Brian Gaynor: DNZ offer fresh slap in face for small investors

There is a strong argument that the DNZ Property Fund IPO is the worst related party transaction, from a timing point of view, since the dreadful Capital Markets/Fay, Richwhite deal in August 1990.

The reason for this is that the Capital Markets/Fay, Richwhite transaction reintroduced the worst excesses of the 1980s just when we were hoping these deals were a thing of the past.

The DNZ/management company transaction also reintroduces the one-sided related party transaction, which has been a big feature of Hanover, Bridgecorp and other finance companies. These deals should be outlawed in New Zealand unless approved by minority shareholders.

One-sided related party transactions and partial takeover offers, where a group of shareholders receive a much higher offer than other shareholders, have been the bane of New Zealand investors over the past three decades.

The takeover problem was solved in July 2001 with the introduction of the Takeovers Code. The Code, which operates under the Takeovers Act 1993, protects most shareholders whether a company is NZX-listed or not.

A related party transaction is usually where a director or shareholder sells an asset or a company to a listed entity. Related party transactions also involve loans granted to directors or shareholders.

Unfortunately most of the related party transactions in New Zealand have destroyed significant minority shareholder value. This was particularly true during the 1980s boom when directors and controlling shareholders sold assets to listed companies at grossly inflated prices.

There was a short break from these destructive transactions until Capital Markets, which was controlled by Michael Fay and David Richwhite, acquired the merchant bank group Fay, Richwhite for $225 million.

The transaction, endorsed by an independent appraisal report written by Tony Frankham of Deloitte Ross Tohmatsu, was strongly opposed because investors didn't want to see a return to the darker days of the 1980s.

These concerns were justified because the merchant bank was worth substantially less than $225 million when Fay and Richwhite bought back the listed company five years later.

The related party problem has been partially solved through the introduction of stricter NZX rules but these only apply to listed companies. The unlisted sector is still largely unregulated in this area, which is why there have been so many related party problems amongst finance companies, unlisted companies and in the property sector.

This brings us back to DNZ Property Fund Limited, which is in the process of raising $151.5 million from the public through the issue of 184.7 million shares at 82c a share.

The origins of DNZ go back to the 1996 to 2001 period when Money Managers established 32, mainly single property, syndicates.

Following the appointment of Paul Duffy as chief executive in 2001 these properties were merged into three companies; DNZ Income, DNZ Foundation Property Fund and DNZ Retail. On September 30, 2008 these three companies amalgamated, together with DNZ Tauranga, to form DNZ Property Fund.

There were two unique features of this group of companies.

The first was the external management contract, which was previously owned by Paul Duffy, Alastair Hasell and Doug Somers-Edger until the former two bought out Somers-Edger a few years ago.

The management contract, which was extraordinarily lucrative as far as Duffy and Hasell were concerned, contained the following provisions before recent adjustments:

* A management fee based on 1 per cent of total assets.

* A rent review fee equal to 15 per cent of any increase or 1 per cent of the reviewable rental, whichever was the greater.

* A property acquisition fee equal to 1 per cent of the purchase price and a disposal fee equal to 2.5 per cent of the sale price, the latter net of agent's commission.

* A project development fee equal to 5 per cent of the total cost of a development.

* A performance fee equal to 5 per cent of the increase in total assets.

* Other fees based on the time spent by the manager on property issues.

These external management fee structures create a huge potential conflict of interest because the manager's incentive is to grow the business, regardless of profitability, whereas the investor is more interested in profits and dividends.

Duffy and Hasell managed the group aggressively with total assets and bank debt growing dramatically since 2001.

This strategy proved to be extremely lucrative for the management company, which distributed total dividends of $16.5 million in the March 2008 and March 2009 years. It appears that dividends paid to some 8000 DNZ investors were less than this $16.5 million although this is difficult to verify because of the September 2008 amalgamation.

The second was the capital structure whereby there were 469,965,609 "A" shares, held by the public, and only 10 "B" shares, held by management. Under the constitution the "A" shares appointed one of the six directors with the "B" shares appointing the other five.

In effect the "B" shareholders had almost total control over the company and the "A" shareholders did not get to vote on the current capital raising or the purchase of the management company.

DNZ grew too fast and now has to reduce debt. It could achieve this aim by either selling assets or raising new capital. The latter option would include the internalisation of the management structure through the purchase of the management company.

DNZ has decided to take the latter approach and this is summarised in the accompanying table, which essentially sums up what this issue is all about.

At present DNZ has net assets of $395.8 million giving a net tangible asset per share of $2.10. The purchase of the management company reduces the NTA to $1.87 and it falls further, as shown in the table, to $1.33 as a result of the IPO.

Thus the three main parties to these transactions will be affected as follows:

* Existing shareholders will have their NTA slashed from $2.10 to $1.33.

* Duffy and Hasell will be paid $43 million for their management company in addition to the $16.5 million of dividends they have received over the past two years.

* New shareholders will purchase shares at $0.82, a 38 per cent discount to the $1.33 NTA.

Clearly the balance here is wrong and shows once again that existing shareholders can be totally gazumped through the related party transaction process.

There were better alternatives as far as existing shareholders are concerned. For example DNZ could have sold $120 million of properties at 90 per cent of NTA, used this to repay debt, cut the purchase price of the management company to $23 million and issued just $50 million worth of new shares at a 30 per cent discount to NTA.

Under this scenario the NTA of existing shareholders would have fallen from $2.10 to around $1.79, instead of $1.33, and new shares would be issued through the IPO at $1.25 each.

This would have been a far fairer and more balanced approach than the one adopted.

The poor treatment of existing shareholders comes at an unfortunate time, as did the Capital Markets/Fay, Richwhite transaction, because investors have just come through an extremely difficult period and they don't deserve to be kneecapped again.

This story won't end here because future DNZ shareholder meetings will be torrid events with new, mainly institutional, shareholders praising the directors for giving them such a sweet deal while existing mum and dad investors will berate the directors for treating them so badly.

Existing shareholders will be totally justified if they give Paul Duffy and his fellow directors an extremely hard time.

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