debt

When the rest of the sharemarket rallied from early March, one stock, which had previously traded in lockstep with the market, was left behind: Infratil going backwards instead.

That's because some investors now think the company has a debt problem, the big bogey of the moment. Those investors may well think their fears are confirmed when Infratil reports a hefty bottom-line annual loss tomorrow, probably around the $200 million mark.

But Infratil is no Nuplex with recession-battered earnings. The losses will mostly be paper losses from writing down the value of its listed investments, particularly its 3.3% of Auckland International Airport, and 33% of Australia-based Energy Developments.

Most likely, Infratil will also write down the value of its British airports, which have been reporting mounting losses as the global recession bites particularly savagely in that country.

In a sense, that's all noise. A key number will be operating earnings, which should come in at about $350m, up 11% on the previous year. The underlying earnings of its key assets, such as its 51% stake in TrustPower and 66% of Wellington International Airport, continue to grow at a healthy pace. But the value of Infratil's assets does matter in the context of its bank debt.

Rob Bode, an analyst at First NZ Capital, says one of Infratil's three banking covenants is that shareholders' funds must be above 40% of total tangible assets.

In early April, Bode calculated this ratio could have fallen as low as 43.3% from 49% in September last year. Infratil had kilometres to spare within the other two operating earnings-based covenants, he reckoned. Later in April Matt Henry at Goldman Sachs JBWere conducted a similar exercise and estimated shareholders' funds were sitting at about 48%.

Of the company's main $520m banking facility, a third is rolled over each year and $174m was duly extended in February. A presentation the company gave to analysts this month showed $327.4m net bank debt at March 31.

Given how gloomy the mood in global financial markets was in February, I would have thought if Infratil really was in trouble with its banks, it would have shown up then. Assuming the banks keep rolling over debt, the first major refinancing event Infratil faces is in May 2011, when $112m of its listed bonds mature.

Infratil has a total of about $750m in listed bonds, including nearly $240m in perpetual bonds, all of which rank below its bank debt, which no doubt gives its bankers considerable comfort, but which also led analysts to the conclusion Infratil is over-geared in the current environment.

All of Infratil's bonds are trading at significant discounts to face value so issuing replacement bonds now doesn't look like a viable option, but who knows how sentiment will have changed by 2011.

Acting chief executive Marko Bogoievski says the bank rollover was uneventful. "There wasn't really even a conversation," he says, although the margin Infratil has to pay has gone up, in line with margins everywhere. Nevertheless, Bogoievski says investor perception is a reality which the company must address. Rather than raising equity at huge discounts, as other companies have been doing, Infratil has been selling assets.

In April it sold Fullers Ferries for $40m, yielding an estimated $12m profit over book value, and later that month it sold properties for $23.1m, a $4.1m profit over book value.

Bogoievski says Infratil will probably exercise its put option to sell its 90% stake in Luebeck Airport in Germany back to the city. That will yield about $60m.

Another possible source of funds is Infratil's warrants which lapse in July. If exercised at $1.62 they could raise $136.7m. The shares mostly traded above that level last week, increasing the likelihood the warrants will be exercised.

While Infratil clearly has plenty of time to sort out its balance sheet, Bode's argument that the company needs to position itself to take advantage of current conditions is compelling. "Arguably, Infratil's model and the market are probably much more prospective than they have been for a long time," he says. With a deregulation-minded government, likely opportunities for private participation in infrastructure projects, and the exit of private equity buyers prepared to pay over the odds for the sorts of assets Infratil favours, "the market is ripe with opportunity".

Rob Mercer at Forsyth Barr suggests Infratil also consider selling its stakes in Energy Developments, Auckland Airport and Austral Pacific.

* Jenny Ruth is a freelance journalist and a columnist for The Independent.

Infratil's sale of Fullers ferries is part of a retreat from underperforming businesses to repay debt.

The infrastructure investor yesterday announced that subsidiary NZ Bus is selling its interest in Fullers for $40 million to Souter Holdings, majority owned by Stagecoach co-founder Brian Souter. Infratil will retain its NZ Bus operations in Wellington, Hutt Valley, Auckland and Whangarei.

Infratil says the deal was part of a programme of divestments which would realise more than $100 million in this financial year. The money would be used to repay debt of about $1.2 billion including infrastructure bonds, perpetual bonds and bank debt. Infratil executive Tim Brown said the $100 million also included exercising the right to sell Lubeck Airport in Germany, worth about $60 million, and the sale of some bus depot properties in Auckland.

