Babcock follows Centro's leadBy Tony...

Babcock follows Centro's lead
By Tony Boyd
http://www.businessspectator.com.au/bs.nsf/Article/Babcock-follows-Centros-lead-$pd20090108-N3RRE?OpenDocument&src=sph

Babcock & Brown's admission that its $2.6 billion in net assets will be wiped out by impairment charges in the six months to December gives the first indication of the size of the debt for equity swap that will have to be swallowed by its banks.

The impairment charges are far worse than $2.6 billion. A review of the value of the assets that are being held for sale in real estate, operating leasing and corporate finance will result in a “substantial negative net asset position at December 31, 2008”.

That suggests a negative equity position of hundreds of millions of dollars because of big writedowns on about $7.5 billion in assets. The assets are split as follows: real estate $4.6 billion, operating leasing $2.1 billion and corporate and structured finance $796 million.

Valuing those assets can't be easy for the Babcock & Brown board – Elizabeth Nosworthy, Michael Larkin, Pat Handley and Ian Martin – and Ernst & Young partner Mark O'Sullivan.

There are virtually no transactions taking place in the sectors where Babcock & Brown wants to sell assets and, at this stage, there are virtually no banks willing to lend to investors wanting to buy assets in those sectors.

But one would assume that the banks have demanded that Babcock & Brown use the most conservative possible valuation criteria. That would ensure that if they decide to rescue Babcock & Brown from receivership and go ahead with a debt for equity swap there would be some prospect of upside in the long term.

One way of working out the likely debt for equity swap at Babcock & Brown is to take a conservative leverage ratio and work backwards while at the same time examining Babcock & Brown's likely earnings.

Babcock & Brown's 25 banks were willing to live with a leverage ratio of about 52 per cent before the world went pear shaped. Their primary debt covenants were net asset cover ratio of 2.1 times and interest cover of 5.3 times.

All those covenants were suspended a month ago in the knowledge that they would be breached at December 31. The company has been at the mercy of its banks for about six months.

Babcock & Brown has about $3.9 billion in debt broken down into a $2.8 billion evergreen corporate facility, a $US200 million senior bridging facility, $150 million short-term facility repayable in December and $690 million in subordinated notes.

No interest will be payable on the notes until the short term facility is repaid. It is possible Babcock & Brown will be able to repay that facility with the proceeds of the sale of management rights.

Under its plan outlined in December, Babcock & Brown said it wanted to repay half its bank debt of $3.1 billion by 2011. In August last year it said it was aiming for a leverage ratio of 20 to 30 per cent. But with the latest writedowns that would seem too ambitious.

The debt has to be set against Babcock & Brown's ability to make money. In the half year to June 2008, the company reported a group profit of $175 million after taking losses and impairment charges of $440 million.

The interim results relied heavily on development activities which accounted for 80 per cent of net revenue. That form of revenue is unlikely to flow through this year. Other revenue lines that will be vulnerable in 2009 are co-investment income, advisory fees, performance fees, principal investment, operating leasing trading profits and third party advisory.

Babcock & Brown is also going to lose a large percentage of its base fee income as it sells management rights to cover short term debt commitments.

Chief executive Michael Larkin has a drastic cost cutting plan that should more than halve annual operating expenses of $1.1 billion. But he will be stuck with sizeable annual interest payments even after converting a big slab of debt into equity.

The company will remain heavily reliant on revenue from recycling assets in order to survive.

In order to create a sustainable situation, Babcock & Brown's bankers are probably looking at converting into equity at least a third and possibly half their $3.1 billion in debt.

Many of the Babcock & Brown bankers were also lenders to Centro so they have a benchmark for doing a deal.

The Centro transaction involved converting $1.05 billion in debt into a hybrid security with a seven year maturity and with the potential to covert into equity. Centro's bankers will own about 90 per cent of the company at the time of conversion.

Centro's bankers also took a $10 million payment up front through the placement of 15 per cent of the issued capital.

Full details of the Centro debt for equity swap are not due to be released until January 15.

There is a drawback from using hybrid securities in a debt for equity swap. Under accounting rules it is classified as a derivative and therefore cannot sit in the banks' balance sheets as an asset held for sale.

Instead it must be marked to market each year and any movements would go through to the profit and loss line. A straight equity issue would allow the shares to be held at fair value.

For Babcock & Brown's bankers, the intricacies of accounting for equity holdings will be a second order issue. Their priority will be assessing the quality of the assumptions made about asset valuations by the Babcock & Brown board of directors because that will go a long way toward determining the size of their ownership stake.