Will the market lend USD500 million to a Canadian reverse merger with a collapsed stock, marginally unprofitable gold mines in China, and a non-legally binding State guarantee?

China Gold International (CGG-TSE) is a Canadian listed company with two not particularly good gold mines in China. One of these mines is very large (but is also directly mortgaged to Chinese banks).

The stock was a reverse merger back-in-the-day. But that was almost twenty years ago. The name on the original reverse merger document is Rui Feng. This is the same Rui Feng associated with Silvercorp Metals. Silvercorp had a famous but ultimately inconclusive fight with short-sellers who alleged fraud.

There are a long collection of past directors who merged in companies with names like "Rapid Results" and who have a record of association with collapsed reverse mergers but those people are long gone.

China Gold International has risen far beyond its origins. It has two real (but sharply underperforming) gold mines. And it has a very high quality shareholder.

Top if the register with over 39 percent is China National Gold.

China National Gold is

• one of only about 100 centrally owned State Owned Enterprises (SOEs) in China,
• the biggest gold miner in the world by ounces and revenue 
• able to borrow as a AAA in China, and having recently completed large bond offerings at low spreads obviously fairly liquid.

This is a very high quality shareholder - especially for a company with reverse-merger origins.

The high quality shareholder however can't be particularly pleased with the stock they bought into.

China National Gold bought into what was then Jinshan Gold Mines Inc buy buying out a position held by (Robert Friedland's) Ivanhoe Mines. They paid Canadian $3.18 per share and they also paid out Ivanhoe on some minor debt provisions. You can find the original press release here (and original source here).

The stock had a little bit of a run-up and then a run down - and then in 2011 China National Gold purchased another 412 thousand shares in the open market. You can find the original press release here (and the original source here).

But since then the stock has just gone down and down and become very illiquid. Here is a chart for the stock over the past ten years courtesy of CapitalIQ.

The stock is now Canadian 56c down from a peak around $6. It is a little worse if measured in Yuan or US Dollars because the Canadian currency has also lost some value. Measured in Yuan the stock has lost well over 90 percent of its value.

The market cap is now Canadian 222 million or 163 million USD. The China National Gold stake is worth about USD65 million if they could sell it. They probably could not because the Canadian stock now has low liquidity.

This is consistent with mines that have (fairly sharply) underperformed the engineering and reserve studies laid out for them about a decade ago.

China Gold International traded debts

Being a shareholder is not the only relationship that China National Gold has with China Gold International. They are the (sole) customer for metal concentrates and gold doré produced and they provided most of the equipment and engineering services needed to actually build the two above-mentioned mines.

By the time you get to the 2013 annual report (copied here) the company has extensive related party transactions where the mines are developed almost entirely by paying China National Gold subsidiaries for detailed engineering services. By the end of 2013 the company owed China National Gold a lot of money (and it still had more money to pay to China National Gold). [The multiple pages detailing related party transactions start on P.16.]

In 2014 China Gold International with the support of China National Gold went to the Hong Kong market to pay for all this. They issued USD500 million in three year debt in 2014. That debt was repaid in 2017 and another three year debt was issued. The 2017 issuance is due for repayment in early July of this year and as of the time of printing China Gold International clearly does not have the money (though may be able to raise it).

This debt is issued through Skyland Mining (BVI) limited - a British Virgin Islands company that was at one stage the owner of the more valuable of the two China Gold International Mines. The debt is guaranteed by Canadian parent company.

I wondered whether it would default. That would of course make China Gold International (the guarantor of the debt) a great short. The combination looked pretty sweet to me. A large amount of short-dated debt and underperforming mines on a stock that is an old reverse merger is is the sort of thing that makes short-sellers salivate.

Alas it is not so simple. Bloomberg says pretty clearly that the debt is guaranteed by China National Gold.

