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Friday 3 July 2015

Reply to Sat D's July 2nd long post on 1MDB (part 1)

SatD is my FaceBook friend for close to a year now and he has been most respectful and polite since then and I will accord him the same courtesy.

I did not know that he has been against 1MDB since it was set-up as the Terengganu Investment Authority in 2008.

SatD says it has been 2,248 days since he first stood up to oppose the setting up of Terengganu Investment Authority, which later was federalized and renamed 1MDB.

Yesterday he wrote a long article on 1MDB titled "Just Units: Pre PAC Questions for Arul Kanda Kandasamy" and specifically focusing on the PetroSaudi-1MDB relationship and the value trail.

However, there are large parts of the article that I disagree with him or he may not know of the full facts, which is why I am writing this.

I will try to answer most points but his article is very long so bear with me as I try to be as complete as I can be.

1. SatD says there is confusion on what is PetroSaudi

PetroSaudi (PSI), based in Al-Khobar, Saudi Arabia, is a private company mandated to carry out investments which can strengthen the relationships between the Kingdom of Saudi Arabia and key countries worldwide.

The words are "private" and also "mandated to strengthen relationships between Saudi Arabia and other countries". Private because it is owned by a member of the Royal Family, which is essentially the government and not owned directly by the Saudi Arabia govt.

While "mandated to strengthen relationships between Saudi Arabia and other key countries" means exactly that. Key countries would include Malaysia too - a fellow oil-producing country,a leader in Islamic Finance and a well-recognized majority-Muslim country too.

What kind of private company would be "Mandated" to improve Govt-toGovt relations? 

Obviously one heavily linked the the government and in this case, the Royal family of Saudi Arabia since Saudi is an absolute monarchy.

And what the auditor wrote in 2011 is entirely on the dot. Nothing differing from the above.

As investment arm of the Kingdom of Saudi Arabia's royal family. Not a investment arm of the Kingdom of Saudi Arabia but the Royal family's.

Which is true because documents after documents have shown PetroSaudi being founded and owned by Prince Turki, the son of the late King Abdullah. Prince Turki subsequently became the Governor of the important Riyadh province.

My conclusion: Both definition is correct. There is no confusion.

2. SatD points out that PetroSaudi has no HQ then as it is being built and hence no place to house the staff

Sat D says "Oh Arul lupa tadi..... Head Office Company ni kat mana brader? Depa sumbat mana semua staff?"
As for the question of where the HQ is, this is not even a question. PSI itself was initially registered in the UK but if the Prince says he wants to bring back the HQ to Saudi Arabia, then let him complete his building to house the HQ.

The staff can operate anywhere they like in their other offices - be it in London, Switzerland, or temporarily in the Royal palaces in Saudi Arabia or any random government building in Saudi.

What's wrong with this one? Not even an issue.

3. SatD says the USD700m zero interest loan is a funny clause.

Let's examine two scenarios. Scenario A which is what actually happened and Scenario B, which what 1MDB and PetroSaudi could also have done

SCENARIO A: USD700m dodgy-sounding 0% loan way that was used

As for the Joint-venture arrangement, Sat D agrees on these parts.
- the entire JV is worth USD2.5 billion with USD1b from 1MDB and USD1.5b from PSI.
- there was a discount on valuation of USD500m given to 1MDB in calculation of the equity ratios of 60-40.
- a sum of USD700m was paid back to PSI from the JV.

Firstly, there was no USD700m mentioned in the introduction letter because.... it was an introduction. The type of proposed asset to inject, the value of the proposed assets to be injected and essentially, the details were not worked out yet.

Now, as the deal progressed, PSI identified some assets and got it valued. Both 1MDB and PSI agreed that this asset is valued at USD2.7 b.

If you inject the whole asset in at USD2.7b and 1MDB puts in USD1b, the agreed equity ownership structure fails - as the JV company would be valued at USD3.7b instead of the agreed USD2.5b.

This would mean PSI's USD2.7b injection would own 73% and 1MDB's USD1b would own 27% of the JV company.

Even with PSI's offer to discount the valuation of its asset by USD500m, the JV company would still be worth USD3.2b - hence PSI's USD2.2b would own 66.75% while 1MDB would own 31.25%

Hence, in order to bring it back down to the agreed USD2.5b valuation where an agreed 60-40 ownership ratio would hold, USD700m needs to be removed from the PSI's assets.

Hence, the assets injected into the JV by PSI must be valued at USD1.5b - hence USD2.7b minus USD500m discount minus USD700m = USD1.5b ngam ngam..

Remember that these assets are not monetary asset and you cannot simply minus of  USD700m of a piece of exploration license. Hence, somehow you must remove USD700m value from the USD2.7b

For the purpose of simplification, let's call PSI's USD2.2b (USD2.7b minus discount of USD500m) asset as ASSET A.

