Small investors lose out in fast moving markets

It is ironic that Slater & Gordon chairman John Skippen was lamenting the impact of short selling which he described as "dangerous" in a magazine interview. He called on regulators to tighten up the rules around short selling but aimed all his criticism at hedge funds profiting from share price falls.

It would seem the regulators have good reason to also investigate how long only funds can make decisions that have a material impact on market movements.

Investment banks are the common thread that joins the short selling debate with the discussion about the rights of small investors being trampled upon.

Exhibit one is ANZ's capital raising, which was done to meet the higher capital standards imposed by the Australian Prudential Regulation Authority.

APRA's new rules on risk weighting of mortgages don't come into force until July next year but ANZ went hell for leather to get $3 billion in capital on Thursday. It made a placement of $2.5 billion in shares to the privileged institutions close to the investment banks handling the deal. That was clearly to the disadvantage of small shareholders in the bank.

Ownership interest diluted

Small shareholders will have their ownership interest in ANZ diluted while value is transferred to the institutions participating in the placement.

This capital raising was the first pressure test for ANZ's new chairman David Gonski. He does not come out of it well when you consider how it was handled and the impact it had on the market.

It did not help that ANZ's raising was accompanied by the first clear evidence that the bad debt cycle in Australia is turning. ANZ said that its total provision charge for the nine-month period to June 30, 2015, was 13 per cent higher at $877 million.

The profit update by ANZ was seen as a profit downgrade. That flowed through the banking sector. But the big hit to share prices of other banks was the sudden demand for stock as ANZ hit fund managers for bids in a very short time frame.

Small investors watched the price of all their other bank stocks fall sharply as the big funds unloaded shares to pay for the ANZ share issue. It would not surprise Chanticleer if there was short selling of the other banks by the underwriters of the ANZ issue to hedge their positions.

Retail investors in ANZ will get their token share of stock later this month with a $500 million share purchase plan. The discount offered on the ANZ stock is so skinny it may not win strong support from small investors.

At least National Australia Bank did a full-blown rights issue when it raised $5.5billion last month.

Another prime example of small investors getting toasted is the recent Slater & Gordon share issue to fund its $1.2 billion takeover of the Professional Services Division of Quindell Plc. It did offer all shareholders equal pro-rata access to the new scrip but its rapid-fire book build for a 2-for-3 rights issue at $6.37 a share gave special benefits to those who got in early.

The institutional book build was done in the 24 hours after the deal was announced on March 30. The institutions and privileged management who declined to take up their stock were able to sell at a share price of $7.08, the theoretical ex-rights price, when the stock was trading at $7.85. They could pocket the difference.

Retail investors, however, were allowed to take up their shares between April 9 and April 20. But by April 20, the stock had fallen to $6.54. There was a small profit on the initial purchase but hardly the same as those available to institutional investors.

The credibility of law firm Slater & Gordon now rests on its ability to convince the market that its due diligence on a $1.2billion acquisition in the United Kingdom was bulletproof.

There is a sense of urgency to that task now that Quindell Plc has published accounts showing that the business Slater & Gordon purchased in May was losing money and had negative net tangible assets.

One way a business can go from being worth $1.2 billion to nothing in the space of three months is if there is a more conservative treatment of the recognition of its revenue and expenses.

From one extreme to another

That's exactly what happened at Quindell. Under the guidance of a new board of directors, a new auditor in KPMG and with advice from another accounting firm PwC, Quindell has gone from one accounting extreme to another.

This would not be possible if Quindell was making and selling widgets. But because it is a professional services firm it can pick and choose how aggressively it recognises the revenue from thousands of personal injury legal cases.

The Quindell Professional Services Division sold to Slater & Gordon was particularly aggressive in its recognition of revenue from thousands of legacy hearing-loss cases. This segment of the business was called NIHL.

Slater & Gordon's due diligence uncovered the games Quindell was playing with NIHL. It was so concerned it decided to remove all revenue and expenses related to NIHL to get a clear view of the core PSD performance.

It also said it had "better aligned non-NIHL Legal Services revenue recognition with Slater & Gordon's approach of using evidence based milestones and other accounting adjustments".

There are varying levels of conservatism in the accounting used by professional services firms.

But none would go as far as the new board of Quindell has done.

It not only abandoned the aggressive recognition of revenue from cases with minimal settlement experience, it went as far as to adopt cash accrual accounting.

That put an end to the Quindell double whammy of recognising profits early and, as far as possible, deferring expenses to a later date. Quindell's new board said: "Revenues and profits are now recognised, in the majority of cases, when liability is admitted by the at-fault insurer.

"Related costs are expensed as incurred, specifically marketing costs which had previously been deferred and expensed only as cases reported revenues and profits.

"Admission of liability is now generally considered to be at settlement of the case and is typically followed shortly thereafter by the invoicing and receipt of cash."

Conservatism quashes recognition of value

Of course, this conservatism virtually denies any opportunity to recognise the value of work in progress, which has been an important feature of Slater & Gordon's success.

In fact, it was a surge in work in progress at Quindell in the last few months of 2014 that prompted Slater & Gordon to upgrade its profit estimates for the Professional Services Division. It annualised the case numbers for September to November 2014 and said that with 93,660 new cases and 77,831 settlements, the pro-forma adjusted earnings were £86 million.

But when you included the 50 per cent earnout agreement in place with Quindell on 53,000 legacy NIHL files, the 2016 estimated earnings rose to £95million.

That number would mean 41 per cent earnings accretion from the transaction, which was well up on the 30 per cent accretion embedded in the £86 million earnings estimate.

Slater & Gordon's credibility and that of its chief executive Andrew Grech will stand or fall on the delivery of these numbers.

Achieving the forecast numbers will be a testament to the quality of its due diligence on Quindell. Other reputations will be riding on the back of Slater & Gordon's credibility test. Investment banking advisers on the deal were global independent investment bank Greenhill.

Accounting firm EY reviewed the quality of Quindell's earnings and its revenue and acquisition cost recognition polices "to ensure they were aligned with Slater & Gordon's more conservative approach".

The other big names with their reputations on the line are Macquarie and Citi. They underwrote the $890million rights issue, which was snapped up by investors and used to fund the bulk of the purchase price.

The remaining $375 million came from bank borrowings.

Disclosure: The author's super fund owns shares in ANZ.

Tony Boyd

Twitter: @TonyBoydAFR

tony.boyd@afr.com.au