after PUFG in their jurisdiction with a reasonable chance of prevailing in court.

That’s a matter of structure and the law. PRC law.

So let’s look at how the transaction has been designed to “achieve” that.

Governing Law and Jurisdiction: Laws of England and Hong Kong Courts.

Hmm. But we want to go after a PRC entity in the PRC unless of course PUFG has many cash rich subsidiaries in jurisdictions where we can get a HK court judgement enforced.

This structure is probably going to work as "well" as that in Golden Belt Sukuk did.

The Parent Company Undertakings

The Keepwell Deed (Page 78) tells us that

The Keepwell Deed is not, and nothing therein contained and nothing done pursuant thereto by the Company shall be deemed to constitute, or shall be construed as, or shall be deemed an evidence of, a guarantee by or any legal binding obligation of the Company of the payment of any obligation, responsibilities, indebtedness or liability, of any kind or character whatsoever, of the Issuer or the Guarantor under the laws of any jurisdiction, including the PRC.

And

The parties to the Keepwell Deed will acknowledge that in order for the Company to comply with its obligations under the Keepwell Deed, the Company may require approvals, registrations, filings, clearance or other authorisation of PRC government authorities. The Company will undertake to use its best efforts to obtain such approvals, registrations, filings, clearance or other authorisation. The Keepwell Deed and any non-contractual obligations arising out of or in connection with it will be governed by and construed in accordance with English law.

In “little words” not a guarantee. 

May require PRC government approvals which Company will use its “best efforts” to obtain. 

Oh, and they will do that at perhaps the least convenient time to learn whether there is an obligation--after payment default occurs.

A keepwell is best written on soft paper, either Charmin tough and soft or Kleenex soft, so that one will be able to obtain the maximum benefit from it. Because it’s likely to be a limited use in getting your money.

The Deed of Equity Interest Purchase Undertaking (Page 82) also repeats that same bit of information

The Deed of Equity Interest Purchase Undertaking is not, and nothing therein contained and nothing done pursuant thereto by the Company shall be deemed to constitute, or shall be construed as, or shall be deemed an evidence of, a guarantee by or any legal binding obligation of the Company of the payment of any obligation, responsibilities, indebtedness or liability, of any kind or character whatsoever, of the Issuer or the Guarantor under the laws of any jurisdiction, including the PRC.

This disclosure appears several times in the prospectus as early as page 6.

If as the unnamed person above says you got the “impression” you had a guarantee, I suppose you can similarly conjure up the “impression” that you were repaid. 

One delusion is as good as the other.

But wait there’s more!

See Post 2.

GFH 2020 Financials – Another Festivus Miracle!

 

Theological Question
If the holiday was invented, are the miracles as well?

Time for a look at GFH’s 2020 financials.

First at reported income. 

And then to what isn’t in the income statement but is economically income or loss.

Summary

GFH reported consolidated net profit for the year of USD 49 million.

98% of that amount was due to two revenue streams from “special” items, not GFH’s main lines of business.

What that means is that GFH’s ”mainframe” LOBs in aggregate are basically breaking even.

It also suggests that the quality of reported earnings is low.

Turning to Retained Earning (Consolidated Statement of Changes in Owners’ Equity) there are two items totaling USD 37 million that I believe represent economic losses. 

The only difference is that accounting principles do not require that they be included in Income Statement.

On that basis, GFH’s adjusted consolidated net profit for 2020 was some USD 12 million. Or 24% of what it reported.

Reported Income

GFH reported FY 2020 “consolidated profit for the year” of USD 49 million compared to USD 53 million the prior year. Roughly an 8% decline.

Net income was then further subdivided with USD 45 million attributed to Shareholders of the Bank versus USD 66 million the year earlier. Roughly a 32% decline. Or 4x greater than the decline in consolidated net profit.

The remaining USD 4 million (of 2020 consolidated profit)  was ascribed to non controlling interests (NCI). In 2019 NCI share of net income was a negative USD 13 million.

