Goodbye 2006, the Year of the Deal

BATTERY POINT TASMANIA 1 JANUARY 2007 - 2006 was clearly the year of the deal. The Australian mining sector alone saw $145 billion in deals. According to Friday’s Australian, investment banking firms did nearly 3,000 buyouts or mergers in 2006, with the top ten firms doing nearly $166 billion in deals.

So what’s next? Has all the low-hanging fruit been picked? You’d think all the obvious deals have been done by now. With the cost of capital low, any under-valued firms with reliable cash flow have already been targeted. There are only so many firms where you can cut costs, find synergies, or operate more efficiently so that you generate a 15-20% return on your investment in a few years. Now that the big fish have been taken, it’s time to look for littler fish.

It’s a bit different in the mining industry, where the M&A activity is more typical of the resource cycle we know and love. Cashed-up big firms look to acquire smaller firms in order to ad to productive capacity and the resource base as underlying commodity prices rise. There are two questions here. Are base metals and resources prices in for a rest? And how much more M&A activity will we see in the mining sector?

To answer the first question, base metals and resources may take a breather. But don’t count on it being long. In the big, big, big picture, Chinese, Asian, and even eventually Latin American and African demand are behind the resource boom. After all, we’re talking about a revolution in the living standards of three to four billion people. That’s a long-term trend with plenty of legs.

In the short term, companies like Zinifex (ASX: ZFX) and Oxiana (ASX: OXR) may find themselves the target of foreign and domestic overtures. There will be other targets. But even with money flowing so freely, doing proper diligence and careful valuation will be more important. Mining is notorious for unpredictable cash-flows, price volatility in the underlying commodity, and heavy fixed capital costs. Those are not the attributes private equity firms typically look for, which is why most mining M&A activity will take place within the industry, by people who know what they’re doing (and not plundering pirates.)

That doesn’t mean you won’t see the private equity boom tail off. But it will probably head in a different direction. Somewhere north, like Asia.

In today’s New York Times, Timothy Dattles of Texas Pacific Group (involved in the Qantas deal) says, “Asia clearly offers long-term potential as a private equity market.” It will be interesting to see if the money-shufflers can do anything but gamble on Asian enterprises. But give the man credit, he talks a good game about Asia’s economic future.

Dattles says, “The great enterprises of the next 100 years are being built today in some of these markets, like China and India. And there is a role for global players in private equity, who bring in the management expertise, the experience in international markets, to partner some of these companies and help them create value and realize their potential.”

Can the pirates teach Asian capitalists how to be better capitalists? Or is this simply a recipe for economic disaster? The Times article continues, “private equity firms have encountered some resistance because of a mixture of nationalist sentiment against foreign ownership, suspicions about the desirability of private equity firms as asset owners and a maze of regulations or policies affecting foreign investment in some industries.

“Texas Pacific had a taste of those difficulties this year when its bid to buy PCCW, the Hong Kong telecommunications company, was rejected because Beijing did not want a strategic asset to fall into foreign hands. The concept of private equity is not always an easy sell in Asia, where companies are often conservatively managed and where some governments see businesses primarily as vehicles for nation building. Moreover, many Asian companies are family firms committed to providing wealth for future generations.

Will 21st century Asian capitalism work the same way as 19th and 20th century Anglo-Saxon capitalism? Will Western business culture find itself in conflict with local traditions and cultures in India, China, Asia, and elsewhere? We asked these questions after our three-month tour of Asia in preparation for writing The Bull Hunter in 2004.

Our answer? There are some attributes of capitalism which have to remain the same everywhere. You need a price, a seller, and a buyer. But the virtue of an open-market is that it is supremely adaptive and can support many local variations. The business culture that emerges in China and India will be distinct from what prevails in New York and London. But at the end of the day, it will all be about the same thing: money. And that’s where the opportunity lies for retail investors.

There are more euros in circulation in the world now (around $800 billion) than dollars. Does this mean the greenback’s day of reckoning has arrived? Not quite.

What people use for cash in real exchanges does matter, of course. The dollar is still used in flea markets, drug deals, and strip joints all over the world. But it will take some doing before the euro replaces the dollar as the currency of choice for derivatives transactions.

Under New Monetarism (the theory which explains the source of global dollar demand), the strength of the dollar is not what is seen, but what is unseen. It’s not the dollars you can put in your wallet that matter. It’s the dollars created from nothing in order to buy and sell derivatives and securitized assets.

Of course we don’t see any reason why you couldn’t price those assets in euros too. If you’re creating something for nothing, why not euros as well as dollars? But for now, the dollar is the favoured currency in which financial assets are priced, by a large margin.

The dollar’s day of doom is coming. But we’ve developed a grudging respect for the greenback in the last few years. And just because something logically should and probably will happen, doesn’t mean it will happen right away. “There is a lot of ruin in a nation,” Adam Smith wrote. There is even more ruin in a currency Empire. But that’s fine with us. It’s just more time to buy gold and real assets.

Wild Oats XI cruised into Sullivan’s Cove late last night and pulled up alongside Constitution dock. There was something electric about watching a ship come in from sea. We can only imagine what it must have been like one hundred years ago, when sea-faring was more dangerous and the principal way of getting to plays like Hobart.

It’s not that sea-faring is inherently safer today. The waves are still huge. The water just as cold. The rocks just as unforgiving. But the equipment surely must be better. At 30 metres, the winning yacht is nearly twice as long as the Lady Nelson, a replica of which sails out of Hobart to please tourists like your editor. The original Lady Nelson was the first ship to sail west to east through the Bass Straight in 1800, a much less leisurely voyage than her replica makes today.

We walked around the marina early this morning admiring Wild Oats XI, Skandia, and Ichi Ban, the top three yachts in the race. Skandia is also a huge vessel, at nearly 30-meters, and with a mast that reaches to the sky. We read on the mast http://www.composites.com.au, which we later checked out.

It’s an Australian company making components for sailing vessels from high-tech composite materials like carbon fibre. To think that in the original scheme of things, the British hoped to find large pine trees in Australia that they could use for the masts of their famous sailing ships. The only place they could find tall pines was Norfolk Island. But Norfolk Island was not exactly friendly to settlement, and the Lady Nelson herself was used in the evacuation of the island’s settlers here to Hobart.

Since it is Friday and the last trading day of the year, we were tempted to join the crew of Skandia for a beer. We saw them revelling outside the Custom House Hotel at the corner of Murray and Morrison Street. But it was just past 7 in the morning, so we figured we’d better reckon first.

Finally, from all the crew here at the Daily Reckoning Australia, we wish you a safe and Happy New Year. Thanks for your patience, support, and attention in 2006. We don’t know what 2007 holds, but we’re pretty sure it will be a lot like all the years before it…a study of the actions of crowds, ideas, and capital.

We’ll leave you with this quote from the prologue to “Foundation and Empire,” volume two in Isaac Asimov’s Foundation trilogy. It somewhat describes what we are up to here at the Daily Reckoning. “Psychohistory dealt not with man, but with man-masses. It was the science of mobs; mobs in their billions. It could forecast reactions to stimuli with something of the accuracy that a lesser science could bring the forecast of a rebound of a billiard ball. The reaction of one man could be forecast by no known mathematics; the reaction of a billion is something else again.”

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