Is it worth it to be the global reserve currency?

The dollar's status as the world's reserve currency is not necessarily the exorbitant privilege it's often described, especially not when facing growth-threatening fiscal deficits and sluggish industrial growth. When one looks at the dramatic need for growth in the US, the status as world reserve currency becomes much more expensive.

Recent news in China and the US underscores the difficulties of the current system, which even after an economic crisis is still structurally the same as before. In China, inflation is increasing (see for example China's recent fine of Unilever) while in the US, GDP growth has slowed to 1.8%. The difference between now and the last cycle is that US consumers have been sucked dry. The US consumer can no longer drive demand. The good news is that the middle class in China, India, Brazil, etc. is growing incredibly fast, driving increases in consumerism and urbanization. The bad news is that as long as the Dollar is the world reserve-currency it will be difficult to realize the full potential of this enormous opportunity. The valuation premium enjoyed by the Dollar due to its unique status is a constant downward drag on US exports as well as Chinese consumption.

But what is the cost of losing the reserve currency? To those with significant dollar-denominated fortunes, the costs are significant. The outflow of capital from US financial markets would significantly raise the cost of capital for US corporations, governments, municipalities, and consumers. It would effectively transfer wealth from the haves to the have-nots, as job growth would increase but the value of dollar-denominated portfolios would decrease. Though it is never a good idea to describe a policy decision as a wealth transfer, that is effectively what has happened in the US since China's entry into the WTO, and a reversal is necessary for the global economy to rebalance.

Ultimately, the "wealth transfer" angle to this policy makes it almost impossible to enact. This is not a new story. The role of Pound Sterling decreased throughout the 1900s as the British Empire declined. Much of British hegemony abroad was focused on the role of Sterling in trade and the great benefits enjoyed by the City as a result. The decline of the British Empire as well as the decline of Sterling were completely unplanned and unmanaged. The transition is simply impossible to manage. Britain, just like the the US now, fights to maintain this status for its currency, with force if necessary. Part of the problem is the disporportionate power of elites in these societies. These factions have the most to lose from a paradigm shift- it takes substantial political change to overcome the inertia of present policies.

Risk pull-back

Oil is down 7% today. Gas is down 6%. Silver is down almost 9%. Rates are about 3 bps lower. Stocks are down 50 bps.

Something is happening in commodities. There are certainly reasons to be bearish. Prices are extremely high. Inventories are generally above their long-term average. Demand is pulling back. Most recent economic news has disappointed- from NFPs to ISM to GDP growth. So a pull-back is justified, but the change in commodities is far more extreme than the de-risking that is occurring in rates and equities. Why is that?

Bill Gross' new investment outlook reiterates his short treasuries thesis, this time relying on evidence from a recent paper by Carmen Reinhart and M. Belen Sbrancia. This paper describes how governments delever by setting treasury yields below real interest rates. It's a fascinating study and a valuable perspective. The last time the US faced an indebtedness comparable to today was during World War II, when total debt exceeded 100% of GDP. It's often assumed that we overcame the massive fiscal debt through 2 decades of substantial growth. But Gross, Reinhart, and Sbrancia remind us that yields on government debt were below real interest rates post WWII, thus effectively deleveraging the balance sheet over time. I've mentioned before the role of the Fed in supporting the government bond market during and after WWI and WWII. Milton Friedman describes the conflict between the Treasury and Fed after WWII, as the Treasury effectively forced the Fed to keep yields low for almost a decade after the end of the war (see Monetary History of the United States).

If Gross is correct and we are living in a world of negative real interest rates for savers, what is the outlook for inflation? Today's move in commodities says a lot. When the government is effectively deleveraging by keeping government debt yields below real interest rates, economic growth becomes the difference between hyperinflation and something more normal. That leaves commodities as the asset class the most leveraged to economic growth. As Gross points out, holders of Treasuries will get burned as yields stay below real rates. But with weaker growth than expected, commodities will no longer capture the yield being stolen by the Fed.

