Brian Gaynor 's Opinion

Investment columnist for the NZ Herald

Brian Gaynor: Mighty River makes Meridian a hard sell

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Australia's Telstra sale gives English and Key pointers on how to do it.

Bill English and John Key have changed the way they handle power company sell-offs, but they could still meet buyer resistance when Meridian goes on sale. Photo / Mark Mitchell
Bill English and John Key have changed the way they handle power company sell-offs, but they could still meet buyer resistance when Meridian goes on sale. Photo / Mark Mitchell

Prime Minister John Key and Finance Minister Bill English have revealed a new strategy for the Meridian Energy share offering.

They will have their work cut out because the Mighty River Power share sale has not been a success and investors will be reluctant to buy shares in another electricity company unless the offer is particularly attractive.

The problem is that the Mighty River Power price-setting process was flawed.

According to the prospectus the initial public offering price "will be determined by the Crown, in its sole discretion" after a bookbuild process.

The document explained that "a bookbuild is the term used in initial public offerings to refer to the process of collating demand for shares from eligible retail investors who apply for shares in the offer and demand for shares at various prices from institutional investors who bid for shares.

"The bookbuild process collates the demand of the parties that want shares, how many shares will be sold and the price applicants bid for shares. The information collated in the bookbuild is then used to assist with the determination of the pricing and allocation of shares."

The problem with this process is that retail investors have to pay before the share price is determined and there is no cap on the price they are required to pay.

The other problem is that the bookbuild process is totally non-transparent. It is all smoke and mirrors, with no information on the size or prices of the bookbuild bids.

Mighty River Power's indicative IPO price was between $2.35 and $2.80 a share. The final price of $2.50 a share was determined by senior Government ministers.

The stock listed on May 14 at $2.61 and stayed at that for 3 minutes and 20 seconds. All trades since May 27 have been below the $2.50 issue price.

The problem is that the price-setting process was stacked against investors, particularly retail participants, because the vendor usually wants the highest price and the investment banks were paid performance fees and commissions based on the issue price.

Mighty River Power's poor performance has left the Government with no choice - it had to come up with an alternative way to sell 49 per cent of its Meridian shareholding.

The new method is similar to that used by the Australia Government when it sold its Telstra shareholding in three tranches.

In 1997, it sold a 33.3 per cent shareholding in Telstra through a process called T1.

The sale was by way of an instalment receipt process in which retail investors paid A$3.30 (A$1.95 for the first tranche and A$1.35 for the second), compared with A$3.40 (A$2 and A$1.40) for institutions.

Thus retail investors received a discount of A10c, or 2.9 per cent, compared with institutions.

Only retail investors who held their instalment receipts for the full 12 months of the investment receipts structure received the A5c discount on the final tranche.

Instalment receipt holders had full voting rights even though they were not issued ordinary shares until the second payment was made.

According to the prospectus: "If the final instalment is not paid, the trustee can sell the corresponding share. If the net proceeds of the sale are insufficient to satisfy the final instalment, the trustee can take action to recover the deficiency."

The issue was highly successful - more than 1.8 million Australians bought shares and Telstra's share price was A$7.08 on the second instalment payment date, a 115 per cent gain for retail investors.

Telstra T2, in which the Government sold a further 16.6 per cent, was two years later.

The total price of T2 shares for retail investors was A$7.40 (A$4.50 for the first tranche and A$2.90 for the second), and A$7.80 (A$4.75 and A$3.05) for institutions.

Retail investors who participated in T2 - and held their instalment receipts to the final payment date - paid A40c, or 5.1 per cent, less than institutions.

T2 attracted 860,000 new Telstra shareholders but was far less successful than T1 because the company's share price was only A$6.27 on the final payment date, 15.3 per cent below the price paid by retail investors.

Thus, retail investors had to pay A$2.90 for the second instalment even though they were getting only A$1.77 a share in value.

It is important to realise that there can be selling pressure on instalment receipts before the second instalment is due because investors have to raise cash. Further selling can occur after the second payment as retail investors have deferred selling until they receive their price discount.

The main characteristics of T3, in 2006, were:

The second tranche was not due for 18 months and investors received three dividends over this period.

T3 was promoted as offering a "14 per cent full-franked investment yield for the first 12 months".

The total payment for retail investors was A$3.60, a A10c discount over the A$3.70 paid by institutions.

Retail investors who held their instalment receipts for 18 months received a bonus of one share for every 25 instalment receipts held.

The A10c a share discount and bonus issue were a 6.6 per cent discount on the institutional price.

Thus, Telstra's retail investors received a discount of 2.9 per cent on T1, 5.1 per cent on T2 and 6.6 per cent on T3.

The New Zealand Government offered a 4 per cent discount to Mighty River Power retail investors in the form of a one for 25 bonus issue for investors who held their investment for 24 months under the same name.

But this was capped at a maximum of 200 loyalty bonus shares for every domestic retail participant.

Telstra T3 investors did much better than T2 investors as the company's share price was A$4.74 on the day the second instalment was payable. This compared with a total retail price of A$3.60 a share.

As well, A42c of fully franked dividends were paid over the 18-month period.

The New Zealand Government announced this week that the Meridian share sale would be through an instalment receipt process, with the second tranche payable after 18 months.

Investors will receive three full dividends over this period, even though they will have paid only 60 per cent of the total amount due.

The retail price will be capped, but there is no discount or loyalty bonus scheme.

The important point is that instalment receipts are leveraged investments offering greater upside, as well as downside, potential.

At Might River Power's present price of $2.18 a share investors have lost 12.8 per cent on the $2.50 a share IPO price.

If the issue had been made on the leveraged instalment receipt system investors would be down 21.3 per cent on a theoretical instalment receipt payment of $1.50.

The Meridian IPO will need several of a number of important features if it is to get widespread retail support. These include:

The issue price and retail price cap are not too high.

Retail investors should get a discount of at least 5 per cent below the institutional price through a price discount and/or share bonus scheme.

Retail investors should get some downside protection over the first 18 months. For example, on the first $2500 worth of shares acquired by retail investors ($1500 for the first instalment and $1000 for the second) the second instalment price should be the lower of the pre-determined second instalment payment or the weighted average instalment receipt price for a five-day period before the second instalment is due to be paid.

Meridian is a very large company and the Government will have to be imaginative to attract widespread individual support.

If it doesn't attract this support then a large proportion of the Meridian shares will be bought by international hedge funds because they have a strong bias towards leveraged investment receipt structures.

Brian Gaynor is an executive director of Milford Asset Management.

- NZ Herald

Brian Gaynor

Investment columnist for the NZ Herald

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the FMA in 2011. He is also a Portfolio Manager at Milford Asset Management.

Read more by Brian Gaynor

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