2020 was an extraordinary year.

Covid caused significant economic disruption across the globe.

So perhaps not so bad for GFH.

But the problem though is that GFH doesn’t really have a good track record in terms of return on average equity (ROAE).

The chart below shows ROAE attributable to GFH Shareholders and then to GFH Shareholders plus Non Controlling Interests (NCIs).

There is another “negative”.

GFH’s revenues and thus net income tend to be dependent on “special” items not on recurring income from its primary LOBs.

So it’s not just a case of low returns but of low quality returns.

Two particular 2020 revenue categories are worthy of a closer look. As you will notice, these two items account for 98% of net income. 

Without them, GFH would have essentially “broken” even. 

Before we start our “excursion” I’d note that we are using consolidated figures as revenues and expenses are not “broken out” by those belonging to shareholders of GFH and those belonging to NCI.

First, Note 22 other income of USD 39.026 million (79% of net income) is composed of:

1. USD 23,2 million in “settlements and write back of liabilities no longer required”
2. USD 8.4 million in “recoveries of expenses from project companies”
3. USD 2.0 million in “income from non financial subsidiaries”
4. USD 5.4 million in [unspecified]

These are hardly what I would consider typical operating income. 

Does that mean that they are bogus? Of course not.

But they are the sort of flows on which a typical bank/FI does not have to depend for a significant share of its net income.

Usually items like this are a minor portion of net income and more similar to the icing on the cake than the cake itself. 

Here that is not the case. 

Without them there is no “treat”.

Also management may have some discretion over the timing of recognition of some or all of these sort of items. Perhaps a useful feature in times of “need”. 

Nice to have hats with rabbits in them.

Second, Note 21 (i), USD 8.418 million gain on the purchase of additional 21% in GBCorp Bahrain. (17% of 2020 net profit). 

This amount is included in Direct Investment Income under Income from Proprietary and Co-Investments where it is roughly 41% of the amount shown.

This is based, as the note tells us, on GFH's preliminary assessment of assets and liabilities of GBCorp.

Also GFH paid the consideration for the purchase by transferring to the sellers “investments held by the Group” not cash.

When one in-kind asset is exchanged for another (in-kind) valuation can be “trickier” (that’s a technical financial term) than usual because two sides of the transaction have to be valued.

Based on a purchase price of USD 21.571 million for a 21.72% share in GB Corp, the sellers ‘ valuation of GB Corp was USD 99.3 million. Or a discount of some 23% from GFH’s preliminary assessment of fair value.

Now it is certainly possible that GFH is better positioned to extract more value from GBC’s assets than the original GBC shareholding group could.

And perhaps the sellers thought they could extract more value from the investments they acquired than GFH could. Or maybe they had pressing financial needs and so had to “fire sale” these assets.

Who sold their shares?

On that point over to the MOICT website to check the CR of GBCorp (CR 65708). From the change in shareholding data there it appears that the two selling shareholders were:

1. Oras Investments (CR 63525) owned by National Amlak Investment AlKhobar KSA for 13.0313%
2. Special Projects WLL Qatar for 8.6875%

National Amlak’s website doesn’t appear to be active. What little information is on its website is “little”. Perhaps a sign of just how motivated a seller they might be.

No idea on SP Qatar.

Typical AA semi-irrelevant but hopefully interesting side note. 

Other GBC shareholders who might be inclined to sell in the future are:

1. Soura Investments (CR 4380) at 12.5% which is held ultimately through a chain of companies leading to Premier Group W.L.L. – a name you may have heard if you “know” Bahrain. For "some" reason, I couldn’t find the Premier Group’s CR on the MOICT’s website. But kindly note AA is not throwing even a single “Stone” here.
2. UGB Holding Bahrain at 12.5%.
3. 2 Seas Investment at 9.043%
4. The rest of GB Corp’s shareholders have relatively small percentages.

Those are the major points I want to make about reported earnings.

