Cadence Capital Limited

Cadence Capital Limited is a boutique investment company listed on the Australian Securities Exchange (ASX).

History

The company started in October 2005 as a very small unlisted investment vehicle, having raised $5,050,700 in capital.It subsequently issued a Prospectus dated 9 October 2006 and lodged it with the Australian Securities and Investments Commission (ASIC). A capital raising of $15,568,744 was undertaken on 24 November 2006. The company has since been listed on the ASX.

Investment Objectives

The Cadence web site states that:"Cadence Asset Management is a manager whose principal investment objectives are:
*To ensure it manages money on an absolute return basis,
*To achieve a high real rate of return, comprising both income (fully franked dividends) and capital growth, and
*To provide investors with a co-investment opportunity alongside the Manager and Board of Directors." [ [http://www.cadencecapital.com.au Cadence Capital Home Page] ]

It is questionable how closely the company has adhered to the first of these objectives (see below for further discussion).

The second objective refers to the dividend franking system that exists in Australia. When Australian companies pay tax, they are able to pay dividends that include a "franking credit" for the company tax already paid. This can make dividends a very tax-effective component of investment returns.

The third objective refers to the fact that the directors have large investments in the company. This is supposed to help ensure that the directors' interests are aligned with shareholder interests.

Performance

The company's performance has been highly variable. In the year ending 30 June 2007, the gross performance of the company's portfolio was 49.04%. However, in the year ending 30 June 2008, the gross performance was -17.80%. In his annual review, the chairman described 2008 as "a year of poor performance" [Cadence Capital Limited Annual Report 2008, p. 2]

Is Cadence Capital Limited an Absolute Return Investor?

In the prospectus [The October 2006 prospectus, with its offer of a portfolio 'managed on an absolute return basis', was approved unanimously by directors Karl Siegling, Geoffrey Wilson, and James Chirnside. (See p.54 for Karl Siegling's attestation of this).] dated 9 October 2006, the company Chairman wrote: "The company offers investors an opportunity to participate in an actively managed portfolio of investments in Australian companies, "managed on an absolute return basis", in a listed company structure." [Cadence Capital Limited Prospectus (dated 9 October 2006), front matter, unnumbered page immediately preceding page 1.] (italics used for emphasis)

This echoes the investment objective on the company's web site that it will "...ensure it manages money on an absolute return basis".

This raises the question of what it means to manage money "on an absolute return basis".

The ASX web site states that:

“Absolute return funds (or Hedge Funds) aim to deliver returns in both rising and falling markets. […] Because the securities they invest in and their management techniques differ from traditional investment management, the performance of Absolute Return Funds is not highly correlated to the performance of traditional assets such as shares, property, or fixed interest.” [ [http://www.asx.com.au/products/managed_funds/types/absolutefunds.htm ASX web page about absolute return investments] ]

Over the 33 months from inception in October 2005 to June 2008, the correlation between Cadence’s Net-of-fees returns, and the ASX Small Ordinaries Index is 0.79. [ [http://www.compoundinghappens.com/Cadence%20Capital%20Ltd.pdf Cadence Capital Limited: Some Troubling Questions, downloaded 25 September 2008] ] This indicates that Cadence's portfolio is much closer to a small cap equities fund than an absolute return fund.

This conclusion is confirmed by examining the list of Cadence's holdings, which it publishes in its annual and monthly reports. For example, the 2007 annual report discloses $49.7 million in long positions, and $6.2 million in short positions. The top 20 long positions were a grab-bag of small companies, including Babcock and Brown Ltd, Everest Babcock and Brown Alternative Investment Trust, and Mariner Bridge Investments Limited.

Corporate Governance

The ASX has [http://www.asx.com.au/supervision/governance/ a web page devoted to corporate governance principles] . These principles are non-binding, but under ASX listing rule 4.10.3, companies are required to disclose in their annual report the extent to which they comply with the corporate governance principles. Cadence is very conspicuous in not complying with several of the ASX corporate governance principles:

* Cadence does not comply with recommendation 2.1 ("A majority of the board should be independent directors".) Cadence has three directors, of whom only one is independent.

