Gearing Ratio, Sources of Debt and Equity Funding for SGP, and Structure of Mortgage Funds - Assignment Example

Question 1d: The principles 1, 2 and 3 of the ASIC Regulatory Guide 46 for this particular subject unlisted property scheme. The Australian Securities and Investments Commission (ASIC), after its review of the disclosure procedures in the unlisted properties schemes, included three key elements in their regulatory guide. This was prompted by the realisation that there were anomalies in disclosure practises. These loopholes were seen to harbour potential risks to retail investors.   Some of the discrepancies include the risks that are associated with the maturity profile, property development details, valuation procedures and the associated risks, distribution details and withdrawal details (ASIC, 2012). In the reviewed disclosure principles, ASIC identified three elements that acted as benchmarks. These included the risk areas that retail investors ought to be aware of before deciding to invest, procedure of addressing such risks, and disclosure documents that verify the product issuer’s compliance. By setting these benchmarks, the regulator sought to offer more protection against bad investments and possible collapse as seen in the past with Provident Capital, Fincorp and Westpoint.  The principles 1, 2 and 3 of the ASIC Regulatory Guide 46 for this particular unlisted property scheme will help in monitoring the entities compliance with these requirements and eventually contribute directly to property market integrity and investor confidence. With regard to Disclosure Principles 1, 2 & 3 and assuming that the Fund will be for retail investors, disclose of the principles 1, 2 and 3 of the ASIC Regulatory Guide 46 are suitable for inclusion into the IM/PDS. They are; Principle 1: Gearing Ratio This is the first principle which addresses the schemes policy on gearing at an individual’s credit facility level. This is a disclosure requirement which helps in addressing disclosure of the gearing ratio of the scheme, the calculation of the gearing ratio and gearing ratio explanation. In this particular scheme, the gearing ratio indicates the extent to which this fund’s asset is financed by the external borrowings. The calculations are as follows Gearing Ratio = Total interest – bearing liabilities Total assets In this case, Total interest – bearing liabilities = $14,000,000 $31,758,000 = 44.08% In our case, the Gearing Ratio responsible Entity aims at targeting a long term average gearing ratio at a maximum of 45%, though this percentage may be exceeded in certain circumstances. In property fund investment, gearing is used in grow the probable returns to investors and consequently the gearing ratio represents the percentage of debt in comparison to the Gross assets that are funded by interest bearing liabilities of the scheme. The gearing ratio shows the extent to which external liabilities fund a scheme's assets (ASIC, 2012). The issuer of the product is required to disclose dates and sources of information other than its financial statements when it is used to calculate gearing ratios. Furthermore, the issuer should explain the associated risks and implication to give credence to the level of gearing. If the issuer is not able to calculate the gearing ratio, the issuer is also required to disclose reasons and the implications of the inability to calculate the ratio. In addition, the issuer has an obligation to explain measures to mitigate or address the risks. The interest cover ratio offers information on a scheme's interest cover and validated a scheme's ability to pay its investors from earnings (ASIC, 2012). As with the gearing ratio, the issuer is required to disclose information used to calculate the interest cover ratio other than its financial statements. Where it is unable to calculate this ratio, a similar procedure is followed as with the gearing ratio. Furthermore, the insurer is obligated to explain what the interest cover ratio entails and the interrelation between income received, and other financial obligation that the scheme has and might affect the ratio.   Principle 2: Interest cover Interest cover addresses the scheme’s policy on the level of interest cover at an individual credit facility level. This is particularly in the interest cover ratio of the scheme, the calculation of the ratio and the subsequent explanation. Interest Cover Ratio will indicate the measurement of the fund’s ability to meet its interest payments on their borrowings from its earnings. This will be calculated as follows: Interest cover = EBITDA – unrealised gains + Unrealised losses Interest expense The level of interest cover which equals to the level of risks is a critical indication of a fund’s financial health and is a key measure of the risks associated with a fund’s level of borrowings and the sustainability of borrowings. The lower the interest cover ratio, the higher the risk that the Fund will not be able to meet its interest payments. A fund with lower interest cover only needs a small reduction in earnings in order to meet its interest payments; any changes to market interest rates may or may not impact the fund’s interest cover. Principle 3: Scheme Borrowing The scheme borrowing principle addresses the borrowing maturity of the scheme and the expiry of its credit facility (ASIC, 2012). It is imperative that the issuer informs the investors on possible breaches of loan covenants. This is shown as a percentage amount of the value of assets or operating cash flow that is used as security before a breach occurs. Furthermore, details of each credit facility should be disclosed and the implications that the rights of the scheme members have when invoked.   