Here are some cut-and-snips from our Bloomberg machine. Here is what Bloomberg says about the bond issue:

This clearly delineates the issuer as Skyland Mining BVI LTD and states unequivocally that there is letter of support by China National Gold Corp.

As China National Gold Corp is amongst the more solvent and liquid Chinese SOEs this debt trades as a quasi-Chinese sovereign debt.

If you go back to the press releases when the debt was issued Bloomberg also clearly states that the debt was issued with a letter of support.

And this is where a short-case ends. I do not feel like shorting the Chinese National Government. This debt trades at par, and if it is really supported by China National Gold it deserves to trade at par.

Trust but verify

I am however an intense fan of Ronald Reagan's approach to dealing with the Russians (or in this day-and-age the Chinese). The Reagan approach was to "trust but verify".

I went looking for the original offer document to find this letter of support.

Bloomberg had no document that verified that a letter of support existed.

So I looked a little harder. Actually a lot harder. And here is what I found.

The 2014 debt issuance

The 2014 debt issuance is explained in the 2014 CGG annual report. To quote:

On July 10, 2014, the Company, its wholly-owned subsidiary, Skyland Mining (BVI) Limited (the “Issuer”), China National Gold and Standard Chartered Bank, Citigroup Global Markets Limited, Merrill Lynch International and CCB International Capital Limited (the “Joint Lead Managers”) have entered into a subscription agreement (the “Subscription Agreement”) pursuant to which the Issuer has agreed to issue to the Joint Lead Managers, and the Joint Lead Managers have agreed, severally and not jointly, to subscribe for bonds in an aggregate principal amount of US$500 million (equivalent to approximately HK$3,900 million) at an issue price of 99.634% (the “Bonds”) bearing interest at the rate of 3.5% with a maturity date of July 17, 2017, rated BBB- by Standard & Poor’s. The bonds were unconditionally and irrevocably guaranteed by the Company. The net proceeds would be used for working capital, capital expenditures and general corporate purposes of the Company. 

On July 17, 2014, all the conditions precedent to the issue of the Bonds as set out in the Subscription Agreement were satisfied and the issue of the Bonds was closed. The Bonds were listed on the Stock Exchange of Hong Kong Limited on July 18, 2014. Details of the Subscription Agreement are stated in the Company’s announcements dated July 11, 2014 and July 18, 2014.

You will note that in this China National Gold was a participant in the subscription agreement.

Also to confuse matters the press releases are not dated 11 July and 18 July. They are in fact dated 10 July and 17 July. I guess this could have been an effect of the International date line between the Hong Kong listing and the Canadian listing.

That said you can find the 10 July press release here (original here) and the 17 July press release here (original here). They detail all the conditions of the bonds.

The 10 July 2014 press release starts as follows:

VANCOUVER, July 10, 2014 – The Board of Directors of China Gold International Resources Corp. Ltd. (TSX: CGG; HKEx: 2099) (the “Company”, the “Guarantor” or “China Gold International Resources”) is pleased to announce that on July 10, 2014, the Company, its wholly-owned subsidiary, Skyland Mining (BVI) Limited (the “Issuer”), China National Gold Group Corporation (the “Keepwell Provider”) and Joint Lead Managers as defined below, have entered into a subscription agreement (the “Subscription Agreement”) pursuant to which the Issuer has agreed to issue to the Joint Lead Managers, and the Joint Lead Managers have agreed, severally and not jointly, to subscribe for bonds (the “Offer”) in an aggregate principal amount of US$500 million (equivalent to approximately HK$3,900 million) at an issue price of 99.634% (the  Bonds”) bearing interest at the rate of 3.5% with a maturity date of July 17, 2017, rated BBB- by Standard & Poor’s.

This press release clearly states that China National Gold Corporation is a "Keepwell provider".

CapitalIQ also has the original offering documents. For those with a CapitalIQ subscription you can find them here - but I have downloaded here. This document confirms China National Gold as a Keepwell provider. [Incidentally the dates on the Capital IQ releases match the annual report again suggesting that it was a dateline issue.]

