Babcock's shadow over Everest

Just as the severity of Babcock & Brown's problems are being revealed to the market (the investment bank fell by nearly 30% yesterday and another 30% today, June 13), it has emerged that the hedge fund group Everest Babock & Brown (EBB) has substantial loans to the bank; in fact all of its loan portfolio is to other arms of the Babcock & Brown empire.

And what sort of interest rates is the Everest funds group paying for the debt on such ventures as the redevelopment of Melbourne’s Royal Children’s Hospital and US residential real estate? “Mid to high teens,” says Jeremy Reid, Everest Babcock & Brown’s chief executive and a recent departure from the BRW Rich 200.

Reid would know the numbers keenly. It turns out that his piece of the Babcock & Brown jigsaw has some $432 million out on loan to other members of the puzzle.

You might think paying those sorts of interest rates would make it rather difficult to turn a profit. They would have to be very good deals indeed.

Not that investors in the Everest Babock & Brown Alternative Investment Trust (EBI) might realise they have such a large debt exposure to Babcock & Brown projects. A presentation and speech at the EBI annual general meeting two weeks certainly talks about “direct investments”: 16% of the $2.7 billion held in the trust, or 18% of the active investments, if you discount the amount held in cash.

Flick to page nine of the chairman’s address and you’ll see a nice slide about “direct investments”, noting that they’re “investment in 'real’ assets; eg, essential services”. The top five “direct investments” are listed as:

• TAHL $US$27.4 million
• Hospital PPP $US22.8 million
• Coogee Resources US$16 million
• B&B Apartment Investment Trust US$15.5 million
• European Ports US$14 million

There are obviously a lot more to make up 18% of the total EBI portfolio. And every one of them is a loan to a Babcock & Brown entity. That’s the Babcock & Brown that’s been monstered by the market every day this week, along with all its satellites.

The EBI AGM was short without a single question from the floor, but Stephen Mayne’s report of the Everest Babcock & Brown AGM (EBB manages EBI) gives the impression there was some critical discussion about EBI’s exposure to the BNB’s troubled Royal Children’s Hospital. One wonders whether investors at the recent annual meeting might have asked more questions if they had realised just how close EBB/EBI was to Babcock & Brown which, through various entities, owns 28.3% of EBB.

The sort of interest rates Babcock & Brown entities now pay and the extent of loans to the group by EBI were disclosed by Jeremy Reid in our interview conducted on Wednesday, before the worst of the Babcock share price plunges.

As you can see from the following transcript, Reid strongly defends the relationship with the Babcock empire and the loans EBI makes to it.

He also outlines an automatic buy-back scheme EBI intends to implement to lift its share price closer to its net tangible asset figure. He believes the rest of the Australian listed investment company sector will follow suit.

Reid is an unusual chief executive. He’s young (31), having founded Everest with family money to specialise as a fund-of-hedge funds investment vehicle. He jumped on to the BRW Rich 200 last year on the back of his 18% stake in EBB '¦ and fell off it this year.

To judge for yourself what might be impacting the EBB and EBI prices, read on:

The interview

Michael Pascoe: Absolute return funds are meant to do best when the overall market doesn’t, yet Everest Babcock & Brown is having trouble. Why?

Jeremy Reid (right): I wouldn’t say that Everest Babcock & Brown is having trouble. There are two things to distinguish between. EBB, Everest Babcock & Brown, is the management company, which has a management contract with the various funds that we manage. We have about $2.7 billion of assets under management. EBI, the Everest Babcock & Brown Alternative Investment Trust, is one of our listed investment vehicles, which focuses on allocating its capital to approximately 25 world-class leading absolute return funds.

Coming up to June 30, it looks like our performance for the financial year will be flat to possibly negative a couple of percent. In light of everything that’s happened within global financial markets, for us to deliver a return which in essence has protected our capital and set us up very attractively to take advantages of opportunities going forward, it is a pretty good place to be.

Obviously we’re disappointed that we haven’t generated a positive return over this period. We have our own money invested alongside our investors. They’re obviously looking to generate positive returns but that being said, if your balance sheet or most of your balance sheets are as good today as 12 months ago, I think you’re in a pretty good shape and the EBI balance sheet is in a pretty good shape.

Let’s take those two entities separately. Everest Babcock & Brown has funds under management of some $2.7 billion but that’s down from about $3.3 billion this time last year.

