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Lesson learnt from McAleese

On the 23rd of December 2015, Australian transport group McAleese Limited announced that due to low levels of activity in the resource sector it would most likely breach a financial undertaking in its syndicated banking agreement and this would be reflected in its interim results for 2016. A financing waiver in late January allowed the group to continue operating subject to certain conditions. This included discussions for alternative recapitalisation options and implementation of new stricter covenants. The waiver will expire in mid-April. Currently, McAleese owes its banks $206 million in loans and has a current asset deficiency of $163 million.

 

So where to from here?

 

This is a classic case of debt restructuring – if unsuccessful, the group could be forced into insolvency. According to management, McAleese is now relying on selling existing debt. The recapitalisation would be conditional upon an underwritten equity component. Given the group’s tangible asset value, many have questioned whether the financiers would be better off in a liquidation process and as a result, the group is now in lengthy negotiations with potential private equity debt buyers.

 

The downfall of the group was the result of poor diversification. Atlas Iron contributes a significant proportion of the McAleese’s earnings (40%) and has been heavily impacted by the subdued iron ore price. In 2015 the group restructured its haulage contracts with Atlas that would allow McAleese to receive a share of profits if iron ore prices reached certain levels. However, these levels were not reached and no income was generated from this profit-sharing scheme. Additionally, the group subscribed to 280 million shares in Atlas last year which have fallen in value by 72%.

 

Although McAleese has no unsecured creditors, this highlights the importance understanding underlying company’s operating environments to justify whether the risk of lending or investing in the debt of a company truly compensates for the return. If for instance McAleese had issued a debt security at an attractive yield investors would be in the same situation the banks are now. This also highlights the need for extensive research on a macroeconomic, sector and company level. Like many companies McAleese has made poor decisions, but for the most part the poor performance of the company can be contributed to factors outside management’s control. As a result, the group has incurred substantial write-downs in the value of assets and given the size of its bank loans if the company had issued senior unsecured debt to investors such a security would now be worthless.

 

The important lesson is that a simple capital structure is not always the best capital structure. Looking at the proportions of various funding sources must be taken into account to identify where the risk of default actually lies. Fixed income investors need to understand the exponential relationship between risk and return and always question why the yield offered is ‘so high’.

 

As for McAleese, it will be interesting to see how their situation pans out as they try to reach an agreement between existing financiers and potential private equity investors or whether the company goes into administration.