We can be pretty sure that the credit on the 2014 bond issuance was supported by China National Gold.

You would expect it to be money-good regardless of the performance of the underlying mines.

And it was. The issuance was repaid in 2017 and another USD500 million was borrowed in the Hong Kong market.

The 2017 debt issuance

The 2017 debt issuance looks somewhat different. Again we can find a description in the CCG annual report (in this case the 2017 annual). Here is the text:

On June 27, 2017, the Company, Skyland Mining, China International Capital Corporation Hong Kong Securities Limited, Citigroup Global Markets Limited, CCB International Capital Limited, Industrial Bank Co., Ltd. Hong Kong Branch and Standard Chartered Bank (the “Joint Lead Managers”) entered into a subscription agreement (the “Subscription Agreement”) pursuant to which Skyland Mining agreed to issue to the Joint Lead Managers, and the Joint Lead Managers agreed severally and not jointly, to subscribe for bonds in an aggregate principal amount of US$500 million (equivalent to approximately HK$3,880 million) at an issue price of 99.663% (the “Bonds”) bearing interest at the rate of 3.25% with a maturity date of July 6, 2020, rated BBB- by Standard & Poor’s. The Bonds were unconditionally and irrevocably guaranteed by the Company. The net proceeds are used for repaying existing indebtedness, working capital and general corporate purposes of the Company. 

On July 6, 2017, all the conditions to the issue of the Bonds as set out in the Subscription Agreement were satisfied and the issue of the Bonds was closed. The Bonds were listed on the Hong Kong Stock Exchange on July 7, 2017. Details of the Subscription Agreement are stated in the Company’s announcements dated June 27, 2017 and July 6, 2017.

This differs in one key respect from the 2014 disclosure. China National Gold is not a party to the subscription agreement.

The press releases dated June 27, 2017 is here (original here).

The press releases dated July 6, 2017 is here (original here).

Here again is the opening paragraph of the first release.

VANCOUVER, June 27, 2017 – The Board of Directors of China Gold International Resources Corp. Ltd. (TSX: CGG; HKEx: 2099) (the “Company”, the “Guarantor” or “China Gold International Resources”) is pleased to announce that on June 27, 2017, the Company, its wholly-owned subsidiary, Skyland Mining (BVI) Limited (the “Issuer”) and Joint Lead Managers as defined below, have entered into a subscription agreement (the “Subscription Agreement”) pursuant to which the Issuer has agreed to issue to the Joint Lead Managers, and the Joint Lead Managers have agreed, severally and not jointly, to subscribe for bonds (the “Offer”) in an aggregate principal amount of US$500 million (equivalent to approximately HK$3.88 billion) at an issue price of 99.663% (the “Bonds”) bearing interest at the rate of 3.25% with a maturity date of July 6, 2020, rated BBB- by Standard & Poor’s.

You will note that China National Gold appears nowhere in this. The "Keepwell" has disappeared. China National Gold is not mentioned in either release.

Again CapitalIQ has a page on this bond (here) and if you have a subscription you can download a longer-form offering document. I have saved it here.

Again it contains no reference to China National Gold or to a Keepwell agreement.

Bloomberg isn't right here - but it turns out it is not unequivocally wrong

Bloomberg is pretty unequivocal - the 2017 bond expiring in early July this year has a letter of support from China National Gold.

But that letter of support does not exist in China Gold International's own press releases.

Bloomberg however is a pretty reliable source normally and so after much scrounging we actually got a copy of the offering document from one of the original brokers. You can find it here.

This offering document lays out what is meant by the letter of support - because yes - there is a letter of support from China National Gold.

The Letter of Support is neither legally binding nor a guarantee, and the Company is not legally obliged to support the Issuer and the Guarantor in the manner contemplated in the Letter of Support. 

