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.

Are Emerging Markets Proving Their Detractors Right?

After more than a decade as the darlings of the investment world, Emerging Markets (EM’s) have fallen out of favour rapidly as it becomes apparent that they are not following the linear path to prosperity that many had envisioned. Whereas previously the investment world focussed on the seemingly unlimited potential of billions of new consumers, recent events in such disparate countries as Turkey, Thailand, Nigeria and Ukraine highlighted the fragility of governance and institutions that is typical of emerging markets. Other EM’s such as South Africa, Brazil and India have not seen political crisis, but have still come under scrutiny due to their falling growth rates and rising inflation.

Over the last decades, EM’s have been the beneficiary of massive capital flows, partly due to their potential for economic growth, but in recent years also due to the flood of money brought on by ultra-easy monetary policy (low interest rates and quantitative easing) in developed markets. With the prospect of ultra-easy monetary policy coming to an end, EM’s will have to provide an attractive environment for capital in order to fund their investment plans. Sceptics contend that most EM’s are stuck in the "middle-income trap”. The theory is that an EM can grow from being a poor country to a middle-income country by capitalising on natural resources or cheap labour, but it then gets stuck in a “trap” when it does not have the strength of educational, legal and social institutions necessary to continue its development into a higher-income country. Capital flows are not effectively absorbed into the economy but instead they fuel a temporary consumption boom. A consumption boom without improvements in productivity eventually leads to a crisis followed by a reversal of capital flows. While each EM has its own unique circumstances, this sequence of events does seem to accurately describe many countries in the EM universe, including Turkey, Brazil, India and South Africa.


Recent events have highlighted the weakness in EM institutions, and their ability to negatively impact the growth potential of a country. In Turkey, Prime Minister Erdogan seems to be turning into the autocratic ruler that many had been warning of. The recent corruption scandal has seen him launch an offensive against the judiciary and police the media, and now even the Internet. Turkey’s mishandling of their monetary policy over the last year, also due to political pressure, has resulted in a dramatic fall in the currency. Nigeria has experienced rapid economic growth in recent years despite its high level of corruption. The firing of Reserve Bank governor Sansui after he exposed a $20bn hole in the state oil company’s finances highlights how weak Nigerian institutions are. Investors see immense potential due to the population of 170 million people, but this potential won’t be realized if the state continues to mismanage the economy.

On the ground in South Africa, we are painfully aware of the difficulty of generating a level of economic growth necessary to reduce unemployment, poverty and inequality. SA has struggled to generate more than 2% growth over the last 2 years and it clear that development has stalled. While SA’s institutions are amongst the strongest in the EM universe, the country is constrained by poor educational outcomes that limit productivity growth.  Recent years have also been characterized by deterioration in the efficiency and effectiveness of government institutions. This has created a high level of uncertainty that has limited investment in the economy.

As a citizen of an emerging market, I am not just an impartial observer in the recent reversal of fortunes. Whilst I think that the euphoria around EM over the last decade was in part due to ignorance about the developmental challenges these countries face, the current pessimism (and market valuations) seems to imply that progress has permanently stalled. EM may currently be regarded as a poor investment destination, but if governments can create the right environment then convergence can resume and EM’s can outperform developed economies for a considerable period of time.

$19 Billion, Whatsapp with that?

The news today that Facebook was buying messaging app "Whatsapp" for an amount of 19 Billion dollars was greeted mainly by shock in the financial media. While most agreed that the amount is excessive for a company which in 2013 had $20 million worth of revenue, some have tried to justify the valuation based on the potential future profits if Whatsapp is able to eventually monetize the user base. Recent tech acquisitions (Instagram, Nest) and the valuation of companies such as Facebook, Twitter and Tencent have drawn comparison with the 90's tech bubble, but i think this is the clearest example that we are actually in the middle of a tech bubble.

Firstly we have the absurdity of Henry Blodget chastising us for thinking that $19Bn is too much http://www.businessinsider.com/why-facebook-buying-whatsapp-2014-2. Blodget is the founder of "Business Insider" and was one of the original internet stock gurus, touting internet stocks like etoys.com publicly while referring to them as "junk" in his private emails.