"In this environment we do have to look at recycling some capital and cut back on where you can't see them generating strong returns. The short term for us is going to be debt repayment but in the medium term there are various opportunities."

He would not comment directly on one analyst's suggestion that Infratil's other underperforming European airports could be next but said it was hard to run with a loss on a low-return asset in the current environment. Around 75 per cent of Infratil's investments, including Wellington Airport and TrustPower, were performing well, Brown said. "You have to say to yourself, can you have 25 per cent of the business not generating a return? In this type of environment you can't."

Souter's purchase of Fullers sees Brian Souter back on deck there after four years. In 2005 Stagecoach NZ sold its bus services and ferry business to Infratil for $253 million. Souter Holdings, which operates Howick & Eastern buses in Auckland, also has a 74 per cent ownership of Mana Coachlines in Wellington.

Brown said the Fullers sale signalled the intention of NZ Bus to focus on developing its core bus business. "The bus business is definitely one we like and we're enthusiastic about it."

Fullers' sale price reflected the market. "It wasn't a great price but I think it was a fair price," he said.

Forsyth Barr's head of research, Rob Mercer, said the sale was a signal that in tough conditions assets that were not strategic would be sold. "Their European airports are underperforming and I suspect they'll be looking to liquidate those unless they want to hold on to them long term. "It sets the scene for how they're going to shore up their balance sheet and get themselves in a position to go forward when they can see the light of day."

Infratil shares closed unchanged at $1.47.

Pacific Brands is a classic of the golden era of private equity.

Bought out of the foundering conglomerate Pacific Dunlop for $730 million in 2001, its new private equity owners ripped out $100 million in cash, geared it up with mountains of debt and sold it back to the stock market in early 2004. They banked $1 billion from the public float.

It was a slick operation all round. The privateers from CVC Asia Pacific and Catalyst Investment Managers, and their investment bankers from Macquarie Bank who teed-up the float, slapped together an impressive board of directors. Fat with other peoples' money to spend, the big superfunds bought it with their ears pinned back, even though it had been loaded with debt to the tune of 3.5 times its earnings (before interest, tax and so on).

The success of the deal was not down to paper shuffling alone. The privateers had turned the manufacturer around. They fixed the supply side. They breathed new life into the brands. Blue collar marques such as Chesty Bonds and King Gee turned bogan into chic.

The irony won't be lost on the 1,850 real blue collar types who are losing their jobs to China - in a company which deployed dinkum Aussie multimillionaire Pat Rafter and billionaire Sarah Murdoch to spruik its products.

Golden era

From lawyers to bankers, management consultants to celebrities, private equiteers to company directors, PacBrands executives to independent experts - rich and super-rich alike - fed high on the hog on this old Aussie manufacturer and its employee battlers.

The brutal reality is that it is ten times cheaper to make a singlet or a pair of undies in China than it is in Australia. ''Offshoring'' of jobs is inevitable and PacBrands merely a high-profile case.

The fee-fest, the brand profiles and the magnitude of the job losses has made Pacific Brands a media event.

For the private equiteers, it was a beautiful thing. Almost any business sold in 2004 to 2006 delivered outstanding returns. This was the golden era and PacBrands was the quintessential private equity play - a three-year turnaround and an internal rate of return (IRR) of 141%.

There were plenty of ''three-bangers'' or threefold returns during these years. Think Just Group privatisation and refloat, the float of another Pacific Dunlop business Repco, the float of JB Hi-Fi, the purchase of Bradken from Smorgon Steel followed by its IPO, the privatisation of Ausdoc followed by breakup of the business.

These deals shone thanks to the buoyant economy and multiple expansion, that is, buying an unloved retail business on 4-5x EBITDA, sprucing it up and bringing it back to the share market on a multiple of 8x. As the great bull market progressed, private equity fund IRRs of 65%-plus were won by most of the players.

Insiders say some 40-odd private equity executives are swaggering around Sydney - it is mostly a Sydney game - each on average $20 million richer for the cause.

Just Jeans represented an IRR of 157%. Like JB Hi Fi it was also a winner for shareholders.

Momentum

It is always an interesting exercise to contemplate the economic benefit, or social benefit for that matter, of all this dealing. Now that Eastern suburbs and Palm Beach property prices are coming off the boil, has the money simply gone? The PacBrands jobs have gone, gone to China. The proceeds of the paper shuffling may have gone too, in luxury holidays, renovations and assorted assets now worth less than they once were.

During the golden era, major international private equity firms began to descend on Australia.

KKR and Carlyle Group among others both set up shop. The other trend was a mushrooming of domestic private equity managers. The superannuation industry was a buyer, a big supporter and most super funds have exposure to private equity funds.

