Naspers’s Euronext listing plan – a sting in the tail for retail investors?

Retail investors in Naspers shares will have to decide whether to pay capital gains tax or take on more Naspers shares. While we will have to wait for the prospectus to confirm the details, Peter Armitage and Mike Gresty of Anchor, a JSE-listed wealth management business, unpack the various options and why this may be a good time to restructure your portfolio.

Naspers or ProsusAt the end of March, Naspers announced that it plans to list a company (subsequently named “Prosus”) on the Euronext Exchange in Amsterdam, which will hold all of Naspers’s non-South African (SA) investments.

Naspers will make a “capitalisation award” to its shareholders of an instrument that shareholders can elect to exchange either for shares in Prosus or for more shares in Naspers. While Naspers hopes that this will narrow the discount at which the group trades to the value of its net assets, we think it will lead to a potentially unappealing choice for tax-sensitive retail investors. Electing to take up shares in Prosus will trigger a capital gain. Alternatively, electing to take up further Naspers shares avoids triggering a capital gain, but investors may find this vehicle trades at a larger discount than it did before.

What will the Naspers structure look like?

Naspers anticipates that, once the transaction is complete, around 25% of Prosus will be owned directly by its shareholders, leaving Naspers with a 75% stake in Prosus, as well as its SA assets (immaterial). The new structure is explained in Figure 1 below.

As far as timing is concerned, at this stage, having originally planned for the listing of Prosus to take place in mid-July, it is now expected to list in September, but an exact date is yet to be announced.

Why is Naspers doing this?

Naspers hopes that the listing of Prosus on the Euronext exchange will be a step towards narrowing the discount at which it trades, relative to its net asset value (NAV). In the SA equity market there are few topics that have been debated more extensively than the reasons for, and likely direction of, the Naspers discount. This discount has widened in recent years and one of the important contributory factors believed to be responsible is that its outperformance of the rest of the market (thanks largely to the stellar performance of its main asset – Tencent) has led to it becoming too large for the SA market. As Figure 2 below shows, since 2013 its weighting in the JSE All Share SWIX Index has risen from just 5% to >20%. As the size of Naspers has grown, it has increasingly bumped up against the single-stock concentration risk limits of institutional funds, making them forced sellers as the share continues to rise. Certainly, Figure 2 suggests this has at least been a contributory factor to the widening discount.

Listing Prosus on Euronext means: (1) its size will not be a constraint; (2) it will be eligible for inclusion in more indices, thus attracting passive index-linked buyers; and (3) developed-market funds that could not buy Naspers/Tencent before, due to limitations on their mandate, will be able to invest for the first time. It is hoped that as a result, Prosus will trade at a lower discount to its NAV than Naspers has done historically.

Will Naspers’ plan work?

Eliminating the size constraint and opening up Prosus to new pools of capital that had not previously had the opportunity to invest is certainly a compelling argument as to why Prosus will trade at a smaller discount to its NAV than has been the case for Naspers. However, what is less clear is what happens to the discount in Naspers itself after the creation of Prosus. Although, admittedly, Figure 2 above reveals the discount is already extremely large and close to its historic high, we think there are a number of reasons the discount in Naspers may actually widen further after the creation of Prosus:

  • The creation of Prosus introduces a new investment holding company between Naspers and the underlying investments. This introduces the possibility of a double holding company discount being applied by investors.
  • Shifting 25% of Naspers’s market capitalisation into Prosus will not reduce its size by enough to prevent it from hitting concentration limits in SA. Many funds may continue to see Naspers and Prosus as a single entity anyway since they are essentially exposed to the same assets.
  • Institutions that do not trigger a capital gain by trading may seek to switch out of Naspers and into Prosus post the listing of Prosus, placing further selling pressure on Naspers.
  • A possible lack of appeal of SA assets that remain in Naspers (albeit not very material) and value leakage resulting from existing long-term management incentives linked to Naspers shares.

Only time will tell how the market decides to treat the discounts in Naspers and Prosus. However, the fact that Naspers soon reversed the initial rally in its share price on release of the announcement could be interpreted to mean that the market anticipates that a smaller discount on Prosus and a slightly wider discount on Naspers would mean no material change in the overall discount from before!

The Hobson’s choice facing retail investors

If the market’s response so far suggests Naspers’ creation of Prosus is much ado about nothing, it is important to realise this does not necessarily apply to retail investors who hold Naspers directly. As such, for retail investors who hold Naspers shares in a tax-sensitive form, we think they will face the choice to either:

  • opt to exchange the instruments that Naspers issues for Prosus shares and, in so doing, trigger a capital gain on around 25% of their Naspers investment; or
  • opt to exchange the instruments that Naspers issues for more Naspers shares. This will avoid triggering a capital gain but runs the risk that the value of their Naspers investment falls because the market begins to apply a larger discount to Naspers for the reasons discussed above.

For investors that have a particularly large weighting of Naspers in their portfolios, this transaction presents an opportunity to consider whether now might be a good time to restructure their portfolio.