Secondly we have the re-emergence of financial metrics that may have no relation to how much profit the business is actually making. We now see tech companies again being valued on metrics such as "price to sales". In the case of social media companies and now messaging apps "price per user" is used to justify a high valuation in the absence of revenue. Whatsapp ostensibly charges $1 per year for each user, but no one actually seems to pay it. A big part of why Whatsapp's user base has grown to an impressive 450 million is that HAS no revenue model (ie it is free). If it did have a revenue model it would not have 450 million users.

I have used whatsapp almost exclusively for the last few years and its speed, ease of use and lack of ads has made it the standard here in South Africa. Their implementation has been excellent and far superior to similar apps which were launched at the time (eBuddy is one i tried but it was slower and full of ads). While Whatsapp is touted as the fastest growing social media app of all time, network effects in instant messaging are much lower than social media and it is a business which is easily to replicate.  Most people have several messaging apps on their phone and can easily switch if necessary. I can also see Apple (iMessage) or Google (gchat/hangouts) launching cross platform "whatsapp" style versions of their messaging apps in the same way as Blackberry did with their BBM messenger. An offering from Apple or Google will be a compelling alternative, and mean that Whatsapp will never be able to monetize their offering as it would risk destroying their user base.

One mitigating factor in the valuation of the transaction is that only $4 billion of the purchase price is in cash, with the rest in settled in Facebook’s expensive (50-110 PE) stock. This makes the headline purchase price somewhat academic.

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On a side note this transaction got me thinking about the nature of implementation and luck in internet start-ups. In South Africa there was a free messaging app called Mxit which was launched around 2003 and was the messaging standard among South African youth for most of the decade. It but it began to lose favour towards the end of 2010 with the proliferation of smartphones and Blackberry messenger. While it still exists today, and recently launched in India, it has been through several management changes and seems unlikely to survive. What amazes me is that this free messaging app predated whatsapp (which launched in 2009) by about 6 years, an absolute age in the tech industry. Even though Naspers, SA's biggest media and technology company, purchased a 30% stake in 2007, Mxit never managed to expand their reach or capture a user base in the way that whatsapp was able to so quickly after its launch. I would be very interested from those close to the story to understand why.

Why the SARB Had to Hike Rates

I attended a lunch today with Brian Kahn, a member of the Monetary Policy (MPC) committee who has been with the South African Reserve Bank (SARB) since 1999. We had met with him a few months ago and he used this meeting to again emphasise that the SARB would follow a conventional inflation targeting framework. He also confronted the issue of the SARB's communication strategy, given that January's rate hike was a surprise to all 25 economists polled by Bloomberg. Brian indicated that the MPC had sufficiently communicated the risk of a hike in its two previous hawkish MPC statements, something I had previously highlighted.

(http://rashaadtayob.blogspot.com/2014/01/economic-conformity-all-25-economists.html)

A lot of time at the lunch was spent discussing the monetary policy framework, the views of the various committee members, as well as the domestic economy and the effect of interest rate hikes on growth. My interpretation of the SARB's thinking is that they react primarily to 3 factors:

1) Inflation
2) Growth
3) Global Rates/Liquidity

Where I think local economists got it wrong was that they spent a lot of time focusing on the domestic environment (1 and 2). They looked at the poor growth outlook and the relatively muted inflation data and concluded that there was no need to hike rates. Many economists thought that rates would remain on hold throughout 2014. My own view is that global interest rates (3), is the overriding factor, and the SARB doesn't have as much choice in its policy as it or economists/analysts thinks. The following chart (source: Bloomberg) shows a long term history of SA's Prime Lending Rate and the FED Funds target rate. 

From this 30 year history it is clear that SA rates are very much a function of the global interest rate cycle, of which the FED is the biggest driver. The cycle has been different this time in that the FED resorted to quantitative easing programs once they had reached the zero bound of interest rates. These QE programs achieved their aim of creating liquidity conditions commensurate with a negative Fed Funds rate. Once the FED began the process of tightening monetary policy in May by announcing the tapering of QE, SA rates could not remain at their record low levels and rate hikes were inevitable. 

Don't Blame Us, Blame the Financial Crisis

In last night's state of the union address, President Zuma explained that the depreciation of the Rand was not due South Africa's economic policies, but rather "global economic problems". Blaming SA's economic malaise on global factors was a constant theme throughout 2013. In our meetings with government representatives and managers of state owned enterprises over the course of 2013, the consistent message was that South Africa was victim of the global environment. Rather than confronting the problem of SA's declining competitiveness and taking steps to improve infrastructure efficiency and cost,  SA's politicians have sought to place the blame solely on the troubled global economy. As one would have expected the results of this approach have been poor.