Most rushed to allocate more of their funds under management to the sector as the boom was in full swing, and soon to end.

There is a natural tendency also for private equity managers to increase the size of the fund with each consecutive raising - hence the funds raised in 2006 tended to be about double the size of the preceding raisings in, say, 2002. The latter though was the ''vintage'' to enjoy, rather than the former. Anything bought in 2006 is likely to be a failure thanks to the downturn.

It is strange that super funds themselves were, until recently, not permitted to gear their investments at a super fund level, but there were no restrictions on investing in private equity funds whose outstanding IRRs were reliant on extreme levels of gearing.

Past the peak

With so much money sloshing around the private equity space from 2006 onwards, and with asset prices inflated by the bull market, there was no way that 2006 and 2007 vintage funds could ever compete with the returns achieved by the 2002 vintage.

For example, vendors of retail businesses that would have changed hands at 4-5 times EBITDA in 2002 now wanted to be paid 8-9x EBITDA to sell. A quick look at the history of retail IPOs over the past 20 years shows that it is a rare business that can command a valuation of more than 7x EBITDA on IPO.

Private equity funds then which stumped up close to 9x EBITDA to purchase retail businesses in 2006 and 2007, and plenty of them did, were punting on being able to grow earnings fast enough to achieve an acceptable return despite there being little prospect for multiple expansion.

Moreover, they were gambling that multiples would hover at historically high levels for at least long enough for an exit to be achieved - say, three years.

Even then an IRR of more than 20 - 25% would be a hard-ask - a long way short of the stellar returns achieved by the previous generation of private equity assets. It seems reckless in retrospect, but then again the money was flowing into the funds, and the privateers get paid for that too.

Bad bets

We now know that neither of these requirements for investment success has held true. As a consequence, private equity in Australia is littered with assets that appear bent on losing money for their investors. Uncomfortable discussions between the lending banks and private equity managers over covenant breaches (ANZ and the Bank of Scotland were the two biggest lenders to private equity) are the order of the day.

There is also the prospect that most of the private equity managers in Australia are currently managing their last fund as the investors have been so badly burned that they will be loath to invest again.

The carnage in the sector has also left managers sitting on their hands, reluctant to draw down funds even if the funding has technically been committed by the fund investors as they know that investors have lost confidence in private equity. This is resulting in roll-up strategies being left in the lurch at just the time when there is value in the market again.

Which assets are in the worst shape? Anecdotally, it would seem the following rules apply: anything in retail is a dog, anything in NZ too, anything in mining services and anything exposed to the high-end consumer.

Retail - Australian Discount Retail has gone belly up for Catalyst and Champ. Gresham has Witchery and Mimco (no wonder Wesfarmers recently wrote down its stake in Gresham private equity), Ironbridge has BBQ Galore (the US arm of which is in administration) and Super A-mart. Archer Capital has Rebel Sport and Amart Allsports. Affinity has Colorado. TPG has Myer, Goldman has Kathmandu and PEP and CCMP bought Godfreys.

New Zealand - Catalyst has Metro Glasstech, Ironbridge has Envirowaste, Mediaworks and Base Backpackers.

Mining Services: There were a few exits here which suggest the PE investors got out just in time. Emeco for one. It was at least a 3x return for the privateers but its share price today is a fraction of its IPO price.

Getting it wrong

In other cases, private equity was left holding the baby.

In a game of pass the parcel between private equity firms, Catalyst bought Valley Longwall (a provider of specialist underground coal mining equipment) from Crescent Capital in 2007 - delivering Crescent 5.7x its original investment and an IRR of 300%. In the present market Catalyst is no hope of replicating that return, if anything.

High-end consumer - Riviera for Ironbridge is the standout here.

How did the private equity industry get it so wrong? Its practitioners are generally held to be as savvy as any in the finance world.

The industry incentive structures explain a lot. Most mid-cap funds pay 2% of committed capital to the management team as a management fee, together with 20% of any return achieved a benchmark annual return of 8% - a performance fee known in the industry as "carry".

For mid-cap funds of up to $500 million, the management team won't be making more than a good professional wage on the basis of the base fee alone. It is only if they earn "carry" that there are big dollars to be made. This structure encourages the manager (usually a team of about six people for a typical mid-cap fund) to "roll the dice", knowing that the payoff for success can be a carry cheque of tens of millions of dollars to divide among the team. The risk on the downside is that the manager does not get to manage another fund and members of the team find themselves looking a job. Assuming they were about during the golden era, they would hardly be queuing with a token at the local Centrelink.

