Friday, 3 August 2012

Externally managed listed vehicles: a corporate governance nightmare

Prior to the GFC the number of externally managed listed vehicles was truly amazing.  There were infrastructure funds, real estate funds, various listed investment funds, assets that were partially sold off by bigger corporate entities as well as many other variations on this theme.

Everyone acknowledged at the time that these structures came with questionable corporate governance structures but no one was really thinking about this in a world where practically everybody was making money.

After the GFC hit though this all changed and these structures went out of fashion.  There are still several companies out there with these kind of structures in place so I thought I would use this post to explain what these structures are and why they have fallen so fa from grace.

What are externally managed vehicles?
Quite simply these are listed companies which have no real management of their own.  They are managed by another company that gets a fee for the services they provide.  They get paid fees for:
  • A base fee for managing the company
  • A performance fee for outperforming their listed competitors
  • Fees for the use of logos and other corporate materials
  • Fees associated with corporate activity

What is the problem with their structure?
There are several problems with the structure.
  • As you can probably tell the first relates to the amount if fees the investors have to pay even when the entity is not performing well.  Generally these fees are much higher than they would be under an internally managed system
  • The second big problem is around alignment of interests
    • Oftentimes the managing entity sold have no stake in the company they were managing so they were incentivised to maximise their fee income through things like corporate transactions where these were not necessarily in the interest of shareholders
    • Further a common practise was for the managing entity to sell the managed vehicle badly performing asses for premium prices so they come get them off their own balance sheet

What has happened to externally managed stocks since the GFC?

When investors woke up to the inherent issues within these vehicles they abandoned them in droves and most still trade at a discount to their net asset value because of the inherent risks associated with the vehicles.

What has ended up happening is that these assets have had their management's internalised so they then operate the way a normal company would. This normally involves a payment to the external manager to give up their rights. This payment is often a very contentious amount as there have been some payments made in the hundreds of millions of dollars. Typically after the stock is internalised the shares significantly outperform the market in the following months.

If the process is all over why am I writing this?

The fact is that the process is not over and there are still a fair few of these dinosaurs left out there.
  • You can make a fair it if money if you pick when the company is going to announce their internalisation but there is significant risk around the internalisation payment.
If you are thinking of investing in these vehicles make sure you keep the alignment of interests issue front of mind as you can lose significant value if the manager s making decisions for self serving reasons.

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