* Cadence does not comply with recommendation 2.2 ("The chair should be an independent director.") Indeed, the chairman of Cadence is also the company secretary, managing director, and sole director of the private company that provides manages all of the company's funds.

* Accordingly, Cadence is also not in compliance with recommendation 2.3 ("The roles of chair and chief executive officer should not be exercised by the same individual.")

* Cadence does not comply with recommendation 4.2 ( which states, that "The audit committee should be structured so that it consists only of non-executive directors [and ...] has at least three members"). The Cadence audit committee has two members, of whom one is an executive.

Another interesting aspect of Cadence Capital Limited from a corporate governance perspective is that it pays a generous level of management fees to Cadence Asset Management Pty Limited, a private company whose sole director is also the chair and Managing Director of Cadence Capital Limited. Over the period October 2005 to June 2008, Cadence's gross annualized performance was 19.43%, while the net performance was 16.23%. This indicates that the average level of management fees over this period was 3.20% per year.

The Cadence Capital Limited 2008 Annual Report discloses that, "Subject at all times to any written guidelines issued by the Board of Directors of Cadence Capital Limited, the day-to-day management and investment of funds is carried out by Cadence Asset Management Pty Limited pursuant to a management agreement." [ [http://www.cadencecapital.com.au/CCL%20Annual%20Report%202008.pdf Cadence Capital Limited 2008 Annual Report, p. 4.] ] It is notable that no other details about the management agreement are disclosed. The corporate governance advisory firm RiskMetrics has been campaigning for Australian listed companies with significant management agreements to disclose the full text of those management agreements, as is required in other jurisdictions such as the USA [ [http://www.businessday.com.au/business/asx-told-to-take-stronger-line-20080918-4jgb.html "ASX Told to Take Stronger Line", Scott Rochfort, "Sydney Morning Herald", 19 September 2008] ] . So far, Cadence has not disclosed the full text of the management agreement.

Liquidity

As a listed company, investors would hope that Cadence Capital Ltd would offer them liquidity. Liquidity has been defined as “The ability of an asset to be converted into cash quickly and without any price discount.” [ [http://www.investorwords.com/2837/liquidity.html InvestorWords.com web site, accessed 30th September 2008] ]

The three key elements in this definition are:
# "Ability of an asset to be converted into cash": For example, by selling “at market” on the ASX.
# "Quickly": most people would take this to mean within a day or (at worst) a week.
# "without any price discount": for a company like Cadence, this means achieving a price reasonably close to NTA.

For a Cadence shareholder, the possibility of converting a Cadence share into cash at all seems almost an impossible dream. For example, as at 15th August 2008, not a single share had traded on the ASX during the month of August. During the last two weeks of July, there were five days on which Cadence traded, although these trades were generally at a 20% discount to NTA. This pattern of very few market trades -- all of them at a huge discount to NTA -- has been typical for most of 2008.

One can seach for information about the the last five days of trading for Cadence Capital Limited on [http://www.asx.com.au/asx/research/CompanyInfoSearchResults.jsp?searchBy=asxCode&allinfo=on&asxCode=CDM&companyName=&principalActivity=&industryGroup=NO the ASX web site] .

The NTA discount is an interesting issue. Some ASX companies that are trading below NTA are infrastructure companies, the where the NTA depends on subtle valuation models and discounted cashflow valuations running decades into the future. By contrast, the NTA for Cadence is simply based on the listed prices of cash and shares that Cadence holds. Valuation models are quite irrelevant. Why, then, should there be any difference between Cadence’s market price and its NTA? The only kinds of plausible explanation are management-related: for example, they would depend on the fees charged by Cadence, or upon the market’s assessment of the skill of Cadence’s management.

