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Quarterly Newsletter - Spring 2007


The Markets

It has been an interesting first quarter of the year, to say the least! After a fairly nondescript start in January, February provided some fireworks in the shape of a worldwide stock market correction that was triggered by the biggest fall in ten years in the Chinese Shanghai Composite index, and March saw another wobble with American banks getting into a tizz when they woke up to the fact that their mortgage lending books were not looking too clever.

So, what happened in China?  Not wishing to oversimplify the problem, China has, above all, become a victim of its own success.  The Chinese economy has grown at a rate that beggars belief.  On an annualised basis, GDP growth over 25 years works out at 9.7%, compared with a global GDP average of 3.1%!  The Chinese government, realising its economy was overheating, started making noises about putting on the brakes, and there were rumours of a proposed tax on share dealings.  That, and the resultant profit taking, was all it took for the markets to react violently.  The Shanghai Composite index fell by nearly 9% in one day!  The knock-on effect was immediate and universal: the Dow Jones fell by 3.3%, the FTSE 100 by 2.3%, and Frankfurt and Paris registered falls of around 3%.  Clearly, investors in multinationals that had a significant exposure to China – and that means virtually all multinationals! – got the jitters.  Furthermore, the unwinding of the yen carry trade threw the foreign exchanges into disarray.  “Carry trade” is the term used to describe the practice of borrowing at very low short-term rates and investing in longer term instruments with higher rates, the attraction being in the difference of the coupons.  This may involve foreign currencies and bonds as well as all manner of derivative debt, and hedge fund managers and speculators often are highly leveraged.

In our January 2005 Newsletter, we devoted a lot of space to China’s amazing economic development and highlighted some of the problems this creates for the rest of the world.  We pointed to the huge foreign exchange reserves, which were then estimated to be US$500 billion, held predominantly in US Treasury bonds.  The latest estimates suggest that China’s foreign exchange reserves have ballooned to US$1,200 billion!  Beijing so far has resisted international pressure to properly revalue its currency, the yuan.  Needless to say, a yuan revaluation would reduce the value of their foreign exchange holdings, but it would help cool down economic growth.  However, the Chinese are worried about the longer term effects as it would hurt their export trade.  In addition, a stronger yuan would allow cheap food imports which could be catastrophic for China’s huge rural farming community.

So, for the foreseeable future, we will continue to see China exporting all kinds of cheaper goods, including deflationary pressure as a side effect.  If, on the other hand, you are a house owner living in the South of England who had the fence blown down by the recent strong winds, you may well curse China’s economic miracle.  The serious shortage of fencing panels, according to the Fencing Contractors Association, is due to the construction boom in China…

The mortgage lending problems in America that rattled the markets during March were of an altogether different nature. The Federal Reserve’s prolonged low interest rate policy, pursued in an effort to keep the economy going and stave off the prospects of recession, had the unwelcome side effect of creating a real estate bubble of enormous proportions.  Broadly speaking, US mortgages offer the borrower far more options than is normal in other countries.  One can choose between fixed or floating rates of interest, select the term and generally borrow against one’s home more freely, often with very low or even  zero down payments.  Unfortunately,  lenders – some  of  them decidedly unscrupulous –  have advanced massive sums under the heading termed “sub-prime mortgages”.  Sub-prime mortgages are a euphemism for loans made to people who are more likely to default on their repayments.  In other words, the borrowers are people with poor credit ratings who normally would find it impossible to obtain finance from regular institutions.  In the sub-prime field, income requirement documentation is questionable at best, and mortgages can even be arranged on a “stated loan” basis (or “liars loans”, as they are affectionately known in the lending industry), which means that neither the declared income nor the state of the property are further investigated. The mortgages are frequently offered at extremely attractive initial terms, only to be massively adjusted at a later stage to reflect the higher risk premium.

So, what are the repercussions of these lax lending practices?  Well, sub-prime mortgages last year amounted to a fifth of the total American home loan market, and the total outstanding amount in sub-prime mortgages is the equivalent of the Californian economy.  To put this further into context, the State of California is reckoned to be the fifth largest economy in the whole world!  An unusually high incidence of foreclosure has already been registered, and about 15% of borrowers currently are in default. 

Needless to say, this situation will have a direct negative impact on the lending industry, and it indirectly affects consumer spending as Americans will feel less well off.  It has been a blessing that US corporate earnings over the last few weeks have been considerably stronger than expected, thus propping up the stock market during this critical time.  Indeed, the Dow Jones index latterly has been registering record highs.