What's Next for the Oil Risk Premium?

Crude prices soared after the situation in Libya escalated at the end of February. The sustained price increase since the conflict erupted is not justified by the amount of production displaced by the conflict. Libya exports 80% of its 1.6 mmbpd of production, so the supply shock is about ~1.3 mmbpd. OPEC has about ~5 mmbpd of spare capacity. When oil prices increased to $145 / bbl in the summer of 2008, Saudi Arabia boosted output to 9.6 mmbpd, well above the current output of 8.3 mmbpd. Notwithstanding capacity additions (which have been significant), Saud Arabia can cover the entire Libyan deficit by itself with spare capacity of 3 mmbpd. There is also significant refining spare capacity in Europe. Though heavy / light differentials will (and have) increased due to the quality difference between Libyan and Saudi oil, crude and product prices have gone higher than justifiable on a supply / demand basis.

Crude has moved further than justified by fundamentals due to the risk of further conflict. Nigerian elections are coming up this quarter and the severity of Syrian protests are growing. But the key driver is undoubtedly the tail risk of conflict escalating in Saudi Arabia itself.

Assuming a fair value crude price (Brent) of $90 / bbl implies a risk premium of around $30 (with Brent around $120-125). The uncertainty of what future conflict might look like makes it difficult to evaluation the value of the risk premium, but the relationship should look as follows:

It's difficult to take a strong stance on whether this risk premium is justified (my gut reaction given the implied probabilities is that the risk premium is overstated). I think a better question is how long does oil deserve this premium? It's hard to see a reason why the premium will disappear as long as we have headline grabbing news from the Middle East. The problem is that there are so many conflicts - Libya being merely the most conspicuous - that a risk premium may be warranted for an extended period. So while the value of the risk premium may be overstated, the premium may endure for longer than those focused on the progress in Libya might expect.

What I'm Reading...4/21/11

Happy Thursday.

Reactions to Finnish parliamentary elections continue to trickle in as if the rise of nationalism in Europe is a great surprise. A blogger at the BBC described the strong showing of the True Finns (19%) as "a tremor hit[ting] the EU" (BBC article link). But growing nationalism in the EU is hardly a new development. (I wrote in June 2009 about the rising nationalist sentiment evident in European Parliamentary elections.) The drastic decline in popularity of the German FDP and concurrent rise of the German Green party (as manifested in the Green Party's historic win in Baden-Wurtemberg) are a case in point. As is the emergence of the Tea Party in the US or Marine le Pen and the Front National in France.

I would argue that we aren't seeing a vast movement to the right, but rather a further bi-furcation of political attitudes. In France, rising support for the Front National comes at the expense of the Sarkozy's UMP. Similarly, rising support for the Socialist party comes at the expense of the Green party and various French leftist parties. In the US, according to gallup Party ID is historically range bound in the US, with 30-40% of the US population identifying themselves as Republicans or Democrats. What fluctuates significantly more is the percentage of Dems/Indies/Repubs who think their parties are too liberal/conservative. Either way, the strong showing of the True Finns is unlikely to disrupt the Portuguese bailout as the pro EU National Coalition Party has already declared support for the Portuguese bailout as unconditional. Sure, the National Coalition Party will have to make concessions on other issues, but bailout will survive. That being said, debt investors seem to have realized just recently that they will likely take a haircut on their debt. The uncertainty of a debt restructuring is far scarier to me than rising nationalism, no wonder gold hit an all-time high today.

On an unrelated note, the WashPost has an article out today questioning China's "green leap forward." I was unaware that most of China's investments in green technology ultimately target Western markets. For example, Chinese investments produced half of the world's production of solar panels in 2010, but 99% of these panels were installed in foreign countries, presumably to those that subsidize these installments, such as Europe and the US.

"A green future will result not from subsidizing immature technology today but from developing competitive green technology that is effective and cheap. Wind and solar power are not yet competitive. Research would be a much better investment for Western countries than subsidizing imports of today’s green technology from China."

