Private Equity Binge Smacks Of '80s Excess
The Age
Monday November 27, 2006
"WE HAVE the amazing spectacle of huge migratory balances of liquid purchasing power, swooping like vulture from capital to capital to fatten where they may. Not inaptly have the results been termed 'an anarchy of purchasing power'." (Roland Wilson, 1934, who was later to become Commonwealth statistician, economic adviser to the Commonwealth secretary to the Treasury, 1949-1965.)
There is nothing new under the sun. Wilson's generation, which saw the Wall Street crash, the Great Depression, and World War II, had a simple motto - never again. It explains the "belts and braces" approach to monetary policy that began to be relaxed in the 1980s when the economic trauma of the 1930s became more of a distant memory.Financial deregulation in the 1980s led to an increase in the number of trading banks from four to 20. Banks make their money by lending. Before deregulation, banks had to compete for deposits on the high street in order to lend. This constraint on their ability to expand their lending meant they competed through the quality of their loan portfolio. Financial deregulation meant the banks could borrow as much as they liked overseas.There were no new credit-worthy, capital-intensive, natural-resource or manufacturing ventures available to take up the lending capacity needed to justify the expansion in the financial system.In this situation, the banks competed by lowering their lending standards. The paper entrepreneurs - the Bonds, Skases et al. - who would have been shown the door if they had brought their highly leveraged takeover schemes to the banks before financial deregulation, were welcomed as profitable customers.But in the new regime, the established banks welcomed the opportunity to expand their lending and the new banks were given an opportunity to justify the expense of operating their new licences. Consciously or unconsciously, the banks engineered a speculative boom in corporate takeovers. Towards the end, no corporation, no matter how large, was safe, including BHP, which came within an inch of being taken over by Robert Holmes a Court.The speculative binge was both the cause and consequence of the sharemarket bubble, which collapsed in October 1987. The wave of bankruptcies that followed left the banks with $28 billion in non-performing loans. The pain for this was shared between Victorian and South Australian taxpayers, who lost their state banks, and the commercial banks' shareholders and customers who lost equity or paid higher margins between borrowing and lending rates.Eventually the crash led to the "recession Australia had to have" in 1990. It was exacerbated by the tax regime, which allowed an avoidance scheme tailor-made for paper entrepreneurs involving separation of income from dividends from interest expense, which allowed all the interest expense to be deductible against tax. Like all avoidance schemes, it was complex. I was responsible for the death of quite a few trees unsuccessfully trying to explain what was going on. My feelings on this are a bit like I imagine the British foreign secretary, Lord Palmerston, felt when he was asked to explain the long-running dispute between Prussia and Denmark over Schleswig-Holstein: "There are only three people who have ever understood it: one was Prince Albert and he is dead; the second was a German professor who became mad; I am the third and I have forgotten all about it." But those who forget history are bound to repeat it. The common link between the 1920s, early 1980s and now is a plentiful supply of money and a dearth of productive investment opportunities leading to an increasing search for opportunities for profit from financial engineering based on leverage and tax avoidance.I doubt if James Packer would have realised $4 billion of Publishing and Broadcasting Ltd assets or Kerry Stokes $3.2 billion against his media assets via sales to private equity groups if they had to pay capital gains tax on the transaction, because the sales are seen as "refinancing" rather than an asset sale. Similarly, the private equity holders of the assets who hope to make a capital gain by "flipping" the assets in four to five years' time rather than earn taxable dividends would not have been prepared to pay such an apparently huge premium above the market price if they knew it would be liable for capital gains tax. It is not only media laws that are tailor-made for the moguls. Legislation now in the Senate will mean that overseas investors will no longer have to pay capital gains tax on Australian investments that have less than half their assets in property. As I understand the situation, the loopholes in the tax act that allowed the 1980s entrepreneurs to separate income from expense to minimise tax still remain.The wash-up from the 1980s showed conclusively that the paper entrepreneurs didn't have any real ability to improve the underlying productivity of the assets they acquired except a largely illusory hope that their slash, burn and break up strategies would expose hidden value.But for the most part their activities were based on a willingness of financial institutions to lend without real regard for risk and a reliance on the sharemarket bubble continuing to expand until assets were divested tax free.Are the deals now being mooted also dependent on a continually rising sharemarket and a tax regime sympathetic to speculation in financial assets rather than investment in productive capacity? The big question is whether there really is value inherent in the corporations that are and will be subject to this latest wave of takeover activity that can only be unlocked by the knowledge and financial genius of the private equity groups or, as in the previous speculative wave of corporate takeover activity, what is being unlocked is the claims of the tax commissioner to corporate tax being accessed in order to finance the interest expense on the highly leveraged money used to finance the takeovers.If this is the case, Australians will be robbed twice: once as taxpayers who must make up the difference or put up with lower-quality public services, and secondly through an underperforming economy as interest rates rise and the opportunity costs of financial speculation crowd out productive investment.kdavidson@theage.com.au
© 2006 The Age