Private Equity or Pirate Equity – What Would Borat Say?

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We have been investigating the idea of private equity the past few weeks, looking for an investment angle. Avast! We think we have one! Full speed ahead! But first we should go right full rudder and ask a question: what is this new predatory phenomenon in the markets?

Private equity—or pirate equity as we privately call it here at the Old Factory—is really just an old idea dressed up in a new pirate costume. In its report yesterday, the Reserve Bank of Australia compared pirate equate with its predecessor—the leveraged buy out. What do both have in common? Debt. That is what has the Reserve Bank Concerned.

pirate_equity.gifWe have posted more on this here on the Daily Reckoning blog. There is all sorts of good stock market and financial booty there, including an elaboration of this RBA point, “LBOs typically result in a significant increase in the gearing of the bought-out company, potentially making it more sensitive to economic fluctuations. In recent years, for example, LBO deals in Australia have often resulted in the bought-out company having a debt-equity ratio several times higher than before the takeover. Companies which consider themselves under threat of an LBO may also gear up in defence.”

Whether a public company can defend itself from a pirate equity firm by increasing its own borrowing (gearing) remains to be seen. But as we watch the battle play out, one thing is clear, corporate raiders have abandoned the ship the junk bond market for the sleek contours of this new financial vessel. They’ve gone from Man-o-War to a one-masted, faster-moving sloop, as befits the pirates they are.

Using a lot of borrowed money, pirate equiteers seize a sizable equity stake in a publicly listed company. It is business leverage acquired with financial leverage, but leverage nonetheless. A little leverage in the right place can go a long way, as Archimedes suggested. And with leverage, private equity firms can force changes in corporate policy direction that either “enhance shareholder value” or “extract hidden balance sheet value.”

You can think of these firms, if you’re in a generous mood, as marquee sports coaches like say, Guus Hiddink. You bring them in for a short period of time to boost the performance of an otherwise underachieving set of assets. The long-term doesn’t really matter. It is the short-term championship you are gunning for.

In the financial markets, it’s the short-term gains the private equity firms are after. Of course, you wouldn’t think even a scheming private equity firm could make money by destroying a company’s long-term prospects. But there are ways of disguising the damage debt does to a balance sheet. Just think of all the tricks estate agents use to make a home appear sturdier and more valuable than it actually is and you’ll get the idea.

Is pirate equity a bad thing, then? We make no moral judgments. But we see it for what we think it is—a powerful tool for the super elite to make greater-than-average returns from the stock market. It is better than a hedge fun because it’s concentrated on “extracting” or “creating” value on a case by case basis. You don’t have to beat the market. You just have to turn around a company or squeeze more blood from the corporate rock.

If it’s a good deal for the super elite, what about the rest of us land lubbers? Well, there’s nothing terribly exotic about how a pirate equity firm identifies its next target. The captains of these funds look for distressed assets that produce regular cash-flow. You can find these companies in ten minutes with a simple stock screen and the right variables. Today, you’d find airlines.

There are many other examples. But in principle, it wouldn’t be hard to trail the pirate equity funds and follow them to their next target. After all, the wind is the wind, and it blows us all in the same direction. The only difference is the size of your sail and the shape of your hull. Even if you’re slower, with a good set of maps and a good captain, you can figure out where the funds are going, before even they get there. More on this the coming weeks my pretties.

By the way, Admiral Arthur Phillip, who led the first fleet to Australia, fell in love with Sydney cove–which as not yet named Sydney cove—because it was, in his words, “the finest harbor in the world, in which thousand ships of the line may ride with the most perfect security.”

A “ship-of-the-line” was a war ship with three masts and two full gun decks. It was the power powerful strategic weapons system of its day and gave the English the ability to project force all over the world and control the world’s shipping lanes.

One of those shipping lanes, the Straight of Malacca, is even more important today than it was then. And, if you can believe it, is still vulnerable to modern-day piracy. According to my friend Chris Hancock, “Maritime shipping still serves as the world’s economic circulatory system. This business connects the world in ways technology never will. Roughly 90% of the world’s exports still are transported by ship. And no other shipping lane on the planet is more essential to economic growth and stability than the Malacca Straits.”

“Bypassing this waterway,” he continues, “would force a ship to travel an extra 994 miles to reach most destinations. In the words of the [U.S.} Department of Energy, ‘If the strait were closed, nearly half of the world’s fleet would be required to sail further, generating a substantial increase in the requirement for vessel capacity.”’ Consequently, any disturbance to the Strait’s regular shipping flow would come at a great economic cost.”

The biggest cost would probably be more expensive oil, considering that nearly all of Asia’s oil imports from the Middle East must come through the straight. This is why it’s rightly identified as one of the world’s crucial “oil chokepoints.” [Editor’s Note: More about the world’s oil chokepoints here.]

But there are other costs too, as Chris points, out, “According to Foreign Affairs, ‘To block this specific sea-lane, the consequences for the global economy would be severe: a spike in oil prices, an increase in the cost of shipping due to the need to use alternate routes, congestion in sea-lanes and ports, more expensive maritime insurance, and probable environmental disaster.” Shiver me timbers!

It occurred to us last night that something is perverted about a modern economy when reasonable people spend so much time talking about interest rates. It is a symptom of how financialized our lives have become, and how credit, like a fungus, slowly infects and covers everything around it. Surely it wasn’t always this way. But the world is absurd. Why not turn to an absurd man for commentary?

Take Borat, What would he say? What movie would he make about Australia? How about “Financial leanings of Reserve Bank for Make Benefit Glorious Profits of the Commonwealth Bank of Australia?”

Commonwealth Bank of Australia (ASX: CBA) raised interest rates on its cards by a whopping 50 basis points last week, twice the RBA’s 25 basis point rise. At least we finally know who is serious about curtailing credit use in Australia—or at least profiting from it.

Penultimately, we have a suggestion for those civic-minded DR readers who view voting as a precious right and serious civic obligation, the donkey ballot! One of the things we love about moving to new countries is learning a new language, and Australia has been a pleasant surprise. From what we can gather, the “donkey ballot” is when you simply number the ballot from one to whatever as a protest vote. It’s a valid vote, and your civic obligation is fulfilled.

More importantly, you don’t actually vote anyone into office. The more we think about it—and think about it honestly—there is only one civic duty we take seriously, jury duty. Though we don’t know if it’s part of the Australian constitution, a trial by a jury of your peers seems like a serious obligation to us. Juries aren’t perfect. After all, they are really just small democracies, but with some important improvements.

For example—and we’re relying on our secondhand knowledge of the American legal system here so forgive us if we’re wrong—in a criminal case where the defendant’s life is as stake, a jury’s verdict must be unanimous. In a civil case where the remedy is merely financial, a majority will do.

In both cases, we would rather take our chances with a good trial lawyer and a jury of our peers than with the arbitrary power of a judge, even an elected judge. The jury trial takes justice out of the hands of the monolithic state and puts in the hands of the moronic public. The public can be just as unforgiving and cruel as the State. But at least morons can be reasoned with, manipulated, and in desperate cases, bribed. There is no reasoning with the State, only bribery, and we don’t know what a Federal judge goes for these days, but it’s probably beyond our means.

That brings us to our new philosophy/slogan on civic duty: Do your jury duty! It is better to put criminals in jail from a jury than in public office through a ballot! We will have t-shirts printed up and distributed the morons protesting the G20 summit this week.

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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