Well put. It reminds me of another report I read today (admittedly- only skimmed) that discusses the failure of the Climate Action Partnership to successfully push climate action despite out-fundraising conservative advocacy organizations 11 to 1 (and outspending on climate change related projects 44 to 1). I haven't had the time to go through it in full yet (its probably 100 pages long), but looks very interesting (ClimateShift "Clear Vision for the Next Decade of Public Debate").

It's hard to comment on news this week without mentioning Trump. It's easy to dismiss Trump's candidacy as a joke, but mainstream Republicans have reason to be worried. While his "birther" focus may not be a legitimate campaign platform for a national election, among Republicans his views align with the majority. A recent New York Times poll concluded only 32% of Republicans believe Obama was born in the US. Up till now, Trump is the only Republican candidate with a wide public recognition who relentlessly attacks not only Obama's policies, but even his legitimacy as President, a lingering issue for many conservatives. No other candidate has gotten as much traction among primary voters, with Gallup's new poll showing Trump tied with Huckabee for the 2012 Republican nomination.

Let's also not forget that seemingly ridiculous beliefs such as the birther issue are common among opposition parties. Ben Smith recently commented that the birther issue is to Republicans as the 9/11 "inside job" conspiracy theory was for Democrats. A full 22.6% of Democrats said it was "very likely" and another 28.2% called it "somewhat likely" that Bush either assisted in the 9/11 or took no action to stop the attacks.

I'll leave you with one last link. Hat tip to Mr. Felix Salmon for a link to a fascinating paper on global beer consumption trends (Felix Salmon's summary).

China moves up the value chain

According to Dealogic, outbound Chinese M&A has totaled $24bn year-to-date. If this level of activity were to continue for the rest of the year, total 2011 outbound M&A by Chinese companies could reach $100bn, almost double 2010 numbers.

The overarching trend of the last 5 years has been an increased focus on natural resources companies. Outbound acquisitions by Chinese companies targeting the mining space have increased from 6% of total deal volume in 2006 to 34% in 2011 YTD. Oil & Gas has accounted for 30-40% of total outbound M&A volume for the last three years.

This trend is also reflected in the target countries with resource-rich Australia and Canada recently becoming the most targeted countries.

To what extent can we expect these trends to continue? As long as state-owned Chinese companies have a mandate to secure resources, we can expect cross-border mining and oil & gas activity to make up the vast majority of deals. But the massive surge in natural resources focused activity masks other equally important trends.

Recently, Chinese outbound M&A targeting higher value sectors has ticked up markedly. M&A targeting Healthcare companies is up from $0mm and $253mm in 2006 and 2007 to $603mm and $204mm in 2010 and 2011 YTD, respectively. On an annualized basis, the number of transactions targeting Healthcare outbound Chinese M&A is up 400% from 2007. Almost all of this activity has targeted the pharmaceutical or instruments sector within the Healthcare industry, which are significantly higher-value sectors than other verticals within Healthcare such as the care or products verticals.

M&A targeting computer & electronics companies has also increased significantly. Deal volume targeting these companies totaled $1,326mm last year (34 deals) compared to $406mm (12 deals) in 2006. If 2011 activity continues at its current pace, total 2011 deal volume could reach $2,000mm.

Though these increases can't compare with the increase in natural resources focused activity, in some ways these trends are more important. The amount of Chinese M&A targeting higher value-added sectors such as pharma and electronics is a valuable datapoint to tracking the nature of China's economic development. It is only logical that over time Chinese industry will increase its presence in higher value-added industries currently dominated by Western and Japanese/Korean companies. What might be surprising, however, is the pace at which this is already happening.

Note: my Dealogic dataset includes all announced M&A by Chinese companies where the target nationality is not Chinese.

Strongest quarter for LBOs since the credit crash

According to Preqin, Q3 2010 witnessed 498 pe-backed deals worth $66.7 bn, up 29% from Q2 and 300% from Q3 2009.

