Blackstone's Woes: Some thoughts on Private Equity

About a year and a half ago, at the height of private equity's success, I put together a presentation on LBOs that examined what makes an LBO work and, conversely, why many of them were destined to fail. The LBO I looked at was the Harman deal, backed by two big names - Goldman and KKR. Based on my analysis then, I concluded that Harman fit none of the requirements for a good target - it did not have significant debt capacity (nullifying the leverage benefit), it was well managed (eliminating the restructuring need) and did not suffer any serious separation between management and ownership (countering the going private argument). If you are interested, I have a paper describing the deal that can be downloaded by going to: 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162862

My purpose in the paper was not to pick on Goldman and KKR but to make the following points:

1. Even smart people (and there are quite a few at both Goldman and KKR) sometimes do stupid things.  No one is immune from the "herd" mentality. Goldman and KKR were caught up in the mood of the moment - debt  would remain cheap and the economy would keep growing forever - and the deal was reflective of these views.

2. First principles in finance are like first principles in physics. If you violate them, they will catch up with you, no matter who you are. What are these first principles? Here is one. If you are a business that does not generate high cash flows right now, even though you may have great growth potential, you should not borrow money (even if there are people out there willing to lend you this money).

All of this pontificating brings me to Blackstone's earnings announcement due today. My guess is that "marking to market" all of their deals will have a devastating impact on their earnings. No one should be surprised and Blackstone is not alone in feeling the pain, but the lesson we should take away is that private equity and hedge fund investors make the same mistakes that other investors make - the only difference is that they do it on a bigger scale.

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Another strange incident... in a market full of anomalies!

In markets such as this one, where investors are reacting to events and rationality takes a back seat, we should not be surprised when we see anomalies... And that is where I would put what happened to Volkswagen's stock price this week. For a brief period on Tuesday, Volkswagen's market cap jumped four-fold to briefly become the largest market cap company in the world (in excess of $ 350 billion). In the process, hedge funds who had shorted the stock lost almost $ 20 billion. It was a classic "short squeeze", sometimes seen with small, market cap companies that are lightly traded, but seldom in a company of this size.
So, what happened? First, more than 60% of the shares in Volkswagen were held by investors who were not interested in selling the shares - 40%+ by Porsche and 20% by the Government of Lower Saxony; the float in the shares was low. Second, Porsche triggered the first run-up in the price by revealing that it would push its ownership stake to a higher number (60% or more). Third, the jump in the overall equity market on Tuesday added fuel to the price increase fire. Finally, the short positions that the hedge funds had were public information. Consequently, investors with net plus positions in the stock knew that they had the hedge funds over a barrel and could bargain for a higher price.
Today, the recriminations are flying. The hedge funds are accusing Porsche of misleading them, by leading them to believe that it would not increase its existing holding in VW. I think that Porsche did take advantage of these hedge funds and made billions in profits; in fact, it made more money from call options it had on Volkwagen stock last year than it made on it's entire auto business put together. At the same time, I feel not one iota of sympathy for the complaining hedge funds, since I am sure that they would have had absolutely no qualms doing exactly what Porsche did, if their roles had been reversed. You live by the sword, you die by the sword...

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What is the message the market is sending?

The interesting theme that emerged from last week's market mayhem is how the story driving market movements has suddenly shifted from banking problems to the overall economy. Until last week, every market move was traced back to banks or investment banks in trouble and the governments' attempts to bail them out. Last week, the collapse of the markets was almost entirely attributed to the recession that investors/economists see looming for next year.
While I am not dismissing the notion, it is worth looking at history to see how good or bad a predictor the market is, when it comes to the real economy. Someone far wiser than I once said that the market has predicted ten of the last seven recessions. I think that saying captures both the strength and the weakness of the market. Most economic slowdowns have been preceded by market declines but not every market decline has been followed by a slowdown. A drop of the magnitude that we are witnessing is signaling that economies will slow down, but we should be not so quick to jump to the conclusion about how steep that decline is going to be.
Note that embedded in every market slowdown are also the ingredients for the recovery of the economy in the future. While we should be worried about how quickly banks can return to what their real mission is - take deposits from savers and lend them at fair (reflecting default risk) interest rates to individuals and businesses - we should also take some solace in the fact that oil prices are down more than 50% from their highs, other commodities are also down steeply and interest rates globally are likely to stay muted. Many emerging markets have seen their currencies lose significant portions of value, making easier for their manufacturers to compete in a global market place. These factors will play a role in the recovery, when it comes.

