Monday, October 22, 2012

After the Boom in Natural Gas

THE crew of workers fought off the blistering Louisiana sun, jerking their wrenches to tighten the fat hoses that would connect their cement trucks to the Chesapeake Energy drill rig — one of the last two rigs the company is still using to drill for natural gas here in the Haynesville Shale. 

At its peak, Chesapeake ran 38 rigs in the region. All told, it has sunk more than 1,200 wells into the Haynesville, a gas-rich vein of dense rock that straddles Louisiana and Texas. Fed by a gold-rush mentality and easy money from Wall Street, Chesapeake and its competitors have done the same in other shale fields from Oklahoma to Pennsylvania. 

For most of the country, the result has been cheaper energy. The nation is awash in so much natural gas that electric utilities, which burn the fuel in many generating plants, have curbed rate increases and switched more capacity to gas from coal, a dirtier fossil fuel. 

Companies and municipalities are deploying thousands of new gas-powered trucks and buses, curbing noxious diesel fumes and reducing the nation’s reliance on imported oil

And companies like fertilizer and chemical makers, which use gas as a raw material, are suddenly finding that the United States is an attractive place to put new factories, compared with, say, Asia, where gas is four times the price. Dow Chemical, which uses natural gas as a material for producing plastics, has assembled a list of 91 new manufacturing projects, representing $70 billion in potential investment and up to three million jobs, that various companies have proposed or begun because of cheap gas. 

“The country has stumbled into a windfall on the backs of these entrepreneurs,” said Edward Hirs, a finance professor at the University of Houston who contributed to a report that estimated that the nation’s economy benefited by more than $100 billion last year alone from the lower gas prices. 

But while the gas rush has benefited most Americans, it’s been a money loser so far for many of the gas exploration companies and their tens of thousands of investors. 

The drillers punched so many holes and extracted so much gas through hydraulic fracturing that they have driven the price of natural gas to near-record lows. And because of the intricate financial deals and leasing arrangements that many of them struck during the boom, they were unable to pull their foot off the accelerator fast enough to avoid a crash in the price of natural gas, which is down more than 60 percent since the summer of 2008. 

Although the bankers made a lot of money from the deal making and a handful of energy companies made fortunes by exiting at the market’s peak, most of the industry has been bloodied — forced to sell assets, take huge write-offs and shift as many drill rigs as possible from gas exploration to oil, whose price has held up much better. 

Rex W. Tillerson, the chief executive of Exxon Mobil, which spent $41 billion to buy XTO Energy, a giant natural gas company, in 2010, when gas prices were almost double what they are today, minced no words about the industry’s plight during an appearance in New York this summer. 

“We are all losing our shirts today,” Mr. Tillerson said. “We’re making no money. It’s all in the red.”
Like the recent credit bubble, the boom and bust in gas were driven in large part by tens of billions of dollars in creative financing engineered by investment banks like Goldman Sachs, Barclays and Jefferies & Company. 

After the financial crisis, the natural gas rush was one of the few major profit centers for Wall Street deal makers, who found willing takers among energy companies and foreign financial investors.
Big companies like Chesapeake and lesser-known outfits like Quicksilver Resources and Exco Resources were able to supercharge their growth with the global financing, transforming the face of energy in this country. In all, the top 50 oil and gas companies raised and spent an annual average of $126 billion over the last six years on drilling, land acquisition and other capital costs within the United States, double their capital spending as of 2005, according to an analysis by Ernst & Young. 

Now the gas companies are committed to spending far more to produce gas than they can earn selling it. Their stock prices and debt ratings have been hammered. 

“We just killed more meat than we could drag back to the cave and eat,” said Maynard Holt, co-president of Tudor Pickering Holt & Company, a Houston investment bank that has handled dozens of shale deals in the last four years. “Now we have a problem.” 

A Master Salesman
Aubrey K. McClendon, chief executive of Chesapeake Energy, had a secret, and he was anxious to share it.
He called Ralph Eads III, a fraternity buddy from Duke who had become his go-to banker. Mr. McClendon explained that he had quietly acquired leases on hundreds of thousands of acres somewhere in the southern United States — he would not say exactly where — that could become one of the world’s biggest natural gas fields. 