Possible Soutions to Cadence Capital Ltd's Liquidity Problem

During the 2007-2008 credit crisis, several other ASX-listed small invesment companies have encountered similar liquidity problems to the ones that Cadence Capital Limited is experiencing. It is interesting to compare the responses from the boards of these other companies with the response (or lack thereof) from Cadence Capital Limited's non-independent board.

Everest Babcock and Brown Alternative Investment Trust (EBI)

Everest Babcock and Brown Alternative Investment Trust (ASX:EBI) is an investment somewhat like Cadence Capital. Indeed, in the April 2008 investment report for Cadence, director Karl Siegling wrote “Cadence currently has an investment in Everest Babcock and Brown trust Units (ASX Code: EBI) trading at $3.21 with a NTA of $3.97. Using similar logic to that outlined above, we are happy to buy the underlying assets in the trust at a 20% discount to NTA.” [Cadence Capital April 2008 Investor Report, unnumbered page 4.]

At an earlier date (June 2007), more than 7.5% of Cadence’s assets were invested in EBI [Cadence Capital Limited Full Year Annual Report for the Year Ended 30 June 2007, p. 3] , with another 2% invested in the infamous Babcock & Brown parent company, that has since lost more than 90% of its market capitalization.

So, for reasons that some may find hard to fathom, the investment manager for Cadence Cadence Capital Limited clearly sees much that is attractive in using shareholder funds to invest in EBI, which is a Babcock and Brown entity that charges a high set of fees. This results in the shareholders paying high fees at the level of Cadence Capital Limited, and then on the money which has in turn been invested into EBI.

It would seem plausible, therefore, that Cadence management might be keen to learn from initiatives that EBI were taking to improve the lot of their investors.In the EBI Chairman’s Address and Presentation (dated 28/5/2008) [ [http://www.asx.com.au/asxpdf/20080528/pdf/319c4psbhxqypm.pdf Everest Babcock & Brown Alternative Investment Trust, Chairman's Address 2008] ] , one finds several pages on initiatives that the board is exploring to improve the EBI NTA discount and illiquidity.

One of the proposed initiatives is a sophisticated discount control mechanism, which includes the following steps:

“Step one. A significant off-market buy-back of EBI units. As typical for other off-market buybacks in Australia, the price will be set by a tender process.Our current portfolio liquidity analysis shows that a minimum buy-back of approximately 10% is achievable over the next 4 months. The Board will continue to monitor liquidity and make a determination on final size at a point closer to implementation. However we are seeking to source liquidity to achieve a total 20% buy-back within 12 months.

Step two. The introduction of a Discount Control Mechanism, a semi-annual liquidity facility that is conditional on where EBI trades relative to its NTA.If EBI trades at greater than a 10% discount to its NTA, over a three month period to 30 June and 31 December each year, EBI will launch an off-market buyback of up to 10% of the fund at a 5% discount to NTA.This means that the unitholders can have confidence that EBI will buy-back units should the trust trade at worse than a 10% discount over a three months period going forward.” [ [http://www.asx.com.au/asxpdf/20080528/pdf/319c4psbhxqypm.pdf Everest Babcock & Brown Alternative Investment Trust, Chairman's Address 2008, page 7 of the Chairman's remarks.] ]

In comparison with all these sophisticated plans, the board of Cadence Capital Limited has not (as of 1st October 2008) publicly announced any attempted remedy for the illiquity and large NTA discount exhibited by the company's shares.

Ellerston GEMS

The "Sydney Morning Herald" reported on 22nd August 2008 [ [http://business.smh.com.au/business/shareholders-queue-up-to-cash-out-of-packer-fund-20080822-409j.html "Shareholders queue up to cash out of Packer fund", by Vanda Carson] ] about another painful situation for investors in what purports to be a listed hedge fund. This particular fund is known as “Ellerston GEMS”. Using the same rhetoric that Cadence use in their promotional materials, Ellerston GEMS supposedly offers the wider public a “co-investment opportunity” alongside the Packer family.

