By Mak Yuen Teen
Note: This is part of a comprehensive case study about Hyflux currently being written, which also covers its business model, financial management, corporate governance, remuneration policies, disclosures and reorganisation. Further commentaries about some of these aspects will be published in due course.
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Prior to 2011, Hyflux’s capital structure consisted of debt in the form of loans and borrowings and other trade liabilities, and ordinary shareholders’ equity. As can be seen from the table below, in FY2009, total liabilities were 65% of total assets, the interest coverage ratio was nearly 10 times, while net operating cash inflows was more $60 million and more than $50 million after interest expense. While the total debt ratio remained fairly stable in 2010, the interest coverage ratio had fallen to 7 times and the operating cash flow less interest was now negative $66 million.
Changes in capital structure, operating cash flows and interest on borrowings
| Financial metric | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 |
| Total liabilities ($m) | 679.16 | 845.20 | 1096.90 | 1312.68 | 1510.21 | 1399.73 | 1724.50 | 2294.15 | 2645.66 |
| Current liabilities/TA | 0.30 | 0.23 | 0.18 | 0.17 | 0.15 | 0.14 | 0.31 | 0.24 | 0.39 |
| Non-current liabilities/TA | 0.35 | 0.39 | 0.36 | 0.43 | 0.48 | 0.37 | 0.26 | 0.36 | 0.33 |
| Total liabilities/TA | 0.65 | 0.62 | 0.54 | 0.60 | 0.63 | 0.51 | 0.57 | 0.60 | 0.72 |
| Total preference shares ($m) | 392.57 | 392.57 | 392.57 | 392.57 | 392.57 | 392.57 | 392.57 | ||
| Total preference shares/TA | 0.00 | 0.00 | 0.19 | 0.18 | 0.16 | 0.14 | 0.13 | 0.10 | 0.11 |
| Total perpetual securities ($m) | 469.10 | 469.10 | 785.28 | 494.80 | |||||
| Total perpetual securities/TA | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.17 | 0.15 | 0.20 | 0.14 |
| (Total debt+pref+perp)/TA | 0.65 | 0.62 | 0.73 | 0.78 | 0.79 | 0.82 | 0.85 | 0.90 | 0.97 |
| Interest coverage ratio | 9.96 | 6.99 | 3.75 | 4.56 | 2.88 | 2.52 | 2.17 | 1.60 | -1.04 |
| Operating cash flows (OCF) ($m) | 60.61 | -49.47 | -56.15 | -233.99 | -422.43 | -226.13 | -43.65 | -272.00 | -214.12 |
| OCF less interest ($m) | 51.35 | -66.23 | -78.74 | -255.39 | -449.95 | -260.96 | -86.44 | -319.77 | -272.57 |
2011 Issue of Preference Shares
In April 2011, Hyflux used a new form of financing through a preference share issue of $400 million, raising $392.6 million net of issue expenses. Olivia Lum said: “We continually evaluate different options of financing for our growth strategy, and view the Class A CPS offering as one of the more suitable options for our needs, and more importantly, non-dilutive to existing Hyflux ordinary shareholders.”
If there was a concern about dilution, the company could have considered a rights issue for its ordinary shares. Of course, with her 31% stake at that time, Lum would have to put in a lot of additional capital to avoid diluting her own stake. Instead, she was able to maintain her control of voting rights and invested just $802,000 in the preference share issue.
The full name of these preference shares (prefs) was “6% cumulative, non-convertible, non-voting perpetual class A preference shares with liquidation preference”. Initially, the company had wanted to raise $200 million but this was increased to $400 million due to demand for the shares.
The prefs have a face value of $100 each with a minimum subscription of $10,000. Up to 35% of the CPF funds could be used to invest in these shares. There is a step-up margin of 2 percent after 7 years – that is, from 25 April 2018, the dividend rate goes up to 8%. The sole lead manager and bookrunner for the issue was DBS Bank and subscription for the public tranche of $200 million was through DBS/POSB, OCBC and UOB ATMs. The net proceeds were to be used for the group’s water and infrastructure projects and for general working capital.
The prefs are classified as equity, and dividends do not have to be paid unless they are declared by the board but are cumulative.
Following the issue of the prefs, Hyflux’s liabilities continued to increase, with total liabilities increasing from $845 million in FY2010, to $1.1 billion in FY2011, $1.3 billion in FY2012 and $1.5 billion in FY2013. The debt ratio was relatively stable over that same period and in fact dipped in FY2011, buffered by the prefs. Meanwhile, operating cash flows continued to spiral downwards especially in FY2013 and FY2014 when they were negative $234 million and negative $422 million respectively, compared to negative $49 million in FY2010.
