Beware of bad incentives

Want to know how to predict the future? Check management’s incentives.

Management remuneration and incentives are a critical but often overlooked part of company analysis. While good managers can produce incredible sums of money over long periods, such as Warren Buffett at Berkshire Hathaway or Brian McNamee at CSL, managers guided by poorly constructed incentive structures can destroy businesses and your investment.

The market was caught off guard recently when Newcrest Mining announced a $5.6bn write off. But the writing was on the wall for anyone that read page 40 of Newcrest’s 2009 annual report.

NCM LTI excerpt Source: Newcrest Mining 2009 Annual Report

The remuneration report shows that management would get rewarded for simply increasing reserves. So how did management respond?

On 23 August 2010 Newcrest announced it would acquire Lihir Gold for $10bn. Earlier this year, $3.5bn of that sum was written off, confirming what we had suspected at the time: that Newcrest had grossly overpaid for the asset.

Newcrest’s share price peaked six months later at $43.48 on 9 November 2010, but has since fallen 68% and now the company has caught the ire of the credit agencies. Management’s poorly designed incentive structure was one clue of the disaster to come.

Recently, I analysed Generation Healthcare (GHC), which owns a collection of medical centres and offers several attractions for investors. Medical centres should be largely insensitive to fluctuations in the economy, and Generation Healthcare’s portfolio boasts a weighted average lease expiry of 11.9 years and annual rental growth of 3-4% (or it’s linked to inflation through the consumer price index). The company also offers a current distribution yield of around 7%, which compares favourably to current deposit rates below 5%.

The company ticks several boxes, but then I looked at the responsible entity’s fee structure. (Click picture to enlarge)

GHC Fees Source: GHC 2012 Annual Report

Generation Healthcare is externally managed by APN funds management. Instead of installing an internal management team and paying salaries and bonuses as many externally managed trusts have since the GFC, Generation Healthcare pays APN funds management a semi-annual fee of 0.6% on ‘gross’ assets plus a number of fees, including a performance fee, reimbursement of costs, a 2% fee on acquisitions and other services fees.

This structure is reminiscent of those employed by Macquarie’s infamous externally managed listed satellite trusts, such as Macquarie CountryWide and Macquarie Office, which were eventually acquired by Charter Hall after investors suffered huge losses due to their debt-fuelled acquisition sprees overseas.

Unfortunately internalising management doesn’t always pay off. Fresh from paying off its external management contract Spark Infrastructure bid for the $2bn Sydney desalination plant in 2012 and would have raised capital if successful. This seemed unnecessary when the company had plenty of options to grow its highly profitable electricity networks, and suggested management was trying to stamp its authority on the company and increase its remuneration for operating a larger and unnecessarily more complex business.

Unsurprisingly, high debt levels and poorly structured incentives usually go hand in hand.  While Generation Healthcare’s gearing seems manageable at 48%, the gearing level for one of its fully drawn debt facilities of $41.2m is currently 64%, which is nudging its covenant of 70%. This is in stark contrast to many other large A-REITS, which have reformed  since the GFC and severely reduced their debt levels.

While Generation Healthcare owns some reliable properties, investors need to be wary of management’s incentives that encourage rapid expansion and the company’s high gearing before thinking about the potential dividend cheques.

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