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INTERVIEW: PAG Says Spring needs to disclose related-party transactions and improve performance

 (For our interview with Spring, please click here)

 

On 26 September 2018, alternative investment management firm PAG launched a takeover to acquire all the units it doesn’t already own of Hong Kong-listed Spring REIT. PAG’s final offer was HK$5.30 for each unit of Spring REIT, a 76.7% premium to Spring REIT’s 24 September 2018 closing price.

In its presentation to Spring REIT’s unitholders in August 2017 prior to the offer, PAG outlined four main issues – (1) underperformance (relative to IPO price and to the performance of other REITs), (2) stranded value with Spring REIT trading at a substantial discount to NAV, (3) missed opportunities (in implementing strategic reviews), and (4) poor decision making, conflicts of interest and failures of corporate governance on the part of Spring REIT’s management team.

 

Spring REIT argued against the bid, citing the HK$5.30 offer being below NAV (Net Asset Value) which exceeds $6 a share.

PAG’s bid fell through in November 2018 after receiving unitholder acceptances that would have allowed PAG to hold 41.5% of the units, but the acceptances were short of the 50% level required for the offer to become unconditional.

REIT AsiaPac spoke to Broderick Storie, PAG Real Estate Partner, to bring unique insights into this milestone in shareholder activism about the REIT structure in Asia Pacific.

 

Question:

PAG’s bid was narrowly rejected despite a very substantial premium. Why do you think this was so?

Answer:

The Hong Kong market is unique when you compare it to other markets around the world – HK-REITs typically have a sponsor as an anchor investor. Sponsors usually hold about a third of the shares, or more,of a REIT, and there is independent research that will back this statistic.

Specific to Spring REIT, we knew from the outset that there was an entrenched sponsor stake and that stake is about 32%. This created a very high hurdle for us to be successful. If you take out the 32% sponsor stake, the acceptance rate was approximately 61.2% of third-party unitholders. So when you consider it from that perspective, the bid’s result shows a vote of no confidence in the manager. (Editor’s Note: Spring’s sponsor, or major shareholder, is Japan-based Mercuria Investments Co. Ltd.)

The reality is it’s always going to be challenging when you’ve got such an entrenched stake, and we were aware of that from the outset. But our action has continued to build a broader unitholder consensus. We have brought attention to some of the fundamental issues both from a performance and a governance perspective, and we hope this will lead to change over the near term.

 

Question:

Would you continue to try to build this awareness and then hopefully in six months or in a year relaunch your bid or do you take the view that this is just too hard, I might as well sell off my shares?

Answer:

I wouldn’t be a particularly prudent investor if I told you everything that we were going to do. I won’t answer too precisely except to say this – we’ve increased our stake in Spring REIT. We’ve been in this vehicle now for almost three years. We’ve got 16.6% of the vehicle, and so we’re a material unitholder. We plan to stay focused on making sure that we protect our investment and we are going to hold the manager accountable. And as you’ve seen from what we did [in 2017] and what we’ve done [last year], we have the resources both in terms of capital and expertise to ensure that we can do the most we can to protect our investment.

 

Question:

You have owned Spring REIT for about three years now. Could you share what led you to take such a significant stake?

Answer:

PAG has about US$30 billion in assets under management. We run three different strategies: traditional private equity, absolute return – which has things like hedge funds and credit funds, and our real estate private equity business. We have the option to go into vehicles like this and build up a stake. That’s consistent with the strategies that we run within our business. And this is not the first example. About four years ago, we had close to 18.8% of Forterra Trust.

 

Question:

I recall that Forterra owned mostly commercial properties in China, and there was a period when its sponsor had certain solvency issues. Was it an opportunistic play on your part?

Answer:

The best way to say this is we’re an opportunistic deep value investor. You’re right it was under pressure because the sponsor had certain debt pressures that were European driven and they were looking for strategic options to deal with that situation. So that’s one example of what we do.

 

Question:

Did you take a position in Spring REIT, as early as three years ago, because you thought the REIT was mismanaged and therefore there was an opportunity for you to come in and improve things? Or was the position taken on the basis the REIT had growth potential and the mismanagement came about later on?