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The New World Order: How this crisis affects valuation

Given how much this market crisis has shaken our faith in systems and numbers, it is no surprise to me that the most common question that I have faced these last few weeks is about how this crisis has changed the way I do valuation.
Before I answer, let me specify what has not changed for me. The intrinsic value of a business is still a function of its capacity to generate cash flows in the future. In other words, I am not going to create new paradigms for valuation just because we are in turmoil. In terms of estimates, though, here is what I believe has changed in these last 6 weeks:
1. The risk premiums we demand for investing in equities as a class and in corporate bonds has increased significantly. On September 12, the equity risk premium in the US was 4.2%. On October 16, it was greater than 6%. The key question we face is whether this is an aberration, in which case equities are massively under valued or whether we are facing a structural break, where we face higher risk premiums from now on. I think the answer lies somewhere in the middle. This crisis has increased equity risk premiums and default spreads for the next couple of years, but I believe that risk premiums will revert back to lower values (4-4.5%) in the long term. (Equity risk premiums in emerging markets have to be scaled up accordingly)
2. It is beyond debate now that there will be consequences for economies globally. The slowdown will affect real economic growth (and consequently earnings growth) next year for companies around the world.
3. The long term consequences for individual companies is likely to be mixed. The shake out and more limited access to capital will put smaller companies at risk and drive many of them out of business. Larger companies will strong balance sheets and significant competitive advantages will emerge the winners from this turmoil. The higher excess returns that they will earn will give them higher values.
I just put together a presentation this morning on the crisis and its impact. If you are interested, you can download it by clicking on the link below.
http://www.stern.nyu.edu/~adamodar/pdfiles/country/crisis.pdf
Hope you find it useful!

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What is going on with the inflation indexed treasuries?

Strange things are happening in markets, but one development that I have seen little comment on is what is happening in the US treasury market. The Treasury has been issuing traditional bonds (where the coupon is set at the time of the issue) and inflation-indexed bonds (where a real return of return is guaranteed at the time of the issue) for more than a decade now. On September 12, 2008, the nominal 10-year treasury bond rate was about 3.8% and the interest rate on the inflation-indexed treasury was about 1.7%. In fact, the difference can be viewed as a market expectation of inflation over the 10 years (about 2.1% a year). Those numbers had been stable for years before.
For the first 10 days of the crisis, the relationship held, with the 10-year nominal and real rates staying relatively unchanged. About 2 weeks ago, the ten-year real rate started rising even though the nominal rate remained unchanged. On Friday, the nominal 1o-year rate was 3.9% (about 0.1% higher than it was at the start of the crisis) but the real rate had rised to 3%. I have attempted the following explanations but none hold up:
1. The real interest rate has risen because savers are more worried about investing in any type of financial asset. (Counter: If this is the case, why has the nominal rate also not risen)
2. Expected inflation has decreased because the economy has slowed. (Counter: If this is the case, both the nominal and real rates should have come down. It is also hard for me to believe that all these obligations taken on by the Federal government will not translate into higher inflation, not lower.)
The only explanation that I can think off is that investors who traditionally hold the inflation-indexed treasuries are selling them for liquidity reasons. If that is the case, we should expect a bounce back in the real interest rate to more conventional levels (about 1.5-2%), which would make inflation-indexed treasuries a great investment. The next few weeks should tell.

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Is preferred stock equity?

