The losses for investors, mainly retirement fund members, in the multi-billion-rand collapse of South Africa’s biggest unlisted company, First Strut (trading as First Tech Group) could total more than R800 million – but they could be fractional for each individual investor.
The collapse of First Strut is being compared to the multi-billion-dollar bankruptcy in 2001 of United States company Enron that left retirement fund members destitute as it sank in a sea of fraud.
Many employees had all of their retirement savings invested in Enron. In South Africa, a unit trust fund or a retirement fund may invest a maximum of 10 percent in the bonds of a single company, such as First Strut.
Asset managers that bought First Strut bonds on behalf of retirement funds and unit trust funds were more prudent, so the holdings of any one fund member or investor are fractional. Investec Asset Management (IAM), for example, allocated 2.9 percent of seven targeted portfolios to First Strut bonds.
Nevertheless, the First Strut losses are significant and raise important questions about why such massive fraud went undetected by regulators, banks, fund managers, credit rating agencies, auditors and asset management consultants for almost 20 years.
The losses are a result of First Strut defaulting on the R925 million that it borrowed on the corporate bond market, most of which will not be recovered. The asset management companies that invested in the First Strut bonds are concerned about loans that the banks did not disclose when the bond issue was arranged. These lenders could now have first claim on any of First Strut’s assets, leaving the bonds with zero value.
There have been concerns for some time about the formal corporate bond market, where large companies borrow billions of rands to fund their operations. Borrowers in this market are subject to the listing requirements of the JSE, but large lenders (buyers of the bonds), such as asset management companies, regard these requirements as insufficiently comprehensive (see “Asisa steps up bond market investigation”, below).
The asset management companies that admit to incurring losses as a result of the First Strut default are emphasising the negligible losses to individual investors in an attempt to explain how what appears to have been 20 years of fraud upon fraud went undetected by themselves, Global Credit Ratings, the auditors and the banks that lent money to First Strut for many years.
The asset managers that are known to have been exposed to the failed corporate bonds (borrowings by First Strut) are IAM, Sanlam, Prudential, Stanlib, Momentum and Fairtree Capital.
Many more asset managers could have been involved, because most South African asset managers applied unsuccessfully for an allocation of the main First Strut bond issues.
IAM has the biggest exposure, with R435 million in institutional portfolios (portfolios used mainly for retirement fund investments).
John McNab, IAM’s co-chief investment officer, says that when Investec decides whether or not to invest in bonds, it takes account of the potential for a default, which could result from market conditions, operational problems with the issuer of the debt and, less frequently, fraud.
The losses for individual retirement fund members will be fractional compared with the 12.5 percent that Investec deducted from the savings of members of industrial retirement funds when it took control of imploding financial services company Fedsure in 2000; or the R175 million that Sanlam paid to make good for its role in the stripping of surpluses of retirement funds in the 1990s.
Kobus Möller, Sanlam’s group financial director, confirmed that Sanlam “invested some R236 million in the First Strut bond, the major part of which is being held in its own corporate debt portfolio”.
Möller would not say whether individual or institutional investors have been exposed to the bonds and, if so, how much they stand to lose.
Bradley Anthony, a director of Fairtree Capital, says his company has an exposure of R131 million to the First Strut bonds.
John Kinsley, chief executive of Prudential, says his company has an exposure of R51 million across 19 of its portfolios.
Lerato Mametse, MMI Holdings’ external communications manager, says the company’s exposure to First Strut was mainly via the Momentum Income Plus Fund. This resulted in the unit price of the fund dropping by almost two percent over the week of July 8, when First Strut defaulted.
Stanlib refused to provide any details of its exposure to the default, saying: “We appreciate the opportunity to respond. We are unable to comment on this matter, due to client confidentiality.”
McNab says the First Strut bond issues had an investment-grade rating of BBB, passed due diligence tests by Investec’s credit committee and were audited by the co-arrangers of the bond issue, Rand Merchant Bank, a division of FirstRand, and Standard Bank.
