Friday, January 27, 2012

Learn from private equity investors!

In a nutshell, 4 out of 5 private equity investors operate as follows (assume that the purchase price of the target company is 100 units): (1) form a NewCo (a new company which will be the purchaser); (2) capitalize NewCo with, say, 30 units; (3) take up debt in the NewCo of 70 units; (4) have NewCo pay 100 units to the seller as purchase price for the target; (5) merge NewCo with target so that the resulting combined company has 70 units of more debt than before and a lot of goodwill on the asset side.

Two major skills are required of the private equity investor in order to be successful: he must know how to assess the value of a company so that he doesn't overpay; and he must know how to structure debt in such a way that it can be serviced in a manner acceptable to lenders. This is where intelligence and, above all, creativity are required ("financial engineering").

Typically, the new merged company is in no position to service the new level of debt in the traditional form (i. e. paying interest on the entire debt from the start and making linear annual instalment payments of principal from the start). Thus, financial engineers need to become creative. The classic tools are:

(a) make as much of the principal as possible due at the maturity of the loan and move that maturity as far into the future as possible. In the case of sovereign debt, this is accomplished through the instrument of public bonds which, normally, are due in one payment on maturity.
(b) determine how much cash will be available for interest payments and translate that amount into the "cash interest rate". Since the company is unlikely to have enough cash for the entire interest, the rest of interest must be capitalized.
(c) implement an excess cash-flow covenant which means that should more cash become available than projected, that extra cash will be used to reduce capitalized interest.

Will the company be able to repay all its debt by maturity? No way! Why do banks still make those loans? Because the expectation (and practice!) is that the company will be sold again and that the new buyer will pay out all existing creditors. Is that a Ponzi scheme? Sometimes yes, but not always. If the new buyer is a strategic investor who incorporates the company into his overall business, the Ponzi scheme has been brought to a successful conclusion.

The Greek debt problem has so far been characterized by the complete absence of financial creativity! All that has been done so far was to repay maturing loans with new loans and replace old interest rates with new interest rates. Period! Sorry, some creativity was applied to the PSI but that's the wrong thing to apply it to. And a lot of creativity was applied by third parties outside Greece between themselves by buying below-par assets and insuring them at par. If it were not so sickening, one would almost have to respect the hedge funds for their creativity in dealing with the March bond maturity.

One should learn a bit from the financial creativity of private equity investors. The most important variable is the amount of cash interest which flows through the budget (interest which is accrued and/or capitalized does not flow through the budget until it is paid in cash).

A fixed interest to be paid in cash generally doesn't work in restructurings. One has to work with variable interest rates and with the instrument of accruing/capitalizing interest.

One could, for example, say that 5% of government expenditures will be allocated to interest (today, interest amounts to about 15% of Greece's government expenditures). Depending on how government expenditures develop, this might translate into a cash yield for creditors of, say, only 1% whereas the creditors require 4%. The difference of 3% would be capitalized during the period of restructuring of, say, 10 years.

An "excess cash flow covenant" could be structured in a variety of ways: should the budget be balanced more quickly than anticipated, one could increase the interest allocation from 5% to, say, 8%. Or one could tie the interest rate/expense to the development of the economy. There are no limits to creativity when it comes to structuring finance.

One could, of course, call Goldman Sachs for help. Or one could ask Greek students of economy to come up with some creative proposals. Who knows? The Greek students might be so creative that they not only come up with workable solutions but also get job offers from Goldman Sachs afterwards...

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