In the last few days, we have seen announcement by both the UK and US governments of their intent to invest hundreds of billions into their biggest banks. In both plans, the investment will be in preferred stock in the banks, and the announcements have described them as investments in equity. But is preferred stock equity? That is a question that is not new but acquires fresh urgency, with these infusions.

Preferred stock is a hybrid security, sharing some characteristics with equity and some with debt. Like equity, it has a perpetual life and the dividends can be skipped, if a firm is in financial trouble, without the risk of default. Unlike equity, the preferred dividend is usually fixed at the time o the issue (as a percent of the face value of the preferred stock) and is often cumulative; failure to pay dividends one year is compensated for by paying the dividends in the next year. In fact, investing in preferred stock is more akin to investing in a bond than stock, with almost all of the returns coming from the dividends. There is one final confounding factor. While interest payment on debt are tax deductible, preferred dividends are not. In my discounted cash flow valuations, I have always considered preferred stock to be more debt than equity, and very expensive debt at that, since it does not provide a tax deduction.

Among US companies, the biggest issuers of preferred stock are the financial service companies (banks, insurance companies) and there is a simple reason for it. While it may be more expensive than conventional debt, it is counted as equity by the regulatory authorities while computing capital ratios for banks. 

So what is the bottom line of these capital infusions by the governments for existing equity investors in the banks receiving the infusions? If I were an investor in a US bank receiving the infusion, I am concerned about the effect of the preferred dividends that the banks have to pay for the foreseeable future out of after-tax earnings, which will lower my earnings and returns on equity going forward on common stock. However, given that the bank will have to raise capital to cover it's mistakes from the last few years, and that the capital will not come easily in this market (Think of the problems Bank of America had last week when it tried to raise $ 10 billion), I will accept this bargain. If I were an investor in a UK bank receiving capital from the British government, I am not so sure that this works in my favor. The British government plan is much more punitive to common stockholders; the dividend rate is set much higher, the banks will not be allowed to pay common dividends until they pay off the preferred stock and the government looks like it will take a much more active role in the way the banks are run. In other words, the British preferred stock infusion seems to encroach more on common equity than the US preferred stock infusion. Not surprisingly, the British banks that are prime targets for the infusion (Lloyds, HBOS and Royal Bank of Scotland) have seen their stock prices drop since the plan was announced, whereas the US banks have seen marginal improvements in the stock price.

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Black, blue and white swans: Comments on Taleb

I want to steer clear of critiquing the work of others but my comments on long odds seem to have evoked a torrent of emails about Nassim Taleb and his work on randomness and black swans. Let me start off by sketching the points on which we agree. I think that Taleb is absolutely right that we (in academic finance and model building) have become enamored with normal distributions when building models. The real world delivers far more jumps, surprises and asymmetric movements than can be justified by a normal distribution. I also believe that what Taleb is saying was said much better by Benoit Mandelbrot several decades ago, in his argument for power distributions (which allow for bigger jumps than the normal distribution). My book on strategic risk taking has an extended discussion of Mandelbrot's work. 

Here is where I part ways with Taleb. While I agree that we are always susceptible to the unforeseen event (the black swan), I do not subscribe to his prescriptions. The first one (and I may be mistaken in this) is that planning, forecasting and valuation are useless since they will all be rendered to waste by the "black swan'' event. This is the equivalent of arguing that it is pointless planning and saving for retirement, since you may be hit by lightning tomorrow... logical, maybe, but not very sensible. The second one is that you can somehow make money off the fact that model builders have a normal distribution fixation.. Taleb argues that since models are built upon normal distributions, investors can make money by buying out of the money options and other investments that profit from big moves. I think that the mistake here is assuming that people who build models actually set market prices. If markets reflect reality rather than models, there should be no scope for profits. 

Here is what I think. We have to make our best estimates of the future and value assets accordingly. We have to assume that there will be shocks to the system that we cannot anticipate and build an appropriate risk premium to reflect these risks. We cannot plan for the unforeseeable... and live our lives expecting black swans to show up.. 

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