When hybrids go bad

Investors bought $285 million of PaperlinX hybrids in 2007, attracted by regular distributions and the prospect of a step-up. Within two years it all went horribly wrong.

PORTFOLIO POINT: PaperlinX hybrid owners are squaring off against shareholders in a striking example of how badly an investment in a hybrid security can go wrong.

Not all is rosy in the land of fixed interest, and the furore being made by PaperlinX hybrid owners is bringing that truth home to investors newly enamoured of the sector.

As we’ve noted before in Eureka Report (see Christopher Joye’s feature, Attack of the hybrids), viewing the usually stable landscape of bonds and debt securities through rose-tinted glasses is as dangerous as stumbling into a rogue stock, and hybrids can be the worst of the lot – potentially giving investors equity-like risks for debt-like returns.

The rapidly degenerating state of relations between the PaperlinX board and some note holders is an example of what can result when a hybrid stops behaving as its investors think it should: the paper merchant is fighting to remain solvent; note holders feeling misled by the company have set up a protest website called PaperlinX SuX! to try to get the answers they say the board is withholding; and on the sidelines a shadowy and unnamed private equity fund is lurking with a low-ball takeover proposal valuing the once $2 billion company at $117 million.

So how did it come to this? In March 2007, PaperlinX sold $285 million worth of step-up preference shares (PXUPA), the most common kind of hybrid issued to the market. They had a face value of $100, paid a twice-yearly distribution made up of the 180-day bank bill rate plus a 2.4% margin (and an extra 2.25% when it steps up on June 30, 2012).

The notes are perpetual and preferred debt, meaning it has no maturity date and the note holders have a claim on the first $285 million available if PaperlinX is sold or wound up.

The company had net debt of $612 million and net debt to equity of 32% at the time and the hybrid was issued to pay down that debt.

Graham Critchley, a founder of PaperlinX SuX!, says PaperlinX relied on three things to market the hybrid to investors: its reputation as a well-known Australian brand; its position as an ASX 100 company (which would be short-lived after the issue); and the heady boom-time mentality affecting investors around the world. By 2007, he says, return on equity had fallen every year since 2002 and pre-tax profit had fallen every year since 2003, despite rising sales. The last year it reported a net profit was 2008.

Distributions from the hybrid were paid for two years until they were stopped in 2009, tentatively restarted in 2010, before being cancelled again in October last year. The only comment from PaperlinX was contained in chairman Harry Boon’s address to last year’s AGM, when he said the end-of-year distribution would not be paid because of “challenging trading conditions” and “ongoing demands for our cash, including restructuring activities”, and that the distributions would not be reinstated until both improve significantly. Boon was the last CEO of former conglomerate Pacific Dunlop before high debt and falling profits caused it to be broken up into Pacific Brands and Ansell.

But Critchley says PaperlinX’s 2010-11 accounts, as at June 30 last year, showed the company did have the money to pay. It had a current ratio of 1.8:1 (an indicator of whether a company has the resources to pay its short-term debts), with which “you can pay a distribution of $11 million, there is no doubt in the world”.

Between August and October “something happened”, Critchley says, that put a stop to the reasonably positive board announcements. “Something happened '¦ that no one mentioned and no one disclosed, and all of a sudden this came out of the blue at the end of October. And that’s why we are all so angry.”

He blames a board that won’t engage and under so much pressure that directors are making stupid mistakes.

On the other hand, note holder and former research analyst at FIIG, the specialist bond and hybrid broker, Brad Newcombe, says it’s understandable that the December payment was cancelled due to poor operating performance and a prospective breach of bank covenants. He says the sudden profit fall was due to profitability in the normally successful paper merchanting business falling off a cliff in the past year, especially in Europe and the Asia Pacific.

The next blow was when the Trust Company, the responsible entity that issued the hybrids, downgraded the fair value of its investment in the preference shares from $100 to $34. Given the state of PaperlinX’s accounts (it’s made a loss for the past three years and is undergoing a strategic review), the downgrade did not come as a surprise, but the extent of the downgrade did. Several shareholders, including Critchley and Newcombe, say fair value is more like $40–60.