Besides those privateers who didn't spend their winnings, the other beneficiaries of the boom were shareholders in listed companies which were taken over by private equity at a premium that was never justified.

Then there are the owners of private businesses that were purchased at prices that they could never otherwise have achieved - and of course, professional hangers-on such as investment bankers, lawyers and accountants. The frenzy threw up perhaps a billion in fees.

mwest@fairfax.com.au

Ten years ago, says Tai Tupa of the Otara Budgeting Service, you had to go into Hobson St in central Auckland to find a moneylender willing to lend to a low-income borrower.
"Now," she says, "there are two or three of them here in Otara, quite a lot at Hunter's Corner and in Mangere town centre and in Manukau.
"Nowadays you can see all those advertisements on TV. They are everywhere. And you can get a cheap car practically anywhere with the finance."

Moneylenders have become as much a part of the culture in South Auckland in the past decade as they have been for centuries in Third World villages in India or in the Pacific Islands, from which many of their South Auckland clients come.
And their clients are often just as desperate as they were back in the villages.

Lata and Kanikita Mohulamu, Mangere parents of seven children aged between 3 and 14, pay a total of almost $800 a week on 11 regular payments including rent, loans for a van, a car, a computer, a vacuum cleaner, a couch and clothes from a visiting clothes truck, plus two general loans from Work and Income and from Instant Finance which they used for the costs of a funeral and to buy food.
Even McAuley High School and De La Salle College take $10 each off the family each week to pay off their school fees.
Kanikita earns $525 after tax in a 40-hour week at Fletcher Aluminium, or up to $800 in a good week with overtime. The family also gets $536 a week in family assistance. But it is not enough, and Lata cries as she explains that she can't afford to buy her 14-year-old daughter a McAuley jacket for the winter. "At the moment my daughter keeps on asking, 'Mum, can I have warm clothes?"' she says. "I say, 'Wait, because I can't afford it at the moment.' I'm feeling sick. She keeps on asking me, 'Mum, I need the warm clothes,' because she walks from home to the bus stop."

Sue Lafaele and Loto Kaio, Otara parents of a 10-year-old boy, pay $676 a week on two cars, rent and two personal loans taken out for two of their parents' funerals and when their power was disconnected.
They both work fulltime - Kaio as a welder from 8am to 4.30pm, Lafaele as a night cleaner at the airport from 11pm to 7am, plus five hours a week for the Service Workers' Union. But he earns only $14 an hour and she gets only $11.30 in her main job, giving them a joint after-tax income of $845 a week.
The higher level of family assistance since April 1 means they are now entitled to $65 a week in family and in-work tax credits for their son. But when they last asked they were told they could get only $7 a week, so they haven't claimed the money. They need the two cars so that Lafaele can get home before Kaio leaves in the morning, and so she can take their son to school and pick him up after school. She sleeps in the evening before going to work.
"I can't sleep during the day. Last year I slept in and forgot to pick up my son. I did it twice, now I don't want to do it again," she says.
The family cut off the gas six months ago and now take cold showers and cook on a barbecue, using electricity only for light and appliances. They have no landline or cellphone. They often live on pork bones. "The only one thing I care about is my son George," Lafaele says.

Unlike middle-class borrowers, who often borrow to bring forward purchases which they could have saved for eventually, this is a world where people borrow simply because they have to. Most have children. In 2000, 27 per cent of Pacific people, 23 per cent of Maori and just 8 per cent of Pakeha were unable to keep up payments for goods on credit in the previous year. Similarly, 24 per cent of Pacific people, 16 per cent of Maori and 5 per cent of Pakeha had got into arrears on their mortgages or rent, and 28 per cent of Pacific people, 23 per cent of Maori and 8 per cent of Pakeha had got behind on power, gas or water bills.
In the past five years, debts owed on goods such as cars, furniture and appliances have displaced rent and power bills as the biggest amounts owed, accounting for 38 per cent of all arrears owed by clients of the Federation of Family Budgeting Services last year. Rent and mortgage arrears were next with 32 per cent.
"The top two used to be accommodation and utilities. Four or five years ago they were by far the top categories," says the federation's executive officer Raewyn Fox.
"For the last two years the greatest percentage of debt has been in the category of retail goods providers including hire purchase and credit cards. We believe that is a direct result of the aggressive marketing of retailers, such as low deposits and six months before you have to start payments on a hire purchase."