100% of ASSET A is worth USD2.2b

How this "minus USD700m" was done is in this form

100% of ASSET A2.2b

Loan of 0% interest due to PSI -0.7b

Total value of injection 1.5b

Thus the new JV company would then have:

100% of ASSET A2.2b

Loan of 0% interest due to PSI -0.7b

1MDB injection 1b

Total value of JV company 2.5b

Total JV company value of USD2.5b - where PSI's USD1.5b would translate to 60% ownership and 1MDB's USD1b would translate to 40%/.

And there is nothing suspicious about the 0% interest loan as it is just an accounting entry to signify a debt that must be immediately repaid - which the USD700m was.

Thus after the loan was repaid the JV company would have the following assets:

100% of ASSET A 2.2b
Cash 0.3b
Total value of JV company 2.5b

Yup, that's the final result for SCENARIO A.


An alternative way that the above 60-40 balance could have been accomplished without a loan transaction is this way: 
100% of ASSET A is worth USD2.2b
hence 68.18% of ASSET A is worth USD1.5b 
In this case, 1MDB would inject USD1b and PSI would inject 68.18% of ASSET A (worth USD1.5b) into he JV. 
Thus total assets of the JV would be :
68.18% of ASSET A 1.5b
Cash 1b
Total value of JV company 2.5b
 However, owning just 68.18% of ASSET A would be troublesome thus, it was decided that the JV company would buy up the remaining 31.82% of ASSET A it does not own.
100% of ASSET A is worth USD2.2b
68.18% of ASSET A is worth USD1.5b  
 hence 31.82% of ASSET A is worth USD700m
Thus the JV company would then use USD700m of its USD1b cash to buy out the remaining 31.82$ of ASSET A.

And the JV company ends up with these assets:

100% of ASSET A2.2b
Total value of JV company2.5b
Exactly the same end result as the Loan SCENARIO A above - but this time without any accounting-entry dodgy-sounding 0% loan but a more respectable asset purchase transaction.
I believe that why 1MDB and PSI did the loan approach (even though it sounded dodgy to the uninitiated) was that it is a cleaner one-stage process instead of a 2 stage process the second scenario would entail

My conclusion: The 0% USD700m loan clause is not funny but is a accounting and legal treatment to deliver the end-result of the partnership structure previously agreed on.

4. SatD levies several criticisms of the change from an equity holding in the JV company to a Murabaha guaranteed convertible loan deal

Specifically, Sat D is unhappy with the following:
1)  "if 1MDB actually sold the shares for cash and repatriated the funds in 2010, check out the FX Rates.....agak2 berapa la FX Loss kat situ aje"

What he means is that the Ringgit strengthened in 2010 compared to 2009 and 1MDB would have lost money converting back into Ringgit - Which is why 1MDB did not cash out then and incur FOREX losses (actually, they cant as they are still bound by the JV agreement) and converted the equity into a Murabaha loan agreement.

2)"Arul, why in the world would you want to convert the loan back into equity"

Well, in 2010 Arul wasn't in 1MDB then as he joined only 5 years later. But then, having an option to convert (at 1MDB's discretion) the loan back into equity means you can participate in any upside if the original JV company became more valuable. 
Isn't this a good thing? Having a conversion option is always better than no conversion option.
3) Why did 1MDB agree to accept additional tranches
Well, this goes back to the original JV agreement where both parties agreed to invest up to a total of USD5b into the JV - hence when 1MDB wanted to convert the equity into a Murabaha loan arrangement, 1MDB had to honor this original agreement and hence this arrangement was carried forward into the Murabaha loan.
4) Whether Arul obtained the necessary approvals from the relevant authorities including Bank Negara before entering into all those transactions then.

Since I am not privy to the documents and the approval process, I think we should wait for the AG report and BNM probe to tell us if there was any breach in the required approvals. Can't answer you here, Sat D.

5) Why did 1MDB not specifically mention in the agreement that all repayments to 1MDB be in cash.

I can only speculate that 1MDB wanted to have the option to receive payment in other forms other than cash. Not having it specifically specified as Cash does not mean not cash.

In any case, as I had previously wrote, the conversion from outright equity investment into a guaranteed, convertible and interest bearing Murabaha loan does not mean that 1MDB had exited the JV with PSI but rather further protecting themselves via stronger corporate guarantee, an assured rate of return higher than their cost of capital of 6.15% and the ability to participate in any equity upside via the conversion option.

I am sure you have heard of a redeemable, convertible, preference share - which is in essence what the Murabaha loan agreement turned out to be. 

Have a read:

To be continued. Rancangan tergendala.

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