Answer:

We thought there was growth potential and at the time we took the view that management would be able to deliver outcomes that were relevant for ourselves and other independent unitholders. Unfortunately, despite providing advice, guidance and views about the company’s direction, they weren’t able to respond in a manner that we felt was beneficial for ourselves and other unitholders. The management did not listen to suggestions from ourselves and the market. And as a result of that as well as what we would consider questionable governance actions, we decided to take action. We’ve got a much deeper track record in real estate investing than the target. And we’re also in a position where we’re well equipped to deal with these sort of underperformance issues.

 

Question:

To what extent can you really drive change in Hong Kong’s capital markets? Do you think there is room for improvement in its regulation?

Answer:

I think that ultimately we will need to see some level of regulatory reform. I think it’s very well documented that the general perception from large global equity investors is that it’s probably been one of the weaker major markets from a governance perspective — both regarding how it’s applied by those vested with the responsibility to administer governance but also in terms of the regulatory protections within the legislation.

I’ll give you an anecdote. We run an alternatives business and we invest our own money, and alongside us, we have some of the world’s largest sovereign wealth funds and pension plans. From a governance perspective, we’ve got a very sophisticated shareholder base. Let’s take the Spring REIT example.  Spring was proposing to acquire an asset off a party that owns 9.8% of the management vehicle of the REIT. In the institutional world where we operate, this situation is a clear conflict of interest, and we would have to not only disclose this but would also be prevented from voting on approving the acquisition regardless of our interest in the vehicle.

However, under Hong Kong’s regulatory regime, that’s not technically regarded as a conflict such that it would preclude you from voting your interest, despite the clear conflict. From a governance perspective, you should be applying best-in-class governance and using the institutional model as a reference point.

 

Question:

There was recently a similar situation in Singapore where despite a bid by a group of investors to change a REIT’s manager failing, it resulted in real change inclusive of the CEO of the manager leaving shortly after. Do you think you will see real change with Spring regardless of the outcome of the bid?

Answer:

If the board and particularly the independent board members have unitholders’ interests in mind and have the experience in these circumstances, I imagine that that should be a discussion that’s occurring because it is the worst performing REIT among the constituents of the Hang Seng REIT Index in terms of unit price performance. It arguably has some of the best underlying assets—certainly the two Beijing office towers which represent about 90% of the current gross asset value. It’s in a grandfathered structure. Additionally if you look at some of the actions around related party transactions, you’ve had very poor governance. If I was a board member, I would be asking the CEO to justify very clearly how he’s going to rectify that.

Secondly, I’d be questioning what their real track record in investing is. They were going to recommend to unitholders to issue units to a proposed vendor (Huamao Focus Limited) at $3.372, which is highly dilutive and well below the $5.30 that we offered. There was a graph that essentially implied that you shouldn’t be worried about the unit price because there is an inverse correlation between yield and unit price. They attempted to justify this with the argument that if you buy something for $100 which has $10 of income; if it goes down to $50 in value, it’s still $10 of income. The yield will be 20% as opposed to 10%, and that’s a good thing, and we’ll forget about the fact you just lost $50. If that is the narrative, I wonder if they would have been able to get the IPO underway in December 2013.

 

Question:

Are there any other players or investors at the centre of the ecosystem who you think has a role to play to drive change? 

Answer:

I should be clear that the regulator is very good to deal with. This was a first for the Hong Kong market, and we found them to be open, direct and engaged. I think the issue itself is there is a need for regulatory reform as opposed to how it is administered.

My view is you’ve got to continue to cultivate broader institutional ownership in the capital markets and particularly in the REIT space. Implicit in institutional ownership if you get an experienced investor helping to hold account managers for underperformance, a direct result is you embed some level of market protection for moms and dads who are invested in these REITs.

Most state finances now are under some pressure, and there’s this growing retirement age population. Retirement savings are a bigger and bigger issue now both socially and economically. A lot of people own shares as part of their retirement either directly or indirectly. So, there’s a real imperative to make sure that capital markets provide an effective means to deliver returns over the longer term. In Hong Kong, where you don’t have a large degree of institutional ownership, you’re not creating a market environment that introduces a level of market accountability that would help deliver on some of those outcomes longer term.