Wednesday, August 7, 2013

Making the Same Mistake We Swore We’d Never Make Again

Making the Same Mistake We Swore We’d Never Make Again[1]

As the credit crisis fades in our memories, the appetite for taking on risk is on the rise.  Either the crisis didn’t inflict enough pain, or the markets already are populated by a bunch of new traders and investors who missed out on the worst of the debacle.  The Wall Street Journal and The Washington Post provide two data points about the growing appetite for risk.  The Journal reports that private equity firms are, once again, paying themselves large dividends by saddling their portfolio companies with mountains of debt.[2]  The Post describes the increasing number of large mergers that are being funded with cash instead of stock.[3]  In a cash deal, debt usually funds the transaction.

Why is this happening?  The most frequent question I get is: Where can I find an investment with a decent yield?  All sorts of investors from retirees to huge public pension plans are scrambling to find fixed income investments that sport some sort of yield.  While US Treasury interest rates have risen in the last several months, the 10-year treasury still only yields 2.6%.  Investment grade corporate debt doesn’t pay much more than treasuries.  As a result, many investors are looking at various forms of high yield debt, which on average only yield a bit above 6%.  According to The Journal, some debt offerings used to finance private equity dividend payouts are sporting yields of about 8%.  A year ago, the same type of deal would have required a yield north of 10%.
Pacific Opportunities (1999)
Although retirees and pension plans are gobbling all of these higher yielding offerings, many investment professionals are worried about the growing risk.   I don’t think we are talking about another credit bubble.  The rise in high yield debt is nothing in comparison to the excesses of the mortgage markets five and six years ago.  However, there may well be a few nasty surprises along the way.  For private equity firms and big corporations the insatiable appetite for yield is a wonderful thing.  The private equity firms are able to get their entire investment back and may be even generate a tidy profit without giving up any ownership.  If the economy turns down or the stock market sours, their money will be safe, and the high yield creditors will be left to bear the risk.  Similarly, major corporations are happy to be able to buy up competitors using other people’s money.

I’m always amazed at how quickly investors forget.  In 2010 and 2011, caution still prevailed.  However, restraint has faded.  Once again, the weakest investors are falling prey to the smartest financiers.

[1] “Piss’n in the Wind,” Jerry Jeff Walker

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