A brewing battle at Vital Healthcare

Analysis: Does Northwest hold all the cards?
Vital Healthcare chief executive David Carr says it's far too early to discuss numbers.

Shoeshine reckons the manager of Vital Healthcare Property Trust has an investor revolt on its hands.

The big question is, does the manager care?

You see, the manager, Canada-based Northwest Healthcare Property Management, owns nearly 25% of Vital and it needs a vote of 75% of investors to remove the manager.

Given that a large swag of investors doesn’t vote, that effectively means Northwest is entrenched as manager.

Moreover, governance of Vital has just changed in Northwest’s favour.

Long-serving chairman Graeme Horsley, who joined the board in 2007 and became chairman in 2011, left earlier this month and was replaced by chief executive David Carr.

That means the five-member board has shifted from having a majority of independent directors to a majority of Northwest allies.

You might think Northwest has addressed this by giving the new chairwoman, Claire Higgins, one of the two remaining independents, a second casting vote – Mr Carr is to bow out of the vote in that eventuality.

But the institutional shareholders say Ms Higgins has a history of voting with Northwest so the appearance of independence is just “smoke and mirrors.”

The company does say this is an interim step and it will announce changes no later than the next AGM.

Just to backtrack a little, Northwest emerged victorious in 2011 after a lot of argy-bargy, which started when the management contract’s then owner, ANZ Bank, offered to sell it to Vital’s investors for $14m.

Vital’s independent directors managed to beat the price down to just $8m but riled-up investors wouldn’t accept that.

Instead, institutional investors including ACC, the NZ Superannuation Fund and Westpac, tried to oust ANZ as manager but that vote failed with only 25.2% of votes cast in favour.

Nabbing the prize
And then Northwest swooped in and took the prize from under their noses, paying $11.5m, a sum it has long since recouped a number of times over.

In the year ended June last year, Northwest collected $20.4m in fees, up from $12.5m the previous year.

That's because both the base and incentive fees are entirely based on Vital’s gross assets which have grown from $514m in 2011 to $1.66 billion.

Clearly, the manager has a whopping incentive to increase the size of Vital’s portfolio and has done just that.

Bowen Hospital, in Wellington, is one of Vital's latest acquisitions.

As the saying goes, turkeys don’t vote for Christmas, so it’s safe to assume Northwest would need a big incentive to modify such a lucrative management contract.

Or as Mr Carr would have it, Northwest bought “an economic interest and brought in a significant amount of global real estate experience to the table.”

As he rightly points out, the returns to investors aren’t to be sneezed at either: In the 10 years ended March, Vital units gained 257%, including distributions, considerably more than the 140% the benchmark Top 50 Index gained over the same period.

Likewise, Vital also outperformed the New Zealand listed property index, which gained 118% over the 10 years, and the S&P/ASX 200 REIT Index, which gained just 37%.

But what happens next is where Shoeshine reckons it starts to get interesting.

Hard on the heels of the board changes, Northwest announced it had acquired 10% of Australian-listed Healthscope for $A2.39 a share, or $A415.8m, by way of a derivative with Deutsche Bank’s Sydney branch.

In other words, Northwest bought an option to buy 10% of Healthscope, which owns 45 hospitals in large metropolitan centres throughout Australia.

Option costs
One of Shoeshine’s mates reckons that, based on option pricing in Australia, that option will have cost anywhere from $A20-40m, depending on the length of time the option provides for.

Northwest said that it and Vital “currently intend to pursue any potential Healthscope real estate acquisitions jointly.”

Shoeshine’s wondering, if Vital is a joint-venture partner, whether it has had to cough up half that option cost.

Graeme Horsley's leaving earlier this month shifted the board dynamic.

Mr Carr won’t be drawn on this, pointing to the fact that such an amount, $A10-20m, isn’t material for an entity of Vital’s size so it has no obligation to disclose it, although he does say the company got advice on this point and he describes taking the option as “a little unconventional.”

“Other than what we’ve disclosed, at the moment I’m not going to get into the level of commitment Vital has made.”

But one thing is clear – Vital’s balance sheet is starting to get stretched. The trust deed limits gearing to 50% and by December 31 it had reached 36.8%.

That was after a number of acquisitions totalling $187m. Vital had also committed to spend up to $106.5m on brownfields development at the Wakefield, Bowen and Royston hospitals over the next four years on top of other developments already under way.

So it’s abundantly clear, if Vital is to buy anything much from Healthscope, it’s going to need more capital.

And that could be what gives institutional investors some leverage over Northwest, although Mr Carr is quick to point out that in Vital’s last $160m capital raising in July 2016, 87% of unitholders took up their rights.

Perhaps a more fundamental question is whether now is a good time to buy.

Top of the market?
One institutional investor says capitalisation rates on all property have compressed significantly, therefore pushing prices to high levels but this is particularly so with medical properties.

Capitalisation rates on medical property are down about 300 basis points since the global financial crisis and on the next closest category, industrial property, the rates are down about 200 points.

His back-of-the-envelope calculation suggests any deal with Healthscope would be likely done at a 5.25% capitalisation rate and costs, including the cost of the option, would effectively drag that down to about 4.5% but Vital’s cost of capital is between 6.5% and 7% – Mr Carr says Vital’s cost of capital is lower than that but won’t put a number on it.

“No independent board would even consider doing this deal. The only way that works is for the manager,” the institutional investor says.

Mr Carr says falling capitalisation rates show the market has developed a better appreciation of the qualities of medical property, including the quality of tenants and the underlying themes and drivers, such as the ageing population and the fact that spending on health outstrips growth in GDP.

The metrics for Vital are vastly superior to those of other properties vehicles. For example, the weighted average lease term is 18.4 years – compare that to Property for Industry’s 5.33 years and Kiwi Property’s 5.3 years.

But he won’t be drawn into discussing how any deal might stack up, dismissing such numbers as “speculation.”

“We think an opportunity of scale like this one is an important one” and such potential deals don’t come along every day.

And other factors would need to be considered, such as the brownfields development opportunities – much of the portfolio’s growth under Northwest’s management has been through brownfields developments which were “highly accretive,” Mr Carr says.

Shoeshine’s going to be watching the battle that develops with great interest.

This week Shoeshine is written by Jenny Ruth.

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