Debt can be wonderful thing. Just supposing a company is growing in line with the FTSE 100. The index has almost doubled in value over the last four years. So, even your average large business should have enjoyed something of an impressive growth spurt during the last few years.
If you had invested in a typical FTSE 100 business, or, even more spectacularly, a typical FTSE 250 firm in 2002, you would have enjoyed phenomenal returns. But supposing, by contrast, you had put your money into a deposit account, and saw your yield rise and fall in line with the rate of interest. You might be able to congratulate yourself for not taking a risk, but surely you would regret your reluctance to embrace the stock market
But supposing you made your investments by borrowing. So rather than investing your money, you are, in effect, investing your bank’s money. Your profit could have gone through the roof.
Typically, private equity firms enjoy 80 percent gearing, meaning for every pound they own, £4 is borrowed.
Some own large stakes in quoted companies. Other private equity consortiums own companies outright and take the firms they own off the stock market. Either way, for as long as either share prices or profits are rising faster in percentage terms than the interest they pay on loans, they are quids in.
And here is a fact that is often overlooked. The relationship between a company’s valuation and profits – known as pe ratio – should have a close correlation to the rate of interest. If the rate of interest is high, say 20 percent, then you would expect a company’s valuation to profits to be little more than a fivefold multiple (although, in practice, average pe ratios never drop so low).
And yet today, while the rate of interest remains low, pe ratios too are modest and much lower than the historical average seen over the last couple of decades.
Combine this with the enormous levels of credit sloshing around the global economy at present, and, all of a sudden private equity firms are able to buy companies at historically low valuations, when rates are low and money easy to come by.
This lucrative model can be made even more profitable if the private equity boys use the assets of the company they are buying to generate even more capital.
So, for example, the talk is that if Sainsbury’s does fall to the private equity companies, the new purchasers will use the retailer’s property portfolio, selling up many of the bricks and mortgage assets, then lease them back, in effect using Sainsbury’s own assets to partially fund their takeover.
But there are dangers implicit in this approach.
Good times don’t last forever. The experience of 1929 tells us how dangerous highly geared investing can be. The high levels of gearing might make a fantastic business model when companies enjoy a percentage growth rate that is higher than the rate of interest on their borrowings, but suppose things flip. This is the big downside, and yet, ironically, in all the ballyhoo over private equity, and talks of asset stripping and job losses, this particular danger often seems to have been overlooked.
But, then again, as we alluded above, company valuations relative to the rate of interest are still modest by historical standards. Maybe, for the time being at least, the industry can afford its high levels of gearing and the disaster scenario is still only a remote possibility.
The danger seems to lie in the possibility that rates might go up. Today, business, governments and individuals in the US and UK are so heavily geared, that we are more reliant than ever on the rate of interest. If rates should suddenly start to rise across the board, as some fear, then the private equity model will suddenly look a good deal weaker.
Perhaps the last word should lie with credit ratings agency Moodys. It has the rate of default amongst the riskier corporate bond and loans issues in the US at a mere 1.57 percent – that’s the lowest level since 1981. But, alas, the agency expects this default rate to rise to 3.07 percent by the end of this year. If Moodys is right – and 2008 sees a continuation of this trend – there could be trouble.
© Investment & Business News 2013