Now to other items not appearing in the Income Statement but which have an economic impact on GFH similar to those on the Income Statement.

As usual for this exercise we’ll turn to Retained Earnings section of the Consolidated Statement of Changes in Owners’ Equity.

First is the USD 59.9 million adjustment to retained earnings to reduce the carrying value of the USD 159.1 million KHCB AT1 Murabaha Sukuk that GFH purchased at a premium of BD 12 million (USD 31.9 million) for a price of USD 191 million. PPIt’s important to note that there is a different impact depending whether we look at GFH Parent Only financials or GFH consolidated financials.

GFH Parent Only still “holds” a BD 60 million instrument and will be paid the 10% p.a. murabaha profit rate on the nominal (face value) of the instrument. On GFH’s consolidated financials, the AT1 instrument and earnings thereon will not appear.

Conversions to common shares (not expected to occur) will be based on the nominal value of the AT1 divided by the price per common share as determined. 

Thereafter, if this were to occur, GFH Parent would have a gain or loss on the price movement in shares. And would show an increase in its equity holding in KHCB. 

On the consolidated financials, GFH’s ownership share in KHCB would increase – assuming a going concern and no other common stock issuance-- the share of KHCB assets, liabilities, and income appearing on GFH’s consolidated financials.

If I am right, the immediate economic impact on GFH Parent of this is zero. The lost BD 12 million premium GFH paid is offset by the BD 12 million subscription/underwriting fee GFH received.

On the chance that GFH is able to sell the AT1 to third parties in the future  it would record a loss or gain depending on the sale price versus its cost.

Such profit or loss would also be reflected in GFH consolidated financials, assuming such transactions did not involve “Group” entities. 

Second, there is a USD 14.016 million charge related to modification of financing assets that was not required to be passed through the income statement. Think of it as a provision or other write-down. Wherever it appears in the financials, it is an economic loss.

Third, a loss of USD 22.985 million on Treasury Share sales. That brings the total cost of this pointless exercise to some US $161 million. That includes the cancellation of roughly 45% of GFH TS to occur this year, but excludes the cost of TS trading this year. Most recent post on this topic here.

So, the additional economic events from 2020 not recorded in the income statement are USD 37 million loss.

That makes “economic” earnings for 2020 USD 12 million. USD 49 million (Income Statement) less USD 37 million (Changes in Shareholders Equity).  

And should you discount the "special items" in reported income even lower than USD 12 million.

KHCB 2020 Financials - A Look at the New AT1 Capital and Capital Reorganization

 

Link to KHCB FY2020 Audited Financials.

As you will remember, following losses in FY 2019, KHCB needed to raise additional capital to comply with the CBB’s requirement that it have BD 100 million in equity.

KHCB decided to issue AT1 (Additional Tier One) capital rather than additional common equity. Presumably, because there was little appetite for the latter. This would also prevent dilution of existing shareholders.

It also decided to “regularize” some 15.788 million in accumulated negative retained earnings by writing these losses against Paid in Capital. 

This is essentially an accounting entry. 

No cash is involved except for the legal work to amend the bank’s articles and memorandum of association and for the share registrar to amend its records of individual shareholders’ number of shares, issue stock certificates where required, etc.

BD 72 Million AT1 Issue (Subordinated Murabaha)

The issue was “successfully” raised, due to GFH “buying” the entire issue.

Let’s look at the details as outlined note 35 of KHCB’s 2020 audited financials.

The issue was for a nominal BD 60 million plus a BD 12 million premium. Total BD 72 million.

GFH “underwrote” the issue for an underwriting fee of BD 12.1 million and then subsequently “bought” the entire issue. IN GFH’s FYE 2020 financials, this fee is referred to as a “subscription fee”.

Whatever it’s called it is an extremely high fee: 16.67% of the total proceeds of BD 72 million.

GFH paid cash of BD 23.6 million (roughly 35% of the BD 72).

