Do We Really Want Fully Mature Capital Markets in Australia?

Australia lags the world in lots of things and a fully mature, evolved capital market is one of them.

We believe that not having one actually saved the bulk of Australia from the worst of the last credit crisis with only isolated, smaller players falling foul of poor investment decisions and fragile funding strategies.

A ‘mature’ market is just so, built-up, developed and at capacity for participants.  Where does it go to for growth?  Left to its own devices it evolves and mutates uncontrollably sometimes for bad and sometimes for good leaving only the fittest of new practices.  Last time and by chasing volume and fees, RMBSs became SIVs and CDOs which became CDOs squared (and higher) – the very weapons of mass destruction prophesised by Warren Buffett years before.

Why couldn’t people just be happy with bread and butter loans and deposits which surely would not have caused so many problems for so many years?  This would undoubtedly also bring the much sought safety to financial markets [As a counter, we are just about old enough to remember the US savings and loan crisis].

Great, but wouldn’t it be boring.

Imagine it…just vanilla bullet bonds being issued, if at all.  A regular stream of known fixed coupons over a known certain time with a known maturity payment at a known future date.

No variable coupons, no call features, no amortisation, no creditor hierarchy…no interesting features for credit analysts to lock themselves in a room and salivate over.

Australia has tried and tried to evolve its financial markets and to many extents it has done a reasonable job but a truly developed credit market is not one that has been achieved yet.  We hope the various current efforts are successful and for many beneficial reasons.

One of the least discussed reasons with limited overspill is greater intellectual interest and deeper issue analysis.  Of course, this then becomes a profit-opportunity when paired with capital markets.  For interest only, we would like to briefly outline what, in our view, is a fascinating evolving story linking equity and credit markets, investor actions and management’s choices and reactions.

In the US, Windstream (WIN) is a provider of voice, data and managed IT services tracing its roots back to the early 2000’s.  A few years, mergers and acquisitions later it became a solid, profitable business but demerged its infrastructure into a REIT now called Uniti (UNIT) in 2015.  This transaction was approved by all concerned including regulators and had various regulatory approvals.  A key feature of the spinoff was a master lease agreement where WIN guaranteed to rent/use hardware now owned by UNIT.  Everyone was happy and both share prices were performing well.

Fast forward a few years and persistent declining revenues and economic reality finally caught up with WIN’s management as it scrapped the (high) dividend.  Share and debt prices of each company declined, somewhat counter-intuitively for UNIT when one considers that its cashflows are more secure with WIN not paying a dividend.

Up until late September 2017, this was mostly a common tale of an over-leveraged company trying to keep going in a declining industry (WIN) as its child (UNIT) attempts to diversify away from its roots.  At this time, the revelation that WIN had received a notice of default from a large noteholder claiming the 2015 spin-off violated the bond agreement prompted large declines in all securities of each company.

This came at precisely the wrong time for WIN having just scrapped its dividend but why would a noteholder now claim default having been silent for perhaps two years previously?  The answer, as suspected at the time and later confirmed, was a hedge fund.

Aurelius Capital took this action after presumably purchasing credit default swap insurance and shorting the equity of WIN.

A judge will rule on the legitimacy of the 2015 asset transfer with most observers backing WIN although Aurelius has probably already closed its very profitable trades.  Indeed the ISDA determinations committee has already ruled that there was not a default, not that this impacts the court case.

Separately, WIN’s management has not been toothless and has attempted to solve the problem by executing debt exchange offers and consent solicitations which would solve the issue instantly and also deliver longer-dated debt at a lower cost.  Although some debt lines have been successfully exchanged, the troublesome one, which Aurelius owns remains for now and it indeed has been challenging the debt exchange with somewhat spurious claims.  Another debt exchange attempt was announced by WIN this week.

Should Aurelius be successful it would likely cripple WIN and the ratings agencies all recognised this with large downgrades which also included UNIT.  There are a lot of people who think that these were overreactions for both entities and substantial value will magically appear once WIN (and by knock-on) are in the clear.

Although there are many commentators who deride the actions of Aurelius as being predatory in nature, we feel that this is in many ways a natural extension of having fully developed capital markets with informed parties able to understand complex issues or gaps in company strategies and exploit them.

So…there is an ultimate price for having efficiency…unfortunately it is most often paid in legal fees.