Related-party transactions, or conflicts of interest, which have been the bane of the NZX over the past 20 to 30 years, were back in the spotlight this week at Kermadec Property Fund's special meeting.
Shareholders approved the internalisation of the company's management contract and the purchase of a funds management business from managing director Mark Francis and his brother Chris. The successful resolution was strongly criticised by the New Zealand Shareholders' Association.
Related-party deals, which have often resulted in a significant transfer of value from minority shareholders to insiders, place a great deal of importance on the role of independent directors.
Peter Wilson and John Loughlin, Kermadec's two independent directors, supported the two proposals, but it is fairly clear that Mark Francis has negotiated a very good deal for himself and his brother.
Kermadec was incorporated in October 2006 and lodged an IPO prospectus the following month.
It listed on the NZX on December 11, 2006 following the issue of 61,250,000 shares at $1 each.
One of the features of the company was its external management structure. Augusta Funds Management, the external manager, is owned by Mark Francis and his brother Chris.
The company initially purchased seven properties, six from the parties associated with the IPO promoters. Unfortunately, these related-party transactions are a fairly common feature of NZX listed companies.
The performance of these related-party properties, which are listed in the accompanying table, has been as follows:
* The Alto Packing building in Hamilton was initially purchased by a proportional property scheme (property syndicate) promoted by Augusta for $3.8 million in June 2003. It was sold to Kermadec for $4.4 million, which then disposed of the property in September 2008 for $4.5 million.
* The Coca-Cola warehouse in Palmerston North was purchased from another Augusta proportional property scheme for $10.7 million, some $1.3 million above the scheme's purchase price. It was sold for $9.8 million in 2010.
* Kermadec acquired the Department of Courts building in Henderson from yet another Augusta proportional property scheme for $8 million and sold it a year later for $8.2 million.
* The building on the corner of Cook Street and Nelson Street in Auckland was purchased by Jamie Peters, a director of Augusta at the time, for $9.1 million in 2005 and sold to Kermadec for $10.4 million. It was subsequently sold by Kermadec for just $7.9 million in 2009.
* The Finance Centre car park and podium in Auckland was purchased in two lots. The first was bought from Peters for $27.6 million in 2006 and two years later a number of other assets were acquired for $17.7 million from parties associated with Mark Francis after Kermadec's shareholders approved the deal. These two lots are now valued at $45.3 million, the same as the combined purchase price.
* Brookfield House, next to the Finance Centre, was acquired from Peter Francis, the father of Mark and Chris, for $22 million. Peter, who was one of the major players in the failed 1980s property developer Chase Corporation, had bought the building for $15.2 million just 18 months before the Kermadec IPO. Brookfield House is now valued at $23.2 million.There is nothing wrong with these transactions. They were all fully disclosed in Kermadec's 2007 prospectus or have subsequently received shareholder approval. However, as with most of these transactions on the NZX, the related parties seem to get the better end of the deal.
Kermadec's share price reached an all-time high of $1.15 in April 2007 but plunged to just 41c two years later as the global financial crisis had a big impact on rental income and property values.
It is now trading at 65c, and chairman Peter Wilson recently wrote: "Kermadec still faces the challenges of being a very small listed property vehicle with its stock trading at a substantial discount to its asset backing of 77c per share. These two factors will continue to restrict the company's ability to grow and to develop into an income stock with a fully diversified portfolio."
Wilson's solution was to ask shareholders to approve two additional related-party transactions at this week's special meeting.
* The internalisation of the management contract. Under this proposal, shareholders were asked to approve the purchase of the management contract from the Francis brothers for $2 million.
* The acquisition of Augusta's funds management business, mainly the promotion and management of property syndicates. Kermadec will pay the Francis brothers $3 million for this business with an additional $2 million payable in the future if the funds management operation meets a number of targets. This combination of property ownership and funds management is fairly common as far as ASX-listed entities are concerned.The Shareholders' Association criticised the transactions for a number of reasons including:
* The $2 million price for the management company was high compared to other small buyouts in recent times.
* The funds management acquisition is at a P/E ratio of 10x whereas a small private company would normally sell at a P/E of 3-4x.
* The total cost of the funds management is likely to be $5 million, all funded by borrowing.The association supported the transaction in principle but "the price seems too high relative to the benefits that can realistically be expected. In our view the independent directors have not been able to drive a hard enough bargain on behalf of all other shareholders".
There was a lively debate on the transactions, including the role of the two independent directors. Wilson and Loughlin told shareholders that the negotiations with the Francis brothers had been robust and the independent directors had negotiated a good deal for shareholders.
Shareholders expressed a wide variety of views. One elderly man told the meeting that the "Francis brothers were stars", while others wanted to know why a commercial cleaning company was included with the funds management company that was being purchased.
There was an unusually large number of institutional investment managers in attendance, with two of them speaking in support of the transactions.
Craig Tyson of OnePath said he was voting in favour because Kermadec would look more like an ASX property company if the resolutions were approved.
Matthew Goodson of BT Funds Management said the price was full but it was a good environment for the Augusta's fund management business because property syndicates would be easier to get off the ground in the current low-interest rate setting. It is disappointing that representatives of large investment institutions are much less likely to attend, and participate, in shareholder meetings of non-property listed companies.
Towards the end of the Kermadec meeting, a shareholder asked several astute questions, including: why will Kermadec have its new head office in a Francis family-owned building, and pay rent to these related parties, when it could occupy some of the empty space in the listed company's properties? Wilson responded that this rental agreement had been negotiated at arm's length, the company had sought separate advice, and it was expensive to move from one building to another. As Wilson struggled to answer this pointed question the penny dropped.
Companies with embedded cultures of related-party transactions and apparent conflicts of interest find it extremely difficult to wean off these unfortunate practices no matter how strong their independent directors.
Brian Gaynor is an executive director of Milford Asset Management.