Serving two masters a recipe for conflict soup

17:00, Jul 01 2014

Chinese walls may be named after a muckle stone structure visible from space, but Chalkie thinks of them more like gauze wafting modestly around Renaissance paintings of voluptuous nudes.

They do the job, but only just.

In legal circles, regulations governing lawyers' obligations to clients are pretty clear: law firms generally can't act for two clients whose interests conflict. And "information barriers" within firms - Chinese walls - are not adequate to manage that conflict.

There are exceptions to the rule, but in Chalkie's experience law firms are usually alive to the awkwardness of advising both sides in a transaction.

The financial services industry appears less squeamish.

Broking firms commonly have a split personality, one side working for companies wanting to raise money from investors, the other side working for people who have money to invest.


It's been that way for a long time, but some practices still strike Chalkie as unattractive.

Looking under the hood of the current spate of floats, it appears broking firms remain comfortable relying on Chinese walls to manage conflicts rather than simply shunning conflicts altogether.

In the case of IkeGPS, a small tech company float joint lead managed by Forsyth Barr and Deutsche Craigs, $25 million is being raised from investors to fuel its global expansion.

The price was set at $1.10 a share in a front-end bookbuild ahead of the prospectus being published and there was enough commitment from investors to cover the $25m sought, although its stretch target of $30m was not reached.

Whether IkeGPS will be as successful as it hopes is anyone's guess. Although the company clearly has clever technology and a viable business plan, it was interesting to see that it also raised money privately in January this year, a few months before initiating its initial public offer.

As the prospectus discloses, among the investors who subscribed for the $1.04 a share January share issue were senior executives from Forsyth Barr, who bought a collective 1.4 million shares.

Another buyer at this stage was institutional investor ACC, which bought 480,769 shares. Canny Wellington-based investment fund Rangatira is also said to have participated.

Companies Office records show there were 2.86 million shares issued in January, so it would seem the Forbar execs took a decent chunk of that capital raising.

Chalkie has no doubt that the Forbar people are walking the talk, staking their own money in a venture because they are excited by its prospects and want to be involved.

Their investment is in escrow and must be held until May 2015, and their interest was properly disclosed to investors in the IPO, if they checked the small print.

It's also apparent that the price they paid was not much less than the $1.10 IPO price, so they are not exactly in line for a windfall, and they were buying when the company was unlisted and there was no guarantee the IPO would be successful.

However, the Forbar executives bought in on different terms to any of their clients buying through the IPO. Back in January, the pricing of the IPO would have been uncertain. Perhaps $1.10 a share was at the low end of the possible range, in which case paying $1.04 risked being seen as opportunistic; or perhaps $1.10 will turn out to be too high, leaving Forbar's skill at valuation in doubt.

Feed those issues into Forbar's dual roles as joint lead manager, helping maximise the IPO price, and investment adviser, helping retail clients maximise return on investment, and you have a potentially tricky situation.

After all that Forbar has been through, Chalkie is surprised its execs were willing to go there. Let's hope it turns out okay.

But working on both sides of an IPO deal is not unusual. The float of construction equipment hire firm Hirepool, cancelled last week, involved investment banking and financial advisory firm Macquarie in several ways.

The Hirepool IPO was to be partly a selldown by its existing shareholders, primarily private equity firm Next Capital and Macquarie, whose funds owned about 65 per cent and 21 per cent of Hirepool respectively.

Macquarie was also a joint lead manager of the offer, along with Deutsche Craigs and UBS.

As far as Chalkie is aware, Macquarie did not actively market Hirepool to its retail client base, which is just as well because it would have made a pungent conflict soup, with one set of investment clients selling out, another set buying in, fees coming off both sides and a lead management crouton thrown in.

As it turned out, several significant investors turned up their noses at the Hirepool IPO price, one of them being Forsyth Barr, whose big retail client base has an influential amount of money.

Chalkie reckons Forbar's investment committee, which decides whether certain securities can be included in discretionary client portfolios, made the right call on Hirepool.

It will be interesting to see how it judges another IPO said to be in the offing, Metroglass.

Like Hirepool, Metroglass is being sold by private equity, in this case predominantly funds controlled by Crescent Capital. Part of Macquarie's empire was at one stage also an investor but Chalkie understands it no longer has an interest.

Metroglass, a maker of glass windows and panels for residential and commercial buildings, has been through troubled times. In 2006 it was sold by its owner-operators to private equity firm Catalyst for $366.2m, but ran into trouble in the recession and was sold again in January 2012 to Crescent for $181.5m.

Its most recent accounts show a company with revenue of $136m and net profit of $8m, which puts it in the same size bracket as Hirepool, although the latter was more indebted and not profitable ahead of its intended capital raising.

Market sources say Crescent has appointed experienced brokers UBS, Macquarie and Forsyth Barr as joint lead managers of a proposed IPO.

If Metroglass does come to market we'll find out its lead management team soon enough, but Chalkie is intrigued by the process of selecting firms to carry out the role.

Part of the investment banking team's job is to advise a company how much demand there might be for an issue, just like a real estate agent will advise their client how much a house could sell for.

And as with real estate agents, Chalkie reckons vendors will tend to pick the lead managers who can plausibly get the best price. This is all fine, but it leads us into the grey area of whether a firm's retail client base is useful in winning investment banking mandates.

This is where Chinese walls come in.

Forbar deals with the potential conflict by ensuring only its investment committee can decide what stocks are eligible for inclusion in retail client discretionary portfolios and that the committee is independent of the investment banking arm. Technically, the committee is considered a professional investor so it can consider IPO investments in advance of a prospectus and can indicate interest in a stock in time for investment bankers to make a pitch, but that does not mean the firm will definitely sell any amount to retail clients.

This is as it should be. Chalkie would expect to see a broking firm making sure its processes are rigorous and putting up Chinese walls to keep its conflicting interests apart. But Chalkie wishes more permanent barriers were the norm.

Chalkie is written by Fairfax business bureau deputy editor Tim Hunter.