Merlin Weekly Macro: When smart finance leads to stupid outcomes

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As a constant source of material in these weekly musings, for good or ill Donald Trump is the President Who Keeps On Giving. But sometimes he leaves us all exhausted and even this author needs a breath of fresh air and a diversion. Courtesy of Pakistan brokering a temporary-potentially-but-unlikely-to-be-permanent ceasefire with Iran, we have been granted just that: a brief reprieve not to talk about Donald Trump.

It is not often that we stray from macroeconomics and geopolitics into the world of high finance. However, this week we are going to explore corporate dysfunction and failure and when markets and the financial communities themselves contribute to it.

NCP: a short tale of corporate collapse

Just before Easter, walking from the railway station in Grantham from the London commute, your correspondent was confronted by a big banner across the adjacent NCP car park. It shouted, “FREE PARKING TODAY”. Only days before, NCP had gone bust. On March 16^th the company was placed in the hands of administrators PwC pending a sale, dismemberment or the financial last rites. Today, still in administration, it remains functioning albeit 22 lossmaking and unviable sites were closed immediately leaving 318 of its car parks open for business, even if its Grantham plot had temporarily become a charity (a new sign tells me that it is already under fresh management with Euro Car Parks).

With an often captive market and seemingly egregious charges, NCP was a business that should have been a licence to print money. But circumstances changed: shopping habits and post-Covid working practices altered demand for parking; rising employment costs and the need for technological innovation added to cash outflows; finally, the company famous for its opportunism finding cheap former wartime bomb-sites and derelict land for parking, was increasingly at the mercy of expensive, complex, inflation-linked leases on high value properties which it did not own. The financial elastic band snapped.

On a cradle to grave corporate life cycle, Wikipedia tells us that after being independent for decades, NCP then had a series of owners. They included US company Cendant (1998-2005) itself now defunct; UK private equity investor 3i owned it from 2005, hiving off the off-street parking operations in 2007 to Australian infrastructure specialist Macquarie. In 2017, Macquarie jobbed the business on to a Japanese consortium, Park24/Development Bank of Japan. At the time of the disposal, Martin Stanley, Global Head of Macquarie Infrastructure and Real Assets, said, " We have worked with the management team over the last 10 years to ensure that NCP is in the best possible position for continued growth.” Misplaced optimism: within three years the seeds of its demise were germinating; within a decade, it was under the Park24/DBJ aegis that National Car Park’s corporate wheels fell off.

Market myopia and a confusion in terminology

That reference to pass-the-company-parcel, unwrapping it a little more every time the music stops, got me thinking back to the bad old days of the late 1990s and early 2000s before the Global Financial Crisis.

Sell-side financial analysts, investment bankers, fund managers and management consultants collectively discovered the concept of corporate balance sheet efficiency. Reducing the emphasis on how effective companies might be at being busy selling goods and services, innovating and investing to sell even more and making and improving profits from which dividends might be paid to shareholders, balance sheet management became all-absorbing. Financial experts worshipped financial acronyms such as WACC (weighted average cost of capital), ROIC (return on invested capital) and EVA (economic value added).

In assessing the value of a company, such concepts were so much more sophisticated than old fashioned PE ratios (Price/Earnings: essentially the number of years for an investor fully to recover the annual earnings per share in the current share price) and even DCF (discounted cash flow, in isolation a largely pointless exercise as a predictor given how much of the net present value calculated on such a basis is in the terminal value of projected future cash flows, usually 10 years out, so far into the future as to be no more than guesswork: depending on the discount rate applied, DCF will give you whatever answer you need; where it can be of great value is understanding the sensitivity of the share price to changes in assumptions, especially varying the company’s rate of sales growth, flexing the operating margin and using different discount rates to see how much the NPV changes in each case as a result).

But back to WACC: if equity was highly priced and debt was relatively cheap, the sages said the best way to reduce the weighted average cost of capital was to ‘gear up’. The premise was based on a fatal confusion between ‘cost’ and ‘rate’. Given companies are not allowed to distribute permanent equity capital (other than in a controlled and legally limited way through share buybacks), they were simply encouraged to borrow more ‘cheap’ money. And more. And more. Woe betide the conservative company with a balance sheet carrying net cash (therefore deemed highly inefficient): to avoid the market ‘derating’ the shares (i.e. meting out punishment with a lower share price, or not according it credit in the valuation to reflect progressive financial performance), such companies were put under great pressure a) to get rid of the cash, preferably through reinvestment in acquisitions and b) to replace it with borrowings.

