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Morningstar | APRA’s Unprecedented Action Against IOOF Forces a Material Downgrade to Its FVE

Following the Australian Prudential Regulation Authority’s, or APRA’s, unprecedented action seeking to disqualify several of narrow-moat IOOF’s leadership team we have reduced its fair value estimate to AUD 5.00 per share from AUD 9.30, increased its uncertainty rating to very high from high, increased its cost of equity to 11% from 9%, and downgraded its stewardship rating to Poor from Standard. We believe all employees facing APRA’s disqualification order will eventually leave the company. IOOF’s CEO Christopher Kelaher and its Chairman George Venardos have already vacated their positions. Additionally, we expect APRA’s actions will likely prompt class actions and further investigations by the Australian Securities and Investments Commission, or ASIC. We also think major reputational damage will make attracting financial advisors and funds into its business more difficult.

The more immediate consequence is likely to be the termination of its proposed acquisition of ANZ Bank’s One Path Pensions and Investments, or ANZ P&I, business. We expect APRA’s actions will force the trustee of ANZ P&I funds to conclude a successor fund transfer is not in the best interest of its members. IOOF had announced substantial "economic" completion of the ANZ P&I acquisition on Oct. 2, 2018, with final completion conditional on the successor fund transfer. IOOF paid an initial payment to ANZ Bank of AUD 800 million (82% of the total consideration) which was used to subscribe for a "debt note" paying IOOF a coupon of 14.4%. This coupon was designed to be broadly equivalent to 82% of economic interest in the ANZ P&I business.

IOOF has yet to provide details on what will occur if the ANZ P&I acquisition does not complete, including what will happen to the debt note. Notwithstanding, our base case is now that the ANZ P&I acquisition will not complete, the debt note will be redeemed with IOOF receiving back its AUD 800 million but with no coupon payments.

IOOF has already gained legal ownership of ANZ Bank’s aligned dealer groups as part of the broader deal and about 670 formerly ANZ aligned advisors have now moved to IOOF. We assume this part of the deal won’t be unwound. We think the reputational damage from APRA’s actions will impact IOOF’s ability to attract advisors and fund flows. However, the full impact of this may be softened if it is able to retain most of the formerly aligned ANZ advisors. However, we also expect ASIC to more proactively regulate vertically integrated business like IOOF (and AMP Limited). This is likely to reduce the competitive advantage of having a large network of such advisors and we intend to review IOOF’s narrow-moat rating on publication of the Royal Commission’s final report in February 2019. We also expect more disruptions in the business in the next few years following APRA’s unprecedented actions. These moving parts plus the general volatility of markets result in a high degree of uncertainty in forecasting funds under management. With this caveat, we forecast the average funds under management in its core platform business will grow by a CAGR of 4.2%, over the next five years compared with a CAGR of 7.4% in the previous five.

We also expect IOOF to be the subject of class action lawsuits, with several class action lawyers already indicating an interest in commencing proceedings. At this early stage, estimating the cost of a class action has a high degree of uncertainty. As a reference point, a few years ago QBE Insurance settled a shareholder class action for about AUD 132.5 million and we have forecast likely class actions costs to IOOF of AUD 150 million spread over fiscal 2020 and 2021. We also expect ASIC is likely to investigate the company over matters including potential breaches of directors’ duties and the future of financial advice legislation. Again, it is difficult at this early stage to predict the eventual costs to the company of such investigations. Nevertheless, we have forecast costs of AUD 50 million spread over the next two fiscal years. Notably, this is significantly higher than the maximum exposure to the Royal Commission of AUD 5 to 10 million recently guided to by the company, which in current circumstances, we expect is overly optimistic.

Based on our assumption the AUD 800 million consideration paid for the ANZ P&I business will be returned to IOOF, we expect the company will be able to fund these additional costs. We expect the company to be in a surplus net cash position of about AUD 450-500 million on return of its AUD 800 million consideration. Notwithstanding, given the uncertainty around the flow-on effects of APRA’s unprecedented actions, we have increased IOOF’s uncertainty rating to very high from high and increased its cost of equity to 11% from 9%.

In addition to Kelaher and Venardos, APRA is seeking to disqualify IOOF CFO David Coulter, Head of Risk Paul Vine, and General Counsel Gary Riordan from being a responsible officer of a superannuation trustee. Unlike Kelaher and Venardos, these three key executives will remain in their positions at IOOF for now but will have no responsibilities in relation to the management of its trustee companies. However, we think it will be untenable for any of these individuals to remain in their key management roles over the long term. An essential part of good corporate governance is maintaining a good relationship with key stakeholders like APRA. We expect the Financial Services Royal Commission will usher in a new period of more proactive and aggressive regulation, making it even more important to maintain a strong relationship with APRA. Given APRA’s extraordinary action in seeking to disqualify five of IOOF’s most senior people, it’s obvious this key relationship has broken down. Therefore, irrespective of whether the disqualification orders are upheld, we expect it would not be in the best interest of shareholders for any of these individuals to remain in their positions. Furthermore, given IOOF’s recent appearance at the fifth round of Royal Commission hearings as well as APRA’s more recent actions against it and the value destruction it has caused, we have downgraded the company’s stewardship rating to Poor.

In summary, APRA alleges that two subsidiaries of IOOF Holdings, Questor Financial Services (no longer operational) and IOOF Investment Management, or IIML, which were trustees of IOOF’s superfunds failed to maintain structures, policies and procedures to adequately manage conflicts of interest. The inadequate structure primarily refers to the dual structure of being a trustee of a superfund, or RSE, as well as being a responsible entity, or RE, of a nonsuperannuation managed investment scheme in which the RSE invested member funds. APRA also alleges that on separate occasions in 2015, these trustees contravened the Superannuation Industry (Supervision) Act 2013, or SIS Act. Two of the occasions relate to losses caused by the trustee or their service providers and for the action of compensating members for this loss from a superfund asset (a reserve fund) instead off out of the trustee’s own funds or third-party funds. This was despite APRA informing the trustee that their own or a third-party’s funds should be used to compensate members. The other occasion relates to the IIML as trustee rejecting a request to transfer default superannuation arrangements from an IOOF fund to a nonrelated AMP fund by way of successor fund transfer without considering the interests of superfund beneficiaries.

These incidents also form part of the basis for APRA seeking to disqualify five of IOOF’s most senior employees. At all relevant times, these individuals held their roles in IOOF Holdings as well as superfund trustees IIML and Questor. All individuals were also responsible officers of IIML and Questor. APRA seeks to disqualify the individuals for their involvement in the alleged contraventions of the SIS Act and for failure to appropriately engage with APRA on these matters. This includes the failure to implement a robust conflicts management framework, a process to prioritise the interest of superannuation members, as well as due to an alleged lack of understanding of their legal obligations and a lack of contrition and not responding to APRA in a timely manner with respect to the alleged breaches. For more details of IOOF’s appearance at the fifth round of Royal Commission hearings and some of APRA’s concerns, please refer to our Aug. 13 note entitled “IOOF’s Unconvincing Evidence Increases Royal Commission Risks.” For a summary of Royal Commission’s Interim Report please refer to our Oct.3 note entitled “IOOF’s FVE Reduced on Royal Commission Fallout, Despite More Clarity on ANZ Acquisition.”