Thursday, September 06, 2007

Babcock & Brown Structured Finance Fund

I was prompted to analyse the Babcock & Brown Structured Finance (BBSFF) Fund because of a OCBC brokerage research note I read on KEER's blog. It looked like an interesting proposition so I decided to investigate myself. I must say it has been a very challenging experience to analyse this fund and BBSFF is one of the toughest cookies I have encountered so far in my limited investing experience. So, here goes nothing.

Greater Yield – and Greater Risk

The BBSFF is a very unique investment on the SGX. It is a mutual fund that manages a portfolio of structured finance assets, including operating lease assets, credit derivatives in the form of CDOs/CLOs, and alternative assets such Biofuel-related loans and Music Copyright assets. The diverse portfolio of assets makes the analysis of the BBSFF quite a daunting task, and it is a challenging exercise to attempt.

During IPO, BBSFF was priced to yield a 9% return. This is higher than REITs which tend to yield about 5-7% and is somewhat similar to the yield of the shipping trusts. In order to return a higher yield, BBSF invests in assets that are riskier than prime real estate, the details of which I analyse below.

Diversified portfolio of risky assets

Operating Lease Assets

The current operating lease assets under the fund include aircraft assets and railroad assets (rollingstock). The fund also intends to acquire shipping assets when opportunities present themselves in the future. This class of assets has similar operating characteristics to the shipping trusts. Essentially the fund either owns the aircraft or stakes in entities that own aircraft/rollingstock and the assets are leased to airlines or railway companies.

What is notable about some of the operating lease assets is that these are not the most modern aircraft like the new A380 or the larger Boeing 747, but the aircraft include smaller and older models like the Boeing 757-200 which is actually out of production. The fleet of A320s, B737s, B757s and other aircraft are mainly smaller short to medium range aircraft probably used for intercity domestic flights in the United States.

Loan Portfolio and Securitisation Assets

The Loan Portfolio includes CDOs/CLOs that include packaged European and Australian non-conforming (U.S. equivalent is subprime) mortgages. This is the group of assets that has most recently been the centre of attention due to the recent American sub-prime crisis. Fears that the US subprime contagion would spread to Europe and other countries caused a significant sell-off in BBSF’s shares on the SGX. However, it appears that most of the CDOs and CLOs in which BBSF is invested consist largely of AAA-rated securities, with a small portion classified as A or BBB. A latest report by the company indicates that it has taken no losses in its credit derivative securities.

BBSF's exposures to Ancora securities (which are CDOs secured on Australian real estate) appear to be doing well. The Australian economy is powering ahead, largely unaffected by the American crisis (the Australian Central Bank recently raised rates yet again) and the US credit market correction has had little, or any, impact on Australian mortgages. A similar story is the case for BBSF’s exposures to UK and European CLOs and other securitization assets.

As disclosed by the fund, BBSF has no exposure to the US CDO market and so far has taken no damage to its portfolio because of the recent subprime crisis.

Alternative Assets

Alternative assets include loans made to biofuel production facilities, investments in music copyright assets, and a mezzanine loan made to the Paramount Bay project, which is an upscale residential development in the US. It is difficult to evaluate the risk of default or loss of these alternative assets, and I am not going to attempt to do so. I can only assume that these investments are of reasonable quality based on the judgment of the fund manager, and evaluate the financial returns as reported in the financial statements.

Accounting Quality

The level of disclosure in the prospectus and the financial statements is quite high, as would be expected of an Australia-managed company. However, there are a few things to note in analysing the company's financial statements.

  1. There is no separation of assets into current and non-current assets, nor liabilities into current and non-current liabilities.
  2. The cash flow statement is reported as a direct cashflow statement rather than an indirect cashflow statement. I attempted an indirect reconciliation between PBT and CFO, but the absence lack of separation between current and non-current assets makes the reconciliation difficult.
  3. The financial statements amalgamate the results of the fund in 2006 since inception with 1H07 results, making the numbers slightly bloated for projections.
Financial & Profitability Analysis

As can be seen, there is a large gain due to foreign exchange exposure. This is an unpredictable and non-core operating item and I have made calculations excluding this number in order to make analysis more accurate.

As we can see from the ratios the fund is significantly leveraged with liabilities at 46% of assets. This is close to the fund’s loan covenant maximum of 50%, which means that there is little space for the fund to take on more leverage.

In terms of operating efficiency, it is hard to comment because of the lack of comparables. The fund’s ROE excluding forex gains is much lower than the ROE including the forex gain, similar for ROA.

Evaluation

10% yield at $0.95 stock price looks like a very attractive number, compared to other REITs and business trusts. However, there are several factors which make the attractiveness of BBSFF as an investment less clear.

a. At a P/B of 1.11, the market is saying that there is value in the fund that is not accounted for by its net assets. In other words, of the $0.95 per share, $0.09 comes from intangible value. My question is, where does this intangible value come from? The expertise of the fund manager? The value of the copyright assets? Where? It is not clear to me why this stock should be trading above NAV.

b. It would be much nicer for the investor if there was a clear mandate for its dividend policy. However, the prospectus only has this cryptic message about the dividend policy of BBSFF:

“Our dividend policy is to pay out the majority of the economic income received from our investments, after payment or provision for our operating and financing expenses. … Economic income is determined by our Company on the advice of our Manager. This determination involves an assessment as to whether distributions received on our investments constitute capital or income. In some cases, this determination involves an element of judgment by our Manager. In this regard we rely upon the experience of our Manager and its knowledge of our target asset classes to make the determination at the relevant time.” (Prospectus p57.)

In other words, much is left to the discretion of the manager and the investor can only assume that he will get what is due to him.

c. Many of the assets are difficult to understand. CDOs, CLOs, music copyright assets, mezzanine loans, and biofuels are difficult to analyse for someone who does not have significant experience in the field of structured finance. Much depends on the judgment and expertise of the manager.

With such a great information asymmetry and myriad of complex investment issues at stake, I think it would only be prudent to make an investment in BBSFF with a significant margin of safety. I personally am not prepared to risk my capital, and will only consider BBSFF if and when it trades near or below book value.

2 comments:

Paul Ho Kang Sang said...

Very insightful.

http://paulhokangsang.blogspot.com

Alex said...

2 comments. The premium on the price is probably because the market perceives the yield as being above market yield for the risk. This stock may operate similarly to a fixed income bond fund, but it is hard to tell without details.

The operating lease assets look good. It is all a question of price and terms. The aircraft operating lease market is predominantly narrow bodied aircraft. The larger aircraft are generally more illiquid - airlines plan to buy and hold large aircraft for their strategic long distance routes and are more flexible in their fleet planning between domestic and short to medium range routes. Barriers to entry/exit are much easier on the shorter routes, with the threat of new entrants and extra slots taking market share. For the larger planes an airline need 500 people a day who want to get from A to B (8-10,000 miles away) which is a big ask and generally means that routes and slots are much less dynamic.