Bridging the risk gap

By Roger Armstrong

Monday 1st April 2002

Bridgecorp Holdings fancies itself as a fast growing, low-risk finance company that's unfairly blocked from listing on the NZSE's mainboard. But the NZSE could be right.

"Minimise the risk", exhorts a TV ad for Bridgecorp Holdings, seeking investors for its secured debentures. Good slogan and great ad campaign, too. My favourite is the one with William Tell shooting the apple off his son's head - only the apple is about five times bigger than the kid and Tell senior is standing at point blank range. The point, like Tell's target, is hard to miss: Bridgecorp is saying it offers one heck of a low-risk investment strategy.

Sadly the ads are only partly true, and for investors buying shares in the company, not in the important parts. While the ads accurately reflect the product being offered - a secured debenture - investors should be wary of thinking it applies to the overall company.

Bridgecorp has a colourful history. It was first a mining concern, then moved into toy retailing in the 1980s, where it was put out of business by The Warehouse's domination of anything bright and plastic. Only a shell company remained to be resurrected in 1993 by Rod Petricevic, one of the inner circle in the early days of Fay Richwhite and former investment hero of the 1980s at Euro-National.

Over the past few years Bridgecorp has achieved explosive growth, and is now one of New Zealand's largest non-bank finance companies. Its shares, listed on the informal "grey" market, have run up from 35 cents to 90 cents over the past year.

Sounds successful, and to Petricevic it clearly is. By paying himself a percentage of declared pre-tax profits, Petricevic earned around $800,000 in the last half year, possibly making him the highest-paid managing director of a New Zealand public company.

So why has the New Zealand Stock Exchange twice turned down this successful company for a listing on the main board? One answer might be that the NZSE is a fuddy-duddy old boys club, which is uncomfortable with Petricevic's past association with clipped high-flier Euro-National. Well, that could be true. More importantly, I suspect the NZSE is simply taking a dim view of Bridgecorp's risk profile.

Why am I so concerned? An examination of the half-year -report shows Bridgecorp's claims are not at all matched by conservatism in the way the company is run nor in the accounts stated. Bear with me as I explain this, because it is a little complex. All finance companies are at the riskier end of the lending market. Banks grab most of the low-risk mortgage business, and finance companies are left to carve out niches in areas such as plant, vehicle, appliance and consumer finance. Bridgecorp's niche is property bridging finance, mostly secured through second mortgages. However, it also undertakes property development and has a $5.6 million investment in a biotech vehicle. Both of these areas are notoriously high-risk.

But when determining the risk of investing in a finance company there is a lot more to consider than just its investments. You need to look at its gearing (debt), business risk, asset quality, concentration of credit risk, the quality of the people making the lending decisions, incentive structures and accounting standards.

So, how does Bridgecorp stack up on these main factors?

In top gear

Let's look at its debt. At the September balance date, Bridgecorp had an equity ratio of 7%. An equity ratio is the amount of shareholders' funds compared to total assets. This is the stuff that cushions the risks of a lender. The more of it the better, from a lender's point of view. Bridgecorp's ratio is the lowest of all major non-bank New Zealand finance companies that are surveyed. As a comparison, Marac has a ratio of 11%, Consumer Finance 10%, South Canterbury Finance 9% and Allied Finance 10%. Bridgecorp has also issued a huge amount of unsecured, subordinated debt. Should trouble arise (such as the company going under) this debt ranks behind any debenture holders (of which there are many), meaning unsecured debt holders have a higher risk, hopefully offset by a higher interest rate.

It is a clever financial structure, allowing shareholder funds to be worked hard while simultaneously giving reasonable protection to secured creditors. So far as the debenture holders go, yes, the "minimise the risk" sobriquet is reasonably right.

But what about the company as a whole? It appears to be aggressively geared, with only a thin layer of shareholders' funds relative to the assets. This is exacerbated by Bridgecorp not being a pure finance company. It is not unheard of for finance companies and banks to be geared 15:1 if the asset quality is good enough, although most other commercial activities (in retail, engineering or property development) are best undertaken with far less leverage.

Bridgecorp's gearing, at around 14:1 (the inverse of the 7% equity ratio quoted above), is probably acceptable for a high-quality finance company, but Bridgecorp is not only a finance company. Take the $30 million or so Bridgecorp has invested in property development and property for resale - an activity that, arguably, should not be geared more than 5:1. (For example, for a $100 million office block -development, I believe the developer should put in at least $20 million of equity.)

And then there's the biotech. Bridgecorp has $5.6 million invested in a potential cure for AIDS, associated with Robin Johannink of Pacific Lithium and Vortec Energy fame. How and why Bridgecorp ever came to own such an asset is an interesting question. When this investment first appeared in the 2000 annual accounts it represented about 50% of shareholders funds. Is this an investment the company undertook willingly, or did it come about through some sort of debt swap? Either way, it suggests a company dabbling in the risky end of the market. Call me a conservative old twit, but I reckon such venture capital investments should be funded totally by equity and certainly not advertised as minimal risk.