The Letter of Support is not legally binding on the Company [which in this case is the SOE]. See “Summary of Letter of Support”. It is not a guarantee by the Company for the payment obligations of the Issuer under the Bonds or the Guarantor under the Guarantee, and there is no assurance that the Company will provide support to the Guarantor in the manner contemplated in the Letter of Support. The Trustee will not, in any circumstances, be able to bring any action against the Company to enforce the provisions of the Letter of Support. Even if the Company intends to provide direct financial support to the Guarantor to meet its outstanding debt obligations, such financial support may be subject to governmental approvals which may not be obtained.

They go on in the offering documents. All it says is that China Gold International occupies a strategic position in the China National Gold group. And hence it is likely that China National Gold will support the debt. It is a non-guarantee guarantee.

Now those 2017 bonds are about to expire (early July this year) and so China Gold International needs to refinance them.

And it is fair to say that the underlying gold mines have sharply underperformed expectations in those three years with the company producing losses in both 2018 and 2019.

China Gold International are cumulatively unprofitable reverse merger with over a billion USD in debt and a collapsed stock price. They are not repaying the money unless someone lends them another cool half billion.

But as they have to come to market they are trying to come to market.

There is a press release in Chinese that explains that they are coming to market for a debt issue of unspecified size. The press release mentions a letter of support from China National Gold but no mention as to whether this letter is a guarantee (as per the 2014 debt issue) or a prop with no legal power (as per the 2017 debt issue).

I guess if there were legally binding state guarantee as per the 2014 issue then there should be no problems getting this done. I guess this is a test of what is required get a deal done.

But as it stands this is a test if a company which barely trades at all and with a collapsed stock and some sharply underperforming gold mines can raise a half billion dollars supported by what appears to be a fictional quasi-government guarantee.

But in this market even that seems likely. As long as it yields over 100 bps. Long live loose monetary policy.





John

Disclosure: we have no position in the stock. We have a small position short the bonds.

Open letter to Institutional Investor Magazine

Last night Australian time Institutional Investor published a piece on Bronte Capital's position in Herbalife.

To quote the opening sentence:

Australian hedge fund manager John Hempton, the co-founder of Bronte Capital, has turned out to be a true believer in Herbalife, the controversial multilevel marketing company that has been under investigation by one federal agency or another for several years. Over the past year, Hempton doubled down on Herbalife...

I observed on twitter that contrary to standard journalism ethics the author (Michelle Celarier) did not seek our comment before publishing.

She told me to check my email. So I did. Ms Celarier did in fact send something.

Here it is:

Michelle Celarier
01:15 (12 hours ago)

Hi John 

I am writing a news story for Institutional Investor about your investment in Herbalife, as you disclosed updated filings for the quarter.   

I note that you've been adding to your position over the past year, according to the SEC. 

I also quote from your recent letter about Herbalife-- and note your performance this calendar year. 

Just wanted to let you know about this. I'm on deadline, so if you have further comment please respond asap. 

Thank you 

Michelle

Michelle Celarier
michellecelarier.com
917 971 0279
m.celarier@gmail.com 

Follow me on twitter @mcelarier

You will notice that this came at 1.15AM Australian time. It came when I was (and could reasonably be expected to be asleep). The story was published before I woke up at approximately 6AM.

This is a clear breach of journalist ethics. But it is also sloppy and demonstrates what happens when you do not check your facts.

There are two reasons our Herbalife position has increased.

a). Our fund was closed and it re-opened. We got considerable flows. We adjusted the Herbalife position to match the flows.

b). We sold a large position in the 50s (when Bill Ackman covered) and we repurchased it (and then some) at lower prices.

The second one is instructive. If you sell a $1000 worth of Herbalife stock at $53 and buy it back at $27 you will wind up with more Herbalife stock. (This trade matches some of what actually happened in our book.)

For these reasons our Herbalife stock position (measured in number of shares) has increased considerably.

