• Home
• /
• Business

The good news and bad news

As General Motors celebrates, Ford and Chrysler are experiencing a headache that has nothing to do with vehicle trading. This is especially true as Ford has finally reported an unexpected profit after seven consecutive quarters of losses.

The dangers of acquisition

Last week I wrote briefly about the difficulties and dangers that accompany mergers and acquisitions. One aspect of the acquisition trail that I lacked the space to focus on last week was the Leveraged Buy Out, (LBO). A leveraged buy out occurs when an investor — such as a private equity fund — acquires the equity of a company using a significant amount of loan capital usually offering the assets of the acquired company as collateral. To put that in simple terms, I buy your company by saddling it with considerable additional debt.

An LBO enables private equity fund management to fund the purchase without putting too much of their own money on the table. In the early days the norm was for approximately 30 per cent of the cost to be in the form of cash with the other 70 per cent being raised from banks in the form of loans. Recently these ratios have tended to change with as much as 95 per cent being in the form of loans in extreme cases.

The intention is that the acquired company, in spite of its new and heavy burden of debt, will so improve its processes and management that within a few years its market value will have increased so that the indebtedness can be discharged and the company sold at a massive profit. Meanwhile the new owners enjoy major bonuses and tax advantages from "their" investment.

The bad news

In times of economic growth the system works very well, but when cash gets tighter there are problems. In the last week some 35 debt transactions were either restructured or cancelled and that could be bad news for Chrysler and Ford — not to mention Daimler Benz.

Having failed to make the very expensive acquisition of Chrysler work, Daimler have being seeking to offload the US car maker at almost any price. Chrysler assets and markets made it appear to be a bargain at the price that Daimler were willing to accept to relieve them of a considerable burden. The bargain attracted the private equity firm Cerberus Capital Management who are putting together some $12 billion to acquire Chrysler, but the bad news is that the banks, in a more difficult economic situation, have been unable to persuade investors to raise the necessary funds. Management state that the deal is "still on track", but what, only a few months ago looked like a real bargain purchase is now subject to doubt.

It is in this increasingly volatile situation that Ford Motor Company has decided to divest the European luxury car makers, Jaguar, Volvo and Land Rover. Interest in the three companies has been strong, but that does not mean that as cash in Europe and the USA becomes tighter the sale will be carried through without problems. Although if, as is rumoured, Tata Motors of India is seeking to acquire Jaguar and Land Rover all may yet be well.

Beyond automotive

As 35 restructured or cancelled debt transactions show things are becoming less easy. Deals that remain on course have needed to be "sweetened" to retain their attractiveness in a changing situation. The "buy out boom" is showing signs of slowing.

On Wednesday last Kohlberg Kravis Roberts, (KKR), possibly the world's most adventurous — and successful — private equity firm withdrew the sale of $10.3 billion in loans that was earmarked to enable the sale of Alliance Boots, the British retail pharmacy chain. Times are getting tougher even for those that appeared at one time to have almost found a licence to print money with little risk.

The markets have tightened in recent weeks as a result of growing economic uncertainty, signs of rising inflation and increases in interest rates in Europe and the USA. A world that was recently viewed as being awash with cash is now becoming just a little more circumspect. As recently as April things were so much easier. Cerberus had no difficulty in raising the $7.5 billion in loans that they needed to take a 51 per cent stake in the financing arm of General Motors.

Asia

With rapidly expanding economies and massive opportunities Asia remains a relatively happy hunting ground for private equity firms determined to use debt to acquire businesses and profits. In general Asian investors have been more cautious than those in the West, taking, for example a more searching and realistic approach to collateral.

The providers of capital that enter the market with care are managing the risk better and are less likely to take precipitate action.

The future

The difficulties being experienced in the West by private equity firms may prove to be more a matter of sentiment than substance. A House of Commons Committee recently invited leaders of private equity firms to appear before it and justify their perceived excessive incomes from LBO's.

The assumption of the politicians seemed to be that high incomes allied to high debt simply weakened the companies that had been acquired. The same has been claimed by the many critics of reverse leveraged buy outs (RLBO's is the process of taking the acquired firm back to the market either by selling it to a corporation or by way of a new or initial public offering.)

Research by Harvard Business School suggests that conventional wisdom has it wrong. "Reverse LBO's seem to consistently outperform other IPO's and the market as a whole."

Comprehensive research shows that they have done better than most throughout the mid 1980's, 1990's and 2000's. What is more, "There is no evidence of deterioration in performance over time".

The current difficulties may prove to be little more than a blip, but there is another lesson in the saga of Daimler, Chrysler and Ford.

The very fact that these corporations are anxious to divest acquisitions and mergers that were made at great cost underlines the basic fact that I expressed last week. Mergers and acquisitions often fail. But a thought strikes me.

Could business managers have a lesson to learn from the money men concerning the improvement of processes and management talent and skills? Perhaps the "private equity pirates" have it right after all. Meanwhile as I write the world's stock markets have experienced what may be catastrophic falls of between two and three per cent that could be leading to a bear market or that might be simple over-corrections that will bring back the "bull" as traders gobble up bargains. Only time will tell. A similar correction happened in February that led to record levels by June, but the signs are still suggesting that we proceed with great care. Just as the nay-sayers sighed with gloomy satisfaction growth data for the second quarter in the USA were published at 3.4 per cent — the best figures since the 4.8 per cent in the first quarter of 2006. As the Chinese say when they want to worry you, "May you live in interesting times".