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Why does Fairfax India use leverage?


shalab
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I noticed it with their annual report but then it was impossible to ignore with the Q1 report. It is not clear why they use leverage so much especially when it is not needed. The obvious explanation may be the correct one - they can collect more fees.

 

I wonder about the people investing in this instrument - reminds one of Biglari Holdings shareholders.

 

https://s1.q4cdn.com/293822657/files/doc_financials/quarterly_reports/2019/FIH-2019-Q1-Interim-Report-(Final).pdf

 

They use 600 MM in loans on 2 B capital. (30% leverage). The number of shares outstanding has also increased year over year by about 2.2%.

 

The whole scheme is seems odd - if one looks at BIAL (the investee) - it is leveraged. Then the instrument investing in it is also leveraged. (FRFHF India). To add to it, the instrument holding it (FRFHF) also leveraged. It is triple leverage  :P

 

Also the fee structure is adversarial in nature for the common shareholder.  There is double jeopardy.

 

The period from January 1, 2018 to December 31, 2020 (the "second calculation period") is the next consecutive three-year period after December 31,

2017 for which a performance fee, if applicable, will be accrued. The performance fee for the second calculation period will be calculated as 20% of

any increase in the book value per share at the end of period

 

Investment and Advisory Fees

The investment and advisory fees are calculated and payable quarterly as 0.5% of the value of undeployed capital and 1.5% of the company's common

shareholders' equity less the value of undeployed capital. For the first quarter of 2019 the company determined that the majority of its assets were

invested in Indian Investments, which are considered deployed capital. The investment and advisory fees recorded in the consolidated statements of

earnings in the first quarter of 2019 was $8,289

 

 

One is better off holding INDA or related funds - the expense ratios are far lower and affordable.

https://etfdb.com/etf/INDA/

 

 

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The obvious explanation may be the correct one - they can collect more fees.

 

Actually, the obvious explanation is that they think the holdings are likely to go up.

 

Also, let's look at the incentives around each fee stream:

1) Levering up can only reduce the management fee in any given year. They charge 1.5% on shareholder's equity less undeployed capital, plus 0.5% on undeployed capital. Levering up and deploying the capital doesn't grow the fee, because it doesn't increase shareholder's equity (but it does reduce the fee as a % over assets*). Levering up and not deploying the capital actually reduces the fee, because the undeployed capital is subtracted from shareholder's equity.

2) Levering up increases performance fees if the fund does well, but if the fund does badly it will kill the 1.5% management fee and Fairfax Holdings' $500m worth of invested capital, which you omitted to mention.

 

Overall it is not at all clear that the fee structure incentivises leverage at this point. It could do if, at some point in the future, Fairfax owns much less of the fund.

 

Re: BIAL, have I missed something here? BIAL is levered (as it should be). Fairfax India is levered (like many holding companies). That's two levels of leverage. What's the third? Fairfax Holdings? That's not relevant for a Fairfax India shareholder.

 

I wouldn't own INDA with a bargepole - 68bp fee on assets* for index exposure to one of the most expensive emerging markets globally? No thanks.

 

*NB calculated over assets, Fairfax India's maximum management fee of 150bps of shareholder's equity is currently 117bps.

 

As always, time will tell!

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...

Re: BIAL, have I missed something here? BIAL is levered (as it should be). Fairfax India is levered (like many holding companies). That's two levels of leverage. What's the third? Fairfax Holdings? That's not relevant for a Fairfax India shareholder.

...

Fair enough, owning Fairfax India through FRFHF is triple leveraged

 

...

I wouldn't own INDA with a bargepole - 68bp fee on assets* for index exposure to one of the most expensive emerging markets globally? No thanks.

..

You are right about stock prices of large caps in India - it is expensive. However, mid caps and some small caps have some great opportunities. One is better off betting on US SP500 than INDA or Fairfax India - I think. I think INDU has done better. Even Fairfax India returns have been lacklustre compared to SP500 in the last five years.

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Yes, it’s triple leveraged through Fairfax itself, but it’s also a fairly small exposure with an attractive upside skew due to the fees. I won’t be surprised if this is a $10bn entity in 5 years and the fees then will be significant. In fact, if you’re worried about how the fees incentivise Fairfax, I’d worry more about equity issuances than leverage.

 

Agree re S&P vs INDU. Not so sure vs Fairfax India, but it’s hard to know. HWIC have a spectacular record in India but I worry the FIH holdings are skewed too much towards cheap but fundamentally low quality assets. But then BIAL and IIFL are superb. We will see. As you say, there’s value in the S/Midcap space and that’s where FIH is playing. Arguably there’s even more value in the private markets and they’re playing there too.

 

FD: I am building positions in FIH and FAH and I expect both to be VERY long term positions.

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I hope it works out for you in the long term.

 

Fairfax India share price increased at 7.2%/year for five years till the end of 2018 and it has dropped since then. This is before fees and expenses. So SP500 has out performed Fairfax India significantly.

 

Fairfax Africa has returned -10.6% per year.

 

 

Yes, it’s triple leveraged through Fairfax itself, but it’s also a fairly small exposure with an attractive upside skew due to the fees. I won’t be surprised if this is a $10bn entity in 5 years and the fees then will be significant. In fact, if you’re worried about how the fees incentivise Fairfax, I’d worry more about equity issuances than leverage.