But to develop the wells, he needed billions of dollars. 

“I can get the assets,” Mr. McClendon told Mr. Eads, a vice chairman of Jefferies, according to three people who participated in that call, nearly five years ago. “You have to get the money.” 

Get it he did. Mr. Eads, a pitch artist who projects the unrestrained enthusiasm of a college football coach, traveled the world, ultimately raising an extraordinary $28 billion for Mr. McClendon’s “secret” venture in the Haynesville Shale, as well as other Chesapeake drilling projects. 

Other bankers working in the glass office towers of downtown Houston were equally busy. While the skyscrapers are home to global giants like Chevron and lesser-known companies like Plains Exploration and Production, they also house storefronts for Wall Street deal makers who play a vital, though less visible, role in the nation’s surging energy production. 

Mr. Eads, 53, a Texas native, is a prince of this world. His financial innovations helped feed the gas drilling boom, and he has participated in $159 billion worth of oil and gas deals since 2007. 

A Sigma Alpha Epsilon fraternity brother of Mr. McClendon, he headed to Wall Street directly after Duke. He first earned a national profile in 2001, while working for the El Paso Corporation, a natural gas pipeline operator. Regulators accused El Paso of creating an artificial gas shortage in California in the previous year, contributing to a power crisis in the state. Although El Paso eventually settled the complaints for $1.7 billion, Mr. Eads said El Paso was guilty of nothing more than coming up with creative financial transactions.
“I wake up every day thinking about how to finance big things,” he said. 

His tall, lanky frame and bellowing voice make him hard to miss, even in a large crowd. And his deal radar is never off, as he works the room at dinner parties and charity events. 

That is how he met Jim Flores, the chief executive of Plains Exploration, who eventually invited him on a duck hunt. 

After Mr. McClendon’s urgent request for money, Mr. Eads put in a call to Mr. Flores to see if he might be willing to finance part of Chesapeake’s Haynesville project. 

“Aubrey and I have calculated it, and it might be the largest gas field in the world,” Mr. Eads said he told Mr. Flores, noting early results from a single well that showed unprecedented gas flows. 

The type of deal he pitched, nicknamed “cash and carry,” was certainly aggressive and innovative. Plains would pay Chesapeake $1.7 billion to gain ownership of about one-third of the drilling rights that Chesapeake had leased in the Haynesville. Plains would also commit to paying out another $1.7 billion to cover half of Chesapeake’s drilling costs, in return for part of the future profits. 

“It’s going to be a great investment,” Mr. Flores said on the day the deal was announced in July 2008.
But the deal, like others later struck by Chesapeake, benefited Mr. Eads and Mr. McClendon and their companies far more than the people writing the big checks. 

Chesapeake spent an average of $7,100 an acre on the drilling sites it had leased in the Haynesville. Plains paid Chesapeake the equivalent of $30,000 an acre. 

Jefferies and the other firms involved in arranging the deal made an estimated $23 million on this transaction.
Much of the money that Mr. Eads raised for American gas drillers came from overseas oil and gas companies, like Total of France and Cnooc, the China National Offshore Oil Corporation. He told them the American shale revolution was an opportunity they simply could not afford to pass by. 

“This is like owning the Empire State Building,” Mr. Eads said, recalling one of his favorite lines. “It’s not going to be repeated. You miss the boat, you miss the boat.” 

In China, he was in awe at just how much money was available to invest. One senior executive at a major Chinese oil company that Mr. Eads declined to identify, citing the confidential nature of the negotiations, explained that the country wanted to move as much as $750 billion from United States Treasury bonds into the North American energy business. 

Mr. Eads was only happy to oblige, helping to secure $3.4 billion from the Chinese for Chesapeake through two deals. 

Not everyone believed the story line of endless profits and opportunity. Mr. Eads said one oil company executive whom he would not identify had rejected his pitch, complaining, “The reason for the glut is you guys.” The executive said he expected natural gas prices to plummet. 

In private, Mr. Eads acknowledged that his pitches involved a bit of bluster. 

