Financial Statement & Security Analysis
Whig Capital

Background & Scope

Whig Capital was retained by JASNI Pty Ltd to review a legacy investment in an unlisted commercial property trust. The Syndicate’s sole asset was a sub-regional shopping centre with a gross lettable area of 15,000 sqm. The Centre was originally developed in the late 90s and is currently anchored by two large supermarkets and multiple specialty retailers. Over four months, Whig Capital evaluated five years of financial statements, management reports and industry data. We also completed a site visit and conference call with the assigned fund manager. The aim was to establish the asset’s economic performance to date and whether the investment offered a favourable risk-reward payoff to unit holders (at current prices). An affiliated party of Whig Capital holds a beneficial interest in JASNI Pty Ltd.


“The first thing you want to do – all things equal – is determine each horse’s chance of winning the race. Then you figure out which one has the best odds relative to its chance of winning”.

by Warren E. Buffett

Our review rested on the question: what expectation about future earnings is built into the current market price and are unit holders being adequately compensated for the uncertainty around those cash flows. Especially given the level of debt employed and historical operating performance. Rather than calculate a precise estimate of intrinsic value, we therefore sought to reverse engineer the implied rates of return based on: short term cash flows; core earning power; and conservative assumptions about future growth.We relied on forecast distributions for the next two financial years, combined with an estimate of available free cash flow the year thereafter. We then relied on critical analysis of the Centre’s operating history, industry conditions and competitive forces, to deduce a probabilistic range of economic outcomes.

Key Findings

We discovered the Centre had drastically underperformed original expectations. Rental income was unchanged since acquisition and profitability was flat. Net operating income to total revenue had hovered around 70%, while return on net operating assets – a measure that removes the effect of leverage – had remained at 8.0%. Notwithstanding a steep Depreciation and Amortisation schedule, the Centre had reported net losses almost every year since acquisition. Poor operating performance had been offset by an unexpected decline in borrowing costs. total interest expenses had fallen 27% since acquisition. Due to tough operating conditions at the tenant level, the fund manager was accepting rental reductions on a number of leases, arguing it was preferable (cheaper) to accept lower rates than sourcing new tenants; given the amount of time tenancies could be vacant for. Overall, the operating asset exhibited average profitability.

Despite a bleak operating record, the Syndicate still managed to deliver respectable returns (about 8% compounded after fees). This was due to a boost in net asset value from lower capitalisation rates, as ascribed by an independent valuer. Thus, the timing of acquisition, high level of gearing employed and gradual decline in discount rates, had conspired to deliver respectable returns. The stark contrast between operating results and investment returns raised a question of valuation. Namely, whether the market was ascribing an appropriate discount to expected cash flows. If investors were pricing similar assets on past glories, then an overly rosy outlook may be built into the price. Further research revealed that institutional investors have in fact been piling into commercial and retail shopping assets at historically high valuations; many of whom are new to the sector.

Based on rough scenario analysis we found the most likely return to unit holders, based on current prices, was around 7% per annum. However, there was also a small likelihood (not an insignificant one) that unit holders could suffer negative returns. We found the Centre had no clear competitive advantage and future cash flows would likely be hampered by the region’s poor socio-economic situation. Rental income was also likely to lag  other commercial property segments, due to growing pressure from online retailers. Finally, we found the fund manager had failed to build a margin of safety into the Syndicate’s capital structure. The level of debt employed was so large that, under certain conditions (such as a normalisation of interest rates) Syndicate cash flows would come under significant pressure.

Findings & Conclusions

“Economic decisions are usually best made on the basis of “expected value” … But, if something unacceptable can happen on the path with the highest expected value, we may not be able to choose on that basis… I always say I have no interest in being a skydiver who’s successful 95% of the time”.

by Howard Marks

The first and foremost goal of every investor is to avoid the loss of capital. By controlling the potential downside of an investment, one inherently increases the potential upside. Investing, therefore, is a subtractive discipline; it is as much about avoiding bad decisions and loss, as it is about good decisions and maximizing gain. In this case, we concluded the potential upside was limited, given the asset’s core profitability, required levels of maintenance and capital expenditure, and the prospect of further declines in borrowing cost. In contrast, the potential downside was severe, because of the Syndicate’s sizeable debt burden. Although Whig Capital expressed no opinion on the direction of interest rates, we concluded that the capital structure was so fragile that any normalisation could cause a permanent impairment of capital. Accordingly, we concluded that the investment did not present unit holders with above-average risk-adjusted returns, vis-à-vis a comparable benchmark, at current market prices.

Client Details

  • DATE:APRIL 2018

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Service Description

Financial Statement & Security Analysis