Fundraising is also up this quarter:

Bain's LBO of Gymboree looks like a slam dunk

When I read this morning that Bain Capital was buying Gymboree Corp. (GYMB) for $1.8 billion, I had never heard of the company. After reading through their 10-K and going over their stock performance, I was surprised Gymboree (a specialty retailer of children's clothing) had not been bought out earlier. This company is an almost perfect LBO target!

Existing debt consists of only about $70mm in leases. Cash flows are extremely stable. Revenues have not declined once over the last decade, growing 11% on average over the last five years. Also, over the last few years as growth has slowed, margins have improved and the company has reduced its operating leverage considerably in comparison to the earlier half of the decade. Gymboree is also less cyclical than other retail companies, possibly due to the fact that in hard times parents will rather cut their own expenses than those of their children. Finally, it's likely that improvements to GYMB's cash conversion cycle could dramatically increase value. If Bain manages to increase payable days and decrease inventories, Gymboree could possibly enjoy negative operating working capital and certainly increase free cash flow to pay down debt.

My analysis below breaks down how this LBO might work. There's obviously a lot about this LBO that we don't know yet, such as leverage, debt pricing, refinancing, and what happens to the existing cash on the balance sheet. Flipping the lease refinancing and special dividend switches in the model changes Bain's expected IRR by 10%. But even then (at 13% IRR), this is still a great LBO given my conservative assumptions (3% revenue growth, lower margins than in recent years, no multiple expansion).

If I were a merger arb, I might even consider betting another (probably financial) bidder will trump Bain's offer.

Gymboree LBO Model com

What Sara Lee tells us about the current LBO environment

About a month ago, KKR allegedly offered to buy Sara Lee for $12B, though Sara Lee's board spurned the buyout firm's advances. It's easy to see why Sara Lee might be an attractive LBO target -- it's not too leveraged, has strong brands and significant opportunities for operational improvements. My analysis (see below) shows that KKR could reasonably expect double-digit returns even if sales growth remains low. So why has KKR not raised its bid or gone hostile?

Given whats happened in the markets we should expect a sharp increase in sponsor activity. The financing market is in great shape and vintage 2005-2008 funds are flush with capital. LBO activity is in fact rebounding as total YTD sponsor backed deals are almost back up to 2005 and 2008 levels. And yet as conditions have improved, we still haven't seen the $10 billion plus mega deals that were the norm before the crisis.

Private equity certainly seems cautious about mega-buyouts. Both potential 10B+ LBOs of 2010 (Sara Lee and Fidelity National Information Systems) fell apart because of disagreement on price. One particular reason for this caution regarding mega buyouts is the pressure on the traditional mega-fund business model. Investors especially question the fee structure of these deals and, given the poor performance of many mega LBOs over the last few years, are understandably incensed by the substantial management fees on these deals.

According to Prequin surveys, a majority of LPs are reconsidering their allocation to large PE funds with some notable firms like Blackstone even returning previously paid fees. Now, with PE fundraising still weak, buyout firms are under pressure to prove their mega LBOs generate superior returns and deserve management fees of 1% or higher. The deals done today may prove to be critically important to securing funding in the future.

My analysis below shows that, although Sara Lee is an attractive LBO at $12B, those returns quickly disintegrate as price increases. In fact, price is more important to generating a return (on a percentage basis) than cost of debt or EBITDA growth.

The model below can also be downloaded as an excel file here. The operating model uses historicals to project EBITDA growth and Cash Flow / EBITDA.

Sara Lee Analysis

3G LBO of Burger King

3G's $3.3B ($4.17B total transaction value) LBO of Burger King is one of the most high-profile LBOs of 2010. This LBO is interesting for a number of reasons. For one, the acquirer, investment fund 3G (funded by a small group of Latin American billionaires), is not a part of the usual suspects one would expect to see on a deal of this magnitude. Also different from most LBOs, 3G has stated it is buying Burger King for the long-haul and is willing to wait 10 years before exiting.

