Christopher Adams: What were they thinking?

Adrian Orr, Chief Executive of the New Zealand Superannuation Fund. Photos / Steven McNicholl, Getty Images

A response from NZ Superannuation Fund chief Adrian Orr has been added to the bottom of this comment piece.

A Portuguese bank on the verge of collapse - what were they thinking?

That would have been the response of many newspaper readers this morning upon learning the New Zealand Superannuation Fund has lost nearly $200 million in taxpayers' cash on a "risk-free" loan it provided to Lisbon-based Banco Espirito Santo (BES) on July 3.

The loan - part of a US$784 million credit package US investment bank Goldman Sachs put together through its Oak Finance vehicle - was made exactly one month before BES collapsed and Portugal's central bank split the country's biggest lender into two, with one part holding the good assets and the toxic assets placed in the other.

Unfortunately, the Oak Finance loan is now stranded in the so-called "bad bank" following a retrospective law change by the Bank of Portugal.

And to make matters worse, the about turn by the Portuguese central bank voided the insurance the Super Fund had taken on the loan, which had led it to believe the investment was bullet-proof, despite ratings agency Moody's deeming it to be "speculative and a high credit risk".

Local market participants, who didn't want to be named, said the situation highlighted some of the "exotic" investment areas the Super Fund was getting involved in.

"There's a bunch of clever guys at the Super Fund and they have a belief that just going into run-of-the-mill, normal investments doesn't deliver a great return," said one industry source. "Other [exotic investments] have worked well for them and this one hasn't."

The source said the fact the loan was made only a month before the collapse of BES raised questions about the due diligence process the Super Fund had carried out.

To be fair, the Auckland-based fund - set up in 2003 with the aim of helping to pay for the future costs of superannuation entitlements - could not have foreseen the Bank of Portugal's law change, which meant creditors with a more than 2 per cent shareholding in BES would be relegated to the "bad bank".

The central bank claimed Goldman Sachs' BES holdings peaked at 2.27 per cent in June.

Super Fund chief executive Adrian Orr has described the law change as a "wild-card, Black Swan event". The Super Fund, alongside Goldman Sachs, is suing the Bank of Portugal over the law change.

It's easy to bask in the luxury of retrospect, but the investment obviously wasn't "risk-free" and surely a bit of digging would have revealed the sickly state BES was in by July last year.

"You'd have to question what sort of due diligence was completed to justify the investment, since this [the BES collapse] happened so soon afterwards," said another market source. "What this will do is encourage the Super Fund to go and re-assess the portfolio - to stress test it more - because you don't like these things occurring."

The Oak Finance losses are merely a drop in the bucket in the context of the $27.5 billion Super Fund, and will have a minimal impact on returns.

But the fund won't be enjoying the headlines, particularly given the association with Goldman Sachs. For the general public, the New York-based investment bank's brand often dredges up memories of the global financial crisis given the role it played in flogging the complex derivatives that sparked that economic disaster.

Goldman came last in recent corporate reputation survey of 100 "highly visible" US firms.

The Super Fund has performed well over the years - posting returns of 9.95 per cent per annum since its inception - but the BES debacle has left it with egg on its face.

Finance Minister Bill English. Photo / Duncan Brown

Business video: Meet the CEOs: Adrian Orr

The pathway to mega-losses

How is the New Zealand Superannuation Fund (NZSF) connected to collapsed lender Banco Espirito Santo (BES)?

The NZSF invested US$150m with Goldman Sachs vehicle Oak Finance. Oak Finance invested this - as part of a US$784m investment on behalf of clients - with BES.

Why did NZSF invest in Oak Finance bonds?
As part of a broader strategy, the NZSF lent to banks where it received more interest than it cost to buy credit protection insurance.

Why did Oak choose BES?
At the time the Oak Finance loan was taken out, BES was Portugal's largest commercial listed bank and had managed to raise €1 billion in a share issue last June. The Bank of Portugal also stated that BES was solid after the shares were sold.

What happened to the loan?
While the Bank of Portugal stepped in to manage the collapse of BES, it found that Goldman Sachs' shareholdings were not covered by Portugal's insolvency regime. The loan has not been transferred to the newly formed bridge bank Novo Banco, and is currently irrecoverable. NZSF and Goldman Sachs are challenging in court the Bank of Portugal's decision.

How does this affect the performance of NZSF?
The Oak Finance investment represented 0.7 per cent of the NZSF. Fund returns this financial year are expected to be 0.69 per cent pa lower as a result of the Oak loan. The fund's expected annual return rate has been calculated to drop from 10.01 per cent to 9.98 per cent.

NZ Superannuation Fund chief Adrian Orr responds

The problem has arisen solely because of the arbitrary and retrospective actions of the Bank of Portugal, subsequent to our investment, in treating our loan unequally to other senior debt holders and causing our insurance to be ineffective. We believe their actions are wrong and based on a misunderstanding of the facts. We have a strong legal case and are confident that we will recover the funds.

There are three key factors in this (and none of these involve BES's credit rating): 1) the fraud that was identified at BES after we invested; 2) the law that was applied retrospectively after we invested; and 3) the Bank of Portugal's wrong interpretation of that law.

We note that all senior bond holders in BES of the same class as Oak Finance remain in the new bank i.e. whole. Our insurance also remains in the good bank i.e. whole. To reiterate, it is simply the laws introduced after the investment was made, and the subsequent retrospective and illegal decision of the Bank of Portugal in singling out this loan to return it to the bad bank that have led to our court action.

The success or subsequent failure of BES is beside the point. For example, if BES had defaulted and not been bailed out, we would have got our money back because the credit insurance would have paid.

By way of background, the Guardians' due diligence focused primarily on getting comfort that the credit protection we purchased would be effective in the event of a default by BES. Part of this diligence was to establish that the loan was a senior unsecured obligation of BES, as the credit protection was purchased on senior unsecured obligations of BES.

We also undertook due diligence on BES itself. BES was Portugal's largest listed bank with a balance sheet of approximately EUR80 billion. BES had successfully completed a EUR1 billion equity rights issue in June 2014. Immediately after completing this equity rights issue brokers estimated that BES had a tier 1 capital ratio of 10.4% and on 30 June 2014, prior to our investment, the Bank of Portugal stated that BES had a solid solvency position.

After we invested, a new management team in BES suspected fraud. This fraud had not been visible to the market nor to the Bank of Portugal (the regulator) prior to our investment. We were one of a number of large institutional investors who invested in Oak Finance.

In regards to the Moody's rating: the rating applies to an unsecured obligation of BES and doesn't factor in the protection we purchased. For us, the transaction was considered low risk because the protection was designed to remove all credit risk. In this way the credit rating of BES was immaterial to the transaction, at the time - what we were being paid to provide was liquidity, not credit cover.