2014 Issue of Perpetual Capital Securities
In January 2014, Hyflux made its first issue of perpetual capital securities (perps), raising $300 million. The perps had an initial distribution rate of 5.75%, with the distribution rate reset every three years. The relevant reset distribution rate was the swap offer rate (SOR) plus the initial spread plus the step-up margin. The step-up margin was 2%. At the time of issue, the initial spread was 4.79%. Therefore, every three years, the distribution rate was to be reset to SOR plus 4.79% plus 2%.
DBS Bank was again the sole lead manager and bookrunner and they were sold in denominations of $250,000 to institutional investors under section 274 of the Securities and Futures Act (SFA) and accredited investors and other persons covered by sections 275(1) and 275(1A) of the SFA. The company said that the proceeds were for investments, repayment of existing borrowing, general working capital and general corporate purposes.
Six months later, Hyflux made a second issue of perps to raise $175 million, this time with Credit Suisse as sole lead manager and bookrunner. The initial distribution rate was 4.8% with a reset in the rate every 2 years. Like the January issue, they were sold in denominations of $250,000 to institutional investors, accredited investors and other persons covered under sections 274 and 275 of the SFA. The proceeds were to be used for the same purposes as the January issue.
The perps ranked ahead of ordinary shares, at parity with the 2011 preference shares and other perps, and behind other creditors. Distributions were only payable if they were declared but were cumulative. The perps were classified as equity on the basis that they were perpetual with no final date of redemption and may only be redeemed at the option of the issuer, but not the holder. Hyflux can opt to redeem the perps at the first step-up date and any distribution payment date thereafter, or on the occurrence of certain redemption events. These redemption events were: if Hyflux became liable to pay additional amounts of tax; distributions were no longer tax-deductible; or accounting standards did not allow the perps to the classified as “equity”.
It is clear that the perps were issued to take advantage of accounting standards permitting them to be classified as “equity”, therefore improving the debt ratios, while at the same time being allowed to be treated as debt for tax purposes. Following a break in the increase in total liabilities in FY2014 with the amount and the debt ratio actually falling, total liabilities resumed its upward trend with total liabilities increasing from $1.4 billion in FY2014, to $1.7 billion and $2.3 billion in the following two years. The debt ratio also increased but the increase was again buffered by the issue of the perps and prefs. The interest coverage ratio continued to deteriorate and operating cash flows remained negative.
The increasing reliance on debt, prefs and perps as sources of finance can be seen in the consistent increase in the ratio of these sources of finance relative to total assets. Between FY2010 and FY2017, total liabilities more than trebled even as it made those large “equity” issues in the form of the prefs and perps.
2016 Issue of Perpetual Capital Securities
In May 2016, Hyflux made its largest security issuance yet, raising $500 million through the issue of 500 million $1 perp, with an initial distribution rate of 6% and a reset every four years, and a step-up margin of 2%. Initially, the company proposed to raise $300 million but this was increased to $500 million due to demand. Of this amount, $329 million was allocated for public subscription with a minimum subscription of $2,000; $165 million was allocated for the placement tranche with a minimum subscription of $100,000, with the remaining reserved for directors, management and employees. Investors were not permitted to use CPF funds. DBS was the sole lead manager and bookrunner, and subscriptions to the public tranche can only be made at DBS/POSB and OCBC ATMs.
The proposed uses of the proceeds under the two scenarios of $300 million and $500 million being raised are shown in the table below:
Use of proceeds of 2016 perp issue
| Use of proceeds for 2016 perp issue | ||
| If $300m raised | $ | % |
| Costs and expenses of offer and issue | 3.51 | 1.17 |
| Repayment of certain outstanding securities | 274.98 | 91.66 |
| General corporate purposes | 21.15 | 7.17 |
| If $500m raised | $ | % |
| Costs and expenses of offer and issue | 5.3 | 1.06 |
| Repayment of certain outstanding securities | 275 | 55 |
| General corporate purposes | 219.7 | 43.94 |
Had $300 million being raised, the company would have used about $100 million to pay debt and $175 million to redeem the 4.8% perps issued in July 2014 that was due for a reset in its distribution rate in July 2016. Under the scenario of $500 million being raised, the company proposed to also apply the additional proceeds to repay or refinance existing borrowings, redeem outstanding perps, and to finance working capital and capital expenditure. Indeed, with the enlarged offering, it also redeemed the $300 million of 5.75% perps issued in January 2014 that was due for a reset in its distribution rate in January 2017.
Therefore, at least $329 million of funds were raised from ordinary retail investors in the 2016 perp issue – possibly more as some may have also subscribed through the placement tranche through private bankers – while $475 million raised from institutional investors and accredited investors were redeemed, mostly from the proceeds of the 2016 perp issue. To put it bluntly, ordinary retail investors essentially bailed out the institutional investors and accredited investors who invested in the 2014 perps.