It contributed the remaining BD 48.4 million as follows:

1. BD 24.5 million in the form of 50% of the interests in the AlAreen Hotels WLL (note 13)
2. BD 5.5 million in property
3. BD 18.4 million in financing assets.

Some additional  comments.

First, the issue was primarily in kind (76%) not in cash. The real value of the issue depends on the value of these assets.

Second, while we see these entries in KHCB’s financials, we don’t see them in GFH’s consolidated report because of the "exigencies" of consolidation. There are some adjustments (to GFH’s financials) which I’ll discuss in a forthcoming post on GFH's 2020 financials.

Third, given the BD 12.1 million underwriting/subscription fee KHCB owed to GFH, the actual net cash contribution by GFH to KHCB was BD11.5 million.  

You will see BD 11.477 million in KHCB's Consolidated Statement of Cashflows as "AT1 Proceeds".  That's the net of BD 23.6 million contributed in cash by GFH less then BD 12.1 million "subscription"/"underwriting" fee paid by KHCB to GFH.

That’s the firm to firm transfer. 

But GFH owns 55.41% of KHCB so its share of the fee paid to GFH is roughly BD 6.7 million so one can say it paid a BD 12 million premium for the issue and received back BD 5.4 million (the NCIs share). 

You'll see this amount USD 13.311 million attributed to the NCIs in GFH's annual report in the Consolidated Statement of Shareholders' Equity.

In  KHCB’s financials the AT1 instrument is carried at BD 47.22 million. Not BD 60 million.

How did that happen?

First, the BD 12 million premium was “booked” to KHCB's retained earnings.

Second, the BD 12 million underwriting fee plus an additional BD 778 thousand of other issue expenses were deducted from the AT1 proceeds of BD 60 million ex premium reducing it to BD 47.22 million.

Write-off of Accumulated Losses Against Paid in Capital

KHCB reduced its issued shares from 1,050,000,000 (par value BD0.10) to 892,481,190.

Each shareholder’s number of shares was accordingly reduced by roughly -15%.

During the period 11 August 2020 through 9 November and following the 15% reduction in the number of its shares, Goldilocks sold 1,945,547 shares reducing its holding in KHCB from 9.96% to 9.78%.

One final observation.

KHCB has been showing Emirates Islamic Bank (EIsB) as shareholder with some 8.41% of shares and GFH with 47%.  

In its FYE 2020 annual report, KHCB shows GFH holding 55.41%. EIsB doesn’t appear as a shareholder. 

There is no explanation of the change.

By contrast GFH has been showing its holding in KHCB as 55.41% since FY 2017 (note 18).

Back in 2016 GFH had floated the idea of acquiring 100% of KHCB.

Later it decided not to, but got a special exemption from the tender offer rules in Bahrain to allow it to only acquire Emirates Islamic Bank’s stake. 

Normally tender rules require that over a certain threshold, the acquirer has to tender for all shares it does not own. This to ensure that all shareholders are treated equally.

Unclear why GFH's acquisition of EIsB's shares wasn’t reflected in KHCB’s financials until FY 2020.

What is a Consolidated Financial Statement and Why You Should Care

Arqala Minor with the Prep School's
Beloved Accounting Teacher Mr. Debits
I studied hard then so I could answer your questions today.

At first blush this topic no doubt sounds like it will be a recitation of arcane accounting principles and standards complete with multiple examples of journal entries and the tracking of matching debits and credits.

I promise you it won’t be. Can’t promise much on length though.

The real point of this post is the second part of the title.

You may be thinking why should I care?

After all the accountants will do their job and “account”. 

“Why should I care anymore about this than the recipe the hummus chef at Hummus Express uses?

The reason you should care is that consolidated financials are not the financials of a legal entity rather they are the financials of an “economic entity”. 

An economic entity that the accountants have “constructed” according to certain (accounting) principles. 

From a legal standpoint, this entity exists solely on the pages of a financial report.

Consolidated financials are designed to give a picture of the position and performance of the economic entity or group.

But they can also be misleading, if one doesn't know what they represent.