“Typically, we represent sellers, so I want to persuade buyers that gas prices are going to be as high as possible,” Mr. Eads said. “The buyers are big boys — they are giant companies with thousands of gas economists who know way more than I know. Caveat emptor.” 

Investment banking revenue at Jefferies reached $1.1 billion in 2011, a record for the firm, up from $750 million in 2007. Energy deals were cited among the biggest drivers of that surge, which came despite major problems at the firm because of its exposure to European sovereign debt. 

Mr. Eads would not say how much he had been compensated for this bonanza. But Dealogic, a firm that tracks Wall Street transactions, estimated that Jefferies collected at least $124 million in fees from Chesapeake since 2007, a large share of its overall revenue on oil and gas deals, which ranged between $390 million and $700 million during the same period, according to two different industry estimates. 

Even before the recent round of deals, Mr. Eads was a wealthy man. He lives in a sprawling, 11,000-square-foot lakefront mansion in Houston and has a wine cellar with 6,500 bottles. In 2010, he bought an $8.2 million home in the exclusive West End of Aspen, Colo., whose other homeowners have included Jack Nicholson and Mariah Carey. 

Mr. Eads’s success has produced no shortage of jealousy in Houston. 

“A lot of people don’t like him because he got ahead of everyone else,” said Chip Johnson, chief executive of Carrizo Oil and Gas, who made two big deals in which Mr. Eads was involved. “He got the reputation for overselling, but I have a hard time believing you can fool the big companies.” 

“Without him,” Mr. Johnson added, “the country would not have had the huge gas supply as quickly as we did.” 

Others have been more critical. 

“He is like the bartender serving drinks for people who can’t handle it,” said Fadel Gheit, a managing director at Oppenheimer & Company, about Mr. Eads. “And the whole gas industry has gotten a rude awakening, a hangover, with gas prices plummeting. The investment bankers were happy to help with a smile and get their cut.” 

A Train Without Brakes
“Quit drilling,” T. Boone Pickens, the Texas oilman, barked to his fellow board members at Exco Resources, a small, independent drilling company based in Dallas that, like Chesapeake, had made a big bet in the Haynesville. “Shut her down.” 

Mr. Pickens, 84, made billions of dollars as a hedge fund manager and wildcatter drilling for oil and gas. He borrowed heavily to build up the oil and gas reserves of Mesa Inc. in the late 1980s before losing the company during its financial difficulties a decade later, when drooping gas prices hurt its ability to repay debts and pay dividends. He wanted Exco to avoid a similar fate. 

There was only one problem: under the contracts that Exco signed, it couldn’t stop drilling. 

The company followed Chesapeake’s lead and struck its own $1.3 billion cash-and-carry deal with the BG Group, a British gas company. BG paid Exco $655 million in cash upfront and agreed to foot 75 percent of the bill for future drilling in the Haynesville in return for a share in future profits on the gas produced. 

When the arrangement was made, it seemed like a winner all around. Exco had more than 53,000 acres of leases in the Haynesville, but like Chesapeake, it lacked the money it needed to drill on all the land. BG’s financing helped Exco to increase the number of rigs it had working in the Haynesville to 22 from four. 

Nevertheless, the agreement, negotiated by Goldman Sachs, came with some important strings attached: Exco had to keep all 22 rigs drilling for gas, even as the price was dropping. BG wanted to reach certain targets for drilling wells and producing gas in the United States, and it was intent on sticking with the plan, even if its partner now insisted that it made no economic sense. 

“They are great partners, but they have their pedal down around the world, and we are part of that,” Douglas H. Miller, Exco’s chief executive, explained to Wall Street analysts last year.
Mr. Pickens was furious. “We are stupid to drill these wells,” he said in a recent interview. 

But Exco was not alone. Many of its fellow gas companies — including Chesapeake and Petrohawk — had little choice through last year but to keep drilling, no matter how low the price fell or how big a glut was forming. 

It wasn’t just the cash-and-carry deals that were forcing them to drill. 

