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Written by Olga Constantatos, Credit & Equity Process Manager at Futuregrowth Asset Management
True, of course, because what they held had been marked down to R0.00 in their funds. The life of a debt investor (or depositor), however, isn’t as simple – as lenders are left to negotiate with the curator and potentially subordinated creditors to fight over the remains of the company to attempt to claw back as much recovery for our clients as possible.
The recent collapse and curatorship of African Bank has again reminded institutional debt investors that credit investments carry the risk of possible loss.
While investors should take all possible steps to mitigate defaults before the event, dealing with a credit default is part of investing in credit-risky assets. This article shows the steps that the team at Futuregrowth, as fiduciaries, took to mitigate the increasing risks that became apparent at African Bank in order to protect our clients’ funds.
Since the curatorship of African Bank, our clients and their consultants have asked how we have managed the “crisis at African Bank”. Our response has been that while the precise timing of the unravelling of African Bank was uncertain, our credit and ESG analysis revealed a company and a sector in trouble from as early as August 2012. At that stage, our regular fundamental credit analysis showed an industry and a company that, in our view, was not sustainable. At African Bank in particular, our analysis revealed a company that was growing too aggressively by loosening their credit criteria, including extending the repayment terms for loans and increasing the quantum of the loans made to individual borrowers. All this to a sector of the population that was becoming increasingly choked by their debt obligations and in an environment where unemployment is significant and the economy starting to slow.
In March 2013, in response to the available information and based on the conclusions we arrived at from our research, we started looking at our fund exposures to African Bank more carefully and we took steps to reduce our client fund exposures to African Bank in particular. We did this by reducing the quantum of our exposures, reducing the term of our exposures by only investing in shorter-dated money-market instruments and by demanding an increased credit spread for all new investments. During the course of 2013 we had opportunities to engage with ABIL management, amongst other players, and we determined that the business strategy was unclear and the level of dialogue insufficient. Thus, our analysis and our view required that the higher risks at African Bank demanded additional credit spread to compensate for this increased credit risk.
In some cases, we were successful in obtaining this additional yield for our client funds and in other instances where we were not, we declined the investment and invested our client funds in other assets, where, in our opinion, there was a more appropriate risk/return payoff. We also took a decision not to participate in any additional senior term debt issued by African Bank – primarily as we held the view that the credit spread on the bonds was inadequate to compensate for the increasing risks – and we continued with our strategy of not investing in bank subordinated debt (which, due to mispricing, is something we have generally applied to all banks).
By October 2013 our views on the unsecured lending sector were publicised (view relevant articles). We made some very public and at the time, including statements about the risk factors in micro-lending in general and at African Bank in particular, and how their business model was no longer a sustainable business practice. While in the early days of SA’s micro-lending business, we saw the industry as a vital provider of credit to the unbanked consumers and five years after the implementation of the National Credit Act, we took the view that the industry had migrated to be a “net social bad” and we suspended any new loans from our developmental funds.
“If you look at another company like African Bank, it’s much closer to home but really, a great example on the matter of sustainability: impoverishing your own customers is not a sustainable business strategy and those chickens came home to roost.”- Andrew Canter, CIO Futuregrowth
By March 2014, our ongoing credit analysis on African Bank confirmed a company with a provisioning policy that continued to be inadequate despite considerable and further asset write-downs by African Bank management and a recent successful rights issue. We thus downgraded (on our internal ratings system) African Bank and revalued the instruments we held. At this stage, our client investments in African Bank had declined from around R6bn in August 2012 to around R1bn in mid-2014 – a substantial decline which was deliberate in response to our analysis revealing the increased risks at African Bank.
The curatorship of African Bank announced in early August 2014 has resulted in all investments in African Bank being effectively “frozen” until the curator is able to work out a plan for creditors to be repaid and the new “Good Bank” to be established. The South African Reserve Bank’s (SARB) announcement of a 90c/R recovery for senior creditors initially provided some certainty and stability for funds invested in African Bank instruments, and while six months has elapsed since the curatorship of African Bank commenced, a final and firm recovery plan/proposal for African Bank creditors to consider is likely to be forthcoming in the next few weeks.
We remain of the view that the SARB will keep the promise made to senior noteholders of a 90c/R recovery. The nature of curatorship allows the curator of a bank to do as much as possible to allow the bank a reasonable chance of survival – this usually implies some form of negotiated settlement for all investors, which in the case of African Bank, is still a work in progress. We continue to work with all the parties (SARB, curator, other senior bondholders etc.) to ensure an optimal outcome for our clients
The failure of African Bank has taught us, and the market, some tough lessons. These are:
- Banks can and will fail. When banks fail, investors will suffer losses as the days of government bailouts for banks are over. Investing in a bank is a potentially risky investment and asset managers need to ensure that they assess the risks properly, mitigate them where possible and ensure that their client funds are being adequately compensated for the risks in each investment.
- Credit analysis and ESG analysis is important and can help to identify, mitigate and price for financial, credit, environmental, governance and social risks that need to be considered. If analysis is done properly, it can provide valuable information that can be acted upon before the actual default happens.
- Where you have invested in the capital structure of a company matters. The recovery on senior noteholders in African Bank (at 90c/R) is substantially greater than both the expected recovery on the subordinated noteholders and the complete loss suffered by the equity investors.
- Legal documentation is all you have to rely on when an investment defaults – the legal documents will detail what constitutes an event of default, the remedies available (if any) and the sequence of events that need to be followed in order to lodge claims and attempt recovery.
- South African listed credit investments, in general, contain weak investor protections in the legal documentation and the bonds issued are mostly illiquid. The weak investor protections and the illiquidity should be priced in to investments and we have already seen investors demanding higher credit spreads for bank paper issued subsequent to African Bank’s curatorship.
At Futuregrowth, we continue to monitor and assess the events as the curatorship of African Bank takes effect and the curator finds a way to resolve the many outstanding matters. While dealing with the “crisis” has been time-consuming for our team, it has shown us that, for the most part, we continue with “business as usual” and that, thanks to our detailed and ongoing credit and ESG analytical process, the “crisis” at African Bank was something that was on our radar well before the curatorship was announced in August 2014.
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