(Dec 20): In the 1970s, long-haired visitors to Singapore were required to cut their hair on arrival as unkempt locks were linked to hippie culture.

Investors in Singapore are now pondering a haircut of a different kind. Hyflux, once a marquee water treatment company, struggled to pay its debts after entering the power supply business. It has since been desperately seeking a white knight. A total of 34,000 retail investors in Hyflux’s preferred debt were left in the lurch. The situation even prompted a public protest.

Utico has offered $300 million for a 95% stake in Hyflux. It will provide $100 million in working capital. The UAE company has offered Hyflux’s unsecured debt holders a haircut of 50% on the par value of its debt. Hyflux’s equity investors are facing a haircut of 90%, as it is valued at $16 million, according to the terms. The company had a market capitalisation of more than $165 million before its suspension in March 2018.

See: Hyflux finally signs $400 mil rescue deal with Utico

Utico’s deal is the second prominent rescue operation of an embattled SGX firm a UAE-owned investor. In 2017, Abu Dhabi Financial Group (ADFG), controlled by Jassim Alseddiqi, took an 8% stake in Noble Group Holdings, which was then one of Asia’s largest commodity traders. Noble had lost more than half its value after an attack by a short seller.

See: Noble group's big reckoning

ADFG’s investment seemed a judicious move as Noble was trading at a massive discount to its book value. The bailout was an unmitigated disaster, however. ADFG lost more than 90% of its investment. Noble’s stock has since been suspended and the company is the subject of an investigation.

The Hyflux and Noble sagas are parables on the hidden leverage. Investors would do well to heed the lessons.

First, the accounting treatment of hybrid instruments and fair value gains may not provide an accurate picture. Perpetual bonds are hybrid securities that do not have a maturity date. Investors hold it indefinitely until the issuer redeems it.

Singapore’s accounting standards have treated perpetuals as equity and not debt.

This camouflaged these liabilities and understated the debt.

Most investors in Hyflux were unaware of its debt trap. The company’s financial statements indicated that it was profitable and cash flow positive until FY2017.

In FY2016, its net profit was $3.8 million. However, if one accounts for the interest due to perpetual debt holders, Hyflux had a net loss of $60 million.

Similarly, Hyflux’s net gearing was just 87% in FY2016. However, if one treats the preferred equity and hybrid capital as liabilities, the net gearing was about 290%. Only the most discerning of investors were aware of the looming minefield.

As with Hyflux’s view on perpetual debt, Noble’s treatment of fair value gains seemed to be consistent with accounting standards. This is the practice of recording the fair value of an asset or liability based on market prices, as opposed to historical costs. The practice inflates the asset base in a bull market for commodities, providing more collateral. In FY2014, Noble’s fair value gains amounted to US$5.8 billion, which was roughly equal to its equity base.

However, the commodities bear market in 2014 to 2018 led to a hole in Noble’s balance sheet. Trading losses compounded the issue. Noble’s credit metrics were far worse than ADFG had initially estimated.

Second, there could be similar pitfalls in Singapore’s corporate bond market. Industries facing a downturn, such as commodities, property and logistics, could be exposed.

CWT is a Singapore-based logistics firm that has borne the brunt of the slowdown in global trade. It has $100 million of corporate bonds that are due in March 2020. Its Hong Kong-listed parent CWT International defaulted on a US$179 million debt in April. Creditors have seized CWT International’s assets, including its stake in CWT.

See: HK-listed CWT International defaults on loan interests and fees; 3 CWT-linked REITs could be hit

Third, the success of the restructuring could hinge on the synergy benefits for the white knight. ADFG sought to buttress Noble’s trading operation, but did not succeed. Hyflux’s existing cash flow situation is precarious.

If Utico is successful in its bid for the company, its CEO Richard Menezes will look to slash costs. Utico has vast operations in the water sector in several Gulf countries that could complement Hyflux’s core operations.

Hyflux’s liabilities may fall under the deal, but its operations need to be leaner for it to succeed. A haircut alone would not do the trick; it would need a facelift to emerge from this crisis.

Nirgunan Tiruchelvam is head of consumer sector equity research at Tellimer (Exotix Capital)