How NZ Super’s Portuguese Bank Loan Went Awry

April 30, 2015 by Loch Adamson

How NZ Super’s #EspiritoSanto Bank Loan Went Awry #newzealand
Are angry stakeholders treating NZ Super too harshly over their #EspiritoSanto Loan?
“What were they thinking?” How NZ Super’s Portuguese Bank Loan Went Awry #newzealand
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The New Zealand Superannuation Fund appears to have made a rare misstep with its investment in Portugal’s Banco Espirito Santo, which led to a $150 million write-down and left the fund embroiled in two separate court cases. But are angry stakeholders treating the fund too harshly?

It was supposed to be a low-risk investment. On July 3, 2014, the New Zealand Superannuation Fund teamed up with New York-based Goldman Sachs Group and a number of asset management firms to provide a $784 million loan to Lisbon-based Banco Espirito Santo (BES), then Portugal’s largest listed bank, in a complex arrangement involving a vehicle named Oak Finance Luxembourg. Shortly thereafter, things began to go wrong.

The first signs of trouble came on July 24, when BES Chairman and CEO Ricardo Espirito Santo Silva Salgado was detained for questioning on suspicion of fraud, money-laundering, document falsification and embezzlement. When a new management team took over, it discovered big losses at BES that had previously gone unreported. In early August, Banco de Portugal, the central bank, was forced to step in with €4.9 billion ($6.6 billion) of support, setting up a new state-supported bank called Novo Banco to collect most of the stricken lender’s assets.

Nine months later, and NZ Super is still dealing with the consequences of its investment in the collapsed bank: Two court cases, a torrent of negative media coverage — and losses of some $150 million.

New Territory for NZ Super

All this represents unfamiliar territory for the $21.5 billion fund, which has earned a reputation as one of the world’s savviest institutional investors since CEO Adrian Orr took the helm in 2007. NZ Super has returned over 10 percent annualized since inception, in part by "tilting" its portfolio toward profitable assets. It also formed innovative co-investment partnerships to identify new private market opportunities. So how to account for the failure of NZ Super’s investment in BES? Or, as the New Zealand Herald bluntly put it: "What were they thinking?"

The fund has strived to answer that question. "In making this loan, the Fund was providing liquidity to the Portuguese banking system," said Orr in a statement in February 19, as the details of the case first began to draw the attention of the media. "The Fund was protected against the risk of Banco Espirito Santo defaulting through the purchase of credit insurance. This is a very standard, insured, investment activity globally that keeps the financial world liquid."

NZ Super states that it could not have known about the bank’s financial troubles, which were disguised by Salgado’s alleged manipulation of the books. A report by a Portuguese parliamentary commission said on April 17 that Salgado was "probably involved in a decision to manipulate the accounts" of Espirito Santo Financial, the holding company for BES.

In any case, NZ Super says it took the necessary precautions on the investment. The fund bought bonds issued by Oak Finance, which in turn used the capital it raised to provide BES with the $784 million loan. NZ Super purchased credit protection on BES and believed that the structure of the deal made it an owner of senior-secured debt in the bank, which would provide some protection if it went under.

It didn’t quite work out that way. After transferring the Oak Finance loan to Novo Banco along with other senior-secured debt, Banco de Portugal moved the loan back to the by-now insolvent lender — the "bad" bank — in December 2014. This not only wiped out the loan’s value, but rendered NZ Super’s credit protection worthless, because the bank was deemed to have undergone a "succession event," in the insurer’s parlance. The fund has consequently taken the precaution of writing down the loan on its balance sheet, although it is hopeful of recovering its losses.

Last week, NZ Super began legal proceedings against the Portuguese central bank challenging its decision to transfer the loan out of Novo Banco. It is also pursuing debt recovery proceedings against BES in the U.K. alongside the other Oak Finance investors, which include an investment vehicle owned by Indian steel magnate Lakshmi Mittal. One key investor ally: New York-based Elliott Management Corp., an activist hedge fund that often invests in distressed sovereign debt and is known for its tenacity in court as well as its superior returns over time.

"The Bank of Portugal acted retrospectively and arbitrarily in treating Oak Finance’s loan to BES unequally to other senior debt holders, causing the fund’s credit protection to be ineffective," a spokesperson for NZ Super told Sovereign Wealth Center via email. "We believe [the Bank’s] actions are wrong and are based on a misunderstanding of the facts regarding Goldman Sachs’ holding in BES and its relationship with Oak Finance."

The crux of the issue is an item that was written into Portuguese law on August 1, 2014, just days after the losses at BES were uncovered. The amendment introduced a new rule to Portugal’s insolvency procedures: Shareholders with more than 2 percent of an insolvent bank would not be eligible for support in the event of a state-led restructuring. The rule, which Banco de Portugal enacted with retroactive effect, was intended to ensure that those responsible for a bank’s distress bear the brunt of its losses.

Banco de Portugal transferred the Oak Finance loan back to the bad bank because it determined that Goldman Sachs owned more than 2 percent of BES at the time the loan was made. NZ Super contests this ruling on two counts. First, Oak Finance was an independent entity, so Goldman’s shareholding was irrelevant. Second, Goldman did not own more than 2 percent of BES unless, as Banco de Portugal does, one includes some non-voting shares the investment bank borrowed for a week in late July using swaps.

"As Goldman Sachs has said publicly and to the Bank of Portugal, Oak Finance was an independent entity from Goldman Sachs International," Orr said on February 19. "We understand that at no point did Goldman Sachs hold a participatory interest in more than 2 percent of Banco Espírito Santo’s shares."

Due Diligence

The question remains, however, as to whether NZ Super did sufficient due diligence on the bank before its investment. The fund cites BES’ quarterly financial statements from May 2014, which showed its Tier 1 capital ratio — the amount of liquid capital a bank holds as a bulwark against unexpected losses as a percentage of its overall risk-weighted assets — stood at 9.8 percent, well above the minimum level required by regulators. It also points to a statement from Banco de Portugal from July 2, the day before the investment, which affirmed BES’ "strong solvency position."

But that reasoning hasn’t stopped some New Zealand media outlets from criticizing the fund for its perceived pursuit of "exotic" investments that put taxpayers’ money at risk. "The BES debacle has left [NZ Super] with egg on its face," wrote Christopher Adams in the New Zealand Herald, the country’s most-read newspaper. "Surely a bit of digging would have revealed the sickly state BES was in by July last year."

This domestic controversy speaks to the difficulties sovereign wealth funds can have in justifying their investment decisions to their ultimate stakeholders. NZ Super argues that what it calls the "Oak Finance matter" should be viewed in the context of its overall impressive performance. "Even after the precautionary write-down of the Oak Finance loan, [the active investment strategy] has added NZ$900 million in value to the fund since inception," according to the fund spokesperson.

Orr himself penned a response to the Herald that pointed out "the problem has arisen solely because of the arbitrary and retrospective actions of the Bank of Portugal, subsequent to our investment, in treating our loan unequally to other senior debt holders and causing our insurance to be ineffective."

If there’s a note of exasperation there, that’s perhaps not surprising, given the tiny dent the Oak Finance fiasco has made in the fund’s overall performance figures. Buried at the very end of the New Zealand Herald’s strident editorial was a line that hinted at this wider story: "The fund's expected annual return rate has been calculated to drop from 10.01 per cent to 9.98 per cent." A loss of $150 million is no tempest in a teapot. But in the context, it’s some way short of a catastrophe.

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