In a flashy webinar hosted by Bruce Whitfield, Fortress REIT tried to address some of the most pressing questions around the proposal to collapse the two share classes into one.
I must be honest, I would’ve just preferred a basic SENS announcement. Bruce is great, but 27 minutes of watching the well-dressed team in a fancy setting was a bit much. Here’s the link in case you want to watch it yourself.
To save you time, I’ll deal with some of the key points below.
First, a trip down memory lane.
Why do dual-share structures exist?
Back in the day (but not quite when Chappies cost one cent), there was a “growth mindset” in the market. I know, I know, that’s hard to believe. To respond to this, the dual-share structures offered a yield-focused investment instrument and a residual profit sharing instrument which did well in the good times and poorly in the bad times. This was done to make property more appealing to a broader base of investors.
These were typically structured as a debenture and a share, which gave holders of the debenture (a debt instrument) a genuine right to receive an income yield. That’s not the same thing as a distribution, which is seen as a dividend by the Companies Act. When the debentures were converted into shares, this nuance was perhaps missed by some.
Andrew Brooking is a founding director of Java Capital, the corporate advisory house that has absolutely dominated in the property sector. He was on the webinar and he is familiar with all these structures because he was intimately involved in creating them. He talked a bit about how the market conditions have changed, leading to a major problem for dual-share structures.
What is Fortress proposing?
Fortress now wants to collapse the A share and B share structure into a single share class. A dual-share structure is risky in a slower growth environment and creates significant challenges for the company in trying to retain its REIT status.
The CFO talks about how the issue impacts both classes of shareholders. Earnings need to reach a certain benchmark before a distribution can go to A shareholders. Until the A shareholders are paid, the B shareholders can’t receive a distribution. As Fortress needs to declare distributions to retain REIT status and the current benchmark isn’t being met, this puts everyone in a tight spot.
After making short-term amendments to the Memorandum of Incorporation in the past couple of years (the founding documents of the company), Fortress needs a sustainable solution. The directors talk about being tired of putting “patches” on.
After making short-term amendments to the Memorandum of Incorporation in the past couple of years (the founding documents of the company), Fortress needs a sustainable solution. The directors talk about being tired of putting “patches” on.
The Fortress Chairman noted that the company was aware of the risks of growth in distributions overtaking growth in property values, which led to a board sub-committee being established just before Covid. Naturally, everyone’s favourite virus accelerated a problem that was already there.
I’m also going to point out that there have been vocal critics on Twitter of the approach taken by Fortress. Although one never has to look far to find a conspiracy theorist, there are seemingly valid questions being asked by analysts around (1) what Fortress could’ve done to avoid this and (2) whether there are conflicts of interest at play here given the holdings of management in each class of shares.
The management team highlights that the independent board is making the proposal, not the management team. The Chairman pointed out that management is incentivised under long-term schemes with an equal number of A and B shares. Finally, the Chairman also noted that management is overweight A shares based on value, which will be disclosed in the circular.
Why is REIT status so important?
Recognition as a Real Estate Investment Trust (REIT) is critical because of tax reasons. REITs pay almost no tax, as distributions are tax deductible. Simply, this means that they serve as a conduit between investors and underlying property investors.
For tax-exempt investors like pension funds, this means that no tax leakage is experienced between the properties and the eventual pensioners. For non-exempt investors, REIT distributions are taxed at income tax rates rather than dividend tax rates. This is important to remember, as a yield on a REIT is subject to higher tax for most investors than the yield on a non-property company.
Brooking pointed out that the loss of REIT status technically isn’t a death blow to Fortress. He’s right on a very technical reading of things. The management team is far more concerned as they understand what would happen to the share price. If REIT status is lost, the shareholder register will probably be thrown into disarray. Pension funds would likely run for the hills, leading to a dumping of shares in the market.
The Fortress team pointed out that the loss of REIT status would also impact the ability to raise capital, which means fortress would have to retain capital to grow. The reality is that the JSE hasn’t been kind to non-REIT property funds, so it really would be a poor outcome.
How do the economics work?
This is where the problems start, you see.
Everyone agrees that the company needs to retain REIT status. I don’t think anyone believes that a dual-share structure is better than a simple structure. That’s where the agreement ends, though.
The way in which the structures are collapsed has a significant impact on the relative values of the A and B shares. Fortress is proposing a 3.01 ratio in favour of the A shareholders.
Brooking defends this methodology by noting that they engaged with a wide range of shareholders and considered the distribution rights going forward. The base assumption behind the ratio is that the company would lose REIT status after failing to declare a distribution in October, something that has never happened before on the JSE.
The Chairman correctly notes that the concept of a fair and reasonable ratio would always be a range and that the challenge is whether the scheme is palatable for shareholders. In this case, if everyone is unhappy, they’ve probably hit the right number.
If the scheme passes, there will be a dividend by the end of October.
Brooking also points out that there are two financial years’ worth of dividends that the company is trying to release to shareholders, as they couldn’t be paid because the benchmark wasn’t reached.