The purpose of the disclosure principles is to promote consistent and quality disclosure practises to enhance retail investor confidence and the credibility of the unlisted property scheme issuer. The disclosure principles cover information that investors need to make informed investment decisions and also level their expectations from the issuer. The Fund’s borrowing maturity and credit facility expiry and any associated risk Debt facility : $14,000,000 at 6.6% per annum at fixed interest over five years Expiry : Due to mature in the fifth year expiring until October 2017 Current loan to ratio : 44.08%. If the scheme cannot be refinanced, the asset may need to sell on a forced sale basis with the risk that it might realise a capital loss. In case of any breach of loan agreement, this may result in penalties being applied or the loan becoming repayable immediately. Interest Cover Ratio The interest cover ratio indicates the measurement of the fund’s ability to meet its interest payments on their borrowings from its earnings. The interest cover ratio for this particular investment is calculated as follows: Interest cover = EBITDA – unrealised gains + unrealised losses/ interest expense. The level of interest cover refers to the level of risks is a critical indication of a fund’s financial health and is a key measure of the risks associated with a fund’s level of borrowings and the sustainability of borrowings. The lower the interest cover ratio, the higher the risk that the Fund will not be able to meet its interest payments. A fund with lower interest cover only needs a small reduction in earnings, or a small increase in interest rates or other expenses, to be unable to meet its interest payments, interest cover is also useful for investors when comparing a fund’s relative risks and returns to investments in similar products. A fund’s ability to meet interest payments depends on a variety of factors. Any changes to market interest rates may or may not impact the fund’s interest cover, as interest rate hedging or other activities designed to manage risk can reduce the impact of market changes on the fund’s profitability. Question 2: Sources of debt and equity funding for SGP There are several sources of debt and equity financing available to different corporations in Australia. The US Private Placement debt SGP secured being amongst them. SGP could have decided to dispose off some of its assets. These include equipment, property, its logos, or machinery that they might have. This will aid them in acquiring funds while ensuring they do not get into debt. SGP could not pursue disposing off some of its assets at this time since they probably did not have disposable assets. All their assets were in use in capital generation of one form or another thus selling them would be unwise. Another reason for forgoing this source of funds would be the urgency of attaining the money required. When money is required urgently, sale of assets might not be the most convenient and appropriate method of acquiring it. This is because it takes time as the assets are not liquid.   Another alternative would be attaining funds from venture capitalists. This is one of the most popular sources of funds for developing businesses. The venture capitalists offer the company funds in return for a say in the management of the corporation). The business will be required to have a high expected rate of return on investments to attract the venture capitalists. This is compensation for the high risk involved. SGP could have sort out venture capitalists they trust and engaged them in the funding of their new project. They are enticing since they are geared up for projects that might seem risky and other financial institutions have deterred from involvement in. SGP decided against this since it means the venture capitalists will be involved in running the company thus loss of some independence in making decisions. This might put the company at a compromising situation thus the management might be dissuaded from engaging in it.   SGP could be qualified to attain funding from the government. The government issues grants to businesses to encourage them to expand their operations to certain areas or products (FAO, 1997). These incentives are available for various products and in various locations. SGP did not choose to apply for a government grant since it will incur extra costs in administration and the large amount of paperwork. In addition, the project might not prove worthwhile. Furthermore, there might not be a government grant available for the project SGP wants to undertake.   