Whilst the weakness of the global economy has obviously been a headwind and EM currencies have depreciated over the course of 2013, the argument that SA's poor economic performance is all down to to global factors does not hold due to the fact that :

1) The Rand has been the weakest performer in the EM universe (Chart 1 from Bloomberg)
2) SA industry has lost significant market share due to declining competitiveness (Chart 2 from Macquarie)

South Africa's weakening fundamentals and poor policy are reflected in the fact that the Rand has been among the weakest performers since the beginning of 2013. Countries which have been proactive in addressing economic imbalances and competitiveness have seen far less currency weakness than SA's 22% depreciation.

Chart 2 shows the decline in South Africa's global market share of services exports. While fellow emerging market countries such as China, India, Russia and Brazil have increased their market share significantly over the last 10 years, South Africa's share has been in continuous decline. A similar picture emerges in the traded goods sector, where the competitiveness  of the mining industry has been impacted by the dysfunctional relationship between labor and business.

Despite government assertions to the contrary, politics has played a significant part in South Africa's economic downturn. The inefficient roll out of infrastructure has resulted in a rapid increase in costs born by business, while government has stood by as labor relations in the mining industry have collapsed. Government's unwillingness to confront the declining competitiveness of the economy means that we are unlikely to see a structural recovery, and the target of 5% GDP growth will not be achieved.

Economic Conformity - All 25 Economists in SA say that rates stay on hold today

“It is better to fail conventionally than to succeed unconventionally.” – Keynes

With the South African Reserve bank meeting today to decide on interest rates, all 25 economists surveyed by Bloomberg believe that rates will be kept on hold. While I believe that there is a very strong possibility (80%+ chance) of a rate hike today, the divergence between my view and that of economists is the largest it has ever been. While one can make the case for either leaving rates on hold or hiking them, the fact that economists have not adjusted their forecasts in the face of a dramatic change in circumstances shows them to be very out of touch with reality.

Three major factors point to the probability of a rate hike today:

1) All our emerging market peers (India, Brazil, Turkey, Indonesia) have taken significant action to hike rates in response to rising inflation and weakening currencies. SA has not moved.

2) The SARB has over last 2 meetings given strong indications that they would not hesitate if they saw risks to the inflationary outlook. While inflation has been subdued to date, the depreciation of the currency along with the rise in petrol and maize prices must put the inflation target at risk.

3) Since the last MPC meeting in November 2013 the Rand has depreciated from R10,13/USD to over R11/USD. This is a move of over 10%, as the Rand under performed our EM peers who have been taken steps in adjusting their monetary policy. A volatile Rand brings economic instability and the weakness of the Rand will eventually take its toll on inflation. 

While a rate hike today is by no means dead certain, the lack of diversity among economist's views shows a remarkable lack of flexibility and courage.

Agang: Not Just the Black DA

Agang (http://www.agangsa.org.za) was officially launched in February 2013 after months of speculation regarding Mamphela Ramphele's plans to re-enter the political sphere. There was widespread speculation that she would tie up with the Democratic Alliance (DA), but after extensive negotiations Ramphele decided to forge ahead separately and launch a new political party. Given the similarity in policy focus between Agang and the DA, the existing infrastructure and resources that the DA possesses, as well as the personal relationship between Ramphele and DA leader Helen Zille, the decision was surprising.

Attending a lunch with Dr Ramphele today gave me a good opportunity to understand the rationale behind the formation of Agang, as well as some insight into their plans for the upcoming election next year. Ramphele started her comments by highlighting the failures of the ANC over the last 5 years. She pointed out that "The economy is going nowhere, education is a disgrace, healthcare is failing the people and there is no confidence in safety and security." The last five years have indeed seen a steady deterioration in the effectiveness of government institutions, which has tested the conviction of even the most optimistic of South Africans. Ramphele castigated South Africans for allowing a monopoly in the political arena, asking "Which democracy in the world would have a ruling party confident of victory, despite its record of failure.”