The choice of Burger King is also a strange one. When BK was bought out by Bain, GS, and TPG in 2002, Burger King was an insignificant and unappreciated holding of the food and beverage behemoth Diageo, allowing the sponsors to acquire BK at a very favorable valuation. But the Burger King of today is much different. Eight years of sponsor ownership have turned BK into a lean company with few easily realized cost reductions. Furthermore, from a strategic point of view, BK has fallen far behind its rival McDonald's and requires massive amounts of capital expenditures to compete (estimated in a recent Bloomberg article to be as high as $3 billion). For more on the challenges facing 3G, go here. Perhaps most surprising is the valuation. 3G did not pick up BKC on the cheap, paying 9.4x LTM EBITDA and 8x LTM net income.

My model of the LBO is posted below. I suggest you do not try to look at it on Scribd but instead go here, and download the excel file. My analysis shows that using conservative growth assumptions and moderate cost cutting assumptions, the Burger King LBO could return 16% annually if 3G exits in five years at the same valuation (9.4x EV/EBITDA) at which it entered.

However, this return is very sensitive to Burger King's ability to cut costs, which is questionable given the rising costs in the industry as well as BKC's previous ownership (Management also expects SG&A to increase by 3% in 2011). If one assumes Burger King has to boost capex to 10% of sales and SG&A as a % of sales increases by 3%, the 15% IRR quickly disappears, even with above trend top-line growth.

That being said, I actually think this deal was a good idea for 3G if 3G manages to leverage its experience in Latin America to grow Burger King quickly in emerging markets. As Burger King grows internationally, its operating leverage from its restaurant ownership will deliver larger margins and significantly increase Burger King's valuation. But overall, like most recent LBOs, the success of the BKC LBO is heavily dependent on exogenous forces. 3G is blessed to have patient investors. It's longer term investment horizon will allow it to wait for an opportune time to exit -- which can make all the difference.

Burger King LBO Model

Going forward...

As I've learned more about finance over the last few years, I've started to shift my focus from markets and asset prices to transactions and operations. On this blog, I've written mostly on macro, geopolitical, and policy issues. Going forward, I expect to have little to say on these subjects. For one, I (regrettably) no longer have time to read as I once did (I recently graduated from school and am working full-time in finance). But more importantly, I've become increasingly interested in the details of operations, capital structure, and M&A. Perhaps the greatest reason behind this shift is that I've found I really like the way investors can influence returns by making financial or operating changes, while in macro investments an investor is merely a spectator, (though exciting as that may be in interesting times such as these the lack of control can be frustrating).

So what I've decided to do is use this blog as a forum to discuss recent M&A deals (trends, valuation, etc.), focusing mostly on LBOs and private equity activity. I'll usually build a model to back up my analysis which I will post on Scribd. The first LBO I will discuss is 3G's recent buyout of Burger King.

My Thesis: Pricing of LBOs from 1999-2009

I finally finished my honors thesis. I wrote about LBO pricing from 1999 to 2009. LBO prices (valuation multiples) rose dramatically as the amount of capital committed to private equity surged almost 10-fold after 2001. I argue that mega-buyouts, such as TXU Corp., HCA, First Data, and Freescale, were designed to avoid the increasing prices of LBOs by acquiring companies other private equity firms could not buy. My results support this hypothesis and show that after an LBO exceeds around $10 billion in Enterprise Value, the valuation of the deal becomes more favorable. After bypassing this threshold, EV/EBITDA decreases .1-.2 for every $1 billion increase in transaction value. This result is statistically significant at the .05 level.

If you are not interested in the results of my statistical analysis, you might still be interested in the first half of my paper. Section 1 gives a thorough history of private equity activity since 1980 and illustrates how the space has changed over the last 10 years. Section 2 reviews academic research on LBO performance and pricing.