Finally, in December, an unnamed private equity group (which Eureka Report’s takeover expert Tom Elliott suspects could be from Europe, click here) made a tentative proposal to buy PaperlinX for a nil-premium $117 million, or a split of 9¢ per ordinary share and $21.85 per hybrid.

Newcombe says $21.85 won’t fly and at that price it would cost $114 million just to take out all the hybrids. “You’ve got to leave something for the ordinaries, but you’d assume you’re going to get a lot more than that in a bid,” he says.

Critchley, on the other hand, is angry that PaperlinX was talking to the suitor yet released figures that conflicted with both the hybrid PDS and the trust deed. “Those ratios just don’t work. If we get $21.85, the ordinary shareholders get about 3¢. There is a prescribed formula,” he says.

Tom Elliott says the proposal puts hybrid and ordinary shareholders in direct opposition. They all have to agree to a pool of money they think the company is worth, but then have to fight over how it’s divided.

There are options open to note holders in the event of a takeover. The Trust Company agreed that hybrid owners could convert their notes to equity if the company is acquired, but the tentative numbers released to the market still don’t stack up if they chose to do this: if every note holder converted their investment to shares, the register would blow out from 609 million to 3.2 billion shares on issue and the hybrid owners would own about 80% of the company.

Elliott says an increase of these proportions in PaperlinX’s shares would force a bidder to lift its bid because at 9¢ each, $117 million wouldn’t cover the whole issue. This is one reason why he thinks the chances of a formal bid getting up is about 50% – a low likelihood in the M&A world.

Hybrids are attractive because they offer a regular income from the debt side (which has to be paid out before dividends are given to ordinary shareholders), and they benefit if the equity has risen when they convert the security into shares.

But it’s the equity side of the PaperlinX hybrid that is burning note holders, because it has fallen consistently since February 2007 and dragged the hybrid price down with it.

This is what the PaperlinX step-up preference share looks like: it is a perpetual security, which makes it more like a share because there’s no maturity date when the company has to buy it back. And you can only redeem it for cash, ordinary shares or in some cases preference shares, on certain dates (the first of which is on June 30 this year), or if the company is taken over or wound up.

PaperlinX hybrids can be traded on the ASX. This hybrid is not cumulative, so if the company stops paying note holders those skipped payments don’t need to be paid once the company gets its finances back on track, removing some of the incentive to do its best to continue paying distributions.

PaperlinX SuX!’s Critchley says that the fact that directors can stop distributions is not the problem – it’s merely another aspect of the equity side of the hybrid; the problem is that there is no objective assessment released as to why the distributions stopped. “They could just say, 'We don’t feel like paying’.”

He says this lack of regulation for hybrid investments is at the heart of the issue: while a product disclosure statement (PDS) for an IPO has to be written to a set standard, there is no such requirement for hybrids, and investors are often lumped with a 100-page bespoke document that many analysts don’t have the resources to properly consider.

The PaperlinX hybrid also hints at another feature of raising capital that investors need to think about: what the event is telling the market.

Kevin Davis, research director for the Australian Centre for Financial Studies (ACFS), says that issuing shares signals to the market that a company’s equity is overpriced as management thinks people will pay more for it than they should.

“One of the mirrors of issuing a hybrid in that sense is that you’re less inclined to send out the bad signals, because it’s more like issuing a debt security.”

PaperlinX is undergoing a strategic review and the board says it wants to get rid of the two-tier system of shares and preference shares. The options include: doing nothing; restarting distributions (which, however unlikely, is the preferred option for the PaperlinX SuX! brigade); or a takeover or a buyback.

Boon floated the idea of a buyback of the hybrids before June 30.

Newcombe says the board first has to find the money to do this, then work out an appropriate discount to face value because there’s no way hybrid owners are going to see that $100 again.

Follow Rachel Williamson on Twitter @RWilliamson_

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