What went wrong at Feltex Carpets and who is to blame for the company's disastrous performance? Do shareholders have any course of action against the vendors, directors or brokers who aggressively sold the initial public offering (IPO) to the public?

To answer these questions we need to go back to 1996 and have a close look at how private equity funds work.

A private equity fund, Credit Suisse First Boston Asian Merchant Partners (CSFB), purchased Feltex from BTR Nylex for $21.8 million in 1996. The aim of most private equity funds is to rationalise and restructure acquisitions, load them with debt and dress them up for a trade sale or IPO within four to 10 years of purchase.

As the accompanying table shows, Feltex achieved earnings before interest and tax (ebit) of only $12.1 million in the 1999 year. This translated into net after-tax earnings of only $5.2 million, far too low for a high-priced trade sale or IPO.

In May 2000, the Australian operations of Shaw Industries were purchased and Feltex was transformed from a predominantly New Zealand-based wool carpet producer to an Australasian company with more than 60 per cent of its production in synthetic carpets.

The Shaw acquisition was almost totally debt funded, a strategy that would allow the CSFB fund to maximise its profit when it eventually sold out.

The Shaw purchase was a disaster and, in 2001 and 2002, Feltex reported ebit of only $5.7 million and $2.3 million, and after-tax losses of $13.4 million and $18 million respectively.

By June 2002 Feltex was in serious trouble, with total equity of only $9.9 million and liabilities of $220.9 million, mostly ANZ Bank loans.

CSFB fund investors must have been seriously concerned about their investment, but they needn't have worried, as the New Zealand broking community, in the guise of Forsyth Barr, was coming to the rescue.

In April 2003, Forsyth Barr was lead manager and organising broker for a $60 million Feltex 10.25 per cent a year bond issue. The issue was fully subscribed, even though the 10.25 per cent rate appears to have been lower than ANZ Bank's average rate in the 2002 year, and the bank had a first mortgage over the group's land and buildings, whereas the bondholders only had a second mortgage.

The bond issue, which had issue costs of $5 million or 8.3 per cent of the money raised, should have offered an interest rate in excess of 12 per cent.

One of the reasons for the low rate was that bond investors would be given preferential rights to any future IPO, or a 1.5 per cent interest rate step-up if an IPO did not eventuate by last September. This signalled that Feltex was being dressed up for sale.

In the June 2003 year, group revenue fell $7.5 million yet ebit rose by $20.2 million. This recovery is hard to understand, because it is extremely unusual for a company to achieve a substantial increase in earnings while experiencing a downturn in revenue.

The company gave a number of reasons, including cost-cutting. But what costs were cut? Was there a reduction in advertising or other important expenditure?

Most companies have the ability to improve short-term profitability by slashing costs, but this strategy can have negative medium and long-term implications. Tranz Rail was a good example as it boosted profitability through a low-track maintenance and rolling stock replacement strategy.

The strong June 2003 recovery allowed Feltex to launch an IPO prospectus in May 2004 offering shares at $1.70 each. CSFB private equity sold all of its 120 million shares, making a profit of $182.2 million on an investment of only $21.8 million.

Feltex also issued 29.4 million new shares at $1.70 and bondholders were able to convert their debt into equity at $1.615 a share. Thus the CSFB fund, which almost drowned Feltex in a sea of debt, exited with a huge profit while New Zealand bondholders, who rescued the group, have lost most of their money.

Once again, this suggests similarities with Tranz Rail.

But the most disconcerting aspect of the IPO was the role of chairman Tim Saunders, former chief executive Sam Magill, present chief executive Peter Thomas and long-standing directors Michael Feeney, Craig Horrocks and David Hunter. As outlined in this column on July 1, they realised combined profits in excess of $14 million from the IPO.

These directors had major conflicts of interest, as the higher the issue price, the more they made.

Thus the CSFB fund offered incentives to encourage bondholders and directors to buy into the IPO, with the latter group given incentive to support a high price issue.

Two important questions remain unanswered:

* Were any of the directors investors in the CSFB private equity fund?

* Did the CSFB fund and/or the directors give any guarantees or covenants to the ANZ Bank and, if so, has this influenced the latest Godfrey Hirst deal?

Feltex achieved its forecasts for the June 2004 year, but fell well short of its 2005 ebit projection of $41.3 million and reported a loss of $10.6 million for the first half of the June 2006 year.

This year, the directors terminated talks with Godfrey Hirst that could have resulted in Feltex shareholders receiving up to 60c a share.

The twist to this: the McKendrick family sold Kensington Carpets to Feltex in the 1970s and the late George McKendrick continued as managing director under the new owners. He was dismissed, went to Australia, set up Godfrey Hirst and retained a dislike for his former employer. His family, which still controls Godfrey Hirst, are now in a strong position to avenge their father's dismissal.

Feltex shareholders have suffered horrific losses for several reasons, including:

* The purchase of Shaw.

* The funding of this acquisition through borrowings.

* The inflated $1.70 IPO price.

* The rejection of the earlier Godfrey Hirst offer.

* And, last, but not least, the total ineptitude of directors.

These directors were seduced by the private equity game plan, were compromised by their IPO profit potential and made a number of dreadful decisions. The financial institutions that promoted Feltex securities to the public also have a great deal to answer for.

Private equity funds are often accused of taking a "pump and dump" attitude towards IPOs, and the Feltex debacle looks like a good example.

Shareholders have the ability to bring derivative actions against the company or directors under sections 165 and 173 of the Companies Act 1993. A major party has been looking at this, but is appalled by the poor legal protection for investors in New Zealand. This is the main reason why these sections of the Companies Act have yet to be used as far as listed companies are concerned.

The problem with Feltex is that the 2005 financial figures are called projections rather than forecasts. A lower standard is required for projections; they have to be reasonable but not necessarily supportable.

The preferred development for aggrieved shareholders is for the Securities Commission to establish whether the Feltex directors have a case to answer. Unfortunately, Jane Diplock and her fellow commissioners seem to have fallen asleep over Feltex.