It’s been a busy week for Sanlam, the Cape Town-based financial services firm that historically entrenched itself in the Afrikaans community and has grown from there. The company released results, announced a B-BBEE transaction and suffered a 4% decline in the share price.

The standout asset management result in recent times has without a doubt been Sygnia, reflected in 35% share price growth this year. The much larger, traditional financial services groups have had a torrid time in these conditions. Old Mutual, for example, is down 37% this year. Sanlam has fared better, down 29%.

Earnings under pressure across the group

Sanlam is a traditional financial services house and has struggled under market conditions, much like traditionally English rival Old Mutual. For example, Sanlam’s investments business earns fees for assets under management (AUM) as well as participation fees for performance. When asset values crash, the AUM fee drops and the participation fee disappears.

Sanlam does have some riskier and niche businesses like Sanlam Specialised Finance, which provides alternative funding to corporates (e.g. preference shares). The company’s announcement notes a “widening in corporate credit spreads” which is a fancy way of saying that if those loans or preference shares were entered into today, the rate would be higher. Because the rate on existing assets cannot be adjusted for risk, the existing loans and preference shares are less attractive and less valuable. This leads to a negative adjustment to profits.

This is a similar concept to the credit loss provision increasing in banks. The accounting is different, but the net result is that the financial services houses experience a drop in profitability as they adjust their asset values downward to reflect the broader economic environment.

A point I make often: price-to-book ratio is useful in financial services because the asset values are adjusted at each reporting date to reflect market conditions. This isn’t the case in most other industries.

Sanlam’s insurance business includes a majority stake in Santam aka SA’s most hated insurance company after refusing to pay Covid-19 business interruption claims. Not only is that brand in the dustbin, but financial results will take more pain from a decrease in the investment income earned on insurance reserves. Insurers invest their reserves in the market and so a general decrease in asset prices causes a reduction in reserves.

The result of all of this is an expected 35% to 45% drop in net operational earnings. Headline earnings per share (HEPS), weirdly, will increase by 5% to 15%. This is due to various accounting adjustments which are not excluded from headline earnings. This is unusual because HEPS is normally a view of sustainable net profits, but not in this case.

Impairments

As is the theme of 2020, Sanlam is recognizing significant impairments. Around R7.8bn will be written off, primarily against the insurance assets in Africa and India. Unlike other impairments we’ve seen in the market in the past couple of weeks (like stakes in UK retail businesses), this is a prudent approach being followed by Sanlam. Their emerging market insurance businesses are generally well-liked by the market and should do well in the long-term.

ARC gets the rats and mice

Sanlam has a long history with Patrice Motsepe. It was the original B-BBEE deal that helped propel Motsepe to his current levels of wealth. Importantly, Motsepe also formed a relationship with Sanlam executives with whom he founded African Rainbow Capital (ARC).

ARC has unfortunately been an unmitigated disaster. Launched to much fanfare, the fund went on a wild acquisition spree buying basically anything that didn’t run away. Like a dog on heat, ARC concluded as many as 20 to 30 transactions in the initial stages, ranging from the sublime to the ridiculous.

On top of this, the company has a management incentive structure in place that the market hates. Literally.

All of this has led to a share price down 66% since the company listed in September 2017. Yikes.

Nevertheless, the Sanlam relationship continues. Sanlam will be doing a new transaction to create a leading Black-Owned asset management company. Interestingly, it looks like Sanlam is simply grouping its rats and mice investments in a single vehicle that ARC can invest in, which is at least as sensible as the rest of ARC’s strategy since formation.

The deal will exclude the investment management businesses of Sanlam Private Wealth and Sanlam Specialised Finance, but will include “interests in third-part asset management businesses in South Africa” – sounds dreamy. Not.

ARC will take a 25% direct stake in this new subsidiary and the flow-through of Black credentials from the listed company will take total Black Ownership to 51%, a key level under the B-BBEE Codes.

The deal is convoluted and complicated, like many B-BBEE deals, but the value in the end will be somewhere around R800m. Because of the relationship between Sanlam and ARC, the JSE requires something called a “fairness opinion” to be prepared by a suitable expert, in this case BDO. This is to protect Sanlam’s shareholders from an unfair or unreasonable transaction.

ARC’s shareholders are probably the ones that need to worry more about unreasonable transactions, if history is anything to go by.

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