McNab says warning signals about problems with the bond issues started to appear shortly before the allegedly self-arranged murder in June of one of the company’s owners, Jeff Wiggill.
One of the conditions that companies such as IAM had set for providing the cash was that First Strut must change its auditors. The new auditors were due to be appointed in June, when First Strut’s financial statements were supposed to be released.
Global Credit Ratings withdrew the BBB rating because the financials were not available. A bond with a rating below BBB is considered a “junk bond”.
McNab says that Investec’s R435-million exposure to First Strut is part of the more than R40 billion in corporate debt that Investec manages on behalf of its South African institutional clients.
The debt was placed in seven close-ended funds (there is a pre-determined limit on the amount that may be in the funds). The funds are part of the Investec Credit Opportunities Strategy Portfolio,.
The total value of these seven portfolios, which aim to produce high-yield returns above those offered by cash, is R15 billion.
McNab says the funds in the Credit Opportunities Strategy Portfolio have an excellent five-year track record (both before and after the collapse of First Strut), with returns above 13 percent a year since inception.
However, he concedes that the default will reduce the returns by about 40 basis points (0.4 percent) over the life of the funds.
The best fixed-income returns come from the corporate bonds, because the market more than compensates investors for expected defaults, McNab says.
He says that a default is not normally the result of fraud but rather of adverse market conditions or operational problems at the business that issued the bond.
The risk of default is factored into the total expected returns of the portfolio. If asset managers wanted to avoid the risk of default, they would have to invest in “risk-free” AAA-rated bonds – but investors would receive far lower returns, McNab says.
PROBE INTO WHETHER LAWS WERE BROKEN
The Financial Services Board (FSB) is attempting to establish the full extent to which investors may be exposed to the multi-billion-rand collapse of South Africa’s largest unlisted company, First Strut.
The FSB is also investigating whether any of the laws and regulations that govern bond issues have been contravened.
Asset management companies are receiving letters from the FSB asking them what exposure, if any, they had to First Strut’s corporate bonds, which were listed on the JSE with an investment-grade rating of BBB.
FSB spokesperson Tembisa Marele says the investigation has a three-pronged approach, to determine whether there was:
* Compliance with the listing requirements for debt securities;
* Market abuse, including whether insider trading occurred and/or false statements were made in connection with the First Strut bonds; and
* Compliance by the credit rating services in assigning a BBB rating to the bonds.
Marele says the FSB is still in the early stages of its investigation.
ASISA STEPS UP BOND MARKET INVESTIGATION
The Association for Savings & Investment SA (Asisa) is expanding a two-year project into listings on the corporate bond market following the R925-million default on corporate bonds by South Africa’s biggest unlisted company, First Strut.
Asisa senior policy adviser Adré Smit, who chairs the association’s standing committee on fixed income, says a work group was appointed two years ago to look at various aspects of the corporate bond market.
The process starts with the JSE’s listing requirements for corporate bonds, he says.
The Financial Services Board (FSB) is in charge of regulating the securities markets, including the bond market, Smit says. The JSE is the FSB’s “policeman”, and its responsibilities include setting standards for the listing of debt.
Asisa’s members are asset management and life assurance companies that invest in corporate bonds on behalf of their clients. As such, Asisa wants to be sure that the listing requirements provide suitable protection.
Smit says the issues that the work group has been looking into for the past two years include:
* The processes that are followed before and after a listing;
* Standardising the terminology used in the corporate bond market; and
* The covenants, or conditions, that apply when a bond is issued – for example, that a company may not borrow more than a certain amount of its equity.
He says the conditions should not be so onerous that they push up the costs of borrowing on the bond market.
The advantage of the bond market for borrowers is that they can borrow with fewer onerous conditions and/or at lower interest rates than would be the case if they approached the banks.
The work group has to consider carefully how to strike the right balance between protection and costs, Smit says.
Although the First Strut default adds urgency to the work group’s investigation, it should not result in a knee-jerk over-reaction, he says.