That $3.3 billion includes unutilised debt capacity where we earned fees and it also includes uncalled capital on a couple of the private equity-style funds that we have as well. So that $2.7 billion number would be closer to $3 billion if you included those two factors. So from a fee earning asset base we’re down from $3 billion to about $2.7 billion.

And the share price has well pretty well crashed, from $1.10 to about 40¢ today. Why do you think that is?

I think there’s clearly been multiple contractions in asset management groups. A lot of these businesses, including ours, have grown at very attractive rates. In the current environment one has to be realistic about sustaining that sort of growth rate, although we think there is very good upside for us, particularly in institutional allocations to absolute return funds. A lot of these vehicles are trading at attractive multiples and, like any market correction, it spits out a lot of opportunities. We would obviously put ourselves in that camp of being attractively priced at the moment.

Has the Babcock & Brown name become a disadvantage?

I don’t think so. It depends on your time horizon. That clearly goes to their own issues at the moment like most financial services businesses. I’m in this for the long term and they are a great long-term partner.

You issued a lot of shares to Babcock & Brown partly for the use of their name, for their deal flow, yet at the moment everything with Babcock & Brown in it is selling at a discount.

Yeah. One needs to distinguish between what’s happening in the listed markets and what’s happening with the intrinsic value of the underlying assets. I don’t want to comment on the Babcock & Brown business, but I will say that a lot of their underlying assets, both in their listed funds and unlisted assets on their balance sheet are world-class monopoly assets with very high barriers to entry and very steady cash flows, and they’re the transactions that we’re looking to either equity co-invest with or be a support and debt lender into and we think those assets are first-class.

In this climate, the valuation of all those assets can be a very prickly issue. With Everest Babcock & Brown’s balance sheet, how much of your asset base are intangibles that are open to question?

Everest Babcock & Brown currently has no investments on its balance sheet. It’s got no debt either and we’re sitting with positive cash of about $10 million. So we do not do any investments via our balance sheet at this stage. We do, however, have within our funds a number of loans to Babcock & Brown entities. We have a particular fund that’s been set up to support our debt lending typically to Babcock & Brown. They go through a regular impairment process. And we have an equity co-investment vehicle, which also co-invests alongside Babcock & Brown balance sheet. As they are originating new transactions, we sit on their balance sheet and likewise that goes through an annual audit and a regular impairment test on the valuation.

What sort of impairments are you looking at then on those loans at the moment?

We’re looking at things that, I guess, any lender would be looking at. We’re looking at kind of the ability to sell the assets into the market; what the mark to market price would be. We’re looking at cash flows of the businesses; we’re looking at the business case and ensuring that’s still intact and is exceeding or delivering on expectations. We’re looking at ratios, its interest and debt covenant ratios and other various ratios in their businesses, just to ensure that the assets are performing in line with expectations.

Just given the general principles of good governance and arm’s length relationships or not, are you getting extraordinarily good interest rates on loans to Babcock & Brown entities or just market rates?

Market rates, because Babcock & Brown at the end of the day is a commercial business and they’re now looking for debt. They’re pricing us against other competitors in the marketplace so we need to ensure that our capital is competitive at all times otherwise they will go elsewhere for the debt.

But from your point of view, from the question mark over the Babcock & Brown name, from the questions it raises about who are you really dealing with when you do business with either EBI or EBB – has it been worth the candle?

I’d say so. There’s a lot of value we derive out of our relationship that isn’t just about deal flow. There’s strategic advice. There’s mentoring. There are clearly introductions to various parties on a global scale. There’s assistance in due diligence that we do on the fund-of-funds business where certain principals are familiar with individuals, have dealt with them in the past. There’s a lot of intangible benefits that we use through our relationship that we think make us a better business.

Well, among the investments that EBI has made, you’ve got $15.5 million in the Babcock & Brown US residential real estate investment. What’s the valuation on that now?

That actual asset is performing exceptionally well and if you think about the counter-cyclical nature of BNB’s investment there, you’re seeing a number of people in default on mortgages having to move out from their homes and ultimately they’re going to be renting. Rental rates were at historic lows and home ownership rates going back two years ago were at historic highs and my understanding is that BNB had a counter-cyclical view at that time saying that home ownership rates in the US would drop and rental rates would increase and that’s exactly what’s happened. As a result of it, they were ahead of the curve and very well positioned to take advantage of that market. So we’ve been very happy with that investment.