The land that the natural gas companies had leased, in most cases, came with “use it or lose it” clauses that required them to start drilling within three years and begin paying royalties to the landowners or lose the leases. 

Exco, Chesapeake and others initially boasted about how many acres they had managed to lock up. But after paying bonuses of up to $20,000 an acre to the landowners, the companies could not afford to lose the leases, even if the low price of natural gas meant that drilling more wells was a losing proposition. 

The industry was also driven to keep drilling because of the perverse way that Wall Street values oil and gas companies. Analysts rate drillers on their so-called proven reserves, an estimate of how much oil and gas they have in the ground. Simply by drilling a single well, they could then count as part of their reserves nearby future well sites. In this case, higher reserves generally led to a higher stock price, even though some of the companies were losing money each quarter and piling up billions of dollars in debt. 

Just as in the earlier real estate bubble, the main players publicly predicted success even as, privately, their doubts were growing, court documents show. 

Mr. McClendon suggested in August 2008 to Wall Street analysts that he had fundamentally transformed the once-risky, century-old oil and gas business into something with the reliability of an assembly line.
“We consider ourselves to be in the gas manufacturing business, and that requires four inputs in our opinion — those inputs are land, people, science and, of course, capital,” Mr. McClendon told the analysts. “We think that’s pretty impressive and hope you do as well.” 

But soon after, he told some Chesapeake employees that the company might have made some big mistakes. “What was a fair price 90 days ago for a lease is now overpriced by a factor of at least 2x given the dramatic worsening of the natural gas and financial markets,” Mr. McClendon wrote in an October 2008 e-mail that has since become public in a lawsuit against Chesapeake. 

And as with so many other shale gas players, Chesapeake struck so many complicated financial deals that it couldn’t stop ramping up the gas factory. 

“At least half and probably two-thirds or three-quarters of our gas drilling is what I would call involuntary,” Mr. McClendon acknowledged at one point. 

For him, the drilling binge had some significant financial consequences. During the good times, Chesapeake paid him handsomely in cash and perks. He achieved a net worth of over $1 billion, and he made it to the Forbes list of the 400 wealthiest Americans. He bought homes in Bermuda, Colorado and Hawaii, as well as a stake in the Oklahoma City Thunder basketball team. 

An unusual company program also allowed Mr. McClendon to buy a small personal stake in Chesapeake’s wells. That is expected to reap more than $400 million for him over the 15- to 20-year life of the wells, although it has strained his personal finances for now. An investigation by Reuters detailed how Mr. McClendon had borrowed heavily from Chesapeake business partners to help finance his share of the wells’ costs. That and other issues drew the scrutiny of the Securities and Exchange Commission, shook investor confidence in him and prompted a shake-up of Chesapeake’s board that included the removal of Mr. McClendon as chairman. 

(Mr. McClendon refused requests to be interviewed for this article, and he did not respond to a list of questions.) 

Mr. Eads appears to have fared better. He had seen the coming crash, and, as any master salesman would, found a way to play both sides. He continued to persuade new investors of the great potential in shale while telling his longtime clients to cash out. 

“It is a great time to sell,” Mr. Eads recalled telling Terry Pegula, the founder of East Resources, who had built up his own operation in the Marcellus region of Pennsylvania from one well to 75 over the course of one year. “With all these new plays popping up, I had a real concern gas prices would weaken.”
Mr. Eads then helped arrange what will go down as one of the great early paydays of the shale revolution: the 2010 sale of East Resources, which Mr. Pegula had started with $7,500 borrowed from family and friends, to Royal Dutch Shell for $4.7 billion. 

There were a handful of other such profit takers, including the Houston businessman Floyd Wilson, who created a company in 2003 called Petrohawk Energy with the intention from the start of selling it. Petrohawk drilled its first Haynesville well in 2008. Last year, it sold itself to an Australian energy conglomerate, BHP Billiton, in a $15 billion deal that brought Mr. Wilson and other executives a payout worth at least $304 million. 

But for many gas drillers, there has been only pain. 

