Time to be a debt detective

The size of a company's debt isn't the only thing that matters. Godfrey's Group and iCar Asia shareholders take note: to whom the debt is owed is just as important.

Question: What’s worse than an indebted small company?

Answer: An indebted small company where the debt is owed to its major shareholder.

Perhaps this trend has been around for a while, but lately it seems to have become more common. If you’re a small shareholder in an indebted company, we recommend you watch out for major shareholders lending to listed companies. The problem is all to do with incentives.

When you’re a shareholder – and just a shareholder – you naturally want the company to perform well. Controlling ‘owner-manager’ shareholders are frequently good stewards of a company’s capital because they bring a rational, long-term focus (although not in all cases).

Changed incentives

However, the incentives change markedly when the major shareholder also becomes a debtholder. Perversely, it could even be in the major shareholder’s interest to run the company into the ground. If the company ends up failing, the debtholder is usually in prime position to pick up the assets cheaply.

Take Godfrey’s Group (ASX: GFY), a retailer of vacuum cleaners (but not the brands anyone wants, apparently). Colleague Alex Hughes considered the stock for the InvestSMART Australian Small Companies Fund last year (see Godfrey’s: multi-bag or garbage bag) but passed because of the risks. The stock has since halved and is now under (a recently increased) takeover at $0.335 a share by major shareholder Arcade Finance.

Prior to the bid Arcade owned 28% of Godfrey’s. And something noteworthy happened in May last year.

That month Godfrey’s repaid its debt facility to the Commonwealth Bank with a $30m facility provided by 1918 Finance, an entity associated with major shareholder Arcade Finance. At that very moment Arcade’s incentives changed: if Godfrey’s ending up failing it would be in the box seat to take full control.

Into the breach

It turns out Godfrey’s business has deteriorated since then. On 9 May this year Godfrey’s issued a profit downgrade and announced it was likely to breach its debt covenants.

Potential takeover arbitrage?

I’ve done well from takeover arbitrage, as well as refusing to sell stock in takeover bids, in the past. I recently considered buying Godfrey’s stock after the 9 May announcement (when it was around $0.30 a share). My rationale was that there was probably a decent chance that Kentgrove would successfully force Arcade to raise its bid slightly, which has since happened. But, in the end, I couldn’t stomach getting involved in what seemed like a dirty fight between the two largest shareholders of this tiny company (market capitalisation $12m).

A breach would likely allow 1918 Finance to place Godfrey’s into receivership. Or it could force Godfrey’s directors to place the company into administration.

This won’t happen now. Rather, the breach was used as a threat to force remaining shareholders to sell their shares to Arcade Finance under the takeover. It’s a dirty tactic but this end of the market is a snake pit, not a playpen.

Arcade played dirty because a company called Kentgrove Capital crept up Godfrey’s share register to own 19.8% of the stock. Kentgrove successfully bet that it would be able to force Arcade Finance to lift its bid from $0.32 a share. It was a high-stakes bet because if Godfrey’s ended up failing, Kentgrove could have lost its money.

Borrowed time?

Godfrey’s isn’t the only company to accept a debt facility from its major shareholder. iCar Asia (ASX: ICQ) also entered into a $5m loan facility with 29% shareholder Catcha Group in November 2017.

iCar Asia currently has $19m of cash so the loan isn’t needed yet. In fact it won’t be drawn down unless shareholders approve an issue of options to Catcha Group at the forthcoming annual general meeting. If I was an iCar Asia shareholder I’d be voting against that particular resolution. As with Godfrey’s, Catcha’s incentives will change if it becomes an iCar Asia debtholder.

Of course, these ‘lender of last resort’ debt facilities are often required by companies just at the wrong time.

Charlie Munger, Warren Buffett’s business partner, has said how important it is to understand the power of incentives. This is another case where you should be aware that your interests as a small shareholder don’t necessarily align with those of a much larger one.

Our Intelligent Investor Equity Income Portfolio is now available as a listed fund trading under ASX code: INIF. Holdings in the Fund will mirror our current Equity Income Portfolio, has the same low costs, but you can buy it on the ASX. You can save yourself the broking commission by applying during the initial offer.

Disclaimer
Intelligent Investor provides general financial advice as an authorised representative under the AFSL held by InvestSMART Publishing Pty Limited (Licensee). InvestSMART Funds Management Limited (RE) is the responsible entity of various managed investment schemes and funds and is a related party of the Licensee. The RE may own, buy or sell the shares suggested in this article simultaneous with, or following the release of this article. Any such transaction could affect the price of the share.

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