Brian Gaynor: Open mind on Hanover-Allied proposal

The proposed Allied Farmers/Hanover Finance deal would be one of New Zealand's biggest, most innovative and high-risk commercial transactions.

It is even bolder than the deals investors are anticipating from George Kerr and the revamped Pyne Gould Corporation.

This week's proposal is an attempt by a low-profile Taranaki company to take control of Hanover Finance's assets from the high-profile and publicly vilified Mark Hotchin and Eric Watson.

The important issues are whether the proposed deal is the best option for Allied Farmers' shareholders and Hanover Finance's investors.

A secondary consideration is that Hotchin and Watson are not let off the hook for their deplorable governance of Hanover Finance.

Hanover Finance is one of the worst examples of poor corporate governance and the country's inadequate securities markets' regulatory regime.

The company's last full prospectus, which was issued in December and signed by directors Greg Muir, Sir Tipene O'Regan, Bruce Gordon and Hotchin, said that it strived to have the best corporate governance, disclosure and credit lending policies.

Nothing could be further from the truth. The independent directors were asleep at the wheel, directors' fees haven't been disclosed and its lending policies were extremely loose.

For example, last year's PricewaterhouseCoopers independent report revealed that Hanover Finance had lent $58,851,000 to five property companies owned by Hotchin and Watson yet the total capital of these companies was just $501 according to Companies Office records.

There may have been more undisclosed equity in these companies but the loans, which were in addition to other related party loans, indicated that Hotchin and Watson were able to highly leverage their property activities through Hanover Finance and make financial killings if these ventures were successful. Hanover Finance investors bore most of the losses if these ventures failed.

Hanover Finance, which was partly a private bank for Hotchin and Watson, said on July 23, 2008 that it was ceasing to accept new investments and was suspending all repayments of principal and interest to investors.

On December 9, 2008 Hanover investors were asked to approve a moratorium, which was endorsed by chairman Greg Muir and PricewaterhouseCoopers (PWC).

Under the proposed moratorium Hanover investors were to receive 8 per cent of their money back in 2009, 10 per cent in 2010, 12 per cent in 2011 and 35 per cent in each of 2012 and 2013.

PWC gave six reasons why a moratorium was preferable to a receivership. Its arguments were flawed for a number of reasons including;

* It recommended that the Hanover management team, which had been a failure, should stay in charge. This was an illogical conclusion.

* It failed to realise that the better quality Hanover executives would not stay under a moratorium.

* Under a receivership investors would have priority over many other creditors, including unsecured creditors. This is not the situation under a moratorium.

The moratorium is flawed because there is a conflict of interest between Hanover's shareholders and the investors.

The investors were due to get 70 per cent of their money back in 2012 and 2013 whereas the shareholders only have to provide their $20 million cash guarantee support if the 8 per cent is not repaid in 2009 and the 10 per cent in 2010. This guarantee is either used or disappears after December 2010 so there is a strong incentive for the shareholders to focus on 2009 and 2010 whereas investors were due to get most of their money back in 2012 and 2013.

The moratorium was approved by investors but eleven days ago Hanover announced that investors would only receive 70 per cent, instead of 100 per cent, of their capital back.

Early this week Hanover Finance released its annual report for the June 2009 year, which was a shocker. The company had a net loss of $102 million and had only $1.9 million of cash. The report gave the clear impression that some of the shareholders' $20 million cash support guarantee would be called upon.

Meanwhile, Allied Farmers has been having its own problems with the company's share price plunging from a high of $3.06 in May 2005 to just 33c before this week's announcement. The share price decline has been due to a combination of poor earnings, too much debt, no clear direction and a six for seven rights issue earlier this year at 40c a share.

In addition there have been major concerns that the Allied Farmers finance company, Allied Nationwide, will have limited prospects when the Crown deposit guarantee is lifted.

The turning point for Allied Farmers was when Robert Alloway purchased a 14.4 per cent stake, mostly through this year's rights issue. Alloway is the former chief executive of private-equity controlled and Hamilton-based NDA Group.

Alloway quickly realised that Allied Farmers had an uncertain future and started looking for a debt for equity swap to strengthen the company and its finance company.

Under the proposal, Allied Farmers will acquire all of the assets of the Hanover Group and investors in these companies will receive Allied Farmers shares instead of their repayments under the moratorium. All other liabilities will remain with Hanover Finance, which will continue to be owned by Hotchin and Watson.

If the deal proceeds, Allied Farmers will have a very strong balance sheet with $396 million of new equity issued to Hanover Finance investors and all of Hanover's loan assets. Allied Farmers' share price performance over the medium to longer term will be determined by the company's ability to collect these loans.

Existing Allied Farmers' shareholders should put more focus on the company's medium to longer term share price performance rather than the dilutionary features of the proposed transaction, which will reduce their shareholding to just 3 per cent.

The company doesn't have an exciting future unless it adopts some bold and imaginative strategies.

Hanover Finance investors are in an awkward position because they made the wrong decision last year. At present they are in the hands of Hotchin and Watson, their management team and Hanover's independent directors. This is not a great place to be and it is likely that the projected moratorium payout of 70 cents will be reduced further.

The question they have to ask is whether Alloway will do a better job in recovering the loans than Hotchin and, if he does, will this be reflected in Allied Farmers' share price.

Hanover investors should keep an open mind on this issue and wait until the notice of meeting documents are available.

This is not a sweet deal for Hotchin and Watson even though they will avoid the $20 million support guarantee. They will still lose $10 million plus interest, which is held in a solicitor's trust account and will be paid to Allied Farmers.

They will have to meet all Hanover's liabilities, including any legal action, although they will receive between $5 million and $10 million from Allied Farmers to meet these. Hotchin and Watson's business reputations have been severely damaged and Hanover has no future.

Finally, one of the best ways to look at the Allied Farmers/Hanover Finance/Robert Alloway mix is to compare it with Pyne Gould Corporation and George Kerr.

Both combinations have a rural operation, a finance company, impaired property loans, a poorly performing share price and a new cornerstone shareholder.

Investors are giving Kerr a big tick for his ingenuity with Pyne Gould Corporation now having a sharemarket value of $365 million. Alloway has probably come up with a more innovative deal which could be a win-win situation for all involved, except Hotchin and Watson.

This may also be reflected in Allied Farmers' sharemarket value in the medium to longer term.

* Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.