South African Hustle - The Externally Managed Property Company

Last month saw the buyout of two small listed property companies in South Africa. Vividend was acquired by Arrowhead and Annuity was acquired by Redefine. One would expect that shareholders in the target companies would have seen a nice profit on their holdings as acquiring company's generally have to pay a premium in a takeover scenario. This was not the case. Healthy profits were indeed realised, but in both cases these profits were effectively channelled to external companies set up to "manage" the property assets of the listed company, leaving shareholders with negligible returns on their investment.

The exceptional performance of listed property in South Africa over the last 10 years, combined with SA institutions generally low weighting to property, has created a huge pent up demand for listed property assets in recent years.  The property and financial sectors have stepped up to satiate this demand, with numerous new listings of property companies providing investors with the exposure that they have been seeking. The returns of many of these new property companies have generally lagged the sector. I believe that this lacklustre performance is due to conflicts of interest inherent in the structure of new property funds. The market convention is to establish two companies when listing. One company is established to hold the physical properties ("Propco") while a separate company ("Manco") is established to provide "asset management" services to Propco. Propco is the listed publically traded entity, while "Manco" is generally owned by the founders, management and related parties and is privately held. This structure enables management and founders of the company to profit handsomely, regardless of the performance of the underlying property company. 

Using the example of Vividend we can see how this practice leads to a conflict of interest between the shareholders of "Propco" and "Manco". The structure has been a fixture of new property listings in SA over the last decade. At the inception of the company, Vividend founders and management begin by setting up two separate companies:

1. Vividend Management Group - A company which is paid an asset management fee in order to manage the assets of the fund. I refer to this as "Manco".
2. Vividend Income Fund - A new listed company which raises capital through a public offering in order to buy property assets, the income on which flows through to shareholders. I refer to this listed company as "Propco". At inception Propco signs an evergreen contract with Manco (Vividend Management Group), wherein Propco agrees to pay Manco a fee of 0,5% of the its total asset value per annum for the provision of asset management services on the property portfolio. 

Given that the Manco's earnings are determined by the total size of Propco's assets, Manco is now directly incentivised to grow the asset value of the fund.  This is done through the purchase of property assets funded by either new equity or debt. The quality and valuation of the properties purchased is critical to the return expectation to shareholders of Propco, but is of secondary consideration to Manco. Given the conflict of interest inherent in this structure it is not surprising that the returns to Propco shareholders have generally been poor, and in some cases disastrous. 

The last 10 years have seen numerous examples of externally managed companies where the Manco's incentive to grow the portfolio, and hence its income stream, has led to the acquisition overpriced or low quality assets. The perpetual "evergreen" contract entitles Manco to a portion of Propco's income forever, so the value of the Manco is directly related to the total size of assets in Propco, regardless of property yield to investors. Once Propco has purchased sufficient properties to provide Manco with an attractive income stream, the owners of Manco then look to capitalise on this through its sale. Manco can be sold to another party as in the case of Vividend and Annuity, but in many cases Manco is sold to Propco itself. 

This market structure has always resulted in an excellent deal for shareholders in the privately held Manco, but results for shareholders in publically held Propco have been mixed. Recent transactions have seen Vividend Management Group (Manco) purchased for R87 million while Accuity property management functions were bought for a total of R103m. A lot of value has been accrued to the shareholders of Manco and in these two cases it has been at the expense of shareholders in Propco. The charts below from Bloomberg show the performance of Annuity and Vividend (white lines) relative to the SA Property Index (JSAPY) from the time of listing to the time of acquisition.

Since listing in April 2012, Annuity (ANP) had no share price appreciation so Propco shareholders only profited from income for an annualised return of 6,39%. Investors in ANP lagged the SA Property Index (SAPY) by 16,49% for the period. The performance of Vividend (VIF) was even worse as the share price actually fell 6% since listing in October 2010. The total return of 4,47% was below cash and a massive 34,62% below the Property Index in just over 3 years.

For delivering these poor performances the Manco’s of Annuity and Vividend benefited to the tune of almost R200m when the Manco's were acquired. Both companies launched with a R500 million market cap, and the original shareholders of Propco’s in these two companies effectively lost R256 million relative to the property index.

Propco shareholders desire growing income and capital growth, which requires the purchase of attractively priced properties or the improvement of existing properties in order to enhance their income generating ability. Manco's are responsible for investing Propco's assets, but they are only incentivised to grow the portfolio so as to grow Manco's income stream. The interests of the two entities are at times directly in conflict, and the decisions taken are often to the detriment of Propco shareholders. 

This is not the only structure of property companies in SA, as mature companies generally having internalised management structures. In these "Internally Managed" property companies, both management and ownership of the property assets reside in Propco. In most cases this is as a result of an "internalisation" of the manco at some point in its history.  Aside from the two companies discussed, there are numerous other examples of the mismanagement of listed property companies due to the existence of external Manco's. For that reason we invest solely in internally managed property companies, where the interests of company shareholders do not directly conflict with management.



Note: Further to the above examples are there also Manco's which are paid a commission on property (generally 1%) transactions on behalf of Propco. In this egregious structure Manco's are incentivised not only to grow the portfolio without regard to quality, but to churn the portfolio as well.