The implicit ‘Fed put’ on virtually all financial assets has ushered in a whole new risk paradigm and the mind-numbing amount that has been allocated to this ‘noble’ cause has left me gasping for breath. The pandemic offered politicians an excuse to pump in more monetary gasoline and the central banks have hardly played coy since the 2008 global financial crisis. Enough has been said about the money printing that has been going on in America, the EU and Japan. The latest installment makes me wonder if socialism is making a backdoor entry into the so-called capitalist societies. Emerging markets are not far behind in artificially suppressing interest rates or printing money. And, cheap money leads to all kinds of self-enriching financial adventures, including trivialisation of debt.
Of the many, two caught my financial-roving eye. One is the latest government-sponsored Infrastructure Investment Trust (InvIT), and the other, a failed, hostile attempt by one of the biggest banks in the world to corporatise a highly profitable ‘NGO’. Let us start with the former. It was music to my ears when, a few months ago, the government paid heed to my thought process which suggested various measures to enhance shareholder value of listed PSUs. Amongst the slew of measures announced, they also decided to ‘convert’/‘demerge’ some annuity assets of listed PSU companies into an InvIT. First off the block are power transmission lines owned by Power Grid. It is a different matter that some assets, which are not annuities, have been packaged as such and sold to gullible investors (covered in my attempt to understand InVits) in the past. This one, however, can well and truly be classified as an annuity asset. Even though this is the first government-sponsored InvIT, the first in the power transmission space is owned by non-government unitholders.
While evaluating the latest entrant, I thought of looking up the existing one first. It was quite astonishing to note that the non-government InvIT keeps rewarding its unitholders with ‘distributions’ while loading it with ever-increasing dollops of debt, hardly paying any taxes and not repaying any loans. Thank God, it at least services its debt with interest. So, the traditional way in which future free cash flow (FCF) are discounted to arrive at fair value seems to have changed dramatically. If the principal amount of debt is not to be repaid, then the FCF goes through the roof of any business that has significant debt.
The icing on the cake is that it has convinced the government to exempt it from paying taxes under the garb of promoting such a structure for the public to take advantage of its benefits. So, true to the sublime creativity of these investment bankers, Ebitda becomes the focal point of every valuation exercise. Just provision for miniscule interest and you get FCF. Sounds magical but that’s what KKR (co-promoter of the private InvIT) has managed to pull off. Depreciation is supposed to be a non-cash item and, therefore, ignored in FCF. Debt repayment is also apparently ignored since it is to be refinanced, not repaid, whenever it comes due. There would be plenty of takers for such debt in an interest rate-starved world.
In the traditional framework, which perhaps is now considered archaic, the order of claims on the income of any enterprise was as follows: lenders, government and then shareholders. This intuitively makes logical sense, too. Also, historically, an asset-liability mismatch was supposed to be a risk which was supposed to be discounted, sometimes significantly. History is replete with disasters that have occurred in cases of such a mismatch. But, this ‘lab-created’ animal (InvIT) turns traditional theory, logic and the ensuing dynamics on their respective heads, and that, in turn, has got me scratching mine.
So, this InvIT has roughly five years’ liability (debt), and assets of 25 years. Traditionally, as such assets were long gestation and non-lucrative for private lenders, not much long-term debt funding was available and therefore, the government had to take it upon itself to develop these ‘Public Goods’. But now, with InvITs, this presents a dream risk: reward for any entrepreneur, at least until the lenders awaken to the risk in it, or till the time the taxman wakes up. Because, if for some reason the cash flows dwindle, or refinancing doesn’t happen, or interest rates go up significantly, all of which have a half-decent probability in the next few decades, we may have another mini IL&FS brewing. We are already seeing unitholders licking their wounds in the roads InVit which I wrote about. I just hope the rot is not as deep to affect the lenders.
Awaiting the greater fool
Moving on to the next development. On the one hand, I have been a bit baffled by how and why certain businessmen are allocating a substantial part of their wealth to charity while on the other, some non-profit organisations are making substantial money. These blurring lines are visible in the annual accounts of many start-ups in which the profit/loss statement is a sea of red, and the balance sheet has negative networth, but their private market value climbs by leaps and bounds every quarter. Profit does not seem to be the criterion. The more loss you generate, the higher the value you have supposedly created for the subsequent round of funding. Basically, the P/L has been rendered irrelevant. The assumption is that the idea shall become the next FAANG (Facebook, Amazon, Apple, Netflix and Google) since it shall be a monopoly and the entry barrier is so high (the amount of capital burnt) that nobody else would venture into it. Then, the monopoly shall milk the cow forever.
