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Aviva Upsetting The Equilibrium

14 March 2018 by Gary Kirk

As bond investors we always need to make sure that the companies we invest with are managing our interests alongside those of other stakeholders in a manner that protects our interests sufficiently. Historically, this aspect of governance has been most relevant to companies run by private equity managers or companies with a single large investor who is in a high ranking executive position.

Sometimes though, companies that have historically managed to balance their stakeholder interests well can change their focus. For example, in the aftermath of the global financial crisis, the banks were highly focussed on debt and less so on equity; in fact, so was the regulator as it sought to build a safer banking system.

This does also work the other way: Keeping in theme with the banks, Lloyds made a huge mistake, in our opinion, in the way that it harshly treated its Enhanced Capital Note holders in order to buy back debt cheaply and replace it with cheaper new capital.

A strong focus on company governance is clearly very important, and with such strong focus currently on the ESG theme we thought it worth writing about another such recent example that produced negative headlines. The company in question surprised us, as it was a UK household name with a strong reputation in financial markets.

On the 8th March Aviva plc made a statement informing investors that they were considering exercising a cancellation at par notice on their preference share notes. These notes have traditionally been held by both institutional and retail investors, were assumed to be irredeemable, and paid fixed coupons, so were considered to be an ideal product for income generation as part of a broader pension portfolio.

Aviva are currently holding excess capital and preference shares are deemed less efficient structures and surplus to requirements. Under the ‘Companies Act’ an institution can cancel (rather than redeem) capital, which in the case of the preference shares would result in the notes being called at par resulting in significant losses for the investors (as they were all trading at large premiums – some above 170.00 prior to the notice). This was a surprise to investors, and would require Aviva to seek court approval for this extraordinary act. The benefit of doing so would be entirely to Aviva shareholders at the sole expense of the preference shareholders.

Aviva’s argument was that this was old, inefficient and expensive debt for them, but we feel there were many ways this could have been avoided or resolved while still maintaining that important balance between shareholders and debt investors. For example, by tendering for these securities at market price, not by calling at par, or by threatening to cancel then holding a coercive tender below the previous price.

The wider issue though, and one that Aviva may have underestimated, is that fixed income investors have always acted with a high degree of mutual trust with the insurance sector. For decades there has been the assumption that insurers would call and refinance subordinated bonds and hence in return bond investors would finance the debt at relatively tight credit spreads – a perfect working synergy for all parties involved (shareholders, policy holders and bond investors). This potential action by Aviva management clearly favours the short-term interests of shareholders at the expense of bond holders; although we would argue that if this action is carried out it will also impact the long term interest of shareholders, since the cost of future debt is likely to increase. Can the company be trusted in acting in investors’ interests when one of their perpetual bonds next reaches a call date? Will they merely act with regards to economic viability or consider investors interests at the same time? This uncertainty will require investors to be compensated with additional spread.

We at TwentyFour were not holders of any of the Aviva preference shares, but we have been alerted by the handling of this matter to a potential governance issue, a feeling which has not gone away after our recent discussions with the company.

In their Governance Statement Aviva proudly claim that “we aim to make our industry work better for everyone. That starts with us building trust with our customers, investors and shareholders by running our business honestly and transparently”. This will clearly be questioned if the company goes ahead and exercises a regulatory par call even if it is legally entitled to do so. We would also take a dim view in the event of a deeply discounted (from recent prices) tender for the preference shares.

This type of activity would unlikely have been picked up as part of a one-off due diligence meeting but borrowers should realise that weaknesses in Governance or other Environmental or Social issues will result in investors requiring additional premium in future transactions to compensate for a higher degree of uncertainty.

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