Till debt do us part

WHAT does having a debt in a company mean?

Of course, in general terms, having a debt on the balance sheet means that at one time in future, the company that has taken the debt is expected to fully repay that debt based on the agreed terms when that facility becomes due and payable. However, if the company is unable to pay its debt, it would normally restructure its facility or it may even extend the tenure of the facility but perhaps on stricter lending terms or in the worse case scenario, file for bankruptcy.

There are many ways a company can raise capital from the market and this can be done either via issuance of shares (both ordinary or preference) as well as debts (either in the form of loans, bonds, notes or other form of facilities like overdrafts, revolving credits and so forth).

There is also another hybrid method to raise capital and this include instruments like convertible loans which are either irredeemable or redeemable, which can also be either secured or unsecured. We also have companies that raise capital via issuance of warrants (either for a nominal sum or issued for free as a sweetener for shareholders to exercise certain other offerings like a rights issue) which upon conversion is part of equity of the company.

Then, we also have companies raising capital via issuance of perpetual securities.

As the name suggests, perpetual securities are debts that are forever due to the holders of the securities and the issuer has a right to never redeem the securities issued. Perpetual securities have certain salient features and this include a payment of certain coupon rate, a call-back and a step-up feature, whereby if at the end of the call schedule, the issuer has a right to redeem the perpetual securities or continue the programme but at potentially higher interest rates.

For the issuer, whether to call back or otherwise very much depends on the prevailing market interest rates at the material time when the call-back kicks in, which is typically at the 5th or even the 10th year from the date of issuance.

If market interest rates are higher even after incorporating the step-up interest, the issuer will not call back but if market interest rates are lower, chances are the issuer will call back the perpetuals and refinance the facility.

Due to the nature of the perpetual securities, in accounting terms, the securities are deemed to be part of equity and not debt, although the likelihood of an issuer calling back the perpetuals is high, mainly due to the step-up features, which are clearly designed to punish the issuer if the securities are not called back.

In Malaysia’s case, there are corporates that have taken the perpetual securities route to raise capital and they include companies like Mah Sing, Boustead Holdings and, once-upon-a-time, SP Setia. Let’s look at the 3 companies in more detail.

Presently Mah Sing has three perpetual securities that it has issued to date and they are:

Tranche 1 – RM540mil perpetual sukuks, which was placed out on March 15, 2015 and carries a periodic distribution rate of 6.8% p.a. payable semi-annually from year one to year five;

Tranche 2 – RM650mil perpetual securities, which was placed out on April 3, 2017 and carries a periodic distribution rate of 6.9% p.a. payable semi-annually from year one to year five; and

Tranche 3 – RM145mil perpetual securities (second issuance), which was placed out on Nov 15, 2018 and carries a coupon rate of 6.55% p.a. payable semi-annually from year one to year three.

In all the issuances, Mah Sing has an option to redeem or call back all or part of the securities at the end of the fifth year (for Tranche 1 and 2) and third year (for Tranche 3) and thereafter on each subsequent periodic distribution date.

Mah Sing also has the option to redeem the papers if there is any change or amendment to the accounting standards resulting in the instruments no longer being classified as equity. This is because, accounting wise, these securities are deemed to be equity and not debt as they are perpetual securities.

Interestingly, for both the perpetual sukuks and securities, should Mah Sing failed to redeem at the end of the 5th year, there is a stepup distribution rate by an additional 3% above the prevailing rate for the 6th year, an additional 2% for the 7th year, additional 1% thereafter and up to a maximum rate of 15% p.a.

In Boustead’s case, they had issued RM1.2bil worth of perpetual sukuks on Nov 15, 2013. Boustead explains in its annual report that the perpetuals are classified as equity as there is no obligation to redeem the instrument, despite the fact that, similar to Mah Sing, it has embedded features such as a call option for the company to redeem at the end of the 5th year of issuance.

If Boustead does not exercise its option to redeem at the end of the 5th year, the periodic distribution rate shall increase by 1.5% p.a. for the 6th year and for the 7th year onwards, the periodic distribution rate will be further increased by 1% p.a. and for every year thereafter, subject to the maximum rate of 15% p.a.

In SP Setia’s case, the company issued in nominal value some RM609mil unrated subordinated Islamic perpetual notes on Dec 13, 2013 and among the salient feature of the bonds were that SP Setia had an option to redeem the notes at the end of the 5th year and at each of the subsequent periodic distribution date thereafter.

Similar to the perpetuals issued by Mah Sing and Boustead, the perpetuals issued by SP Setia too had a step-up feature from its original distribution rate of 5.95% p.a., which increase at the rate of 1% per year to a maximum of 20% p.a. if the company does not exercise its option to redeem the notes at the end of the fifth year from the date of issuance.

Guess what? As per SP Setia’s fourth quarter (4Q) results announcement, the company had actually redeemed these perpetual notes as indeed the step-up feature probably made sense for SP Setia to do so. Should it not do so, the distribution rate would have increased to 6.95% p.a.

Hence, this brings the question – are perpetual securities, especially those that are embedded with stepup distribution rates, really perpetual? If not, why are they part of equity?

By defining perpetuals as part of equity, it distorts the balance sheet of the issuer as it is not deem as debt.

The chart shows the extract of Mah Sing’s and Boustead’s 4Q balance sheet items as at Dec 31, 2018.

In the quarterly statement to Bursa Malaysia, Mah Sing informs the investing public that its total borrowings are about RM568.2mil (inclusive of RM3.9mil in the form of finance leases) but it did not deem the perpetual securities as debt as the accounting rule deems these perpetuals as equity. On the contrary, because issuance of these securities have raised cash for the company to the tune of more than RM1.3bil, Mah Sing tells the market in its quarterly statement that it is a net cash company when, if one includes the perpetuals which are clearly debts and not equity, Mah Sing is actually a net debt company of about RM673mil or net gearing of about 19.3%. A similar argument too holds for Boustead although in Boustead’s case, the net gearing is just larger than what is reported as borrowings.

Let’s simplify the argument. If a company has a total equity of RM100mil and borrowings of RM30mil and cash of RM10mil, the company’s net debt level is about RM20mil or net gearing of 20%.

What happens if the company goes to the market to raise perpetual securities of RM50mil with call back and step-up features similar to what we see in listed companies today? Accounting wise, the total equity would rise to RM150mil, total borrowings remains the same at RM30mil but cash position would increase from RM10mil to RM60mil. Suddenly, the company turns from a net debt to a company with total net cash of RM30mil! Never mind if the perpetuals are due in five years time but in the mean time the company can tell investors and the market that the company is a net cash company and it has a war chest to acquire others, or expand its existing business.

With this accounting trick, perhaps more and more companies should embark on raising perpetual securities as the debt raised is not recognize as debt but equity and a company can now proudly inform the market that it is a net cash company when in actual fact it remains a net debt company.

While some analysts do adjust for these items despite the accounting rule that classifies these securities as equity, the message that the company is giving to the market can be said to be misleading especially due to the fact that the perpetuals actually penalizes the company in the form of higher coupon rate if they are not redeemed after 5 years as we had seen in the case of SP Setia.

In summary, while treatment of equity is straight forward, the treatment of perpetual securities needs to be scrutinize further so as to give the investing public a right picture and not a misleading one, especially when it is about the health of company’s balance sheet. Of course, for some companies, debt can remain forever but should the debt level rise too much, perhaps its time to say “Till debt do us part”.