The rather curious case of Epic's fee payments

After years of study, there is growing acceptance that homo sapiens has evolved into two distinct branches. One comprises the vast bulk of humanity, the other comprises individuals known as bankers.

Although superficially alike, the latter can be distinguished by their skin, which is thicker than normal. It also has special properties giving unusual adhesion to most forms of money.

In tests using a drained swimming pool filled with Zimbabwean currency, bankers were found to emerge from the pool with up to 25 per cent more cash sticking to them than the non-banking control group.

Scientists initially hypothesised an epidermal layer of tiny hooks, like Velcro, to explain the effect, but now favour a theory of electro-magnetic attraction at the cellular level.

Edinburgh University's department of parapsychology is also testing observations that bankers can detect the contents of a wallet within a range of about five metres, even through stud walls.

These attributes are an advantage in financial transactions, and Chalkie reckons there could be something like this going on in an investment structure called Equity Partners Infrastructure Company (Epic). Basically, Chalkie's study of accounts and documents with small print suggests Epic has paid out millions more in fees to bankers and their ilk than it has to its investors.

Not only that, in Chalkie's view, the circumstances around some of the fee extraction lend support to the theory of bifurcated evolution.

Let's begin with the money raised from investors – $94.7 million in a May 2007 share offer to buy infrastructure assets, namely a 1.22 per cent stake in British utility Thames Water, held indirectly through a chain of intermediate companies.

The share offer was lead managed and promoted by entities associated with Macquarie Bank, who earned fees for their roles in the deal, as did other parties including the fund's manager.

For example, the lead manager got fees of 4 per cent of the capital raised, plus $500,000, while the promoters got 2 per cent of the capital. In all, fees gobbled up $6.9m of the money raised from investors and the amount left to buy into Thames Water was $88.5m.

This was only the beginning of the fee fest, but before we move on it's worth noting an aspect of the deal Chalkie hasn't included in the fee calculation.

Epic bought its Thames Water stake from an entity associated with Macquarie Bank and documents imply it paid 1.15 a share for 28.15 million shares in the relevant holding company – an investment totalling 32.5m.

The documents also say: "The Thames Water Holding Co shares were acquired by Macquarie Water on 1 December 2006 for a price of 1 a share."

So in the space of six months, Macquarie made a 4m gain on the stock it sold to Epic – at the time about $11m.

We'll return to the Thames Water purchase price later, because there's a curious detail in the Macquarie contract that seems to have further nasty implications for investors.

But back to the fees – the next fee kicking in for Epic was the management fee payable to Equity Partners Infrastructure Management (Epim), owned at the time by interests associated with South Island businessmen George Kerr and John Darby, also recipient of earlier fees as joint promoter. Epim was the management company for Epic.

Epic's management contract required it to pay fees of 1 per cent of gross assets to its manager every year, as well as 1 per cent of any additional transactions and a future performance fee thereon.

Between 2007 and now, management fees paid to Epim total $6.7m.

The next fee chunk is fairly small, comprising transaction fees on some minor acquisitions – a little bit more of Thames Water and a smidgen of British utilities Arqiva and MGN Gas Networks, all acquired from Macquarie entities for a total of $7m. The fee cost was $705,464.

Then Epic decided to make a bigger move, buying 17.5 per cent of British motorway service station chain Moto.

This time the sellers were an entity associated with Macquarie and two Australian super funds with assets managed by Macquarie, who sold down a quarter to a half of their stakes in Moto's Bermudan holding company to Epic for 19.7m, or $51.2m.

Fees associated with the purchase were $4.8m, of which about $500,000 would have gone to management company Epim in accordance with the 1 per cent transaction fee.

But wait, there's more. Buying into Moto meant Epic had to get more money, and it did this through a rights issue and public share offer raising a net $28.8m.

The money did not come free, however. Costs associated with the offer included underwriting fees ($838,695+GST to Macquarie) and lead management fees ($500,000 plus 3 per cent commission, again to Macquarie), adding up to $3.5m.

The fee bag is starting to bulge now and Chalkie admits the numbers can swim before the eyes, but there are one or two more fees we need to mention.

The first lot arose after Moto found itself bogged in debt and needing to raise money – a need satisfied by a rights issue.

Epic subscribed for $11.6m to keep its stake the same, generating transaction fees of $125,807.

Again, it had to raise money itself to pay for the shares, and managed it through a $6.5m share placement to Torchlight Fund No 1, an investment fund run by Kerr. Fees for the placement were $195,000.

Having dealt with those little details, we are down to some hefty items as Epic found itself in dire straits and needing to sell assets.

Late last year it sold its Thames Water stake for $76.6m, less transaction costs of $2.2m.

These costs included a $1,312,636 "completion fee" to management company Epim, although Chalkie was unable to find any requirement to pay such a fee in Epic's management contract.

A few months later Epic decided to terminate Epim's management contract for technical reasons related to a takeover of Epim's owner, Pyne Gould Corporation, which had acquired the business from Kerr and Darby.

The change generated a termination fee of $5.5m, plus a performance fee on the Moto investment of $3.3m.

The former, although eyewateringly high, is at least in line with the terms of the contract. The latter, in Chalkie's view, isn't.

According to the contract, a performance fee is payable on Moto only if its internal rate of return (IRR) on investment exceeded 9 per cent a year at "realisation date", which in this case is the date the contract was terminated.

Given Moto stopped paying dividends in September 2010 and its value was assessed by KordaMentha last month at between $32m and $55m, well below investment cost. Chalkie struggles to see how any combination of capital and income returns could provide an IRR of more than 9 per cent a year.

As KordaMentha noted: "We have been advised that performance fees were negotiated between the parties."

Still on performance fees, it appears Macquarie is now gunning for a payment of $8m in respect of Thames Water. Again, the contractual arrangement allowed for a performance fee if the projected IRR was at least 8 per cent. It's clear Thames did not meet that hurdle in New Zealand dollar terms, but unfortunately the contract was based on returns in sterling.

Returning to the curly detail, that Chalkie reckons has nasty implications, the contract also appears to give Macquarie's fee calculation a leg-up by basing it not on what Epic actually paid, which was 1.15 a share, but on an "imputed purchase price of 1.03".

Thus, it seems Epic was deemed to have paid 29.5m for its Thames Water stake, not the actual price of 33m. So when the sale came in at 36.6m, there would presumably be an uplift on the return calculation.

However, the Macquarie fee is under dispute so Chalkie has left it out of his estimate of total fees.

In the wash-up, the total comes in at $33.3m, mostly paid to interests associated with Macquarie and Epim.

So, what of the returns to investors?

Dividends paid out since the fund began have totalled $27.2m.

So it looks like the fund has generated more for banking types than it has for its investors.

Of course, if it had also produced stonking capital returns, investors might think the bargain was still a good one. Alas, no.

From the float price of $1 a share, Epic's value was assessed by KordaMentha last month at 23c-45c a share.

All in all, it adds up in Chalkie's view to a dismal experience for investors. The bankers, however, seem to Chalkie to have done rather well.

- Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.