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Evaluating management: a bondholder’s perspective

26 January 2018

Evaluating management: a bondholder’s perspective

Our management evaluation criteria are similar across equity and fixed income

Across our funds, the various asset classes and all securities we consider for inclusion in our portfolios, our investment process is guided by our 3 Ms. Opportunities to which we allocate capital must meet our criteria for some form of Moat (a defensive barrier that wards off competitors), a Margin of Safety (the security must trade at a lower price or offer a higher yield than our estimate of intrinsic value) and good Management.

When we evaluate a company’s management team to decide whether to purchase equity in a business, we look for the following:

  • transparency in governance and communication
  • individuals who are materially invested in the company through equity ownership
  • a track record of astute capital allocation focused on long-term shareholder returns

(Gustav Schulenburg gives more detail on page 2.)

When we consider fixed income opportunities, our management evaluation is a nuanced application of the same underlying principles.

Management feeds into the matrix we use to score and price credit risk

In fixed income, risk is our key concern. Since we are lending client capital to the governments, companies and banks whose debt instruments we buy, we need to assess the likelihood that they will pay it back to avoid any permanent loss of capital. We also need to price the credit risk we are taking: what is an appropriate return to receive for the money we are lending?

It is much the same as when you go into the bank to ask your relationship manager for a loan. The bank will want to know more about you to determine the risk of you not paying your debt instalments, and at which rate they should lend you the money. They will probably ask about your debt history, how much debt you currently have (gearing), what your cash inflows and outflows are (affordability), and what assets you own (collateral).

Similarly, our fixed income team runs an in-depth credit vetting process for each institution we consider buying debt from. Once vetted, we determine the long-term, through-the-cycle, risk-adjusted return we would be comfortable to receive from each security. We perform this analysis through our internally generated credit scoring and pricing matrix, which considers management as a key factor.

Management teams are often the gatekeepers to a company’s success

In fixed income, we specifically look to understand how management teams have done the following:

  • Allocated capital
    This includes new investments and capital expenditure to generate positive free cash flow.
  • Structured the balance sheet
    Have long-term investments been paired with long-term funding to better match cash flow profiles?
  • Dealt with nearing debt maturities
    Were they refinanced in time and are sufficient facilities available to repay short-term debt?
  • Maintained positive relationships with banks and investors
    How well has management communicated with the market?
  • Maintained headroom in covenants (agreed restrictions in debt agreements)
    Ideally, management should try to refinance debt or ask for a relaxation in terms of the agreement long before the covenant might be breached.

We also consider how aligned management teams are to the business (whether they are personally invested), if disclosure is transparent, and how they apply accounting policies and derive accounting estimates. Too often we have seen good companies fail due to poor management decisions. In these cases, both equity and fixed income investments bear the brunt.

A few examples of management getting it wrong

If we look back at some recent examples of companies that have had to restructure their debt, the impact of management is evident. Case studies include African Bank Investments Limited (ABIL), Eqstra Corporation Limited (Eqstra) and Edcon Limited (Edcon). So, what went wrong?

Case study 1: ABIL

Very broadly speaking, ABIL lent money to high-risk clients. While this is not necessarily cause for concern, management did not make sufficient provision for bad debts. In due course, ABIL incurred higher bad debts than management provided for, which ate into its equity and weakened capital adequacy ratios. Management then raised capital through a rights issue (to fill the gap on the balance sheet), while at the same time increasing the provisioning policy – which reduced equity again. This spiral caused both debt and equity investors to lose confidence, as they tried to evaluate what the provision for bad debts should really be. Poor provisioning masked the true condition of the company, which ultimately had to be bailed out by the South African Reserve Bank.

Case study 2: Eqstra

Eqstra was a holding company with operations that included mining, fleet management and industrial equipment. Its management team exercised poor judgement in a different way, by entering into contracts with unknown risks. For example, they were unable to claim revenue or recoup costs at some mines when it was raining. They also applied aggressive valuation policies to property, plant and equipment, which led to significant write-downs when the assets became defunct in the commodity downturn. This, in turn, resulted in the business breaching covenants. In this case, aggressive accounting policies and excess risk placed strain on the balance sheet and cash flows.

(Eqstra subsequently underwent a restructuring, during which it sold the industrial and fleet management divisions and renamed the mining division 'Extract'. Extract is undertaking a strategic change in direction and becoming an investment fund. It is also exiting existing mining contracts.)

Case study 3: Edcon

Edcon carried excessive debt after it was bought out by private equity firm Bain Capital. This limited management’s ability to execute the capital expenditure necessary to maintain operations. In an attempt to boost revenue, they grew a significant credit sales book – which they subsequently sold to Absa Bank Limited – and took on excess inventory they couldn’t sell. When Absa reduced credit sales, Edcon’s overall sales declined significantly. In the end, poor management of working capital, a high debt burden and an inability to maintain market penetration saw debtholders take control of the business.

The flipside: a few examples of management getting it right

In contrast to the previous examples, we can look to Capitec Bank Limited (Capitec), FirstRand Bank Limited (FirstRand), and The Land and Agricultural Bank Limited (Land Bank) for examples of what good management teams can achieve.

Case study 1: Capitec and FirstRand

Despite having a similar industry profile to ABIL, Capitec has a conservative, liquid balance sheet. In addition, management actively manages and updates credit scorecards and impairment provisioning to ensure that risks in the prevailing market conditions are accurately reflected. In a similar vein, FirstRand’s management team has proven themselves to be good capital allocators through both their investment decisions and the timing of their bond issuances. Both businesses are robust and successful in equity and fixed income markets.

Case study 2: Land Bank

Amid all the market noise around poor management at South Africa’s state-owned enterprises (SOEs) such as Eskom, Transnet and South African Airways, we recently saw an attractive opportunity in Land Bank. Its management team has been able to reinstate profitability to the bank, while also setting up strong governance processes. They have further restructured the bank’s balance sheet by extending debt maturity profiles.

Having successfully maintained investor confidence when other SOEs didn’t, we increased our exposure to Land Bank last year at a time when the local market was generally negative towards government-related entities. As a result, we were able to lock in above-fair-value, risk-adjusted returns for our clients. The market has since become more comfortable with Land Bank and we have seen credit spreads reduce (as shown in Graph 1). This has resulted in a capital profit in our positions.

What about management of our sovereign investments?

When we invest in local government bonds, we are lending money to a democratic republic, not to a president or political party. South Africa has an autonomous judiciary, efficient financial and capital markets, and a reserve bank that runs its inflation targeting mandate both successfully and independently. If we look through short-term noise and prevailing uncertainty to focus on long-term prospects, we believe that the yields currently on offer from South African government bonds – and the margin of safety they present – justify a moderate holding.

We view ourselves as long-term partners of the companies we invest in

This makes it crucial to trust their management teams. While we always evaluate management before deciding to invest, we also remain cognisant that company leadership, regulations and circumstances change. We continuously reassess our investment views and all associated risks to ensure we do not become complacent.

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Click here to read the next article: 'The hidden force that creates the world's greatest teams' by Paul Bosman

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