In the real world, one conducts business with legal entities not accounting constructs.

One buys the stock or debt of a legal entity. One signs other contracts with a legal entity.

Contracts with legal entities are enforced against legal entities and their assets.

Not against economic entities.  

One only gets protection from the "group" if subsidiaries of the parent guarantee the obligations of their parent.

What are the benefits from understanding consolidated financials?

First, the “ships” of many a credit officer or “wise” investor have floundered on the conflation of “consolidated” financials with legal entity financials. Legal entity financials look much different than those of a consolidated group.

Assets (including cash) that appear in the consolidated financials that one thought were available to the Holding or Parent Company are not.  Because they are  assets that belong to a separately incorporated company.

One which is likely to have other shareholders (NCIs) whose permission would be required to "use" them for the Holding Company. And whose reluctance/refusal to give permission to use their "money"   to bail out the Holding Company is probably a safe bet.

Absent a guarantee from the operating subsidiaries, if you lend to the parent company or invest in its securities, you have a claim against the parent company and its assets and cashflow as reflected in its legal financials.

Second, if you understand what you’re looking at, you will be able to get a better sense of the performance of the legal entity whose stock or debt you own. And whether you should accumulate or divest. 

Sometimes you can get an insight into problems in the "group" merely by looking at the NCI share of income.  

In 2019 the NCI share of income at GFH was minus $13 million.  If we assume a 50% split between GFH shareholders and NCIs, this means that GFH also experienced a similar loss. But in GFH's case there was other income that absorbed that loss. The size of the total loss would suggest that there were problems in a major subsidiary.  KHCB would be a likely candidate.

How does consolidation work?

Consolidated financials include not only 100% of the assets and liabilities of the subsidiaries and associated companies that meet the accounting tests for consolidation, but also 100% of their revenues and expenses (thus, their net income). 

Any transactions between the "group" companies are eliminated, i.e., removed from the financials.

When subsidiaries are not 100% owned by the Holding Company, two adjustments are made to reflect the non controlling shareholders’ interests (NCIs).

On the balance sheet a single line adjustment is made on the liability side by creating a component of total equity called Non Controlling Interests. 

No adjustment is made for assets and liabilities of the NCIs on the balance sheet. If you're looking to the consolidated financials as an indication of the assets the "group" has you should not "count" those belonging to the NCIs.  But you have no idea what assets and liabilities "belong" to the NCIs.

A similar approach is taken on the income statement. A single line adjustment is made in net income for the 100% of NCI revenues and expenses by distinguishing a component called “net income attributable to NCIs” from “net income attributable to shareholders of the group”.

Keep in mind that this is a single adjustment across all the subsidiaries. If NCIs have net income of $104 in some subsidiaries and a net loss of $100 in other subsidiaries then the amount shown will be $4.  Again the absence of detail is not particularly helpful for analysis.

Also keep in mind that NCIs are unlikely to be exactly the same parties across all subsidiaries.

Let's turn to Citigroup to get real life examples of these key points with the intent to make them more concrete.

To be very clear there is no negative connotation in the choice of Citigroup.

Rather there is a rich vein of information in their 2020 FY annual report. (Form 10K) 

Compare this to Note 33 in JPMorgan’s FY 2020 Annual report. (Form 10K) which has less detail.

2020 Revenues (Page 301)

Citi Parent’s net income is shown on the extreme left. Citi consolidated on the extreme right with adjusting entries in the middle.

There are wide differences in amount in each revenue or expense category.

In the end the net income for both Citi Parent and Citi consolidated is equal at $11.047 billion. 

But the details show that there are two critical differences between the two sets of financials.

First, Citi Parent does not conduct significant business on its own as reflected in the individual revenue and expense items. Its cashflow is largely secondhand and dependent on payments from the subsidiaries.

Second, subsidiary dividends drive Citi Parent’s cashflow. And, thus, are (a) volatile and (b) subject to constraints on payment.

