Martin Lawrence
Fund governance Frankensteins
The saga unfolding at Babcock & Brown Power (BBP) serves as a telling reminder of the broader risks associated with investing in listed infrastructure vehicles that are controlled by their promoters and riddled with takeover defences. Investors awaiting a shake-up following the announcement of a funding shortfall will need to be patient. BBP's governance structure is so deformed that it makes the ousting of management, either by independent directors or by a takeover, next to impossible.
This happy outcome (for BBP’s managers, not its security-holders) is a result of several ingenious features of BBP’s structure:
– A 25-year management agreement between BBP and a Babcock & Brown subsidiary that cannot be terminated by the board or by security-holders for underperformance without triggering the need to pay out the remainder of the contract. This agreement continues even if there is a change in control of BBP.
– A 10-year ‘exclusive financial advisory agreement’ with another Babcock & Brown subsidiary that may only be terminated with six months’ notice after 10 years and only if BBP “reasonably believes that BBA (a Babcock & Brown subsidiary) no longer possesses sufficient resources” to provide the services and BBA has been unable to address these concerns.
– Asset management fees payable to another Babcock & Brown subsidiary under a 25 year “asset management agreement” that will only become payable if fees cease to be paid to Babcock & Brown as manager.
Unlike other listed infrastructure funds, at least these features should come as no surprise to BBP investors. The product disclosure statement for the December 2006 IPO bluntly warned that:
“Accordingly, a person … taking over BBP is likely to have a disincentive as they would not necessarily be able to appoint their own manager or manage BBP’s assets themselves. The restrictions on termination of the management agreements may have an adverse effect on the price of stapled securities if BBP does not perform as expected.”
This inflexible structure goes some way to explaining BBP's current travails, which began when the fund made two announcements on May 22 and 23, revealing in piecemeal fashion that it had a funding shortfall of about $230 million and was considering asset sales to reduce its gearing.
The two-step disclosure helped slash more than 30 per cent off BBP’s already wounded security price. News that the parent of BBP’s external manager, Babcock & Brown (BNB), was willing to help meet any funding shortfall failed to halt the rout (although the security price has recovered a little since BBP announced it has completed its debt refinancing).
Analysts were predictably savage, with Macquarie Research claiming that the clumsy nature of the two-step communication “destroys the credibility of those controlling the company”. A typical governance response would see the board hold management to account on behalf of investors, with the entire group also subject to the ultimate sanction of removal through the mechanism of a takeover.
And BBP investors are not the only ones in this situation. Security holders in several listed infrastructure vehicles that are trading well below declared NTAs are realising that the negative premium associated with poor governance in the sector may not be a temporary phenomenon.
The concerns evident in BBP have wider implications for investors, particularly given the curious decision by the ASX not to compel the disclosure of all terms of management agreements. A small host of similar governance Frankensteins are listed on the ASX, and the number of similar monsters listed overseas is growing.
These listed vehicles offer none of the means of accountability that investors have traditionally relied upon. Security-holders and their directors are rendered powerless by the fact that the manager cannot be removed or is too costly to change. The arrangements are akin to directors of a listed company employing the CEO and all senior executives on interminable 25-year contracts.
The fundamental lack of accountability that management arrangements like those at BBP allow is not an abstract governance concern. It is detrimental to the efficient allocation of capital because it removes the discipline that listed markets are meant to impose on managers, either through their removal via the board of directors, via takeover or via a security-holder vote (in the case of managed investment schemes).
Before the next wave of captive entities emerges, the ASX should bring its disclosure rules into line with the US, and force promoters to reveal their management agreements in full. At least that way investors in similar entities will be able to quantify the price of management entrenchment at inception, rather than when the negative premium of poor governance becomes a permanent feature of their valuation.
Martin Lawrence is head of research at RiskMetrics Australia and co-author of the report Infrastructure funds: managing, financing and accounting – in whose interests?
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