Published December 18, 2006
Babcock & Brown IPO: not quite a no-brainer
By OH BOON PING
SOON-to-be-listed Babcock & Brown Structured Finance Fund is projecting a 9 per cent yield next year based on its offer price - surely one of the most attractive initial public offers this year. But is this a no-brainer investment that investors should rush into?
A look at the asset classes that the fund invests in quickly reveals that it warrants a serious look. However, attention should be paid not just to its promising prospects but also the associated risks. Babcock & Brown said that its initial portfolio, acquired for $397.7 million, consists of near-equal allocation across assets like biofuels financing, loan portfolio and securitisation such as collateralised debt obligations (CDOs), and operating leases in aircraft and rail. The IPO consists of 6.47 million public offer shares and 316.99 million placement shares at $1.06 each, and Babcock & Brown said that investors can expect to receive total payout of 10.06 cents per share by the end of next year. This comprises a dividend of 9.54 cents for 2007 and 0.52 of a cent for the period from the listing date to Dec 31 this year.
To be fair, the segment which includes renewable energy financing is a potential money spinner, given the boom in the energy sector. And Babcock & Brown's projected payout also serves as an assurance somewhat. But it is also clear that the fund has no comparable on the local bourse that can be used as a performance benchmark, and complex products like CDOs are very new to most retail investors here. This means that these investors may not fully understand the risks of buying into the fund.
Take the example of CDO - a pool of underlying debt obligations, which has its risk redistributed across investors via tranches. Yes, most of us know that there is default risk that comes from the underlying pool. But what complicates the picture in a CDO is that the default of one party may result, to different degrees, in the default of other parties in the portfolio. As such, the performance of the individual tranches depends largely on the degree of correlation of the defaults that may occur in the underlying portfolio.
The instrument also faces legal risk as legal and documentary issues are factors in ensuring the efficiency of risk transfer and of clearly defining the role of the different parties involved in a CDO structure. Third party risk is also present in a CDO, as the inability of a third party to meet its obligations could jeopardise the viability of a transaction. In the case of cash-flow CDOs, this takes the form of counterparty risk vis-a-vis the counterparties of interest rate or foreign exchange swaps, or providers of external credit enhancers.
So in assessing the risk-return trade-offs for this one asset class alone, investors already need to carry out a substantial amount of research, which may not be easily available. As such, a 9 per cent yield may come with risks that retail investors are not able to measure easily.
Business outlook-wise, Babcock & Brown is optimistic about prospects in aircraft operating leasing, citing factors such as the growing proportion of global commercial fleet subject to leases, from 26.3 per cent in 1986 to 50.7 per cent in June this year. To be sure, aircraft values and lease rates have shown continued improvement since the trough of 2002-2003, and lease rates on in-production long-range wide bodies and certain narrow-body aircraft, posted double-digit growth over the past year.
However, one should also note that high fuel-related costs, geopolitical risks and health-related threats such as Sars or avian flu will continue to affect the outlook for the sector. Plus, most of its assets are parked in North America, Europe and Australia, and local investors may not be able to make informed judgments about the market conditions in those countries. This is especially critical as any downturn in the US will directly affect the returns and default risks of the portfolio. A look at its portfolio also reveals that its assets are often inaccessible to most retail investors, which may not be a bad thing since investors now have more investment options. But as these investments are relatively illiquid, this also heightens the liquidity risk when it comes to disposal of assets. Investors would do well to look further into these issues before calling their brokers.