Is this a good time to restructure?

Investors may well have avoided this over the last year due to the belief that Naspers’ valuation was at particularly depressed levels. In Figure 3 below, we show the share price as a multiple of expected earnings for Tencent, which accounts for >90% of Naspers’s NAV today. In 2018, Tencent’s share price declined 47% from its January high, initially as part of a broad-based China Inc. sell-off in response to the US-initiated trade war with China, and subsequently due to a freeze on new online game approvals by Chinese regulators. This price decline resulted in Tencent’s valuation falling from what was, admittedly, a lofty 50x projected earnings to 25x projected earnings. The latter appears cheap when considered against Tencent’s historic valuation range. Subsequently, as mobile gaming approvals have resumed and there has been growing optimism regarding a US/China trade deal, Tencent has recovered strongly and with it, Tencent’s valuation. Now valued at 36x expected earnings, this is around the average based on the past five years.

Limiting exposure to Naspers

Within the SA market, Naspers has been almost the only listed investment via which investors could play the technology growth theme, as well as having been a solid rand hedge. Its superior past investment performance notwithstanding, a nagging concern to consider is Naspers’ overexposure to a single stock in a single market (Tencent in China), which accounts for >90% of Naspers’ NAV. As incredibly successful as Tencent has been, and still with compelling growth prospects ahead, the ban on new game approvals last year was a timely reminder of the risks posed by the heavy-handed regulatory environment in which Tencent operates. Suffice to say that the first thought that runs through Chinese regulators’ minds when they reach the office each day is not the interests of investors (particularly foreign ones). Such left-field risks can be mitigated by controlling the size of one’s position in Naspers.

Are there viable alternatives?

A further concern that may have prevented investors from considering restructuring their Naspers investment into a fund has likely been that their exposure to the technology theme would be significantly diluted and thus risk underperforming Naspers going forward. Anchor has recently launched a dedicated technology unit trust, which may be a worthwhile alternative to consider. This should be better balanced across more companies and countries.

Naspers or Prosus shares?

While generally avoiding triggering a capital gain and thus eluding crystalising a tax liability is the best course of action to maximise wealth in the long term, we argue that this is one instance where shareholders should consider departing from this principle, opt for Prosus and trigger the capital gain. While economically, shareholders will have the same exposure to Naspers’ net assets either way, we believe the real issue dictating which is the best option will be where the discount at which these two companies (Naspers and Prosus) will trade relative to that NAV in future. While we think the case is strong for Prosus’ discount to narrow, we believe Naspers’ discount may widen. In this instance, shareholders who opt to take up more Naspers shares to avoid triggering a capital gain will miss out on any value uplift from Prosus’s discount to net assets closing. Missing this opportunity severely undermines the power of compounding that would normally support the option that results in a deferral of capital gains tax (CGT).

Critical terms of the transaction

From the point of view of an investor holding Naspers N shares, the following is a summary of the critical terms of this transaction:

  • Naspers will make a “capitalisation award” which, depending on the option selected by each shareholder, will be either (1) additional Naspers shares; or (2) Naspers “M” ordinary shares, which will convert into Prosus shares once it lists.
  • Shareholders will have a binary choice – either more Naspers or Prosus shares, but not a combination of the two.
  • The Prosus option is the default option. This means that investors who do not take any action will automatically take up a direct holding in Prosus.
  • Shareholders that opt to receive more Naspers shares will receive 0.36986 additional Naspers share for each Naspers share they hold. Shareholders that opt instead to take up their entitlement of Prosus shares will receive 1 Naspers “M” ordinary share (which will convert into 1 Prosus share) for each Naspers share they own. The math behind the ratio of additional Naspers shares for those that take this option, means they will have the same economic split in terms of their exposure to Naspers and Prosus as those that opt to take up Prosus shares. We note that the latter will own Prosus directly, while the former will have indirect exposure to Prosus via their Naspers stake.
  • Having originally planned for the listing of Prosus to take place in mid-July, an administrative hiccup with the distribution of the circular to shareholders has led to a slight delay. It is now expected that Prosus will list in September – an exact date is yet to be announced.

Below, we have reproduced a diagram provided by Naspers, which illustrates the two options available to investors.

Tax implications

Subject to the important disclaimer that investors should seek appropriate tax advice relevant to their own circumstances, the general tax principles explained in the Naspers circular confirm our original understanding for tax-sensitive investors holding Naspers shares. In summary, this is as follows:

  • The capitalisation issues under either alternative will have a zero base cost. This means they are treated as if you received the shares for free.
  • Those opting for additional Naspers shares will not trigger a CGT event on receipt of those shares. However, it is important to note that receipt of further Naspers shares with a zero base cost will lower the average base cost of those investors’ holding of Naspers shares. This will increase the capital gain when the Naspers shares are eventually sold. This means, for those that opt to take up additional Naspers shares rather than Prosus shares, CGT is not avoided but merely deferred to the future point in time when the shares are sold.
  • For those opting to take up their entitlement of Prosus shares, the conversion of Naspers “M” ordinary shares into Newco shares is treated by the SA Revenue Service as a sale and is therefore subject to CGT with a zero base cost.