In 2020 Citi Parent did not receive $9.894 billion of that year’s net income in cash (roughly 90%).

And will not until the subsidiaries pay it dividends.  Until it receives the cash it cannot use it to settle obligations, make investments, etc.  

Government agencies or regulators have the right to restrict the amount of dividends that a regulated firm—think primarily FIs--may pay under various measures to "protect the financial system". 

In all firms shareholders must approve the payment of dividends through formal processes, e.g. AGM.  So one can't simply ring up the subsidiary and ask for $1 billion in dividends by tomorrow.

As to volatility, in 2019 and 2018 (pages 302 and 303), Citi Parent received dividends 10x those in 2020.  In both of those cases the dividends were more than 100% of those years’ net income.

Also look at the penultimate column on the left "consolidating adjustments".  That will give you an idea of intragroup transactions "eliminated" on consolidation.  You will also see this on the balance sheet, statement of cash flows. 

2020 Balance Sheet (Page 304)

Here the difference is even more stark.

Citi Parent had total assets of $386.134 billion, while Citi consolidated had assets of $2,260.090 billion (almost 6x Citi Parent).

Even more telling, 95% of Citi Parent’s assets were equity in subsidiaries (55%) and advances to subsidiaries (40%). Probably most holding companies look like this. They after all are “holding” equity in subsidiaries.

Compare that to the consolidated financials where there is a greater range of asset types and a greater range of liquidity as well as much larger amounts..   

That has implications when there is corporate distress.

Distress at the subsidiary level is usually but not always the cause of distress at the Parent. 

At this particular time the Parent will be even more dependent on the subsidiary for cash because it most likely has no significant operations of its own. In such a case dividends are unlikely.  Selling the equity in the subsidiary or pledging it as collateral is unlikely.  

The most likely scenario is that the Parent will have to wait for its share from the liquidation of the subsidiary's assets.

Because the Parent holds equity in the subsidiaries, it is last in the priority of payments. Senior creditors get paid first, subordinated creditors next, and equity holders get what’s left. Usually that’s nothing or close to nothing.

There is also a risk that Parent extensions of credit to the subsidiaries may be equitably subordinated to other subsidiary creditors or recharacterized as equity. This of course depends on jurisdiction and the specific circumstances/form of the extension of credit.  

If this happens, the cash flow from the subsidiary to the Parent will be even less.

Even if it doesn't,  Parent Company creditors and investors are likely find themselves at the very end of the cash "waterfall".  

Not where they thought they would be when they extended credit or invested. 

GFH Treasury Shares – More Shareholder Value Destruction on the Horizon

It’s hard to understand the “logic” being applied by GFH’s board and management with respect to Treasury Shares, particularly given GFH's weak state.

On 16 February 2021 GFH announced two proposals:

1. The cancellation of 141,335,000 in Treasury Shares.
2. The issue of 94,339,623 in new “bonus” shares.

I’ve written before that the cancellation of Treasury Shares is a direct waste of shareholder funds. One buys shares from the market paying cash and then one cancels them and receives nothing. A dead loss.

The first proposal will result in the cancellation of 45% of GFH’s Treasury Shares (total value of USD 69 million). So USD 29 million. 

A large amount for a bank like GFH that has reported net income of USD 50 million the past two years.

If approved, the first proposal will bring the total of shareholders money “whistled” away in Treasury Share transactions to some USD 161 million before 2021's TS trading losses:

1. USD 3 million in losses on 2017 TS sales
2. USD 27 million in losses on 2018 TS sales
3. USD 28 million in losses on 2019 TS sales
4. USD 51 million in losses on 2019 cancellation of TS shares
5. USD 23 million in losses of 2020 TS sales
6. USD 29 million loss on the proposed 2021 cancellation of TS shares

As I noted in my most recent post on this “strategy” it does not make sense nor does it appear to have resulted in any benefit to shareholders in general.

Imagine instead that GFH had not “spent” (or more appropriately mis-spent) shareholder money on TS. 

