Shareholders take risky gamble

Capital notes make undisciplined expansion easier and may enhance the wealth of executives and directors. By BRIAN GAYNOR.

A large gathering of Sky City shareholders approved a $150 million capital notes issue at Tuesday's extraordinary general meeting.

The resolution received unanimous approval even though these notes have been a contributing factor to the poor performance of Brierley Investments and Fletcher Challenge.

Sky City's share price responded positively to the decision but there is an uneasy feeling that the tail has wagged the dog.

It seems that Bill Trotter and Credit Suisse First Boston - rather than the board of directors - are having the biggest influence on the company's financing decisions.

Capital notes also had an important influence on this week's offer for St Lukes Group.

Westfield Trust's 170c a share offer looks attractive only because St Lukes' share price slumped after a notes issue in mid 1999.

Capital notes, which are called junk bonds in the United States, are unsecured, subordinated debt securities issued to investors.

They pay a fixed rate of interest and are used by companies to borrow money when the banks are reluctant to advance more funds.

The notes are attractive to investors because they pay a high rate of interest. The rates are high because the notes are relatively risky. They appeal to companies as they have no compulsory repayment date. When the notes mature they can be rolled over for another period, or the proceeds can be used to purchase ordinary shares at 98 per cent of the sharemarket price.

The problem with these funds is that they are not subject to the normal disciplines of equity or debt. Ordinary shareholders and the banks can have a strong influence over a company's decision making but noteholders are relatively powerless.

Brierley Investments and Fletcher Challenge had a large pool of capital note funds that made their undisciplined expansion easier.

The availability of this money allowed them to hold on to poorly performing assets that should have been sold.

Capital notes can be particularly dangerous in the hands of a weak board of directors.

Two large stockbrokers, Credit Suisse First Boston (CSFB) and UBS Warburg, have been behind most of the New Zealand issues.

Brierley Investments had its first notes issue in 1992 and by June 30, 1994 had $462 million on issue.

Fletcher Challenge entered the note market in 1995 and two years later had raised $973 million.

Nufarm (formerly Fernz), St Lukes, TransAlta and Capital Properties are the other companies to issue capital notes. The last two used notes to fund acquisitions and did not raise any new monies from this source.

CSFB is a common thread running through these companies. The broker was involved in the Brierley Investments and Fletcher Challenge issues and through its connection with the former became involved with Sky City.

Bill Trotter, the chief executive of CSFB, was appointed to the Sky City board in March and two months later the current issue was announced.

Sky City is raising $100 million, which is underwritten by CSFB, and can accept a further $50 million of oversubscriptions.

The $150 million is particularly large because Sky City had shareholders' funds of only $153 million as at December 31, 1999.

The group is purchasing the Adelaide Casino next month for $A180.25 million and has renegotiated its traditional long-term borrowings with a syndicate of bonds.

This consortium will provide Sky City with two long-term debt facilities, $310 million and $A203 million ($254 million).

If Sky City fully uses these facilities and raises $150 million through the note issue, it will have shareholder funds of $153 million and long-term debt of $714 million.

The Sky City chairman, Jon Hartley, says the capital note funds will be used to "pursue new business opportunities which may arise in the future."

Why does Sky City need an additional $150 million of debt when it already has a long-term facility of $564 million, has no apparent use for the $150 million and has a positive operating cash flow of between $55 million and $72 million a year?

In the United States a number of these junk bond proceeds have been used to buy back ordinary shares.

This strategy has been criticised because its main objective is to enhance the wealth of executives and directors who own shares and options.

It can benefit all shareholders in the short term but the long-term impact may be negative.

The obvious place for Sky City to use the note proceeds is in Australia, yet none of the group's directors have experience of the gaming industry across the Tasman.

Another important issue is the appointment of Bill Trotter to the Sky City board.

Overseas experts on corporate governance argue that senior executives of a finance or law firm that advises a listed company should not be appointed to the board, because they are unlikely to contest the advice of their own organisation.

Mr Trotter is one of the most widely experienced financiers in New Zealand yet one would not expect him to debate, question or vote against advice received by Sky City from Credit Suisse First Boston.

In accordance with Stock Exchange rules, Sky City shareholders were supposed to approve CSFB's underwriting role because of Mr Trotter's board position.

Sky City applied to the Exchange for a waiver. The request was granted and no details of the agreement between CSFB and Sky City were contained in the notice of meeting.

Mr Trotter is also a director of the New Zealand Stock Exchange.

Mr Hartley told the meeting that directors were pleased with Sky City's trading prospects, but shareholders were more concerned with the group's poor share price performance.

In March 1999, Brierley Investments sold its 65.6 per cent shareholding to the public through an instalment receipt process at 755c a share.

As Sky City now has 18,900 shareholders, compared with just 2000 before the Brierley share sale, most of those attending the meeting were well out of the money and were dissatisfied with the company's performance.

Twelve months ago St Lukes' shareholders were a relatively happy bunch.

The group's share price was at a premium to net asset backing and the shares consistently traded in the 185c to 195c range. On June 1, 1999 the company announced a $150 million capital notes issue with the right to accept oversubscriptions up to a further $50 million.

Warburg Dillon Read (now known as UBS Warburg) was the lead manager and underwriter. Chairman Bill Falconer told shareholders that the funds would be used to repay borrowings and thereby increase St Lukes' flexibility to pursue further development, refurbishment and acquisition opportunities.

The issue raised $175 million and the notes were listed on the Stock Exchange on July 29. The group's ordinary share price closed at 185c that day and has fallen steadily since.

It is too simplistic to blame the share price decline on the capital notes issue but many shareholders believe it had some influence.

The issue was heavily marketed to St Lukes' shareholders and it is inevitable that a substantial capital raising will have some influence on the value of other securities.

Mr Falconer has annoyed many shareholders by stating that the merger will allow the group to reduce its borrowing costs, yet just 12 months ago the company was aggressively selling high-cost capital notes.

As the offer from Westfield Trust is deemed to be a merger rather than a takeover, it will have to be approved by St Lukes' minority shareholders at an extraordinary meeting.

This will give shareholders an opportunity to express their dissatisfaction over the impact of the notes issue on the share price.

* Disclosure of interest: Brian Gaynor is a St Lukes shareholder.