To quote Albert Einstein “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

As a rule, it makes good financial sense to delay payment of CGT for as long as possible. Ignoring trading costs, where investment returns offered by different investment opportunities are identical, the power of compounding means an investor who delays triggering CGT, because of switching between investments, will end up with a higher net worth than one who switches along the way. Delaying CGT does, of course, expose the investor to the risk that CGT rates increase in the interim – something that is entirely possible given the fact that SA’s CGT rate currently remains below that in many other countries.

Since the exchange ratio for the additional Naspers shares option gives investors the same economic exposure to Prosus as shareholders who opt to take up Prosus shares, it appears (on the face of it), more sensible to defer CGT for as long as possible by opting for Naspers shares. If only it was as simple as that. The issue is that, while Naspers and Prosus are ultimately exposed to almost the same investments, the discount at which these companies will trade relative to these investments will likely be different.

Currently, Naspers trades at a discount of c. 40% to its underlying value of net assets. As far as the rationale given by Naspers for listing Prosus on Euronext is concerned, it points out: (1) its size will not be a constraint, unlike Naspers currently on the Johannesburg Stock Exchange; (2) it will be eligible for inclusion in more indices, thus attracting passive index-linked buyers; and (3) developed-market funds that could not buy Naspers/Tencent before, due to limitations on their mandate, will be able to invest for the first time. As a result of these factors, Prosus, it is hoped, will trade at a lower discount to NAV than Naspers has historically.

As to whether Naspers’ rationale will play out in practice and Prosus’ discount to underlying NAV will narrow, it remains to be seen whether the market agrees once the listing takes place. However, we think the logic is sound and we note that since the plan to create Prosus was announced, Naspers’ discount to net assets has narrowed. This implies the market is pricing in an expectation of Prosus’ discount narrowing as well. While the case for Prosus to trade at a smaller discount is compelling, this does not apply to Naspers. In fact, we think there are several reasons why, once Prosus is listed, Naspers may trade at a larger discount to its net assets than it did before:

  • The creation of Prosus introduces a new investment holding company between Naspers and its underlying investments. This establishes the possibility of a double holding company discount being applied by investors.
  • Shifting 27% of Naspers’s market capitalisation into Prosus will not reduce Naspers’ size in the SA market by enough to prevent its weight in the local index exceeding most investors’ single-stock exposure limits. In any event, many funds may continue to see Naspers and Prosus as a single entity anyway since they are essentially exposed to the same assets.
  • Institutions that do not trigger a capital gain by trading, may seek to switch out of Naspers and into Prosus post the Prosus listing, placing further selling pressure on Naspers.
  • A possible lack of appeal of the SA assets that remain in Naspers (albeit not very material) and value leakage resulting from existing long-term management incentives linked to Naspers shares.

In short, investors who opt for more Naspers shares to defer the CGT obligation may forego the one-off opportunity to benefit from any closure of the Prosus discount. By way of an example, we assumed a starting position where Naspers is trading at a discount to its NAV of 40%. Post its listing, Prosus’ discount to NAV narrows to 25%, while Naspers’ NAV remains stable at 40%. We further assume that the NAV grows at a rate of 15% p.a. We find that, after 5 years, investors who opted to defer the CGT cost and take up additional Naspers shares were 4% worse off than those that opted for Prosus. Over ten years, the gap had narrowed to 2% in favour of Prosus (thanks to Einstein’s eighth wonder of the world). It suffices to say that, should the discount at which Naspers trades to its NAV widen post the Prosus listing, for which we think there is a strong case, the case for selecting the Prosus option becomes even stronger. Conversely, of course, if the discount at which Prosus trades relative to NAV narrows very little, one would be better off to defer the CGT by opting for additional Naspers shares.

Summing it all up

For tax-sensitive investors, all else being equal, it is sensible to avoid paying CGT for as long as possible and thus allow the power of compounding to work in your favour. However, in the case of the choice Naspers is offering its shareholders, we believe all is not equal. While economically, shareholders will have the same exposure to Naspers’ net assets initially either way, in our view the critical question investors need to ask themselves is what happens to the discount at which Naspers and Prosus trade relative to net assets in the future? While the rationale for Prosus’ discount narrowing appears sound, we think that, at the Naspers level, the discount may widen. Those opting to take up additional Naspers shares will likely fail to benefit from the initial one-off narrowing of the discount anticipated in Prosus. This severely undermines the normal compounding advantage of opting to defer CGT.

Albert Einstein is right though – compounding is a powerful force. Given enough time, deferral of CGT will eventually win out. However, the risks that CGT rates increase or that the fortunes of Naspers and Prosus diverge in the interim, lead us to believe that the time horizon required to make up the initial missed opportunity is too long. We therefore conclude that the most sensible course of action in this case would be to take up the Prosus option and pay the CGT.

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