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Hyflux saga demands better debt disclosure rules

CHINA is forcing companies to be more upfront about their debt loads, and Singapore should too.

In January, China tightened up domestic accounting rules for perpetual securities by spelling out when issuers can report them as equity in their books, and when they must show up as debt.

Corporate perpetuals, or perps, are hybrid securities that have no maturity date. Investors can expect to hold the perps forever, or until the issuer decides to exercise its option to call or buy back the perps after a specified period of time.

For this reason, Singapore issuers have always recognised perps as equity instead of debt in their books. They argue that perps are not contractual obligations to pay investors, and should not be recognised as financial liabilities.

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But most of the time, perpetual does not mean forever.

With the exception of perps issued by Reits (Reits are not allowed to issue perps with step-up coupons if they want the equity treatment), most perps in Singapore are structured with a coupon step-up feature that creates an incentive for issuers to redeem them after a number of years.

Under China's new rules, all perps that rank the same as senior debt, or those with a step-up interest rate that is higher than the industry standard, must be classified as debt.

Singapore should consider accounting and disclosure reforms too.

Hyflux saga

First, even when you set aside the question of whether perps are equity or debt, Singapore investors suffer from a total lack of consistency in how perps show up in companies' financial reports.

One of the things that water treatment firm Hyflux has repeatedly emphasised after it became insolvent last year was that "it was not until 2017 that Hyflux recorded a net loss".

In fact, Hyflux was already losing money for ordinary shareholders in 2016.

Indeed, it reported a restated net profit of S$3.8 million attributable to owners of the company in 2016. But this group of "owners" includes owners of Hyflux's outstanding S$900 million perps and preference shares, as well as another S$475 million perps still outstanding at the time.

After making deductions for coupons owed to these quasi-debt holders, Hyflux actually made a net loss attributable to ordinary shareholders of S$59.9 million in 2016 - an eye-popping difference.

Notably, this line item can't be found in any of Hyflux's quarterly income statements. You have to search for the figure in the notes to the annual report, or derive it using the 2016 loss per share figure.

Without breaking any rules, Hyflux was able to make its bottom line look rosier than it really was.

This is important, as the notion that Hyflux was profitable in 2016 formed the basis of its argument that it was justified in paying out dividends to ordinary shareholders (including major shareholder Olivia Lum), despite its negative cashflows.

Second, whether perps are recognised as equity or debt has huge implications on a company's financial leverage ratios.

By counting its perps and pref shares as equity, Hyflux's net gearing was understated for years.

Even when the deadline to retire its S$400 million pref shares was looming in April last year, failing which the annual interest cost for Hyflux would be hiked from 6 per cent to a punitive 8 per cent, Hyflux only viewed the securities as debt after it was faced with the prospect of liquidation.

Close the disclosure gaps

Clearly, whether perps are more like debt or equity is a judgment call that management and investors will both have to make over the course of a company's life.

OCBC credit research analyst Wong Hong Wei noted: "Regardless of structure, one important thing to keep in mind is that the nature of perpetuals can change over time."

Changing market conditions and individual credit considerations can affect whether the perpetuals will be called, he said: "For example, we see First Reit and Lippo Malls Indonesia Retail Trust perpetuals as more equity-like currently as they are unlikely to be refinanced more cheaply versus when they were first issued."

So excluding perps from equity classification depending on how they are structured, as China has done, is a good start, but may be too rigid for some people's liking.

There are simpler ways for Singapore's regulators to make issuers' quarterly report cards much clearer for investors to understand.

For a start, issuers should be required to make it explicit in their income statement when their reported profits are attributable to ordinary shareholders only, or to perp and pref shareholders as well.

Some issuers like Ascendas Reit already provide this level of detail by stating clearly that profits are attributable to "unitholders and perpetual securities holders", instead of using the ambiguous term, "owners".

Ascendas Reit also reports "distributions paid to perpetual securities holders" in its cashflow statement. The distribution amount reserved for perps is shown in A-Reit's income statement. Hyflux provides no such disclosure.

In the interest of transparency, such disclosures need to be standardised across the Singapore market. At the very least, doing so is a way for issuers to assure investors that they have their eyes on the right metrics.