Let’s consider the features of the 2016 perps, which I have tried to simplify so that it as understandable as possible:
- The initial distribution rate is 6%, based on an initial swap offer rate (SOR) of 1.8% on 16 May 2016 and an initial spread of 4.2% per annum
- The distribution rate is reset every four years based on the following formula: the 4-year SOR on the second business day prior to the relevant reset date plus the initial spread of 4.2% plus the step-up margin of 2%
- Distributions can be deferred (deferred distributions will be added to the principal and earn interest at the distribution rate, and deferred distributions must be paid before distributions to junior claims, and junior claims cannot be repaid or redeemed without paying these deferred distributions)
- On winding up, the perps rank below senior creditors’ claims, on par with other perps and prefs, and above ordinary shares
- The perps do not have a fixed redemption date, but are redeemable at the option of the issuer (but not the holder), including, inter alia, if the tax authorities rule that there are additional amounts payable by the issuer, distributions are ruled not to be tax-deductible, or changes in accounting standards require the perps to be classified as “debt” instead of “equity”
The 197-page offer information statement (OIS) provided illustrations of how the distribution rate will be recalculated at each reset date under various scenarios, including a scenario where SOR is negative and the reset distribution rate in future may be lower than the initial distribution rate of 6%. I wonder how many investors, even sophisticated ones, will understand what SOR is, that it can be negative, and the distribution rate in future can be lower than the initial distribution rate of 6% if the perps are not redeemed.
Clearly, the authorities recognised that the 2016 perp issue was risky as they did not allow CPF funds to be used. With the minimum investment amount of $2,000 and subscription through the ATMs, even the most unsophisticated retail investor could subscribe.
The 2016 perp issue came with a 12-page Product Highlights Sheet (PHS) that included on the second page a section on “Investment Suitability” which explains who the investment is suitable for, and by inference, who it is not suitable for. It also referred the reader to the “Risk Factors” in the OIS and the summary of risks in the PHS.
Product Highlights Sheet
Was the information in the PHS fairly presented?
After the section on “Investment Suitability”, the rest of that page and the next six pages provided information on the background of Hyflux, the key features of the securities, key financial information, and business strategies and future plans. The key risks are then summarised into two pages.
On the key financial information, the company provided information on revenues, pre-tax profit and after-tax profit for first quarter of the latest two financial years and the latest three full years; summarised cash flow information for the first two quarters of the latest two financial years and latest two full years; and total assets, total loans and borrowings, total liabilities and total net assets as at the last two full years and the end of the latest quarter. The most significant factors contributing to the group’s FY2015 financial performance were also set out.
What I believe is lacking is clear and sufficient information on cash flows. For both the OIS and PHS, cash flow information was provided only for two financial years, compared to three financial years for income statement information. Why was this so?
There was no mention of cash flows in the discussion of the significant factors contributing to the group’s performance in the PHS. Only profitability was mentioned.
On page 44 of the OIS, there is a statement which said: “In the event that the Group suffers a deterioration in its financial condition (such as a serious decline in net operating cash flows), there is no assurance that the Issuer will have sufficient cash flow to meet payments under the Securities.”
Operating cash flows had been negative since FY2010, exceeding negative $200m since FY2012, except in the year preceding the issue of the 2016 perpetual securities when operating cash flows improved to negative $44 million.
Should the negative operating cash flows since FY2010 have been clearly highlighted as a risk? Cash flow information for two quarters and two full years does not provide the full picture of the struggles that Hyflux was having in generating operating cash flows.
Hyflux also presents two different operating cash flow numbers in its cash flow statements – in the annual reports, the OIS and the PHS. For example, the figure below shows an extract of the cash flow information provided in the PHS. The usefulness of the “net cash from operating activities before service concession arrangement projects” is questionable. Since such projects are very much part of the business model of Hyflux, what is the point of showing cash flows without such projects?
More importantly, these “pro forma” numbers look better compared to net cash used in operating activities, which are the numbers that really matter. Ordinary investors may well be misled by these “pro forma” cash flow numbers.
Cash flow information from Hyflux’s Product Highlights Sheet
Let me be clear about one thing. It is likely that even if all information is perfectly presented in the OIS and PHS, it would probably not have made a difference to most of the ordinary retail investors who bought the perps.
But this raises the following questions. Are the perps suitable for ordinary retail investors, especially given that they are often used by companies wanting to “manage” their balance sheet for financial reporting purposes by making their debt ratios look better (even though they very much want them to be treated as debt for tax purposes)? Should they have been able to apply for the perps through the ATMs, when it is likely that they would not have read the offer document or even the product highlights sheet? Should there be relatively low limits for investing in such securities through ATMs? Why were the 2014 perps deemed to be suitable only for institutional investors and accredited investors, but the 2016 perps were considered otherwise, when they had essentially identical characteristics?
I believe the authorities should reconsider the suitability of perps for ordinary retail investors, especially with more issuers resorting to such securities.