LBOs From 1999 to 2009

A Shift in American Conservatism

Over the last decade, the Republican party has not lived up to its conservative values regarding fiscal issues. Until recently, the far right-wing focused increasingly on social issues. Consider, for example, Bush's gaping budget deficits. Or better yet, the rise of politicians such as Huckabee or Palin, both of whom's appeal is their social conservatism. Both can be described as either uninformed, undistinguished, or both in the fiscal realm. Given recent developments in GOP politics, it seems this trend has finally reversed, though ironically this reversal may not be as good for the deficit as one might expect.

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Grantham on Bubbles

Jeremy Grantham of GMO has made some interesting comments recently on bubbles. In this FTfm interview, Grantham argues there is nothing more damaging to an economy than a breaking asset bubble. In his Q1 2010 quarterly letter, Grantham identifies bubbles in US equities, emerging nation equities, and commodities. Grantham also recommends continued allocation to these assets, a strange recommendation considering Grantham is a value investor, who traditionally shy away from overpriced assets.

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Kraft-Cadbury Was a Good Deal Despite Recent News

Much ado has been made about the Kraft-Cadbury deal. The consensus seems to be (especially after the overlooked pension shortfall) that Kraft overpaid for Cadbury and, even worse, used its own undervalued stock to do so. Recently, Kraft revealed CEO Irene Rosenfeld's compensation for 2009 was $26.3 million, up 41% from 2008. The compensation committee "heavily weighted the significant effort and the ultimate acquisition of Cadbury" to determine the payment. To some, the Kraft-Cadbury deal is the perfect example of empire building, suggesting that Rosenfeld executed the Cadbury deal to increase revenue (which generally determines CEO compensation) without much attention to the price. This criticism reflects the common conception that most M&A destroys value and is driven by ego and compensation. In my opinion, this view is misguided, both for M&A generally and Kraft specifically.

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A Few Words on the SEC's Suit Against Goldman

Reading the SEC's allegations against Goldman (available here), I was reminded of the case against Bear Stearns hedge fund managers Cioffi and Tannin. From the excerpts of emails given by the prosecution during this case, it seemed that Cioffi and Tannin clearly deceived investors. However, the defense argued that the prosecution's damning quotations had been taken out of context and did not reflect the concrete views of the defendants. Furthermore, it was difficult to link these discussions to actually proving that the managers mislead investors. Cioffi and Tannin were acquitted of any criminal wrongdoing.

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Expect LBOs to Make a Comeback

I've been unable to post recently because I've been finishing a long thesis on LBO pricing from 1999-2009. I will post the paper on this blog in the next coming weeks. Until then, I thought I'd share my outlook for private equity activity going forward.

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Russia's Rising Influence in Its Near-Abroad

It seems as if Russian-American relations have improved significantly over the last year. The rhetoric coming out of Russia towards the US has been much milder. Russia has shown increasingly strong support for sanctions against Iran. Most importantly, Obama and Medvedev signed the new START treaty about a week ago in Prague. Perhaps Obama's push to "reset" relations with Russia have worked. However, I doubt that's the case. A country as driven by realpolitik as Russia would never compromise on personal politics alone. A closer look reveals Russia has reason to be accommodating given its strong successes in securing its "near-abroad" over the last year.

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Economic and Market Update with Prof. Spellman

I've started working with Dr. Lewis Spellman (LewSpellman.com) in a variety of capacities. One thing we're doing is putting together general market updates for various presentations of Dr. Spellman. Here is what we came up with for the beginning of March 2010:

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Perspectives on Chinese Currency Manipulation

Recent actions by members of Congress attempting to force Obama to tax Chinese imports if China does not revalue its currency have re-ignited the debate on Chinese currency manipulation. A few clearly opposing stances have emerged:

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Valuation Matters

It's common sense that equity returns depend on the starting valuation. In other words, mean returns from an asset class mean little for an asset where returns are mostly dependent on capital gains. When capital gains are a significant proportion of total returns, starting valuation should be more important than historical performance. It seems simple and obvious, but most investors who are allocating a long-term portfolio still don't pay enough attention on valuation.

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