Blue Sky - some notes and an agenda for ASIC

Blue Sky Alternative Investments Limited collapsed after a short-sellers report from Glaucus - a now-disbanded two person short-selling research shop.

Blue Sky managed many funds - a macro-futures fund, a big fund trading water rights, a venture capital fund - and the funds were sold to investors (mostly retail, some institutional).

Blue Sky claimed to have $3 billion under management on which they collected base and performance fees. They only had about 100 staff at peak.

And they went bust.

The official story - promoted by several members of Blue Sky Management - is that Blue Sky was a fine institution - but reliant on public trust - and it collapsed because of a misleading short-seller report. They think that the collapse of Blue Sky was akin to a run on a bank. Lies were sufficient to cause the demise of an otherwise sound institution.

This is not obvious from the accounts. And it assigns magical powers to short-sellers that I did not know I had. (I am a short-seller.)

I do not know what went on at Blue Sky beyond what is in the accounts - but just the accounts are fascinating enough.

Here is a quick run through them:

The Blue Sky 2014 Annual Report

Blue Sky was on its way to being a successful asset manager in 2014.

Here is the key section from the shareholder letter:

Assets under management had doubled from $350 million to $700 million. They bought “Investment Science” – an award winning fund manager.

They raised $60 million for a listed (and closed end) fund called Blue Sky Alternatives Access Fund. Those are wonderful for an asset manager because they produce fees that do not disappear. You do not “redeem” a listed fund, you simply sell it on the stock market.

Finally – and most importantly – they raised $35 million from the public which they were going to use for co-investment in their funds.

The profit and loss account is repeated below.

This P&L surprises me a little. The main expense of both asset managers I have worked for is staff. Asset management largely consists of desks and computers and lots of people. Analysts, compliance etc. But in this case employee benefit expense is only $8.5 million – and the biggest expense is “other expenses” detailed in Note 8. So it is worth thinking what they might be:

Some of these expenses I am familiar with. Fund establishment expenses for instance are ones that I have borne but never in that sort of quantity. That said Blue Sky ran many funds – so they are plausible. Blue Sky also managed investment property – but I have never seen the manager (rather than the funds) bear the costs associated with sales of that property. But I have personally borne expenses that would normally go in small funds as part of the cost of getting funds running. So I am happy to accept it.

That said – in 2014 Blue Sky is a fast-growing and profitable asset management firm that had raised $35 million in cash at parent company level which it invested in the funds it managed.

The 2015 Annual Report

Here is the core extract from the shareholder letter in the 2015 annual report. Funds under management had increased to $1.35 billion – roughly doubling. And profitability grew nicely. The underlying funds were performing well with approximately 15 percent annualised performance since inception.

The P&L account made progress too. Operating revenue is $58 million. For a fund manager this is an a very large revenue pile offset (again) by sundry other expenses.

Remember the core expense of a fund manager is people and the desks to put them in. $58 million in revenue should leave an awful lot of fat after that expense.

There wasn’t a huge cash raise this year – so the amount of co-investment in the Blue Sky managed funds was not large.

The 2016 annual report

2016 was very like 2014. The company raised money again to co-invest in funds. Here is an extract from the shareholders’ letter.

Note the critical detail here – the company raised $66.8 million in cash at the parent company. That cash was mostly left on the balance sheet that year though some was used for co-investment in the funds that Blue Sky managed (see discussion below).

The Chief Executive also noted that funds under management had grown to more than $2 billion and they were targeting $10 billion. Returns were of course good.

At the end of the year they held $35 million in investments in their own funds. These are itemised.

Note that a net $11 million dollars was invested in the funds during the year (16.5 million in additions, $5.1 million in disposals). 

Operating cash flows in the year were $13 million so the bulk of operating cash flows were invested in Blue Sky funds. Their past investments did well too.

But the core observation here is an organisation in rude health., It has $35 million in investments, and a cash balance over $60 million mostly raised in the secondary market. Revenue was about $60 million and staff expenses still modest.

The 2017 annual report

In 2017 Blue Sky went from strength to strength. Here is the key extract of the annual letter.