But the position measured in the percentage of the fund at cost has actually shrunk. We did not "double-down" as the article suggests - we actually took some off the table.

The article is false and should be withdrawn.

The statement that we doubled-down is contrary to both our risk management policy and what actually happened.

That said: for the record we still think the stock is a good value at this price. We have a full-sized position now (or we would buy more). But that is not a newsworthy story. The only story Michelle Celarier has is that a fund manager is bullish about a stock they own.





John Hempton

Watch what the Chinese do

I don't easily believe Chinese statistics - especially regarding something as awful as COVID-19. Believe your eyes and common sense over Chinese statistics.

When China (officially) had 19 deaths they started building massive field hospitals. Believe what you see (the hospitals) but take the 19 deaths as a rather dubious estimate (as per that time).

By contrast when the Chinese Government say COVID-19 is highly controlled in China you can believe them because there are Westerners and Western companies throughout China and what you can see (Shanghai and Chongqing as functional cities) comports with the statements and the actions of the Chinese Government.

My general view: watch what the Chinese Government does - rather than what they say.

This is a story about journalists returning to their home in Beijing before a Government crackdown on foreigners. 

Watch it.

You can see the Chinese take COVID-19 very seriously indeed.

We can conclude that

a. The Chinese have seen the virus. They think they know what it can do. They are scared. Do not believe the Chinese numbers. The truth is much worse. But believe the Chinese actions. They think fear is appropriate.

b. The Chinese have proven that a super-hard lockdown lasting seven weeks in affected areas 2.5 weeks in Shanghai etc can work. Their major cities have low virus load and major Western cities have not.

c. The Chinese Government are super-scared of reintroducing it.





John

Coronavirus – getting angry

I am going to give you a few stylised facts about severe acute respiratory syndrome coronavirus 2 and the data.

First – no matter what you say about the Chinese data – and the Chinese data was full of lies at first – China has controlled the outbreak. Shanghai, Beijing, Chongqing are all functional mega-cities with no obvious health catastrophes.

The virus has been managed to very low infection rates in Singapore and Taiwan. The numbers (completely real) in Korea show a dramatic slowdown in infection.

Korea has not shut restaurants and the like. The place is functioning. But it has had rigorous quarantine of the infected and very widespread testing. It has complete social buy-in.

China tests your temperature when you get on a bus or a train. It tests you when you go into a classroom, it tests you when you enter a building. There is rigorous and enforced quarantine.

But life goes on – and only a few are dying.

In Singapore nobody has died (yet) though I expect a handful to do so before this over. This is sad (especially for the affected families) but it is not a mega-catastrophe.

There is a story in the Financial Times about a town in the middle of the hot-zone in Italy where they have enforced quarantine and tested everyone in the town twice. They have no cases.

The second stylized fact – mortality differs by availability of hospital beds

A.    Coronavirus provided you do not run out of hospital beds probably has a mortality of about 1 percent. In a population that is very old (such as some areas in Italy) the mortality will be higher. In a population that is very young base mortality should be lower. Also co-morbidities such as smoking matter.

B.    If you run out of ICU beds (ventilators/forced oxygen) every incremental person who needs a ventilator dies. This probably takes your mortality to two percent.

C.     Beyond that a lot of people get a pneumonia that would benefit from supplemental oxygen. If you run out of hospital beds many of these people also die. Your mortality edges higher - but the only working case we have is Iran and you can't trust their data. That said a lot of young people require supplementary oxygen and will die. If you are 40 and you think this does not apply to you then you are wrong. Mass infection may kill you. Iran has said that 15 percent of their dead are below 40. 

I will put this in an American perspective with a 70 percent strike rate by the end.

Option A: 2 million dead

Option B: 4 million dead

Option C: maybe 6 million dead.

By contrast, Singapore: a handful of dead.

China has demonstrated this virus can be controlled. The town in Italy has demonstrated it can be controlled even where it is rife.