Additionally, SGP could have used their retained profits as a source of funds. This is advisable since the company is utilizing their own funds (FAO, 1997). They will not owe a bank or any other financial institutions. Furthermore, it helps the company save on issue costs and avoid a shift in the control of the company as a consequence of issuing new shares. In addition, consultation of the shareholders is not necessary since directors are the ones responsible for the determination of the company's dividend policy (Australian Securities Exchange, 2010). SGP, therefore, would have been unable to use this source if the directors decided against it. In addition, the amount of money available as retained profits would not have been enough for the project they wished to undertake.  Another alternative is for SGP to issue more shares through a rights issue. Through this, they will issue more shares giving the existing shareholders the right to buy new shares at a reduced price (Australian Securities Exchange, 2010). The shareholders will subscribe money for new shares proportionally to their existing shares. This is advantageous for the company since it is a cheap and quick means of raising funds. The offer will be appealing to the shareholders if the company is thriving.  SGP could have obtained a mortgage on property that is clear of any charges. It would have to place the property's title deed as security with a mortgage broker or insurance company. In return, they will receive money on loan. It could also issue debentures which could be fixed or floating charge. The form of the debenture will determine the security. The company did not pursue this since this means attaining regular and long term creditors. SGP picked upon Long -term Private placement debt in effort to curb chances that anyone in the public domain becomes a shareholder in the company. The advantage of such capital acquisition schedules is that the company can control the type of investor they need . The ability to choose privately, who should and should not subscribe to the business securities allows for smooth managerial flow. Companies that undertake public offerings often suffer the consequences of high expectations from public. These two factors affect the running of the firm adversely and may lead to a negative performance. Due to the lengthy procedures of companies in acquiring loans and making savings, d launching a Public Offering, it is quicker to access Capital through Private Placements. Procedures such as Underwriting and Credit Assessment of the company usually take long due to statistical technicalities involved. On the contrary, private placement debts do not involve such thus reduced time wasting. Question 3: Calculate the Management Expense Ratio on the basis of the total Assets as at 31 December 2011 for. PPC (Consolidated Management expense X Total Assets Year 1 Management expense = 0.6% of Gross Asset Value Total Assets = $31,758,000 0.6 X $31,758,000 100 =$190,548 Year 2 Total Assets = $31,758,000 0.6 X $33,345,900 100 = $200,075.4 SDG (Consolidated) On 19 June 2012, SDG secured a long dated US Private Placement debt to the equivalent value of a $155.3 million Placement debt =$155,300,000 Management expense X Total Assets Management expense = 0.6% of Gross Asset Value 0.6% X =$155,300,000 100 = $931, 800 Question 4: The structure of mortgage funds and its systemic flaws A mortgage fund or a mortgage trust is a popular way of having regular income. It takes investors’ money and secures loans by mortgaging or making purchases. The investor then receives the interest on the payments of the mortgages after necessary deductions for expenses incurred during the fund's operations. The loans can be secured over different properties including construction and development, commercial, retail or residential properties. Furthermore, the fund manager works out a regular income to the investor called a distribution monthly, quarterly or semi-annually.   The mortgage fund can be set up in two key ways; pooled mortgages or contributory mortgages (Hindmarsh, 2010). Pooled mortgages are low to medium risk funds where all investors have a share in all mortgages. This type of mortgage fund ensures spread of risk and earnings in equal measure. Contributory mortgages are medium risk investments where the investor chooses which mortgage to invest in. This means that the rate of return is varied as are the risks. The risk is, therefore, dependent on the borrower to whom you lend to.   A mortgage fund is a superior investment form compared to other cash management trusts because of the rate of return and diversification. This is because they are not related to any other asset classes. In addition, the mortgage fund is considerably secure than investments in stocks or bonds; they are attached to tangible assets (Hindmarsh, 2010). Typically, mortgages are based on loan to value ratio. Most people, therefore, prefer to combine a low loan to value ratio with short term loans to minimise the incidence of risk of fluctuating prices of the property.     