Things grew about 50 percent across the board – with fee earning assets now about $50 million. Here is the key part of the shareholder letter.

Revenue was over $70 million after share of operating profits from their investments and just shy of $70 million prior. As per usual much of the cash balance got poured into their funds as co-managed investments.

You can see this on the asset side of their balance sheet. Investments in retirement villages (which they operate) is $54 million. Investments in associates and joint ventures is another $51 million.

The retirement villages are the Aura village – but even that was doing well as they booked an increase in fair value.

We know these funds were eventually returned as Blue Sky sold the Aura projects. This was after the final 2018 annual report as per this press article.

https://www.theweeklysource.com.au/blue-sky-returns-686-5m-in-funds-including-for-three-aura-projects-to-investors/

The other investments were also moving along nicely. Here is the reconciliation:

You will note that this lists the specific investments. They are quite profitable (with $8 million of appreciation). Net additions were about $9 million (25 additions, 15.9 disposals). They were continuing to pour money into their investments. As their investments were profitable this seems a good thing.

The 2018 annual report (also the final annual report)

The 2018 annual report was written after the short-seller report – and the results had begun to fall apart. Here is the core part of the shareholder letter:

The Chairman described the year as Blue Sky's annus horribilis.

That said the financial position is pretty good because they raised $100 million in cash from shareholders just before the Glaucus short-seller report came out. This extract makes this clear:

There was no debt. They also state clearly they expect cash from the balance sheet to be “recycled”, that is they expect to cash some of their existing investments and to invest more.

The asset side of the balance sheet shows the deployment of all this cash (notably the cash they raised).

Note that the investment in retirement villages is now $112 million and the investment in associates is $46 million.

The retirement village reconciliation is below:

As of the 2018 annual report this investment was still doing well – they booked almost $5 million in unrealized gains. But they did pour in and capitalize $47 million of cash. That said this is $112 million invested in Aura – and as noted in the above press article this was largely returned to investors.

The investment in associates is also reconciled in the annual.

This time they made modest losses, booking 6 million in losses and partially reversing the prior year gains. They did however make net additions absorbing some more of the cash they raised.

The actual investments are listed too:

Presumably these investments were there at the end too.

What happened next?

There are no more annual reports from Blue Sky.

Blue Sky ran out of money and they took a further $50 million in cash from Oaktree.

They couldn’t meet the terms of the Oaktree loan and they were put in liquidation.

On their numbers they had a couple of billion of funds under management which presumably come with management fees of 1 percent or so. They had collectively raised almost $200 million in cash at the holding company (with equity offerings in 2014, 2016 and 2018) and they had $50 million in cash raised from Oaktree. And they had invested that money into funds that they said performed well.

And then they could not repay the money to Oaktree.

Three hypotheses

I have only three hypotheses to explain this situation.

Either

• a)     The cash raised was invested in funds that remained there when Oaktree put the firm into liquidation – and Oaktree wound up for $50 million with investments that had about $200 million in cost. Oaktree made out like bandits.
• b)    The cash raised and the accumulated profits were invested in Blue Sky funds – but that Blue Sky is such an atrocious investor that $200 million in investments at cost were not enough to repay Oaktree on liquidation or
• c)     The investments were never made – and were fictional from inception. The cash raised wasn’t invested. It was diverted for purposes unknown. And likely the profits that Blue Sky booked along the way were fictional.

The second explanation - the one that management lost all that money - is the most innocent of these. Loosing money is a pity, but it is not a crime. [That explanation is also difficult for Blue Sky management who wish to stay in the asset management business without a tarnished reputation.]

I do not have any access to Blue Sky's liquidation reports or internal accounts. But ASIC has been made aware of this analysis - and if by this time next year we have not seen an answer to where the $200 million raised went to then I will be disappointed.

I wrote this all out because I am a little off-put by the negative press that short-sellers have received here - even though - on the face of it it looks like a cool couple of hundred million (a quarter of a billion including the Oaktree loan) have just gone missing.

But at this point Blue Sky has gone to zero. It is not up to short-sellers to explain what really happened. That is up to Australia's corporate regulators.

This is a really important case for them.




John