"Snapping Point?"

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As I have mentioned before, this blog relies a bit more than I’d like on the Financial Times because its writers have a greater understanding of the inner workings of the financial markets and take a jaundiced view of recent developments. One has to wonder if the two traits are linked: if you have a decent understanding of what is going on, it’s hard to be chipper about it.

Exhibit A is an analysis by John Authers and Gillian Tett that goes through the bull and bear cases for the market (i.e., good fundamental growth, strong corporate profits, underinvested retail customers vs. scary leverage and asset bubbles).

The entire article is very much worth reading, but the sections on derivatives and their ramifications illustrate how dramatically industry practice has changed in a short period, and not in a good way. You have non-existent due diligence, faith in credit derivatives replacing credit analysis (note that credit derivatives have never been tested in a serious recession) and lax documentation. If (more likely when) things come apart, a lot of people will have a lot of explaining to do:

So what are the main reasons for concern? Mr Bolton’s [the UK’s best known fund manager’s] unease centres around the credit market. Since the S&P was last at a high, new derivative instruments have transformed lending. Banks are no longer the only players on the hook when loans turn bad. That is partly because they are increasingly selling loans to other investors such as hedge funds, but also because there has been an explosion in the use of credit derivatives – which provide a form of insurance against the risk of credit default.

This makes banks less vulnerable to individual defaults. But it could also be making them feel so comfortable about lending risks that they are making more risky loans. Outside investors such as hedge funds are gobbling them up, either because they also think they are protected with credit derivatives or because they are desperate to find somewhere to place their cash.

This has triggered a collapse in the standards used to conduct and fund deals. Mr Moulton of Alchemy says that bankers are selling companies to private equity players with nothing more than a scanty report written by an accountancy firm that has not even visited the company up for sale – or read its accounts. “Deals are being done with almost no due diligence,” he says.

In recent months, most of the legal covenants that once protected lenders have been stripped away from many deals. “We have [seen] transactions recently where 40 per cent of investors did not even read the bank disclosure documents,” says Robin Doumar of Park Square Capital, a credit fund.

The net result is that private equity funds can raise money with fewer strings attached – at the same price, or even cheaper, than before. That lets them launch increasingly aggressive bids.

The identity of those selling also rings alarm bells. The decision by Sam Zell, the legendary Chicago-based property magnate, to sell Equity Office Properties, his main investment vehicle, to private equity bidders looks like a classic signal of a market top. So do the decisions by Blackstone, the private equity investor, and a number of hedge fund groups to take themselves public.

Tobias Levkovich, US equity strategist at Citigroup, points out that the buoyant credit market creates an “incredibly attractive” logic for buying shares. In the US, he says, the high yield that risky companies pay to raise money using “junk” bonds is more than 2 percentage points lower than the equivalent yield produced by companies’ cash flows. So a private equity buyer can take over a company and comfortably cover the cost of borrowing without doing anything to improve the company’s profitability. This is pure financial arbitrage.

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