Raising capital the unconventional way

QUESTION: How does a property developer undertake a fundraising exercise?

While developers being developers will continue to embark on new launches despite the massive oversupply seen across all property segments, any development must be funded either via internally generated funds, borrowings or if the project is well accepted by the market, buyers, who will be billed progressively.

If the project has low take-up rates and if the developer has insufficient cashflow, the developer would have no choice but to seek external funding and this could either be in the form of equity (via placement of new shares or rights issue), hybrid securities (like redeemable convertible preference shares or RCPS), bank borrowings (term loan, overdraft and syndicated facility) or via the issuance of debt papers (like medium-term notes, bonds or even perpetual papers, which can be either debt or equity).

All funding options have an impact on a company’s financial position.

Worrying debt level

A look at some of the largest developers in Malaysia shows that most of them are rather stretched when it comes to the net gearing level.

Among the top 10 property developers listed on Bursa Malaysia, Matrix Concepts Holdings Bhd has a very low net gearing level while UOA Development Bhd is sitting on a net cash of almost Rm1.8bil.

Other developers have net gearing ranging from as low as 28% to as high as 82%.

As net gearing levels are rather high, major developers are seeking funding that is not debt like or hybrid structures to mask the company’s actual debt level to the extent that some are claiming they have a healthy balance sheet when in fact the health of the balance sheet is driven by issuance of perpetual papers, or hybrid papers like RCPS, which allows these companies to raise cash and at the same time, the liability portion is deemed as equity and not debt.

Debt recycling

It is rather rare in today’s corporate world whereby a listed issuer undertakes one corporate exercise for the sole purpose of undoing a previous corporate exercise.

Of course, there is a carrot-and-stick story behind a recent proposal by a listed issuer for an Islamic RCPS issuance whereby a lower preferential dividend rate was proposed against the current RCPS in issue.

At the same time, the company also saves on the future higher preferential dividend rate under the stepped-up mechanism, which kicks in after the fifth anniversary from the date of issuance of the existing RCPS in issue.

Hence, the proposal is seen as beneficial to the shareholders due to the lower dividend rate to the holders of the new RCPS.

But as the company’s share price has corrected quite a bit compared with when the current RCPS was first issued, the new proposal will see greater dilution due to a lower conversion price for the new RCPS.

In addition, there is also no telling whether the company will issue another tranche of RCPS when this proposed new RCPS is subjected to a stepped-up dividend rate by an additional 1% per annum commencing from the fifth anniversary from the date of issuance of RCPS, and up to a maximum rate of 20%.

RCPS and perpetual securities are debts.

This column had previously commented on the issuance of perpetual securities issued by a few listed entities as it is seen as a loophole to mask the actual debt level of a listed company, as perpetual, and in the case of RCPS, a certain percentage of it, are deemed to be equity.

In accounting terms, for perpetual papers, it is assumed that the papers are 100% equity as there is no contractual obligation to deliver cash or other financial assets to another person or entity or to exchange financial assets or liabilities with another person or entity that are potentially unfavourable to the issuer.

Even distribution made on perpetual is recognised out of the equity in the period in which they are paid and thereby understating the actual reported earnings of a company in the statements of profit or loss and other comprehensive income.

In most cases, where these instruments are issued as perpetual papers, the underlying instrument carries a stepped-up mechanism whereby, if they are not recalled, the issuer ends up paying a higher preferential dividend rate to the holders of the papers.

In essence, while the accounting rule seems to imply there are “no contractual obligations”, these papers are a straight debt to the company and nothing else.

In some instances, some companies are becoming serial perpetual issuers as they retire one perpetual paper with another and in some cases, they even issue multiple perpetual papers to mask the company’s financial strength.

Imagine, by issuing let’s say a Rm500mil perpetual note, a company tells the investing public and stakeholders it has “a strong balance sheet with healthy cash” but in essence, the cash is from the issuance of perpetual.

The company could also mask its actual debt level as perpetual, as far as accounting is concerned, sits as part of equity.

Hence, the company does not recognise the perpetual as debts while dividend paid (in fact this is also masked as a dividend,

when in fact they are interest expense of the company) does not hit the statements of profit or loss and comprehensive income, thus overstating reported earnings.

Five years later, as there is a stepped-up dividend that is costlier and punishing to the company, the company retires the perpetual papers and issues a new perpetual series.

Effectively, these papers are not perpetual, but the listed issuers are using them perpetually.

For RCPS, these instruments will only convert into equity if the conversion price is attractive to the holders of the papers from the time of issuance and if they are “out-ofthe-money”, holders of the papers will expect redemption from the issue, typically at the fifth anniversary from the date of issuance of the papers.

Banks are fully exposed

Statistics from Bank Negara reveal that the banking system as a whole has some RM1.94 trillion of loans outstanding and housing loans alone make up Rm664.4bil as at March 2022, translating to 34.3% exposure, the highest ever.

Between 1998 and 2017, the housing loan share of total loans outstanding has risen from a 10.7% to 30.8% but the increase between 2018 and March 2022 has been more gradual, rising from 31% in January 2018 to its current level of 34.3% as seen in Chart 1.

Chart 1 also looks at the total loans extended to the property sector, which includes both the residential and non-residential property and this too has gradually climbed up from 46.4% in January 2018 to 48.3% as at the end of March 2022.

With increasing exposure to the property sector, it is of no surprise that the banking sector as a whole is mindful of extending not only new housing loans to borrowers, but also supporting property developers with banking facilities.

Of course, buyers with legitimate and supportive income streams are still welcome while companies with healthy balance sheets will have no issue in raising bank borrowing as a source of a fund but for the overly stretched balance sheet of some developers, the conventional funding has indeed dried up and hence the unconventional method is gaining popularity, especially RCPS, unrated perpetual, or even the traditional bond issuance with maturities between one year to as long as five to seven years.

Raising capital in an unconventional way has become the norm to mask the actual net gearing level of property developers.