Life goes on in Singapore. Schools are open. Restaurants are open in Korea.

The right policy is not “herd immunity” or even “flattening the curve”. The right policy is to try to eliminate as many cases as possible and to strictly control and test to keep cases to a bare minimum for maybe 18 months while a vaccine is produced.

The alternative is literally millions of people dying completely unnecessarily.

What is required is a very sharp lockdown to get R_o well below one – and put the virus into exponential decay.

When the numbers are low enough – say six weeks – you let the quarantine off – but with Asian style monitoring. Everyone has their temperature measured regularly. Quarantine is rigid and enforced. You hand your phone over if you are infected and your travel routes and your contacts are bureaucratically reconstructed (as is done in Singapore). And we get through.

And in a while the scientists save us with a vaccine.

The economic costs will be much lower. Indeed life in three months will be approximately normal.

The social costs will be much lower.

Every crisis has its underlying source. And you want to throw as much resources (and then some) close to the source. Everything else is peripheral.

The last crisis was a monetary crisis and it had a monetary solution.

This is a virus crisis and it has a virology solution.

Asian Governments are not inherently superior to ours – but they have done a much better job of it than ours. The end death toll in China (probably much higher than stated) will wind up much smaller than the Western death tolls. I do not understand our idiocy.

John


PS. Longtime followers of this blog will know that I have rarely publicly agreed with Bill Ackman. I do here. This minimises economic and social cost of the virus. I am not sure the stock market bounces hard with a rational policy, only that it minimises the damage.

I regard the current course of English speaking democracies (other than New Zealand) as mass murder by the political elite. I think history will regard it that way too.

Coronavirus is more popular than sex (except in South Africa)

I was wanting a way of judging just how serious the coronavirus outbreak is in Iran. Alas government figures are not to be trusted. And figures from other sources - mostly anti-government blogs and the like - are also not to be trusted (as they have an agenda).

I went for the old fall-back. Google Trends.

Here is the google trends for coronavirus in Iran. It is clearly skyrocketing.

Okay - but this does not help me. I needed something to judge it against.

I figured that it would need to be something that was searched for a lot. So I went for the staple: sex.

Here is coronavirus vs sex in Iran.

I am beginning to conclude that coronavirus is more popular than sex (at least as a search topic).

It sounds pretty serious.

So I thought I should benchmark it.

I figured the British are likely to be big searchers of sex. Maybe I am mistaken - but there seems something desperately English-schoolboy about googling "sex".

Yep - coronavirus is more popular than sex in the UK too.

And so it was with almost every jurisdiction I tried.

Except South Africa.

Sex is more popular than coronavirus in South Africa.

Is that because the South Africans are really into sex or that they are not scared of coronavirus?

I have no idea.

Not all research is productive.





John

Pretium Resources: short memory

This post requires correction/clarification.

There are at dozens of press reports that state the mining accident happened at the Brucejack Mine. See here for example. 

However some reports (and some supporters of the company) state the accident happened to a mine worker at the mining camp.

This is supported by the production statistics - which did not show a major interruption at the time.
The company has never met it grade requirements - or at least the grade as outlined in the original mining plan. But it has usually (if not always) met the tonnage plan (as in tonnes mined).

There was no large interruption.

Further correction. The 2018 first conference call explicitly says the accident happened at camp and not at the mine.



The old post



I am not going to comment about the results of Pretium Resources. But the first few sentences of the conference call made me sick. To quote:

Joseph J. Ovsenek CEO, President & Director 

Good morning, everyone. Welcome to our 2019 results and 2020 outlook call. Participating on the call with me today is our CFO, Tom Yip. 

First and foremost, I again want to thank everyone at Brucejack, Smithers and here in Vancouver for their hard work that contributed to another profitable quarter. Our Brucejack Mine has proven itself to be a safe and a consistently profitable mine ever since achieving commercial production 2.5 years ago. 