Well, the question stands. They bought residential real estate in the US at the top of the market a couple of years ago. What are you carrying that investment in your books at now? What’s the asset value worth of that residential real estate in EBI’s books?

It’s held at cost and we are actually in the process now of being repaid, so that investment has been a very good investment. Our loan’s up for maturity and we are literally as we speak, being repaid.

Is that just a loan? I thought you actually had an equity investment.

No, just debt.

I thought in your annual report it was showing up as $15.5 million in Babcock & Brown’s Apartment Investment Trust.

No it’s debt against those residential homes.

You weren’t concerned when Babcock & Brown revalued upwards their residential real estate investment by $100 million, by about 10%, in their last accounts?

If you say so. I’m not aware of that.

I just want to clarify something. I’ve got the chairman’s AGM presentation. In the slide that shows the current portfolio for EBI direct investments, it lists the top five. It doesn’t say whether they are loans or equity investments. Should that be spelt out?

They are all debt investments.

So they’re all debt?

Good point. I’ll make sure that next time we do a presentation that’s specified.

So in terms of breaking down your portfolio, there’s actually no direct equity investment?

Correct. We are very attracted to the support-added debt lending space at the moment. Obviously banks are pulling back on their lending. Asset prices have come down. The banks are more conservative on their loan to value ratios (LVRs) so equity sponsors are having to put more equity in and spreads have blown out, so we’re getting paid very handsomely on our debt. We think that’s actually a very attractive business right now in the cycle. Over the past three or four years the borrowers had all the bargaining power as lenders have jumped over themselves, in our view stupidly, to lend money. Now all of a sudden the lenders have all the power and are demanding much better terms, much better ratios, demanding more equity below them and are lending at much lower LVRs and getting much better paid for it.

So 18% of EBI is a corporate lending business?

Correct. If we can lend money at mid to high teens and be very well secured against solid infrastructure cash flow type businesses, we are very comfortable with that.

How much of that 18% is to Babcock & Brown-related entities?

It’s actually all.

The whole 18%. Do you think that is nicely transparent? It’s good governance?

We have an independent investment body that oversees '¦

Who’s that?

Internally within Everest.

So it’s independent internally in a mob that’s part of the Babcock empire?

Well I would not say that we are part of the Babcock empire per se. Babcock & Brown are clearly substantial shareholders in our business but we are independent thinkers. We have a lot of my own family money invested in the Everest business and in everything that we do, and first and foremost we want to ensure that our capital and our investors’ capital is well looked after and invested in an appropriate way. Everything that we do is audited independently and everything we do is always looked at from a risk/return perspective.

It’s just that all the money you lend happens to be to Babcock & Brown entities – 18% of the trust.

We do look at third-party transactions. We have done third-party transactions in the past, so we’re not exclusively to Babcock & Brown by any means, but when we weigh up our investment options from a risk/reward perspective, we get much better transparency from Babcock & Brown.

You’re also in the process of introducing an automatic buyback facility to underpin the EBI share price – a proposal to introduce a buyback of 10% should the price fall 10% below the NTA and that buyback would be at a 5% discount to the NTA.

Correct.

One way of looking at that philosophically is: you’re going to use your investors’ funds for a 5% return. Shouldn’t you be able to do better with that capital invested in absolute return funds?

I think that’s a good point. It’s a tradeoff between ensuring that our vehicle trades well in the market and our ability to generate attractive long-term risk- adjustment returns. We’re basing our model on the UK experience where there’s a number of listed funded hedge funds that all trade at approximately negative 3% and positive 3% spread on their NTA, and they have similar discount control mechanisms in place. What we are expecting as a result of this discount control mechanism, the unit price of EBI will track closer to its NTA and as a result of it you are less likely to have to actually use or exercise your buyback position. That’s the experience in the UK and we hope it will be a similar experience in Australia. What we also expect is that other listed investment companies will follow suit and as a result of that, as an industry we will trade a lot better and a lot closer to our NTA, like what happens in the UK.

You don’t think you could use that capital to get a bigger return for your investors than just propping up your own share price if you took a medium or long term view?

In the medium to long term, I think once our share price is trading closer to its NTA, ultimately it’s going to be good performance that will prevail. We will look to expand the capital base again and take advantage of good trading and a good structure to generate long-term attractive returns, but right now we feel it’s important to ensure that our shareholders are looked after in the short term and in the long term.