Well, in order to save our time,
I prepared the background for you.
So, the story is that Russian preferred shares,
they are sort of special financial instruments.
And again, the country's free market is sort of very young.
The process of privatization was started as late as in 1991 and again at
that time there was an idea that because formerly,
all the enterprises were state-owned.
Then during the process of privatization they said, "well,
why wouldn't we give preferred stock to the employees as the weakest,
the least educated, the least understanding of
what's going on in the capital markets that are being born?"
And again, they said
the 25 percent of share capital will distributed among these workers and
the minimum dividend to the preferred shareholder would
be 10 percent of net income and no less than common dividend,
whatever happens to the net income number.
So again, that was
a classic case of a good intention and you know that the road to hell is paved with them.
And as a result,
what I will show on the next pages of flip chart is that
the misunderstanding at that time or what could
happen resulted in some fundamental conflicts of interests and
the potential negative effect on the investments and the investment climate.
So if we kept that in mind then here,
I show you the preferred shares cash flow story.
So if this is the cash flow as a percent of net income and this dividend per share,
well, I wouldn't put any numbers here,
it can be shown that if we have 25 percent of preferred
and if the preferred dividend
is at least 10 percent of net income,
then we see the folly chart.
Then if cash flow available to equity investors is less than 40 percent of net income,
this is this area, then preferred dividend is higher than the common dividend.
We can see the preferred cash flow,
which is here in the red,
is always greater or equal to common cash flow which is here.
And again, cash flow if it's
less than 10 percent you know that nothing goes to common dividend because
all of that goes to preferred dividends.
So here clearly the preferred cash flow is higher and therefore,
we can expect that preferred shares should be always
more expensive on the market than common shareholders.
But again this is a chart from 20 years ago but it
was shown that actually the market valued them completely differently.
The discount to common was somewhere from 20 percent at the times
of the most liquid and active market and up to 50
percent at times when markets were sort of turmoiled.
So, we see the obvious contradiction.
Something that must be more expensive is actually cheaper.
So that's poses a big question and this is, so we say, why?
And then the next page I will show you the gross of simplified case
that supports the following very strange idea
that given the structure of Russian preferred shares it can be shown that in perpetuity,
all returns they are being pocketed by preferred shareholders.
So the case goes like this.
Let's say that if return on invested capital is
10 percent and he preferreds will be just 10 percent not 25.
By the way, if the rate is lower than 25 then the dividend is prorated to that.
Now, commons, 90 percent and the minimum dividend 10 percent of net income as required.
So, in year zero what do we have here?
We have the initial invested capital,
90 comes from common shareholders,
10 comes from preferred shareholders.
Now this 100 is invested and produces a ten dollar return.
Now this is the same capital that travels here in
year one but then here we have 110 altogether.
But of this ten,
one dollar is a 10 percent preferred dividend and then, let's say,
for suppose the nine dollars is being reinvested,
so we end up the first year with a falling numbers.
This part which is total invested capital is now
109 and then the preferred dividend of one dollar.
Let's see what are the returns.
We start with the return for commons.
This is 90 percent of this,
90 percent of 109,
and if you divide that by 90,
the initial investment you will see that the return is nine percent.
Well, so far so good.
Well, this is kind of lower than the return on invested capital.
So the difference must be pocketed by whom?
Well, by preferred shareholders.
Why? Because now preferred shareholders,
they have 10 percent of 109 that is indeed at the same nine percent return.
But they have a cash dividend of one dollar
which is another 10 percent on their investment.
So the total return to preferred shareholders is
19 percent which is more than double the return on commons.
And it can be shown that if we preceded then
all value in perpetuity accrues to preferred shareholders.
So, that is clearly a huge conflict of interest because
these guys are decision makers and these guys are the value pocketers.
So we can see this conflict of interest,
a value accruing to preferred shareholders but at
the same time and now we have an explanation to the chart that we've seen up there.
That is because preferred shareholders did not engage.
They did not enjoy legal protection.
For example, common shareholders could also vote on any issues
regarding preferred shareholders and in order to have a decision confirmed,
they needed 75 percent but not of
all shareholders but of those present that the shareholders meeting.
And we mentioned before that
preferred shareholders were just workers at these enterprises.
They were the least likely to show up at these meetings and therefore, there was,
I'm showing just one case where
the legal protection of preferred shareholders could have been abused.
And there were dozens of others, for example,
you could play with the number of this net income.
Because at that time
the Russian Accounting Standards
were very far from the International Accounting Standards.
Now it's much better.
That's why I'm studying this case sort of against
the background of what was 20 years ago.
And as a result,
these multiple abuses, they did take place and therefore,
we could see that common shareholders could have been deprived of
their value if they kept honouring the rights or preferred shareholders.
But that would be against their vested interest.
And therefore, we can see that lack of
good corporate governance that not only resulted in this conflict of interest
but it negatively affected
the overall investment climate and it resulted in under-investment.
Well, at that time we even offered some
speculative of strategies of how you could still play on some
of these inefficiencies but we pointed out that's
extremely short term and in our conclusions at that time because
we made several presentations on the topic because it was not clearly seen
by many investors at that time and
then put together some notes and we said that basically,
the preferred shares, the way they existed were inefficient and they were
posed to disappear unless and until
some changes in the treatment of that would take place.
Some of them did indeed take place, some of them didn't.
But for us, the key story here is the contribution of the lack of
good corporate governance in the potential value in this case, destruction situation.
Konstantin KontorDirector and Professor of Finance and Strategy