However, it is becoming increasingly obvious that America, saddled with a slowing economy, ever increasing twin deficits and a substantially weaker dollar, is no longer quite the dominant economic power it once was.  America’s indebtedness vis-à-vis the rest of the world and its consumption have only been sustainable due to the increased production in Asia, with China nowadays taking on a bigger role.  Equally, the integration of the Eastern and Western parts of Europe, as well as the development in other emerging countries, underline that the balance of economic power is shifting away from the US. 

However, the problems of high lending and possibly inflated property prices are not an exclusively American phenomenon.  The UK’s regulator, the Financial Services Authority, warned that the UK’s own sub-prime sector could go the same way as the troubled US market if it fails to tighten up lending criteria.  It is indeed a familiar story when the FSA also feels that borrowers are taking on too much debt secured against their property, and that continued house price inflation may be hiding the sector’s difficulties.

The outlook for the UK stock market looks pretty healthy, with equities as cheap versus bonds as they have been for the past 30 years.  Investor sentiment is positive, spurred on by high liquidity and a lot of corporate activity, including private equity participation. 

Private Equity

Private equity firms have been much in the press recently, mainly as a result of Kohlberg Kravis Roberts (KKR) proposing to take over Boots.  Private equity has been around for decades in many different guises, ranging from small business angels helping a corporate fledgling with seed capital, venture capitalists, funds that provide expansion capital to companies at an early stage of their development (such as the Lacomp British Enterprise EIS Funds!) to private equity firms of various sizes, ending up with giants such as KKR and Blackstone. Whereas business angels and the Lacomp EIS Funds simply invest their own funds in companies, private equity firm acquisitions tend to be highly leveraged with debt.

It is the leveraging that can cause concerns: a private equity firm may put up very little of its own money, and  the takeover  is  financed through bank loans and by issuing high-yield bonds (often called “junk bonds”).  Collateral for the loans typically are the tangible and intangible assets of the target company.  The debt needs to be serviced and repaid, and it is one of the reasons people are wary about the new owners’ motives.  Are they simply going to run the business to create as much cash as possible - maybe through some asset stripping? - to repay the debt as quickly as possible, or do they genuinely have the long-term interests of the company – and its employees – at heart?  The debt has another side effect, which is loved by the new owners, hated by the Chancellor of the Exchequer and viewed with mixed feelings by the rest of us: since the interest payments are both huge and tax-deductible, a company could well increase its profits massively and still pay a lot less corporation tax!

An analogy once compared private equity firms with people buying a second property with the aim of “doing it up” and selling it at a profit.  They would look for a house or a flat with improvement potential in an up-and-coming area, put down a small deposit and borrow the rest from a bank, secured against the property in question.  It is, indeed, very similar to a leveraged buy-out.

It all started in America in the fifties but quickly moved across the pond to the UK.  Slater-Walker and asset stripper John Bentley were early British examples in the sixties, and Lord Hanson and Gordon White’s Hanson Trust became a major player in the eighties.  Many people thought badly of private equity firms, branding them “corporate raiders”, “asset strippers”, “vulture rather than venture capitalists” and, famously, “Barbarians at the Gate” when KKR launched a hostile bid for RJR Nabisco in 1988. The Nabisco deal was worth over US$30 billion, a staggering figure at the time, and nearly 20 years passed before it was exceeded, although there have been deals involving even bigger amounts in the last couple of years. 

However, equally many people do not share this negative opinion, seeing private equity as rather beneficial for many companies.  Let’s face it, there are plenty of examples of companies that are run by management teams that are bordering on being complacent and find it difficult to think in terms of shareholder value.  Therefore, the threat of an unwelcome approach is not necessarily a bad thing. It could even be argued that debt imposes a stricter regime on a company’s management.  So, private equity need not only be seen as ruthless devotion to cost-cutting and cash-generation; it may well result in better-run businesses offering bigger returns to shareholders. 

Whilst Boots may be one of Britain’s oldest retailers, there are plenty of other household names that have been acquired by private equity, including companies like Kwik-Fit, Halfords, Somerfield, Odeon and UCI cinemas, Debenhams, United Biscuits, Birds Eye, Pizza Express and the AA.

One thing is for certain: private equity firms’ activity has massively stimulated the stock markets across the globe, and investors would be unlikely to have seen the sort of performances from their investment portfolios if they didn’t exist.

26th April 2007