Moneylenders have multiplied to meet the demand. South Auckland budget advisers report interest rates commonly around 30 per cent, plus fees, on items such as cars and appliances.
For shorter-term loans, corner shops such as Lelei Finance in the Mangere Town Centre lend money on the security of chattels such as a TV set or tapa cloth at interest rates of 20 to 25 per cent a month. For a six-month loan, Lelei owner Lelei Ufi says the interest would total 120 to 150 per cent.
"That is the rate that most of the pawnbroking business charges to the clients," he says.
An extreme case which bills itself as "New Zealand's largest payday advance company", online lender cantwait.com, charges 10 per cent every seven days for money lent until your next pay day - the equivalent of at least 520 per cent on an annual basis.

Vaiola Pacific Island Budgeting Service adviser Tupe Ieti says the default penalties for failing to meet payments can be horrendous. She had one client who borrowed $500, disputed the terms, and was slapped with an extra $70 on the loan for every week she failed to repay it.
"She borrowed $500 and it got up to $6000. The client was desperate. She was on a benefit," Ieti says. Ieti threatened to take the lender to the Commerce Commission and eventually persuaded the company to wipe most of the penalty charges and accept gradual repayment.
Last week the Government announced further law changes that will require moneylenders to be registered, with penalties for lenders who fail to register or fail to disclose past convictions for dishonesty or fraud.
But there are no restrictions on interest rates and Lelei Ufi says he will continue charging 20 per cent to 25 per cent a month.

For several years now the housing market has defied predictions of a downturn. Several periods of moderating sales and price growth have been followed by waves of renewed strength, thereby creating an aura of invincibility.

Real estate agents have a vested interest in nurturing that impression.  It is wrong, though, to conclude that, because the adjustment has not happened so far, it will not occur at all. Even though the timing may be uncertain, the reality is that a downturn is inevitable.

The housing boom has relied to a great extent on households' increased appetite for debt and it is the fast-growing cost of debt servicing that will ultimately force the long- awaited correction in housing demand.

The rise in household debt has exceeded income growth in every year since the early 1990s. The ratio of debt to disposable income stood at around 60 per cent in 1990 and reached 110 per cent in late 2001.

Since then that upward trend has accelerated as strong economic growth and falling unemployment have increased household optimism about future earnings.  Mortgage rates that were low by historical standards and high house price inflation reinforced the increased willingness to borrow.

The debt to income ratio now stands at more than 160 per cent. Not only is that level the highest among developed economies, New Zealand borrowers are facing significantly higher interest rates than elsewhere. As a result, a comparatively large portion of aggregate household income is required for debt servicing.

The ratio of debt servicing to disposable income, which averaged around 8.5 per cent during the 1990s, has increased to 13.5 per cent since then.  In the United States, Canada and Britain that figure is only about 8 to 9 per cent, while it is 11.5 per cent in Australia. A 13.5 per cent income share may not appear very high, but it has to be remembered that this is an average across all households. A large share of households has no mortgage at all. Taking that and rental income on investment properties into account, the average debt servicing ratio for households with mortgages is probably close to 25 per cent.

More important than averages, however, is the distribution of debt, with an increasing number of highly geared borrowers now struggling to make ends meet.

Households added nearly $19 billion to their liabilities during the past year, an increase of 13.7 per cent. If that pace were maintained, the already high cost of debt servicing would continue to rise at twice the rate of income growth. That trend is clearly unsustainable.

Bringing the rise in debt servicing cost into line with income growth would require the additional annual borrowing to fall from $19 billion to around $10 billion, a considerable adjustment that would impose a major constraint on growth in household demand.

THE OUTLOOK for consumer spending in both the Treasury and Reserve Bank economic forecasts is based on the scenario of a slowing debt uptake. The Treasury expects consumption growth to ease to 1.6 per cent per annum over the next few years, while the Reserve Bank is more pessimistic in projecting it to trend down to zero over the same period.

Similar dips in consumer spending growth in 1998 and 2000 led to brief periods of falling house prices. Taking history as a guide, a more protracted slowdown, as is forecast for the next few years, is likely to lead to a more substantial correction.  Moreover, having supported the housing market on the way up, the increased share of investment properties may be a factor that reinforces the slowdown.

In many cases those investments are not profitable without ongoing capital gains. The prospect of a multi-year period of falling or stagnant prices may cause investors to put those properties back on the market sooner than originally envisaged.

Even though residential property may be a safe and high-yielding asset over the long term, it is not a good idea to enter the market ahead of a multi-year downward correction.

While it remains uncertain when the tipping point will be reached, the debt fundamentals suggest that the housing boom is living on borrowed time.

# Ulf Schoefisch is an independent economic consultant.