Instead of borrowing USD 300 million at 7.5% per annum, it would only have needed to borrow USD 140 million resulting in an annual saving on interest of some USD 12 million a year. 

An amount equal to 24% of reported FY 2020 net income!

I’ve argued that cancellation of TS is unlikely to have a material impact on GFH’s share price given the relatively small percent canceled.  And that there are other less costly ways to increase the per share price of GFH. 

But note those would not increase the value of GFH.

Once again via the second proposal GFH will undo what little effect there is by issuing 94 million new bonus shares.

GFH is a weak institution.

Low quality of earnings. Subpar ROAE. Concentration in illiquid assets. A sub investment grade debt rating. 

Poor market performance of its stock, now trading at a P/BV ratio of 0.6X

All this would seem to argue for a more careful stewardship by the Board and management of the bank.

Given all that, it is also hard to understand how the CBB allowed these proposals to be put forward.

That leaves the decision in the hands of the shareholders.

Based on the past the probability of shareholder action to reject these proposals seems low. 

Market Commentary: Archegos

Perhaps the One Call You'd Prefer Not to Get

You’ve probably read how Archegos “blew” up the market.

It sounds like the result of a deliberate decision by Archegos.

What it seems happened is that A couldn’t make a margin call, prompting creditors to sell off the pledged shares.  Billions of USD worth.  No small beer here.

Also there has been a lot of talk about Archegos' responsibility, but not so much about those who provided the explosives.

Some additional observations.

Sophisticated Investors

No so long ago, I read an article in the financial press, either the FT or WSJ, discussing the “big boys’ market”.

That’s the market for supposed sophisticated investors. 

It is generally a tenet of free market economic dogma that regulation and protections aren’t required in this market, because unlike retail investors, the “big boys” know enough to look out for themselves.

As near as I can tell, two of the big boys apparently managed to do just that. Others not so well.

Risk Management and Profit

It’s also a story about the dynamic tension in firms between those two elements.

As sadly is the case, the lure of profit overcomes the hard cold facts of risk management.

No surprises here.

We’ve seen this in Gamestock where the short positions were multiples of the free float, setting up a “classic” illiquidiity trap for the shorts to name just one of many such occurrences.

LTCM.

Greensill.

Mr. Hwang was encumbered by some past regulatory enforcement baggage. 

But redemption is possible in the market when accompanied by the right level of profit to wash “sins” away. 

The Sermon at the Bourse

Reuters had an interesting article under the title “Comeback quashed for faith-driven investor Bill Hwang.”

In it he is quoted as saying: 

When we create good companies through the capitalism that God has allowed, it enhances people’s lives….God delights in those things.

I’ve searched my copy of both the so-called Old Testament and New Testament and cannot find the Sermon at the Bourse. Perhaps I missed it. 

Perhaps, this teaching is based on more skillful exegesis than I am capable of. A not unthinkable possibility.

Analyst Disclosure: I don’t hold much with anthropopathism given my categorical rejection of anthropotheism. (See Xenophanes.)

But for argument’s sake let’s take Bill at his word.

Or perhaps I should say the Lord’s word?

A host of theological questions come from his statement.

Here are but a few.

If God is delighted at times, it seems that logically at other times He must be (a) sad or (b) neither glad nor sad.

Given the size of the reported losses at Archegos, Nomura, Credit Suisse might God be severely depressed today?

Besides the emotions of delight and sadness, does God have other emotions?

Does God feel hot or cold depending on the season of the year?

If God allowed capitalism, did He also allow socialism?

Assuming the translation of Bill’s remarks is accurate, “allowed” doesn’t seem to be much of an endorsement of capitalism by God.

God has apparently “allowed” all sorts of things. 

Not all of which are good: Brexit, Disco, Spam, supply side economics, lost matches and missed trophies by Arsenal,  Not to mention more serious events.

If all the above questions sound absurd to you, you've gotten my point about the absurdity of the assumption that got us here as well of the validity of the two "a's" above.