Unravelling the corporate warp and weft…

Directly linked, as complex derivatives developed, was the concept of ‘securitisation’: markets reckoned almost any form of corporate asset or cash flow could be extracted, aggregated, chopped into identical tiny pieces (securities) and issued as tradable instruments (similar to shares or units). Fixed asset securities could be offered using the company’s land, buildings and capital equipment as collateral (hence Mortgage and Asset Backed Securities). Companies could even securitise their inventories (the stock of goods they would hold to sell to customers), debtors (people who owed them money, a process that used to be known as ‘factoring’) or any other cash streams that moved.

Balance sheet optimisation also led to the development of what became known as ‘OpCO/PropCos’: splitting the company’s operational activities from its supporting infrastructure (e.g. retailers from their shops, brewers from their pubs etc); the PropCo might also easily divest its newly assigned fixed assets on sale and lease-back arrangements to free up capital. Thus, the thinking went, by the simple mathematical expediency of improving the numerator and reducing the denominator, if the whole operation became more streamlined and profitable while at the same time reducing its fixed assets and the financing cost (for which read ‘rate’) of supporting the company, therefore its capital employed was lowered and it bumped up its Return on Invested Capital. Endorsed by shareholders, executive management teams’ remuneration packages often became linked to improving ROIC. What was not to like?

…leaves a company full of holes

Fool’s gold! Once a PropCo was divorced from its OpCo, the business was open to self-induced asymmetric risk. It was increasingly not under management control while at the same time becoming more susceptible to events beyond management control. The PropCo could sell its assets to a third party leaving the operating company hostage to expensive rents on the properties essential to the running of its business. Equally, when a company factored its debtors or securitised its inventories, then someone else was a) in control of its cashflow and b) taking a cut from it. What had been a homogenous ‘company’ would in its literal sense dis-integrate. Yet it was still expected to function as normal despite indebtedness often being pushed way beyond the levels it would normally require apparently to reduce the weighted average ‘cost’ of capital.

Logic said this was so much tosh and nonsense. For those of us brought up in the era of quill pens for writing, and squared accountancy paper, pencils, rubbers and eight fingers and two thumbs for financial modelling, and Terry Smith’s indispensable financial bible “Accounting For Growth (The Book They Tried To Ban!)”, such financial chicanery was both mad and bad. But we were dinosaurs and has-beens. This was the new modus operandi, the sophisticated financial paradigm also providing a new rich seam of investment banking fees.

It was toxic. Even today, the chickens are still coming home to roost.

Darwinian principles but not at any cost

In the financial world, Darwinian discipline is essential to the efficient allocation of capital; badly run companies must be allowed to fail. Inefficient or unproductive capital should be recycled into more efficient businesses with the vision to expand and contribute to the growth in national wealth. In the quoted corporate sector, the role of active fund management both in owning and stewarding companies is immensely important (aspects to which passive investing contributes little or nothing). So too the constructive challenge from the hedge fund and private equity communities with their different perspectives on value creation to keep us on our toes and to prevent complacency and inefficiency. This is the natural order of things of trying to keep ahead and match fit in a competitive capitalist world.

But the pendulum can swing too far. Blindly chasing maximum efficiency rather than pursuing optimal use of capital can sometimes do more harm than good. History says that the period described above was an act of considerable corporate harm. Very bright people on both sides of the investment fence had little understanding, were careless even, of how companies worked in practice and how sensitive those businesses could be to casual financial re-engineering. Instead, they saw them almost as insulated and isolated academic exercises in financial modelling on tidy computer spreadsheets. It was stoked by the seductive potential for the realisation of easy short term gains. In many cases, misguided management teams were complicit.

GEC. RIP. QED.

In the UK, the biggest and most notable casualty of such misplaced ‘enthusiasm’ (which rapidly became egregious corporate vandalism through the agency of a new and aggressive management team with a mandate to break up the old company and acquire new businesses), was GEC. The General Electric Company was a long-standing world class British electronics and defence conglomerate with over three billion pounds in cash in the bank (a considerable sum thirty years ago), built and grown over decades under the canny, conservative stewardship of its chairman Arnold Weinstock. Conglomerates were increasingly perceived as lazy, lacking focus and inefficient. Following Weinstock’s retirement in 1996, through a series of disposals and bad acquisitions one of our biggest, richest and most strategically important companies was reduced to debt-riddled corporate rubble in next to no time.

GEC was a national corporate treasure. Its pointless sacrifice on the altar of Mammon is an important lesson to us all in the financial industry and the corporate sector. As a case study, GEC should be required, repetitive annual reading for every financial analyst, investment banker, fund manager, management consultant, company chief executive and finance director. It serves as a reminder that sometimes we can lose our collective marbles and be too smart for our own good.

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