Wednesday, November 29, 2006

Catching up with Alan

Guambat can assure everyone that, while there are many joys in moving to the Micronesian Big Smoke, the morning read isn't one of them. Sitting down to morning cuppa just ain't the same when looking at the PDN rather than reading the SMH. Throwing in the MarVar is helpful but doesn't fill the bill.

Obviously, Guambat can find the SMH online, but Guambat is a tad old-fashioned, which will likely come as a great shock to my reader. Guambat likes the utility of the newspaper; the laptop battery burns the thighs whilst on the throne.

So, Guambat doesn't regularly pour through the stories and intrigue and opinion of the SMH that he once fed daily on. Only occasionally does he spend time tabbing through the online version.

And so it was that Guambat finally found time to look back over recent Alan Kohler SMH columns. Kohler was a regular favourite of Guambat, and has oft been thrown into the Stew. He's a busy boy, that Alan, appearing on ABC shows and also writing for Melbourne's The Age and who knows what else. There's something rather snide-ish about his stuff that appeals to Guambat. It was actually a couple of items out of The Age that got Guambat's attention this time.

A recent column corroborates an argument that Guambat made a short while back, namely that money creation was being booted along at a much greater rate than happened in the past due to the new-fangled finance products and leveraged structures. Guambat had this to say:
And then there's "Private Equity". Just as booming dot.com era companies created their own money supply from highly inflated corporate script to buy out other companies, today's financial swash-bucklers create their own money by highly leveraged snatch-and-run buy-outs. See the Hertz deal, for instance. The thing that makes that bit of pretty larceny work is easy credit that the Carlyle Group, KKR and others can tap into. Those deals put billions of newly "released" (created) money into the system without increasing the economic value of the company one iota.

In his column, Alan Kohler had this to say:
All looks right with the world. Except for the gathering boom in corporate leverage via LBOs.

A total of $US350 billion ($A451.8 billion) has been raised by LBO/private equity funds around the world this year, which means more than $US1 trillion is available for takeovers, assuming a two-to-one ratio of debt to equity.

Once pension fund allocations to private equity reach 15 per cent of the superannuation pool, which would not be too far off, that will enable the private equity firms to buy 50 per cent of the assets of the super funds, thanks to gearing.

Alternatively, a 15 per cent allocation to private equity increases potential market liquidity by 50 per cent. Thirty per cent of super funds into private equity would double the pool of money.

And the larger allocations from pension funds these days, as opposed to the smaller sums from high net worth individuals with which the private equity industry got under way, means the funds are bigger and with the gearing the takeovers have to grow at three times the rate of the equity available.

To a great extent, LBOs are a matter of simple maths. Roger Montgomery of Clime Capital [Guambat knew him as "Flash" back when Roger was just a lad in a brokeage shop] produced an interesting illustration of this for me yesterday. He assumed an EBIT multiple of 12 times, with depreciation reinvested in capital maintenance (which is why we shouldn't use EBITDA). Thus an acquisition of an asset for $100 has an annual EBIT of $8.35.

Gearing levels (debt to equity) is usually three times, so the deal needs $75 debt and $25 equity. At 1.5 times interest cover and a 7.5 per cent cost of secured debt then $5.62 of interest must be paid. This leaves $2.73 pretax earnings ($8.35 minus $5.62) and a 10.9 per cent return. If profit growth is 10 per cent compound for three years this raises EBIT to $11.11.

The debt holders are paid $5.62 interest (we have a fixed rate loan with no capital payment) and pretax earnings move to $5.49 in year three.

Is the asset still worth a 10.9 per cent pretax return, or 9.4 times EBIT? If it is, the value of the equity is $50.61. The return to equity holders is thus 100 per cent over three years or 26 per cent a year.

Most funds say their required internal rate of return (IRR) is 20 per cent so they are way ahead. Indeed a 20 per cent IRR requires an equity value of $43.20 or enterprise value of $118.20 or a mere 18 per cent up over three years or just 5 per cent compound growth. And the key is the use of debt; cost-cutting, synergies, better management, etc, is the icing.

One consequence of the extra debt required to make this arithmetic work is that it raises the regulatory stakes in the economy. Increased household debt has already made the economy much more sensitive to interest rate increases than it was; the growing level of corporate gearing will make it very difficult for the RBA to regulate prices with interest rates without causing a recession.

Another of his columns a couple of weeks ago seems to have presaged today's release of trade figures which showed Australia chalked up a surprising blow-out in the trade gap, due in large part to unexpectedly weak export commodity sales, this time coal and coke.

Alan's comment was:
THERE is something rather unsettling about a commodities boom that leaves exports weak but provides the money for massive tax cuts that fuel inflation to the point where the money must be taken away again through higher interest rates.

The domestic economy appears to be slowing and exports are feeble. We've now had the first drop in employment in the current cycle.

Yet the return of the Reserve Bank's overnight cash rate target to the 6.25 per cent prevailing six years ago was completed during the week, making eight successive 0.25 per cent increases.

There hasn't been an RBA governor since Nugget Coombs who has taken over in the 16th year of economic expansion.

The task, therefore, is not to rescue the place but to keep the good times rolling.

There is no reason to think the expansion won't continue into a 17th and then 20th year, but imbalances have been growing during the boom and the task of economic management has become delicate.

In particular, despite the huge flow of money into superannuation, or perhaps because of it, Australians are not saving.

What's more, exports are mysteriously not responding to the commodities boom, while Australia's businesses and super funds are investing massively offshore.

The resulting current account deficit and investment outflow is largely financed by borrowing, mostly by Australian banks, and mostly off their balance sheets

In an important paper on Australia's 16-year boom to be published next week by the Lowy Institute, HSBC's chief economist, John Edwards, recounts Ian Macfarlane's reply to the Chilean Finance Minister, Nicolas Eyzaguirre, when asked in November 2005 the secret to Australia's success.

Macfarlane explained that it was Australia's ability to borrow in its own currency, an answer that was perhaps in part tailored to his audience.

That ability inoculates Australia from the sort of currency mismatch that brought Thailand, Korea and Indonesia unstuck in 1997.

But it's actually a bit of a trick — Australian banks generally borrow in US dollars and then hedge into $A, using Australian bond sales into Japan in particular.

Nevertheless it means the currency risk is borne by foreign lenders, not Australian borrowers, which allows the currency to bear the impact of external shocks, without the banks going broke or interest rates having to rise so the customers go broke.

But it also means the system depends on the creditworthiness of Australian banks and, as Edwards points out, "… this in turn depends on the creditworthiness of Australian households".

"The stock of bank loans to Australian households is twice as big as the stock of loans to Australian business. This is one of the reasons the Reserve Bank of Australia was concerned by the housing boom from 1996 to 2004."

In addition, corporate debt is increasing as a result of the boom in leveraged buy-outs, otherwise known as private equity. So even as business investment starts to taper off, business debt is rising rapidly, to the point where there may soon be problems.

In this context, the new RBA governor has started work on a hiding to nothing: we have high inflation and virtually full employment, justifying higher interest rates, but we also have very high, and still rising, debt, making that very dangerous.

The only trail out of this jungle is paved with exports. As John Edwards says in his paper: "With the long sequence of large current account deficits in the last two decades, Australian liabilities to the rest of the world now match nearly six-tenths of output, and will continue to grow faster than GDP unless and until Australia can run a persistent surplus of exports over imports."

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