 

Agree re S&P vs INDU. Not so sure vs Fairfax India, but it’s hard to know. HWIC have a spectacular record in India but I worry the FIH holdings are skewed too much towards cheap but fundamentally low quality assets. But then BIAL and IIFL are superb. We will see. As you say, there’s value in the S/Midcap space and that’s where FIH is playing. Arguably there’s even more value in the private markets and they’re playing there too.

 

FD: I am building positions in FIH and FAH and I expect both to be VERY long term positions.

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I think it’s fair to say that the share price performance is after fees and expenses!

 

Poor performance to date is part of the attraction for me. I think one can argue both are attractively valued. The other part is it makes sense to me to partner with good investors in growing economies.

 

That said the vast majority of my liquid net wealth is in things that are more akin to the S&P, so we are not that far apart.

 

Whether the S&P can reproduce its performance of the last decade, though, remains to be seen.

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Using leverage during a period of low rates to buy basic infrastructure plays in a growing country with good demographics seems reasonable to me. If they were purchasing speculative tech companies your argument would make more sense.

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Hope it works out for you and others putting their money into it.

 

The fund is already big at 2.6 billion. India economy is at 2.7 trillion. So it is at ~0.1% of India GDP. If it goes up to 10B to harvest more fees, it will be at 0.4% of India GDP. So for someone to do better than SP500, a lot of things have to go right. India economy is slowing down like everyone else.

 

Furthermore, when FRFHF issues statements, one has to look deeper to see what is marketing talk for the faithful and what is not. When they say Modi is the difference, one has to look at the numbers before and after in companies financial results. I don't see any major difference personally. In fact, India has been ruled by 100-200 families who are interested in protecting their family businesses while hurting the average person. This hasn't changed and is unlikely to change anytime soon. So tread carefully.

 

Let us say this can compound at 8% in dollar terms, higher than the last five years average in very favorable conditions. After paying 20% performance fee and 1.5% management fee, your return will be 4.9%.

 

 

I think it’s fair to say that the share price performance is after fees and expenses!

 

Poor performance to date is part of the attraction for me. I think one can argue both are attractively valued. The other part is it makes sense to me to partner with good investors in growing economies.

 

That said the vast majority of my liquid net wealth is in things that are more akin to the S&P, so we are not that far apart.

 

Whether the S&P can reproduce its performance of the last decade, though, remains to be seen.

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Let us say this can compound at 8% in dollar terms, higher than the last five years average in very favorable conditions. After paying 20% performance fee and 1.5% management fee, your return will be 4.9%.

 

 

Why do you think it would compound at 8% in dollar terms when the investments seem to doing better. IIFL (inspite of the recent NBFC issues), BAIL etc are all growing at 12-15% range when the economy is going through a lot of stress and liquidity issues.

 

8% in dollar terms is the broad market returns over the long term. If that is what they achieve, then yes the outcome will be bad. However the entire thesis is that team can do better than that in the pvt and public markets.

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Also worth noting that the performance fee isn't 20%, but rather 20% of the amount above a 5% hurdle per annum growth in NAV.  Because the performance fee is based on NAV, I think, in effect, it comes out after the management fee.

 

So, for your 8% example, I think the return would actually be (8%-1.5%) - (8% - 1.5% - 5% * 0.2), or 6.2%, not 4.9%.

 

 

 

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You do not have the correct performance fee terms: FFH takes 20% of the return beyond 5%, not 20% of the total return. In your example of an 8% return, that would be 20% of 3%, plus the 1.5% management fee, so client teturns would be 5.9%, not 4.9%.

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RichardGibbons' calculation makes sense: FIH's net asset value (essentially, book value) growth will inevitably be slowed by the 1.5% management fee that is charged, son an investment gain of 8% will not mean that book value goes up by 8%. The exact calculation depends on the timing of that charge. If, for instance, the 1.5% is levied against asset value at the beginning of the year, then instead of 8% growth, we will have 6.5% growth, plus a performance fee which would be 20% of the 1.5% in excess of 5%, giving an additional 0.3%, so that the total return would be 8%-1.5%-0.3%= 6.2%.

 

If the management fee is charged at the end of a year with 8% growth, then it would be 1.5% of 108%, or 1.62%, leaving 6.36% net asset value growth, minus 20%*1.36%=0.272% as the performance fee, and the investor would keep 8%-1.62%-0.272%=6.108%.

 

In any case, the important point that both of us were trying to make, is that the performance fee is 20% of whatever return there is in excess of 5% per annum, and not on the whole return.

 

In fact, it is even slightly more complicated, since there is a highwater mark that also needs to be considered. The last asset value calculation for the sake of determining the performance fee was done for Dec 31, 2017 (it is done every 3 years), and book value was $14.46 at that time. It has dropped since then, and at last count it was $13.61 on March 31st. So book value would have to exceed $16.74 ($14.46*1.05^3) on Dec 31, 2020, for there to be any performance fee at all, and then FFH would get to keep 20% of the excess beyond that $16.74. That means that for you the new FIH shareholder, the first $0.85 in book value gain is on us, the previous shareholders that have already paid the performance fee up to $14.46. After that, there's $2.28 in book value gain that is beneath the 5% p.a. threshold. Only after those 23% in gains (from $13.61) is there any performance fee to be paid to Fairfax.  There's still the 1.5% annual management fee, though.

 

dtb

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