Now mining accidents happen. Mining is a dangerous profession.

But Pretium had a death at the mine less than two years ago. Which of course proves the mine is "safe".

https://www.bclocalnews.com/news/smithers-man-dies-at-brucejack-mine/

Maybe this is a definition of "safe" that I was not previously familiar with.

If you die working for these guys they will soon forget it and forget you. And of course declare your workplace to be "safe and consistently profitable".




John

A MiFID solution that works

We had troubles getting brokers to organise us meetings with management and/or past staff or customers. This is a core to the research process at Bronte (and should be core to your process too). MiFID made this harder as the brokers in Europe wanted to get paid for their (inferior) introduction services.

We found a solution. Kate Pike.

Kate used to work at Morgan Stanley in London and whilst there she was the best corporate access person we ever used. Then - for perfectly understandable reasons - she moved back to Australia. So we decided to give her a day and a half a week doing our corporate relations (and other stuff).

Fabulous does not begin to describe it.

To give an example: we were interested in a company that sold trace ingredients in fish feed for salmon farms. Without any fuss (though probably with huge hidden effort) Kate got us a phone meeting with the purchasing manager of Biomar. Biomar is the largest fish-feed maker in the world. The Biomar guy knew the prices and competitive landscape in every trace ingredient. This is the sort of meeting you pay an expert network tens of thousands dollars for.

And Kate does it for us on a relatively modest salary a day a half a week. And she is so cheerful about it too.

Not only is Kate fabulous - but she accepts pay in Australian dollars. These Pacific Peso expenses should be just fine for a New York based fund.

I am putting this advert out with vested self-interest in mind. If Kate finds enough work to fill the rest of her week (and pay for private school fees) then we reduce the risk that she goes elsewhere.

So please somebody - hire her. This is a global offer. Time zones work very well for an American based hedge fund for instance.

And did I mention Kate is wonderful.



John

PS - contact her at kate@brontecapital.com

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

Thinking aloud about bank margins - Part 2

Part 1 of this series laid out a bleak future for monetary policy and/or banks. As interest rates go down so do bank margins and there are limits on how far interest rates can be cut because eventually they take bank margins below levels adequate to cover losses or even below levels adequate to covering operating costs.

If this is right ultra-low interest rates are non-stimulative because they stress the bank sector causing the bank sector to tighten (not loosen) lending. Monetary policy hits a wall of non-effectiveness and ultimately bank bail-outs.

This is essentially the Raoul Pal view of the world. He sees no policy way out of the next recession -particularly in Europe - because if you don't cut rates you are stuffed and if you do cut rates you blow up the banks and you are stuffed anyway.

--

As I said at the end of the last post I am not sure it is always so simple and/or so bleak. That is because ultimately there are two drivers of margins a weak one (Central Bank policy) and a strong one (the competitive landscape the banks face).

In Europe both of these are driving bank margins down for most but not all banks. But it doesn't need to be that way and more deft policy-makers have different options.

But to see why need to run you through a stylised history of banking margins.

Lloyds bank as the best bank in the world

Just over twenty one years ago The Economist wrote a glowing article about what was then a roll-up of British High Street banks. It was Lloyds TSB.

A glowing article about Lloyds seems peculiar now as the bank was bailed out in the crisis and has lurched from disaster to disaster ever since. But under the title of The Lloyds Money Machine the economist wrote the following:

... Lloyds TSB runs head-on into a problem that most other banks would envy: it simply earns too much money. By some estimates the bank is sitting on £3 billion more than it needs. It would gladly use this for acquisitions. But short of buying another big British bank and closing down hundreds of branches, which would almost certainly be blocked on competition grounds, it is difficult to imagine an acquisition that would be as profitable as Lloyds TSB's current business.

