Never say never, but it’s looking nigh on impossible for Canada-based NorthWest Healthcare Properties Real Estate Investment Trust to make its A$1.258 billion Healthscope deal stack up.

The fact that NorthWest signed the deal of course suggests it must be confident it can succeed but New Zealand analysts can’t make sense of it.

NorthWest does have time on its side – the deal is contingent on fellow Canadian Brookfields’ takeover bid via a scheme of arrangement for Healthscope succeeding.

Healthscope’s board is recommending Brookfields’ offer, but its shareholders won’t vote on it until May or June and it will need at least 50 percent of shareholders to vote and 75 percent of those voting in favour in order to succeed.

NorthWest has told its own investors that it has already lined up debt funding of C$710 million, so that takes it nearly 60 percent of the way.

It says it expects to end up owning between 25-30 percent of the Healthscope properties.

It doesn’t say so, but it appears the lower end of that range would be via its near 25 percent stake in Vital Healthcare Property Trust, the NZX-listed vehicle NorthWest manages.

The upper end of that range would probably mean both Vital and NorthWest’s Australian joint venture with GIC Private, the Singaporean sovereign wealth fund, participating – NorthWest owns 30 percent of the JV.

So NorthWest has to come up with C$125-150 million of equity itself and says it expects to find this money “with a combination of net proceeds from the sale of its existing investment in Healthscope and previously funded deposits.”

NorthWest acquired an effective 13.4 percent stake in Healthscope last year through derivative contracts to buy what it described as “a seat at the table” in the battle over who would end up owning Healthscope’s properties.

(The other party to the derivatives contract, Deutsche Bank, holds only 8.7 percent of Healthscope but is still bound by the contract to deliver 13.4 percent.)

The average entry cost of that stake was A$2.36 per share and, if it is sold into Brookfields’ offer priced at A$2.50, NorthWest will be A$32.7 million ahead on the deal, with total proceeds of A$583.8 million. 

However, it will have to share that with Vital, from which it borrowed A$81 million to finance the deal with Deutsche Bank.

Borrowing lots of money is a strong theme running through NorthWest’s affairs.

Its September-quarter report – the December-quarter report is due in the early hours of Saturday morning, New Zealand time – shows it consolidates Vital, even though its ownership is a little under 25 percent.

Since it would take 75 percent of unitholders voting to remove NorthWest as manager, there’s a strong argument that NorthWest does have effective control of Vital and is therefore entitled to consolidate it.

NorthWest’s mortgages and loans at Sept. 30 were 53.2 percent of the value of its investment properties while total liabilities were 67.5 percent of total assets.

That’s an unusually high amount of debt for a listed property company – Vital’s trust deed and banking covenant limits borrowing to no more than 50 percent of gross assets.

Vital’s gearing under the trust deed is currently 39.5 percent (it’s 43.7 percent under the somewhat different rules of its banking covenant) and NorthWest has committed Vital to spending $223 million on developments within its existing portfolio over the next three years, including $80 million before June 30.

However, NorthWest’s accounts also show it has borrowed C$94.2 million, or NZ$109.7 million, using its stake in Vital as security. At the current market price of $2.08 per unit, that stake is worth NZ$220.4 million.

Now Vital isn’t in on the deal to buy the Healthscope properties yet – the manager said last week that “discussions with NorthWest remain ongoing and a non-binding term sheet is well advanced. However, there can be no guarantee that an agreement will be able to be reached.”

Since the manager is NorthWest, it is effectively saying it is negotiating with itself.

It’s obvious that neither NorthWest nor Vital can buy the Healthscope properties without getting fresh equity from somewhere.

Possibly, that could come from the GIA JV. Since it isn’t a public company, it’s hard to tell whether it is ready or able to participate, although when it was formed last year, NorthWest said it could spend up to A$2 billion compared with the A$412 million existing portfolio that NorthWest sold into the JV.

But from Vital’s perspective, the deal is problematic on economic grounds, even if its unitholders were prepared to cough up more equity.

The price NorthWest has agreed to pay for the 11 Healthscope properties represents a weighted average capitalisation rate of 5 percent, below the 5.73 percent cap rate of Vital’s existing portfolio – as property prices rise, cap rates contract.

What that means is NorthWest has agreed to pay a very full price in a market in which values have already risen very strongly.

Illustrating that, in June 2015, Vital’s cap rate was 8 percent.

But the actual purchase price for Vital will probably be closer to a 4 percent cap rate – about 20 basis points will go to stamp duty and the other 80 points represents the impact of the fees NorthWest will charge Vital for managing the properties.

Vital’s cost of capital is about 6 percent so buying something yielding 4 percent doesn’t make sense.

Of course, NorthWest does have control over the fees and the manager’s board is currently reviewing the fee structure – that’s contrary to the board’s charter which says such a review should be carried out by the independent directors only.

Both the outcome of that review and of NorthWest’s Healthscope “negotiations” with itself are due by March 31, but the signs aren’t promising from the perspective of outside investors in Vital.

Even after announcing that fee review last November, NorthWest doubled down on its rapacious attitude towards milking fees from Vital – both NorthWest’s base and incentive fees are calculated from Vital’s gross assets, regardless of how well Vital’s investors fare, and it often charges other fees as well.

Last week, when announcing Vital’s results for the six months ended December, NorthWest revealed that its fees jumped nearly 75 percent to $22.1 million while net profit attributable to Vital’s investors fell 11.5 percent because of that fee increase.

Despite that, NorthWest decided to borrow in order to pay unitholders a 4.38 cents per unit distribution, representing 104 percent of distribution income, up from 4 cents, or 81 percent of distributable income, in the previous first half.

Unitholders at the last AGM in December complained vociferously about NorthWest treating Vital as its “private piggy bank.”

Since NorthWest bought Vital’s management contract for $11.5 million in 2011, it had collected about $100 million in gross fees to June 30 last year so the latest clip of the ticket takes that to about $122 million.

Of the latest fee increase, NorthWest has already charged Vital A$8.2 million for the Healthscope properties purchase, even though it hasn’t yet committed Vital to participation.

If Vital doesn’t participate, NorthWest says it will refund A$5.2 million of that fee. Meaning it intends to keep A$3 million for something that won’t happen.

Analysts are currently scratching their heads to figure out how NorthWest could make Vital’s participation in the Healthscope deal make sense.

Changing Vital’s fee structure is obviously one avenue and it’s also possible that some of the Healthscope properties might have higher cap rates, so NorthWest could have Vital buy those while the GIA JV buys the lower yielding properties.

“It doesn’t look on the face of it that a deal makes sense,” says one Vital analyst. “On the information we have – which may not be the final information – it doesn’t look like there’s any way that this thing can stack up.”

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