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Management behaving badly

By Roger Armstrong

Sunday 1st September 2002

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It ain't nothing new. Executive men (and, increasingly, women) have been behaving badly with other people's money since the first investor pumped money into his mate's business. The tail end of the US boom - with its huge pay packets, big option allocations and, latterly, executives being clever with the accounts or committing outright fraud to boost the value of their shares and options - is just the excessive culmination of this trend.

On the other hand, making management behave has been the role of the board of directors ever since public companies came into being. Academics call it "agency theory": ensuring the managing director acts as an agent for shareholders rather than for him or herself. Because even when managers are decent, honest people - as they are most of the time - there is a continual tension between the interests of shareholders and those of the executive.

In New Zealand we do not have blatantly excessive executive salaries, option packets are relatively modest, there is little in the way of creative accounting and, touch wood, there has been no recent fraud. Yet we still have badly performing companies. A good bit of blame can be laid at the door of this conflict: managers' agendas versus the importance of looking after every last cent of shareholder wealth.


Cash and cachet

The oldest and most problematic area arises from the natural desire of managing directors to play with more and bigger toys every year. At the most basic level, expansion is often very lucrative for managing directors - the bigger the organisation, the bigger the pay packet - provided they don't stuff it up so much that they lose their job.

For example, consultants recommended that New Zealand Post managing director Elmar Toime receive a large pay increase when the company opened Kiwibank. Opposition politicians had a field day questioning the independence of Toime's support of the Jim Anderton-inspired bank as a sensible business idea when he potentially stood to gain financially from the deal.

It isn't just money. Managing the same operation day after day in the low-growth New Zealand market would drive any half-ambitious managing director to drink. The answer, from the managers' point of view, is often to expand. Moving into Australia via acquisitions has been a favourite; buying another New Zealand business is second choice.

Trouble is, financial studies from around the globe suggest that up to 75% of companies growing via acquisition actually destroy value for shareholders. There are no studies in New Zealand, but there is strong anecdotal evidence of companies such as Air New Zealand, Telecom and Mainfreight damaging themselves through acquisition in Australia. Boards would do well to restrain their terrier managing directors from lunging at acquisitions as a way to stave off boredom and gain kudos among their peers.


Contractors expand

Companies subject to management contracts, as opposed to those with their own executive teams, are probably the most at risk of being run more for the managers than shareholders. Typically, such companies have been set up as vehicles for property or utility ownership. The management company normally gets paid a percentage of the assets under management. The bigger the company (that is, the larger the assets under management), the higher the management fees and the better the individual executive salaries.

There is a huge incentive for the managers to continually expand such companies via rights issues, placements and so on.

Whereas individual managing directors tend to have scruples (and a board) to get in the way of the pure salary-maximisation strategy, management companies often have an obligation to their own shareholders to eke as much value out of a contract as possible. Also, many of the boards of the companies in question are controlled by the owners of the management companies, which means there is no independent voice working hard for shareholders.

The best New Zealand example of such a company is Kiwi Income Property Trust (KIP). It started life in 1993 with a market capitalisation of $46 million and has now pushed that to $580 million. The company has had a succession of capital raisings. The problem for shareholders is that the company's units almost always trade at a discount to the theoretical worth calculated by adding up the building values and subtracting debt. This discount is typically 10-15%, although recently KIP has traded at the low end of the range. There is good theoretical basis for the units trading at a discount to their estimated worth. The market is probably implicitly subtracting the value of the management contract when calculating an appropriate capitalisation.

But there's a new factor in the KIP equation - the recent sale for an undisclosed amount of the management contract to Colonial First State, a subsidiary of the Commonwealth Bank. In July, soon after the sale, the company did its most recent capital raising - a 1:6 rights issue at 82 cents. Of the money raised, 2.5% is being sucked up by costs, and the share market is likely to place a value of about 87 cents on the remaining 97.5 cents in the dollar.

So, how is a rights issue in unit holders' interests? It's not. Those wanting to invest more money in Kiwi Income Property would be better off buying existing units at a discount to valuation rather than putting more money in through a rights issue and seeing 13% gobbled up by costs and the typical market discount.

Needless to say, the rights issue is totally in the interests of the owners of the management contract. Is it any coincidence that such an issue has followed so soon after someone paying out big money for the management contract?

Kiwi Income Property management would probably argue that the money will be used to add value via developments. But the unit holders should prefer that existing assets be sold to fund such activities. Besides, KIP itself estimates that the Northland mall extension being funded via this issue will produce only an approximate 4% development margin; considerably less than the discount that will probably be applied to the new monies.

It is interesting to compare the actions of KIP with those of Infratil, which is buying back its shares in the market at a discount to valuation to increase the worth per share for remaining investors. Infratil has a strong independent board, whilst KIP directors are mainly associated with the manager.

The wealth effect of the KIP rights issue on unit holders is not large but it is the principle that counts. It is vital for shareholders and unit holders to have a board that looks after every last cent of their money.

Disclosure of interest: Roger Armstrong owns shares in Mainfreight

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