Towards the end of lunch Ramphele finally addressed her decision not to join forces with the DA, which would have broadened the support for the current opposition party. It is well documented how close Ramphele was to agreeing to join the DA as party leader. The decision comes down to the fact that she believes that the DA does not understand and acknowledge the deep effect of apartheid's legacy. While this does not prevent the DA from being effective in governing and maintaining current institutions, it makes them less effective when it comes to redressing the deep imbalances that are still prevalent within South African society. These shortcomings are reflected in the inability of the DA to attract black votes. Ramphele pointed to the alarming fact that around 60% of black voters believe that the DA will bring back apartheid if elected. Given these impediments it makes sense for Agang to maintain a separate party identity, while working in closely and in coalition with the DA where necessary.

Ramphele aims to win around 20% of the vote in next year’s elections, which is an ambitious target for party which is only 7 months old and staffed by just 30 people. Agang realises that they are a largely unknown entity amongst the majority of voters, but an upcoming branding exercise led by the team which worked for Barack Obama aims to forcefully place them into the public consciousness. While the ANC is likely to retain its majority in next year’s elections, increased competition from credible opposition parties such as Agang can only be good for the development of democracy in South Africa.

Rashaad Tayob

First Strut: South Africa's First Corporate Bond Default

Corporate default is described as a deceptively rare event. This is especially true in South Africa where the generally high quality of corporate bond issuers has meant that until now there have not been any defaults in the listed bond market. We avoided investing in this bond for our portfolios, and the rationale for this is spelled out in an article i wrote for Nedgroup Investment's quarterly newsletter:

http://nedgroupinvestments.co.za/insights/Single/660

Rashaad Tayob

The Central Bank Dilemma: Inflation vs Growth

Today I attended a meeting with an official from the South African Reserve Bank (SARB). It was a good opportunity to get some insight into their thinking given that the current stagflationary environment (the combination of low growth and high inflation) places conflicting demands on monetary policy. Low growth necessitates loose monetary policy, while inflation above the 6% upper target implies the need for rate hikes. Interest rates were left unchanged at last week's (19 Sep 2013) Monetary Policy Committee (MPC) meeting, but the Governor Gill Marcus gave a distinctly hawkish speech, which hinted at the real possibility of rate hikes in  the coming months.

I have long held the view that interest rates at 5% in SA are too low given the 3-6% inflation target and the fact that inflation is likely to remain close to or above the 6% upper threshold for the foreseeable future. A few months ago the dominant sentiments was that rates would remain low for an extended period due to the global interest rate environment. Despite a significant depreciation of the Rand and the ensuing inflationary pressure, in April 2013 the market had moved to price in a further rate cut.

This all changed in May when the Fed announced the potential for reduction in the bond purchases (tapering of quantitative easing), which caused the Rand depreciation to accelerate and yields to spike. While the market has since settle, the consensus view has been that a weak economy would preclude the need for rate hikes.

Last weeks MPC had economists scrambling to amend their interest rate forecasts as the MPC’s language seemed to be aimed at preparing the market for a rate hike in the coming months. Like all Central Banks, the SARB has to find a balance between controlling inflation and promoting growth, but in the last meeting the governor repeatedly reminded the market that maintaining inflation within the target band is the Reserve Bank’s primary mandate.

Given the outlook for continued inflationary pressure due to the depreciation of the Rand, as well as the shift in the Reserve Bank's focus back towards controlling inflation, I would not be surprised if the rate hiking cycle starts in the coming months.

A Public Service Announcement (Brought to you by a billionaire hedge fund manager)

Ray Dalio is the founder and head of one of the most successful hedge funds in the world. I first heard of him when i read his "Principles" document, which explains his belief system and how he incorporates these beliefs into the management of his his company. I was quite taken by this document and as a director of a small investment management firm I attempted to replicate several of the "principles" in our company.

http://www.bwater.com/Uploads/FileManager/Principles/Bridgewater-Associates-Ray-Dalio-Principles.pdf

Dalio doesn't appear in the press too often, but when i have heard him talk, his view his views on investments has been insightful. He has spoken before of the economy as a "machine" and he has now distilled his understanding into simple 30 minute YouTube video. Much of the content will be familiar to those in the markets, but the clarity with which the economic cycle is explained makes it worth watching regardless of one's level of financial understanding.