A good way of getting a clearer picture of Bridgecorp's funding structure is to copy an old investment technique used by the rating agencies. They set aside an appropriate portion of the company's shareholders' funds that finance non-core activities and ask how much equity is left over, relative to the assets and liabilities of the core -business. Setting aside $6 million equity for the property interests and $5.6 million for the venture capital investments leaves $10.2 million supporting Bridgecorp's assets of $268 million. That's an adjusted equity ratio of just 4%. Remember, the lower the ratio, the worse it is - from a lender's point of view.

To its credit, Bridgecorp says it wants to quit its development arm and become a pure finance company. To be true to the slogan, it needs to do that now, and quit its biotech asset, too.

Risky business

That's the gearing, now what about the asset quality and credit risk? The Bridgecorp accounts show a high concentration of credit risk to certain "counter-parties" (clients, business associates and so on). Bridgecorp's exposure to one counterparty at its interim balance date measured the equivalent of 50–60% of shareholders' funds. Another measured 40–50% and 12 others have exposures above 20%. How does that compare with other finance companies? Marac Finance claims to have no exposures more than 5%. Consumer Finance (which lends to retailers "in bulk") has just one exposure in the 30–40% range and another two over 20%.

In addition to the concentration of credit risk, Bridgecorp's "impaired" (or problem) loans worsened in the last six months. "Past due" loans grew from $1.8 million to $9.4 million. "Non-accrual" assets, where there is doubt about collecting the principal and on which interest is no longer being accrued, increased from $3.5 million to $7.2 million. "Restructured" assets, where the terms of the original loan have been altered and in some cases swapped for other assets, fell slightly from $6.4 million to $6.1 million. In all, 10% of the company's loans fell into these three problem categories.

Given all this, I'd expect the company's level of bad debt provisioning to be higher than it is. The total provision of $3.3 million equates to 1.4% of mortgages and loans (or 14% of the problem assets). Compare this with Marac and Consumer Finance. Their problem assets amount to only 1% of the loan book (a tenth of the level of Bridgecorp's) but Marac has provisions of 0.6% of assets (just under half that of Bridgecorp) and Consumer Finance 2% of assets.

Okay, so Bridgecorp has farmed out some of its risk by securing mortgage repayment insurance from Lloyds covering "in excess of 50%" of its New Zealand mortgage book. Without seeing the fine print it is hard to know how comprehensive such insurance is, but it does not cover Australian loans, nor capitalised fee income and interest payable on New Zealand loans.

Low interest, high fees

What about the accounting and cash flow? Unusually for a finance company, Bridgecorp gets a large portion of its income from fees rather than interest. Over the past two-and-a-half years fee income has averaged 105% of interest income, whereas other finance companies' fee income is typically a small part of the business, at under 10% of interest income. When borrowers requests a loan from a finance company, they are quoted an interest rate, plus a fee. Bridgecorp appears to favour quoting a low interest rate/high fee combination.

The fee is only paid to Bridgecorp on maturity, but in an accounting sense it appears to be booked from day one. A more conservative policy would be to amortise the fee over the period of the loan. Consider someone wanting to borrow $1 million for a year. A finance company could offer the individual a 15% interest rate and no fees, or 8% a year and a $70,000 approval fee. The cost/income to the individual and the finance company are roughly the same, but with Bridgecorp's accounting treatment $77,000 income would be booked in the first month for the low interest rate/high fee offer, compared with only $12,500 if the high interest rate/low fee combination was chosen.

What does all this mean? The way Bridgecorp handles its fees makes its profit figures look better. If a finance company has a steady loan book, there is little profit difference between accounting for fees the Bridgecorp way or amortising them. But when a company is growing fast - as Bridgecorp is - this policy boosts reported profit. The structure of Bridgecorp's offering may appeal to a lot of borrowers as it minimises cash flow costs until the time the investment is realised. The flipside is that Bridgecorp suffers poor cash flow while growing.

In the past two-and-a-half years Bridge-corp reported cumulative profits of $17.2 million, but cash flow from its operations show a cumulative $11.5 million deficit. Finance companies usually pretty much match cash flow to reported profit.

Bridgecorp's accounting policies and bias towards fee income mean its accounting profit is in excess of its "economic" profit in any period it grows fast. Higher stated profits lead to higher stated shareholders funds. I have to wonder how low its gearing ratio would go under a more conservative income recognition policy.

Investors should also be aware that Bridgecorp's accounting policies set up an incentive for the company to strive to continually grow its loan book - or otherwise struggle to stop profit from falling. You don't always want growth if you can't maintain the quality of the asset you're loaning against. There's also a personal incentive for Petricevic to make the company grow. He gets a percentage of declared pre-tax profits, which is how he became such a well-paid executive.

In summary then, Bridgecorp's clever leveraging of non-secured loans and the use of mortgage insurance means the "minimise the risk" slogan does have some validity when applied to the debenture holders. As for its future listing on the NZSE, its aggressive approach to growth and accounting means Bridgecorp is still some way off the blue-chip label Petricevic probably needs, before being welcomed onto the local exchange with open arms.

Roger Armstrong has no disclosure of interest

Roger Armstrong
finn.ltd@ihug.co.nz

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