Debt – Threat or Loan to Own

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New York – every so often is it is good to take a forest view from a macro perspective and identify some of the major themes in the financial markets and their implications for the research industry.  Since we have discussed in detail the impact of new or threatened legislation, CSAs, CCAs, etc., we will focus here of the trends in capital. The major trends are:

  • A great degree of liquidity looking for solid returns
  • A continued escalation of the number of hedge funds seeking above average returns
  • A swelling in the ranks of private equity and leveraged buy-outs

These three taken together indicate that there is large pool of capital, all of which is looking to generate outsized gains. After all, capital which is not at work is a liability to those who control it.

The prospect of light regulations and the ease of entry into the hedge fund industry has made everyone a hedge fund manager: just like the TV ad in the late nineties,  where two people are sitting in their plaid shirts at their kitchen table saying “we used to run a hardware store, Now we’re day traders”.

The way hedge funds make money is by having superior strategies to, and acting faster than, others in the market. This gets more difficult the more high-octane strategies that are being played simultaneously. And given the high fees charged clients, high returns are absolutely required to keep these funds in business. Trouble is when performance is lackluster it becomes more difficult to drive these excess returns. But the hedge funds have a secret weapon-leverage.

Over in the private equity business, the trend to taking companies private has accelerated strongly over the past several years.  In taking out the public equity concerns of a company, the newly private company necessarily takes on a much larger chunk of debt.  According to my corporate finance text a high or rising debt-equity ratio is a bad thing, so why is it (as it was in Milken’s day) now such a good idea.  One potential explanation is SOX.

The imposition of SOX increased the cost of public entities. This raised the cost of issuing equity versus debt. On a weighted average cost of capital basis, the use of debt will, at least initially, reduce the WACC of the company and enhance the valuation of the enterprise. Again-leverage.

Private equity get paid when they take the company private and they paid when they engineer a re-IPO into the public domain or sell to other concerns within their investment timeline. One could argue that the public/private/public flip is one of the most profitable business on Wall Street at the moment.  But is it in the best interest of corporate America.

An article in the Wall Street Journal today indicated that the workout firms are staffing up in anticipation of greater demand for corporate restructurings in the coming year.

However, another option exists, the hedge fund lenders and/or the private equity leverage, could be endemic of a “loan to own” strategy by these groups.

In the current financial environment, several forms of research will be highly prized:

  • Forensics that look at the balance sheets in detail
  • Earnings Quality that look at short term obligations
  • Short Ideas that identify over-leveraged companies
  • Credit analysis firms, which look at corporate debt and equity
  • Capital structure analysis
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