PrefBlog

Assiduous Reader pugwash doesn’t say much, but when he does it’s to the point.

In the comments to October 20 he asked:

Newb question:

At current prices, why doesn’t BAM (for example) buy some of its prefs back.

… and I replied …

Don’t be so down on yourself, it’s a perfectly good question.

There have been scattered reports of LBO Debt Buybacks:

Kohlberg Kravis Roberts & Co. and PAI Partners bought loans used for their takeovers after prices tumbled in February. The purchases helped cut the global backlog of leveraged buyout debt to $91 billion from $230 billion nine months ago, according to Bank of America Corp.

… and more recently:

Apollo, TPG and Blackstone are reported to be close to a deal to buy USD 12.5 billion in “distressed” buyout debt, at the bargain price of what the New York Times has identified as “in the mid-80 cents on the dollar.” This is lower than the USD 87 cents identified as the average trading price by a special Credit Suisse index, but more than the 70-80 cents that many other buyout loans are currently trading at.

With respect to BAM particularly … the glib, meaningless answer is that they expect to be able to invest those funds as vultures, earning more than they could save from a buy-back of their own debt. Brookfield has a very expansionist agenda and could well just be waiting for a major bankruptcy, for instance, to put good assets that fit with their portfolio on the market for a song.

Even if that is not the case, there is always the question of liquidity. They have about $3-billion in liquidity now and they may be hoarding it … why buy back 5-year debt when they have the same amount of debt maturing next year that might be a nightmare to refinance? Nobody knows for sure how long this very tight environment is going to last … so everybody’s sitting on whatever cash they have …

… and now he’s followed up the crusher …

Thanks – helpful answer:

Which breeds a follow on question – how about the buy back situation with split share prefs (particularly short dated ones).

Doesn’t it make sense in today’s market for the issuer to buy back the pref at way below the $10 they will have to pay in a few years time.

Wouldn’t this also improve the asset coverage ratio.

Or is this what the difficult to understand retraction feature, you mentioned in September for eg WFS is all about.

Well, there’s a glib and cynical answer to that one and it’s tempting just to say: a buy-back is a voluntary reduction of Assets Under Management by the Manager; therefore a voluntary reduction of pay; and how likely is that?

But there is also the question of reputation. There are many shops (e.g., Mulvihill, Quadravest, Faircourt, inter alia) that make quite a good living packaging split shares and default on one series of prefs might make it harder to sell another.

I’m not a big believer in reputation, at least not as far as investment returns go (outright theft, fraud and such is another matter). The Street’s memory is short – the markets for Monthly Auction Preferred Shares and bank-issued 100-year floating rate bonds collapsed twenty years ago and now everybody’s pretending to be surprised about the collapse of the Auction Rate Securities market in the States. If nothing else, most readers will know that there are many stockbrokers and asset managers with little or no investment ability but who – somehow! – are able to attract money. The business is about selling, not performance.

Mulvihill is a particularly good case in point; I got extremely upset with them in the wake of the Tech Wreck for proposing to buy back full units of Global Telecom (GT.A & GT.PR.A) at a time when the asset coverage of the preferreds was less than 1.0, and when the combined price of the securities was less than NAV.

I took the view that there was nothing in the prospectus to prevent them from buying back the prefs only; and that buying back the capital units was an irresponsible waste of preferred shareholders’ money. They took the view that the prospectus forced them to buy back equal numbers of the two classes. The prospectus is very badly drafted; interested readers may decide for themselves who was right.

Anyway, my point is that despite my strong disapproval of their actions with respect to the buy-back plan, I have still been willing to invest in WFS.PR.A. Another day, another dollar … if you do business only with people you agree with all the time, you’ll soon not be doing much business.

So, speaking of WFS.PR.A (which is currently under Review-Negative, and I suspect a downgrade to Pfd-3 is forthcoming) let’s have a look at the prospectus:

Subject to applicable law, the Company may at any time or times purchase Preferred Shares and Class A Shares for cancellation at prices per Unit not exceeding the NAV per Unit on the Valuation Date immediately prior to such purchase.

… and we see that they’ve learnt something about prospectus-writing, because right there on the front page it says:

The Preferred Shares and the Class A Shares are offered separately but will be issued only on the basis that an equal number of each class of shares will be issued and outstanding.

