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This story was found at: http://www.theage.com.au/articles/2008/02/14/1202760494565.html


These labyrinthine deals hide doubtful details

Michael West
February 15, 2008

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FIRST MFS was going to buy City Pacific. That was in August. Then City Pacific was going to buy MFS. Then, a few weeks ago, MFS collapsed and the deal was off, but now it's back on.

What's going on? The game is called "let's try to survive by doing another deal".

And timing would appear to be almost as critical to City Pacific as it undoubtedly is to MFS.

One of its mortgage funds has $326 million of loans from property developers that fall due by March 31 — that's six weeks. A further $707 million is due before December 31 (City Pacific First Mortgage Fund).

The City Pacific model works this way: the company runs a swag of trusts that it markets to small investors — "give us your savings and we'll give you a return of around 8%".

"It's property, it's safe."

Then it on-lends these funds to both its own property development arm and to outside property developers, too — taking its cut along the way.

Problem is, interest rates are rising and property developers are a little more stretched then they were last year.

And last year, City Pacific had almost $100 million in loans "past due" at the June balance date — in other words, in technical default.

City Pacific also burned $48.8 million in cash in the year to June 30, and had generated $82.5 million in 2006, which amounts to a $130 million downturn in cash flow over the period.

This sizeable turnaround to the negative can be ascribed to cash receipts from customers falling by $74 million to $128 million last year.

Payments for inventories rose during that time by $25.7 million. Payments to employees were up by $10 million and the Tax Office picked up an extra $12 million for a total of $29 million.

The rub with booking large accounting profits rather than profit from good old cash flow — as most financial engineers now know all too well — is that you still have to pay the tax man according to your accounting profit.

To be fair, property development is a game of lumpy income and City Pacific may be just about to sell large chunks of its asset base to arrest the cash-flow deficits and pay down debt. Though, this would countervail all market intelligence.

Second mortgages and receivables are on the rise in the City Pacific accounts and $89 million of the loans it provided to developers carry an interest rate of 21.55% average, suggesting these developers are high risk.

Hence, the MFS deal. An acquisition of MFS assets would provide City Pacific boss Phil Sullivan and his troops with the perfect opportunity to have a lightning capital raising and drag some equity in the door.

As for MFS, corporate doctor KordaMentha will no doubt be hawking its assets to the highest bidder.

The funny side of this MFS debacle — in reality a tragedy for small investors who relied on the advice of financial planners fed large on trailing fees — is that only a few weeks ago City Pacific made an offer to MFS of $1.33 billion.

Not that City Pacific has $1.33 billion to play with, but the offer was conditional and it was using a less valuable commodity than cash — its shares. It's all about relative value.

Unlike its proteges Babcock & Brown and Macquarie Group, MFS is plagued by a rash of guarantees to its associates and assorted entities.

The parent company is liable to fund its foundering trusts and associates, whereas the other financial engineers were smart enough and financially powerful enough to have done their deals and spun off their subsidiaries with little recourse.

As for Allco, the appointment of Ferrier Hodgson is finally proof of just how desperate its situation is. Like MFS, it has tried in vain to slap together a deal to make it look like business as usual.

Alas, Allco founder David Coe and his colleagues will find the era of the financial engineer has drawn to a close — especially now that the rump of the financial press has finally worked out the gig and no longer spruiks the structured wares so ardently.

The empires of leverage are unravelling faster than the rapid retinue of leveraged, byzantine deals that put them together in the first place.