The bank had fat margins and was busy cutting costs. The article goes on:

Peter Ellwood, former boss of TSB and now group chief executive, believes that even without further acquisitions the bank can continue its impressive run by cutting more flab and by persuading its existing customers to buy more of its products. Costs have already been brought down to 52% of income, a low figure for such a large bank. Once Lloyds and TSB are allowed to merge, analysts at Dresdner Kleinwort Benson reckon, the bank could shut more than 800 branches without weakening its high-street coverage, thus saving up to £300m a year. Along with these savings will come proceeds from the sale of businesses that underperform. The bank is seeking to sell Black Horse, its estate-agency arm. Its small Latin American banking and consumer-finance network may follow.*

At the time Lloyds was the thirty-fifth biggest bank in the world by assets but the biggest by market capitalisation. It was hyper-profitable and traded at a svelte seven times book.

And then it all went horribly wrong. The bank took only a decade to be nationalised.

What went wrong was competition. At the time Lloyds revenue to risk weighted assets was 8 percent. This was the highest number I have ever seen on a major bank anywhere.

These fat margins attracted competition mostly in the form of Northern Rock and Fred Goodwin's Royal Bank of Scotland behemoth. These guys never saw a loan they didn't want to undercut. Revenue to risk weighted assets in British banks went down by 75 percent. If you do it as a percentage of assets revenue as a percentage of assets fell from over 5 to about 2.

The point of this is that this happened in a non-zero interest rate environment. Competition killed margins and excessive willingness to write loans meant that margins were destroyed just as credit losses ticked up. You can find a full set of Lloyds accounts from CapitalIQ downloaded here.

German (and Italian and Japanese) banking margins have been terrible as long as I have looked at banks. In both markets there was strong competition and a shortage of borrowers (at least relatively). Also in Germany there were aggressive Landesbanken who fulfilled the margin compressing role of RBS. It is kinda-nice when you fund yourself with a quasi German government guarantee. It is not nice to compete against someone who has a German government guarantee.

By contrast the oligopoly banks of Australia and Canada have made lots of money with a good economy despite being breathtakingly stupid. In banking - as in other industries - you make money out of market structure as much as anything.

Before everyone stuffed around with the definition of risk-weighted assets I used to compare revenue to risk-weighted assets by country. These are still roughly right in terms of profitability,

• The thinnest margin banks in the world were Japanese with revenue to risk weighted assets of about 1 percent.
• Then were the Germans and the Italians at about 2 percent
• The Americans were in the middle - between 4.5 and 5.5 percent with a single outlier - the most effective major bank at screwing their customers in America - and that was Wells Fargo. Wells Fargo was about 6 percent.
• Then there were the highly oligopolistic Canadians at 6-6.5 percent.
• Finally - the fattest margin banks in the world were Australians. And that was at 8 percent. 

Our friends at Lloyds went from 8 percent at the time of the article to something in the mid 2s now. The world wasn't quite turning Japanese - but maybe turning German.

But there are outliers - and some of them are surprising. The Irish Banks look in Ireland pretty darn profitable. The Scandinavian banks are alright too - despite (say) Swedish interest rates going negative before everyone else.

Even some French regional banks are okay.

And these banks are profitable even in a negative interest rate world.

Swedish banks faced negative rate early - and they came out kind of well.

If central bank policy is going to work the central bankers are going to need to learn from the banks that have maintained reasonable profitability in the face of negative rates. This may be the single most important lesson for central bankers in the next decade.

If I knew all the lessons I would tell you. I don't. I know several of the outlier banks but nailing down quite why they are outliers is hard. But I will look for you.

Till next time when I will have a look at the outlier-banks.





John

PS. Whilst for years I used revenue to risk weighted assets as a measure of profitability it doesn't work that well anymore because of changes in the definition of a risk weighted asset. For the next post I just intend on using revenue to total assets. It tells the story well enough.

*For the record the (retrospective) silliness of that Peter Ellwood quote didn't seem to hurt him later in his career. He got his knighthood somewhat later.