To judge by the reactions of some, financial markets have gone completely off the charts, says Lex in Wednesday’s FT. Goldman Sachs says its quantitative funds experienced “things that were 25 standard deviation moves”. LBO activity, from the auction of Cadbury’s drinks unit to the sale of TXU, is said to be at risk. KKR and Blackstone have lowered their expectations for the LBO market. Meanwhile, banks have been hoarding cash, prompting the ECB’s biggest ever intervention.
“Yet, the uncomfortable fact is that by any historical standard, nothing that serious has happened”, notes Lex. “For example, in the second-last week of July, US junk debt yields jumped by 50 basis points using Lehman Brothers’ index. But since the end of 1986, a weekly rise or fall of at least 50 basis points has been seen no fewer than 37 times. Also, the idea that equity volatility is unprecedented is dubious. The S&P 500 index has lost 6 per cent in four weeks. An equivalent move in either direction has been seen 123 times since 1986.”
True, some of the price moves in specialist areas, such as mortgages, have been far more severe, acknowledges Lex. “But how could the business models of generalist equity vehicles, banks or buy-out funds be in jeopardy?”
The answer, of course, is “leverage”. Goldman’s Global Equity Opportunities fund had gearing of six times before Monday’s bail-out. This year, for European LBOs, gross debt hit six times EBITDA. Assuming typical capital expenditure levels, that implies cash flow cover of interest of 1.3 times. Europe’s quoted companies run at 10 times, Lex notes.
“This cult of debt has its origin in asymmetric pay structures that can overcompensate risk,” concludes Lex. “It has been compounded by the trend of allowing managers, whether of structured debt or private equity funds, to - in effect - value their own portfolios. The tremors of the financial superstructure show how fine margins for error now are. It is hard not to wonder what would happen if something serious – such as a downturn in US profits – occurred.”