The Ellerston GEMS fund did not do well since listing at $2.50 in 2007. The last traded price on Thursday 21st August 2008 was $1.78. This compares with a 30th July 2008 NTA of $2.33. The discount is about 24% -- approximately the same discount that Cadence shareholders have had to deal with.

At least the Ellerston directors have proposed a plan to deal with the situation. Their original proposal would have allowed unitholders to redeem units for cash at a 7.5% discount to NTA subject to various limits on the number of acceptances over the next few years. The Ellerston shareholders were reportedly furious about the proposal, and some proposed that Ellerston GEMS should be wound-up completely. A full wind-up would return more value to the shareholders, and the money would flow back more quickly.

The "Sydney Morning Herald" reported on 4th October 2008 [ [http://business.smh.com.au/business/packer-fund-drops-56m-and-agrees-to-go-off-market-20081003-4ti2.html "Packer fund drops $56m and agrees to go off market", by Vanda Carson] ] that the Ellerston directors improved the plan a little bit. Under the new plan, shareholders would only suffer a 5% discount to NTA, altough the money would only be returned to them in stages over the following year. This plan was approved by 96% of shareholders.

The Ellerston GEMS shareholders are reportedly very disappointed and angry, but at least they are getting a way better deal than Cadence shareholders are getting (Cadence shareholders have recently been selling on-market at NTA discounts well in excess 20%).

Macquarie Capital Alliance Group

The Macquarie Group receives a lot of criticism about its dealings with “satellite” management companies. However, Cadence shareholders could find very much to admire in a transaction that was confirmed to ASX on 16th June 2008 by Macquarie Capital Alliance Group:

“MCAG Independent Board Committee Director Dr Ken Moss said, “MCAG board and management have considered a range of strategies to maximise value for MCAG security holders. MCAG’s businesses have robust medium-term business plans, however, since listing, MCAG’s securities have been relatively illiquid and the trading price has been disappointing.”

“Today I am pleased to report that the independent directors intend to unanimously recommend the MAIG take-private proposal in the absence of a superior proposal. The proposal is very attractive as it represents a 62% premium to the last closing price and a 53% premium to the three month VWAP.” [ [http://www.asx.com.au/asxpdf/20080616/pdf/319myw06wvj8nx.pdf Macquarie Capital Aliiance Group Ltd. press release pp. 1-2.] ]

The problem for MCAG shareholders sounds very similar to the problem for Cadence shareholders: the securities were trading too low compared with NAV, and the trading was illiquid. However, the MCAG directors found a spectacular solution for their shareholders! They have arranged a deal for MCAG holders to sell their securities at a 62% premium to (what was then) the current market price. What a spectacular difference!

The Possibility of Winding-Up Cadence Capital Limited

It is currently impossible for shareholders to realise anything close to NTA by selling their shares in Cadence Capital Limited on the ASX. For anyone who is inclined to sell (or who even needs to be able to demonstrate to their banker that they would be able to sell), there is a very pressing need for some liquidity mechanism.

The company could simply be wound-up under [http://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/s491.html section 491 of the Corporations Act 2001] , with the cash proceeds then returned to shareholders. This simply requires a Special Resolution of 75% of shareholders. ASIC provides instructions on this process on [http://www.asic.gov.au/asic/asic.nsf/byHeadline/Winding-up%20a%20solvent%20company its website] .

References

External links

* [http://www.cadencecapital.com.au/ Cadence Capital Limited home page]
* [http://www.asx.com.au/supervision/governance/ ASX Corporate Governance web page]
* [http://www.compoundinghappens.com/opinion/Cadence%20Capital.htm Cadence Capital Limited: An Excellent Example of Australian Corporate Governance]
* [http://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/s728.html Section 728 Corporations Act 2001]