A proposal by Fortress management to amend the company’s memorandum of incorporation (MOI) has caused a great deal of wailing and gnashing of teeth among investors. While at first blush it seems certain classes of shareholders could feel justified in being pulled over the table, there is more to this story than meets the eye.
But first background to the structure. The practice of offering investors two share options that carry different distribution rights, which is unique to the SA listed property sector, was introduced nearly 20 years ago to cater for investors with different risk profiles. In fact, you might recall that ApexHi had three classes of shares at one stage.
Fortress is one of less than a handful of real estate investment trusts (Reits) that still employs this structure, which worked well when Reits were raising capital almost every week and the outlook for growing distributions was shinier than that new McLaren in the head office basement.
A-shares have a preferential right to dividends, with growth typically capped at 5% a year (or CPI-linked — the Fortress A-share has a dividend benchmark that is the prior comparative period’s dividend benchmark, escalated by the lower of CPI or 5%), making these an alternative to bonds and cash for pensioners or other income-dependent investors looking for predictable, annuity-type cash flow. B-shares are the higher-risk option as they receive the balance of the distributable income after A shareholders have been paid.
This is the structure Fortress listed with. This is the structure shareholders knew they were buying into. Then along came Covid-19 and Fortress distributions became harder to come by than a Proteas hundred. Fortress did issue a distribution in 2021 to A shareholders of 74.7c, while B shareholders had to do without for a third consecutive period.
In a nutshell, the board of wants to amend its MOI to provide Fortress A (FFA) and Fortress B (FFB) shareholders with an equal pari passu dividend for any periods in future where the FFA minimum entitlement is not met. If passed, it would be a positive surprise for long-suffering FFB shareholders but most likely a negative surprise for FFA shareholders.
At first blush the proposal looks unfair, but it is actually consistent with the spirit of the MOI and it leaves FFA shareholders better off than they would be under the current MOI.
How so? Under the current MOI, FFA shareholders are not entitled to any income and therefore all income must be retained. Fortress is arguing that it may need to search for an alternative solution, with one of the possible risks being a cessation of Reit status. As a Reit the distributable income is, say, 100. Once Reit status is lost this 100 would be taxable at the 27% corporate tax rate, reducing distributable income to 73.
For as long as Fortress is not a Reit, the FFA entitlement will exceed the distributable income and therefore FFA shareholders will not receive any dividends. Not only that, but the growing entitlement (lower of CPI or 5%) puts the time at which dividend payments are likely to resume further into the future.
All income will be retained in Fortress and will accrue as net asset value — to which FFA and FFB shareholders are entitled equally. But assets would be subject to capital gains tax (with loss of Reit status) reducing net asset value for both FFA and FFB shareholders.
The benefits of the proposal are that without it retained income would be taxable, retained and accrue equally to net asset value for FFA & FFB shareholders. The proposal does not change this outcome, but instead achieves essentially the same without the tax drag (income and capital).
The original MOI ensured no payment of income should the FFA entitlement exceed income, ensuring that retained income would be for the benefit of both classes of shares. Overall, it is clear that FFA and FFB shareholders underestimated the risks attached to the capital structure. The gun was locked and loaded in the original MOI when it was “agreed” that they would not be entitled to any income if their claim exceeded the available pot.
Taking this as a given, the board is actually putting FFA shareholders in a better position than they would be if they voted against the proposal, while FFB shareholders are also better off as they receive income and avoid taxes.
The original sin — which makes this all seem terribly unfair — is that the MOI limits the right to preferred income of the FFA shareholders if the business is taking strain. Both FFA and FFB shareholders knew all the T&Cs when they acquired their claims.
But they would be foolish now to vote against a proposal that leaves them both better off than the alternative. In the same way it would be foolish to argue with a person who has a gun to your head.
• Avery, a financial journalist and broadcaster, produces BDTV's Business Watch. Contact him at Badger@businesslive.co.za.
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