In the past, mortgage funds were operated from solicitor's books since it was considered a preserve of a few. The introduction of managed investments act in 1998, and the financial services reform act of 2001 saw more regulation introduced to the mortgage investment industry than before for consumer protection. The two acts are now known as Chapter 5C of the Corporations act of 2001 and Chapter 7 of the Corporations act of 2001 respectively (Hellwig, 2009). As a result of the new legislation, legal firms that acted as mediators for investors and borrowers had to meet new statutory requirements such as obtaining a license. The costs associated with these regulations were not commensurate with the returns, and most legal firms had to choose an area of specialty between mortgage operations or legal practises.   During the financial crisis, mortgage fund operators such as Provident Capital, Fincorp and Australian Capital Reserve were forced to into receivership. Despite their investments being secured against nonconforming mortgage products, a lot of the debenture holders in these companies suffered serious losses. For example, Provident Capital had a deficiency in terms of assets to offset the claims held against it (Abbott, 2012). This means there were other systemic flaws that led to such losses. Some of the systemic flaws include disclosure and appetite for credit risk.  According to Abbott (2012), Provident Capital had loaned a majority of the money raised from its debentures to property developers. In addition, the property developers defaulted on their interest payments a fact that was not disclosed to the debenture holders. Furthermore, this was a contradiction of the loan to value ratio that is used to choose the borrowers (Abbott, 2012). Therefore, investors who would otherwise incur medium risk were exposed to additional risk that was undisclosed. Otherwise, the investors should have suspected the high rate of return offered would translate to a high risk. Australian Capital Reserve also used its position to fund Estate Property group which is its parent company. It raised money through the issuance of unsecured deposit notes. This was also the case with Fincorp and Westpoint which had collapsed prior to Australian Capital reserve's collapse.  Additionally, the failure by the mortgage fund operators pointed to glaring laxity in monitoring of fund operators. According to Kruger (2007), the Australian Securities and Investment Commission were late to find the loopholes in high yield debentures. This included the advertisements and the information provided on the prospectuses. Considering that this was aimed at retirees, the commission should have been more vigilant. In addition, most of these funds were unlisted and hence little scrutiny as their listed peers hence leaving shareholders unprotected.   Furthermore, the mortgage operators may have been victims of flaws in risk assessment by rating agencies. Hellwig (2009) suggests that the risk models that are the basis of the ratings may be flawed. This is because they are sometimes over- optimistic about mortgages and related mortgage backed securities. This is because property appreciation does not automatically reduce credit risk in mortgage contracts. Furthermore, there should be a consideration about the market driving the real estate industry. This is usually during the adjustment of financial structures that affect the real estate prices to correspond to the change. A good example is in 2003 when investment banks moved to mortgage securitization. Hellwig (2009) asserts that the rating problem may be largely attributable to these flaws. References Abbott, B. (2012, June 7). Insurance Business Online. Retrieved October 18, 2012, from Provident Capital in receivership: what risk lessons can be learnt?: http://www.insurancebusinessonline.com.au/cri/article/provident-capital-in-receivership-what-risk-lessons-can-be-learnt-141437.aspx Australian Securities Exchange. (2010). Capital Raising in Australia: Experiences and Lessons from the Global Financial Crisis. Australian Securities Exchange. FAO. (1997). Sources of Finance. In FAO, Basic Finance for Marketers. Hellwig, M. F. (2009). Systemic Risk in the Financial Sector: An Analysis of the Subprime- Mortgage Financial Crisis. De Economist, 157(2), 129-207. Hindmarsh, D. (2010, March 30). Intellichoice. Retrieved October 18, 2012, from Mortgage fund: http://www.intellichoicefp.com.au/investments/mortgage-fund.html Kruger, C. (2007, May 29). The Sydney Morning Herald. Retrieved October 18, 2012, from Investors stranded by collapse: http://www.smh.com.au/articles/2007/05/29/1180205201995.html Watkins, D. (2012, February 27). Wall street strategic Capital. Retrieved October 18, 2012, from 11 essential funding Sources for Commercial Financing: http://www.wsscapital.com/blog/funding-sources Read More