I am unable to digest it as of now. I must surely be missing something, and I shall share my thin wisdom when I get some answers from my ongoing quest. But more importantly, the blurred lines — between losses and assets (intangible), public good and a private enterprise, trust and corporate (the type of entity and the activity it does being out of sync) — and the various components of the capital structure with all types of instruments floating around are complicating matters. This can be said with respect to the basic assumptions associated with the respective nomenclature, even though it seems as if all these are used primarily to dodge taxes and regulators or very simply, to dupe the holders of such instruments (remember perpetual bonds, CoCo bonds and such?).
Now, back to the other financial absurdity that I mentioned earlier. In a shocking and first-of-its-kind move, JP Morgan made what can be termed a ‘hostile bid’ on presumably the most lucrative part of the biggest sport in the world. Currently, most sports governing bodies work as an NGO with nobody really being the owner but just a manager who enjoys perquisites. Despite FIFA’s suspect policy with respect to choosing sub-standard Asian teams over top-class European teams to play in the World Cup (under the garb of promoting football but to encash a lucrative untapped market) or being corruption-ridden when choosing the host nation for the World Cup, the money involved has kept growing. The enticed bankers at JP Morgan finally decided to test the waters and came up with a novel scheme to swoon away the top European teams into a ‘Championship’ of their own by tempting the clubs and the players with a higher prize/pay. By brokering such a deal, the bank imagined it would take away the most lucrative chunk of FIFA and feast on all the revenue from exclusive rights. The glitch, however, came from the fans; so much so that in a particular country, even the prime minister rose to their defence!
Looking at the profit/loss statements of the top clubs, some of them make decent profit, and have a reasonably strong balance sheet in the traditional sense. Some of the biggest ones, however, do not make a lot of money and are neck-deep in debt, but their equity value has only gone up year after year. I took a mix of six clubs from the English, Spanish, Italian and French League. While their combined revenue was a little short of €4 billion, their combined net profit was about €100 million, and their combined equity value was more than €6 billion and combined debt was €6 billion. Over the years, most of these clubs’ revenue have been inching up. Their operating profit is going up and the number of fans on social media is growing. Conveniently, these are the parameters that the clubs focus on and so do the likes of KPMG and Deloitte while assessing how valuable the clubs might be.
However, the two parameters that are swept under the carpet are debt and net profit. The debt is split into five components viz. financial debt (long term), transfer debt (on player’s transfer), staff debt (salaries payable), tax debt (tax payable) and creditors’ debt. It is quite astonishing that the debt is split into such components, and out of this, hold your breath, the long-term debt is ignored for all important purposes. The rosy operating profit shown excludes profit/loss on players trading, amortisation of players’ transfer fees and finance costs.
To give you some background, it all started more than a decade ago with Malcolm Glazer doing a leveraged buyout of Manchester United. The Glazer family loaded the club with significant debt right after the takeover and has been since milking the club dry. The icing on the cake has been that the supposed value of the club has also been growing. The same set of Wall Street bankers lured a Russian oligarch and then the GCC Sheikhs followed. This compounded the absurdity that was started as a one-off. The trick changed to all sorts of gimmickry except making profit. So, you peg the value of the club to a new paradigm or a benchmark. It could be revenue or stadium capacity or operating profit or number of fans and so on. To get this, you borrow cheap money (or just pay from your pocket if you are a Sheikh or an oligarch) and overbid for the best players in the world. With those players, you get the fans, and with them, you get the endorsements and the merchandise sales. You keep playing this game while the operating profit keeps soaring since they ignore two key cost components of players transfer fee amortisation and interest.
The journey of the basis of valuation has come of age. Anciently, the primary benchmark used to be P/E. In the terminal part of the Greenspan era, it transformed into EV/Ebitda since money became almost free. As if that was not enough, in the FAANG era, the new basis was EV/Sales. Finally, now in an era where money supply has seemingly doubled in less than a year, the new paradigm is to stick EV to a random benchmark like total addressable market or gross merchandise value or application downloads or subscriber base, fleet size or inventory size and now, to stadium capacity or social media fan base! Once upon a time, telecom companies were valued at $1,000 per subscriber. That is not the case anymore. We also know what happened to Hertz and Oyo.
In effect, the ‘Fed put’ allows you to pile on debt, outbid to win an overvalued asset to raise revenue, and the equity value goes up. It doesn’t matter if you aren’t making any profit as long as you pay interest. So long as you keep ‘growing’, shareholders don’t care about profit, and lenders don’t worry about any repayments. I wonder how principal repayments will be made if the lender asks for it? The only way is by rolling over debt. For every traditional lender asking for repayment, there are five new ones fueled by monetary gasoline. That has kept the absurdity going.