All wrong at Allco

The latest unpleasant moment in a escalating series of unpleasant moments came on Wednesday, when two margin lenders lost their nerve and dumped 22 million shares in the group founded by John Kinghorn (more recently of RAMS Home Loans fame) and which Coe and the other nine principals continued to build over nearly three decades. The sales, which generated less than $60 million from shares once worth about $300 million, drove Allco shares to record lows.

While Coe and his fellow principals are to some degree victims of current market circumstances they are not alone, with plenty of senior executives being hit by margin calls. Their experience is exacerbated by the unusual structure of their group and by the unfortunate timing of the severe market downturn, which has overwhelmed a group in transition.

For most of its history Allco has been a privately-owned, highly-successful business specialising in large and complex cross-border leasing. While they had dabbled with using public funds to support the growth of their business, it wasn't until 2001 that the Allco team decided to seriously tap the market, floating Record Investments as a captive funding vehicle. Some of the current problems of the principals, as opposed the Allco itself, stem from mistakes made with the detail of that float and the remedial actions the principals were forced to make.

A major problem for the principals was that Record was astonishingly successful. Within a few years of listing it value had soared from less than $200 million to more than $1 billion. Their mistake was that they owned less than 10 per cent of the company but provided its management free, absorbed its expenses and had given the vehicle first right of refusal over all the transactions Allco originated. It couldn't do anything independently without Record's approval.

That eventually led to a collision with Record's chairman, former Macquarie Bank chief executive Tony Berg, which ended with a renegotiation of the agreement in 2005 and Record issuing $158 million of shares to an unlisted vehicle, the Allco Principals Trust (APT). This lifted the principal's stake to about 25 per cent. Berg departed and the principals controlled Record – they now had a very big slice of the action.

To fund their increased investment, the partner used another vehicle, Allco Hybrid Investment Trust (HIT), which issued $250 million of hybrid securities to investors, with most of the proceeds being invested in mezzanine funding for APT. The rest was earmarked for co-investment with Allco in deals it originated.

While the truce agreement with Record created better alignment of interest, the market still mistrusted the relationship so in 2006 Coe decided to use Record as the vehicle for a backdoor listing of the Allco group to create an integrated investment bank like Macquarie or Babcock & Brown. Allco created funds for third party investors, adding annuity streams from managing them to its origination capabilities.

When the sub-prime crisis hit last year, Allco was hit hard, along with, to a lesser degree, Macquarie and Babcock. Not only are these vehicles leveraged, rather opaque and reliant on continuing to tap markets for new funds to build their fee income streams, but Allco had some peculiar issues of its own.

It had recently failed in its high-profile attempt to lead the private equity bid for Qantas, which disconcerted and confused investors, and was still in transition from a privately-owned structured finance business, albeit a very successful one, to its new funds management model. The transition from a private partnership between the principals to a more transparent listed entity is still a work-in-progress.

Last year's high-priced takeover of the Rubicon property group, with close links to Allco, Coe and Allco director and Rubicon's founder, Gordon Fell, created controversy in the market and added to Allco's vulnerability.

There doesn't appear to be much wrong with Allco itself. Its underlying assets are, ultimately, planes, trains, ships, property and infrastructure – all in short supply in a supply-constrained environment. Those asset classes will still need to be financed, even in a post-sub-prime economic environment.

However, as fellow Spectator Alan Kohler has explained, Allco was one of a number of stocks with a heavy hedge fund presence on its register because they are favoured by margin lenders. When the hedge funds dumped Allco shares the price tumbled and triggered a margin call of its own on APT.

Two of its four margin lenders sold their security – about half APT's Allco holdings – while the remaining two, including National Australia Bank, are in negotiations with APT over a standstill agreement that would protect both parties from crystallising more firesale losses by offloading the remaining shares in the current environment.

The recovery in Allco's share price (it was up 65c to $2.86, still a far cry from its peak of $13.24 a share in February last year) will offer a tiny bit of hope that they can hang on until Allco's performance provides some reassurance to the market that it is within the principals' own funding structure, not any issues within Allco itself, that the problem lies. The principals will also hope that all the hedge funds have now fled and a more balanced market in Allco's shares will emerge.

The Allco principals, however, aren't yet out of the woods. When HIT issued its hybrid securities the effective security was provided not only by the Allco shares in APT but by a charge over a further 8.9 million shares and 4.8 million shares in HIT itself held by the principals.

HIT has now revealed that the principals provided more security in December last year, adding another 20.1 million Allco shares to secure some of the margin loans. Having already had about six per cent of Allco sold from under them by the margin lenders, they have another 52.8 million shares, or more than 14 per cent of Allco (as well as other assets) still at risk within APT.

The forced extra investment in Record to bring the recalcitrant offshoot into line in 2005 paid off spectacularly for a while as Allco's share price rocketed. At its peak the paper value of the shares that have been sold and those still held or pledged as support for the margin loans was about $1 billion.

Today the remaining shares are worth about $150 million. APT's debt is said to be more than $700 million, so all of the principals' experience and expertise in complex financings will be called on if they are to escape their lenders' clutches and salvage some value for themselves from the APT structure.