So in the case of WFS.PR.A, they have the ability to buy-back full units for cancellation, as long as they do it at a price below NAV, which will improve the NAV of the remaining units. This situation is particularly poignant for WFS.PR.A because it is currently sitting on a whack of cash – which has cushioned the blow of falling share prices in this awful market. As of June 30:

• Canada, 35.9%
• US, 23.3%
• International, 23.0%
• Cash, 21.3%
• Other, -3.5%

Note also that 17.6% of the equities held were hedged with Puts. Putting that cash to work buying units might be a Good Thing: As of October 16, NAV was $13.82; WFS.PR.A closed at $8.00; WFS closed at $3.93; so the units as a whole closed at a 13.7% discount to NAV.

The other consideration they must account for when determining whether or not to buy back units is whether they will pre-empt unitholder retractions or be adding to them. From a business perspective, a simple pre-emption is a wonderful thing, since they will have lost the AUM anyway and it’s simply a question of who gets to keep the discount. I have previously noted that the discount is so extreme that even the Monthly Retraction, with its 4% built-in fee, is attractive. The “Annual Concurrent Retraction”, for which the retractor will receive full NAV, is even more attractive to arbitrageurs, but doesn’t happen until June.

So the question, as of October 16 prices, is who gets to keep the 13% market value discount to NAV? In a buy-back, the company gets to keep it; in a monthly retraction, the company only gets about a third of it; in an Annual Retraction, the company gets none of it. A buy-back would certainly make sense for both the Preferred Shareholders AND the capital unitholders … but, unfortunately, they don’t get a vote. It’s in the lap of Mulvihill.

Another highly interesting situation worth highlighting is the potential for FIG.PR.A to be partially called. Their prospectus has none of this silly stuff about keeping the number of shares equal; instead it states:

Preferred Securities may be redeemed in whole or in part by the Trust upon notice to Securityholders in accordance with the Trust Indenture at any time that the aggregate principal amount outstanding of the Preferred Securities exceeds 40% of the Total Assets. All Preferred Securities outstanding at maturity or immediately prior to the termination of the Trust, if earlier, will be redeemed by the Trust. The Preferred Securities would, in any such case, be redeemed at par, plus any accrued but unpaid interest.

This implies that redemption at par is an option for the company whenever asset coverage falls below 2.5:1. The surprising thing is that they have done it, redeeming about one-sixth of the preferreds in March. Now that distributions have been halted for the capital shares:

Faircourt Asset Management Inc., as Manager of Faircourt Income & Growth Split Trust (TSX: FIG.UN, FIG.PR.A) and Faircourt Split Trust (TSX: FCS.UN, FCS.PR.A) announces today that in accordance with the terms of Trust Indentures governing the Preferred Securities and the maintenance of a minimum 1.4 times asset coverage to be maintained by the Trusts, dated November 17, 2004 for Faircourt Income & Growth Split Trust and March 16, 2006 for Faircourt Split Trust, monthly distributions on the Trust Units (TSX: FIG.UN, FCS.UN) will be suspended until further notice, in order to protect the Trusts’ Net Asset Value and to preserve the Trusts’ ability to rebuild and meet their respective investment objectives in the long term.

… and the prefs are under Review-Negative, there is the potential – POTENTIAL! – for another partial call at par, which would be very good news for the preferred shareholders, given that FIG.PR.A closed at 7.67-70, 1×1 yesterday. Note, however, that they also have authorization to buy back the preferreds:

The Trust Indenture will provide that, subject to applicable law, the Trust may, in its sole discretion, from time to time, purchase (in the open market or by invitation for tenders) Preferred Securities for cancellation up to a maximum in any calendar year of ten percent of the aggregate principal amount of Preferred Securities outstanding at the beginning of that calendar
year.

So, what can I say to summarize? Rule #1 is, of course, be familiar with the prospectus. If investing was easy, it wouldn’t be fun! Bear in mind at all times that what’s good for you is not necessarily good for the Manager – I have not heard back from the company yet, but until I do, my working hypothesis is that the BSD.PR.A suspension of retractions is abusive to the shareholders. And if you decide to play any arbitrage games, remember at all times that it’s not a straightforward arbitrage – there are a lot of things that can go wrong.