Exco, whose production of natural gas was still rising in the Haynesville as of early this year, saw its credit rating downgraded in May. It reported a loss of nearly $780 million for the first half of the year, before write-offs and other adjustments, even after it reduced its work force and rig count. BG, its joint venture partner, reported in July that it was taking a $1.3 billion write-down on its shale gas investments in the United States, including the Haynesville deal with Exco. 

Plains Exploration, which celebrated its first deal with Chesapeake back in 2008, reported a loss for the first quarter this year, but has since shifted heavily away from gas to oil production and is making money again. Warm weather last winter exacerbated the glut to historic levels, reducing prices even further, since so little gas was needed to heat homes in many parts of the nation. 

Chesapeake’s stock price sank this year after it was revealed that Mr. McClendon had taken a personal stake in Chesapeake wells and then used those investments as collateral for up to $1.1 billion in loans used mostly to pay for his share of the cost of drilling those wells. The company is trying to raise $14 billion this year by shedding assets, a goal it has almost reached with huge recent sales of West Texas oil and gas fields and pipelines to Royal Dutch Shell and Chevron. 

To help the company through this difficult patch, Mr. McClendon turned to his old friend, Mr. Eads. Jefferies & Company, joined by Goldman Sachs, offered Chesapeake an emergency $4 billion unsecured bridge loan, at 8.5 percent interest, to give the company a lifeline until it could sell enough assets to keep afloat. (The company says it intends to pay back the entire loan this year from recent sales.) 

In hindsight, it should have been clear to everyone that a bust was likely to occur, with so many new wells being drilled and so much money financing them. 

But everyone was too busy working out new deals to pay much heed. 

The bust has certainly hit the Haynesville hard. Some local landowners, having spent their initial lease bonuses, are now deeply in debt. Local restaurants and other businesses are suffering steep losses now that so many drillers have left town. 

“At this point we’re struggling,” said Shelby Spurlock, co-owner of Cafe 171 in the town of Mansfield. The restaurant is decorated with wall collages of drill worker uniforms from companies that are leaving the area. Once open from 4 a.m. to 10 p.m. and employing four servers, the restaurant has cut its hours and is down to two servers. “Our very existence is in danger,” she sighed. 

Mr. Eads, ever the deal maker, is unfazed. He tells anyone who will listen that the price of natural gas will eventually recover. He is making money, meanwhile, helping struggling companies and opportunistic investors strike deals at the new, lower prices. 

“These shale assets are forever,” he said. “They are going to produce for a hundred years.” 

Sunday, October 21, 2012

CVC’s Australian loss: An isolated carcass

HOMEOWNERS who don’t keep up with their mortgage payments are liable to see their property repossessed by the bank. The same fate can befall private-equity firms that used large amounts of debt to finance big takeovers in the boom years, and can no longer pay back the loans. Just ask CVC, a London-based private-equity firm, which this week lost control of Nine, an Australian television network it paid A$5.6 billion ($4.5 billion) to acquire in deals between 2006 and 2008.
The channel will end up in the hands of a clutch of private-equity firms and hedge funds specialising in distressed debt. In the past 12 months these “vulture” investors bought the bulk of A$3.3 billion of loans extended to Nine from its banks at a fraction of their face value. Led by Apollo Global Management and Oaktree Capital, two American funds, they muscled out CVC by threatening to place Nine into bankruptcy. CVC will lose all of its A$1.9 billion equity investment, in what is thought to be the biggest private-equity loss in Asia, and among the biggest ever.
Distressed investors are sometimes maligned, but this deal is an advertisement for their restorative powers. A struggling magazine division had depressed earnings, making Nine’s large debt pile even less sustainable. With the magazine business divested and the debt excised, the company is now profitable. Upon hearing of the agreement, the broadcaster’s chief executive proclaimed: “Nine’s back!” Its fortunes, if not CVC’s, look much improved.
The problem for the vultures is that other carcasses are proving harder to unpick. Europe is where their hopes are highest. A survey by PwC, a consultancy, found distressed-debt investors have raised €60 billion ($79 billion) to buy loans from European banks, mostly with a view to precipitating defaults at the underlying firms and then taking control. Private-equity giants such as Carlyle and TPG have redirected staff away from normal buy-outs towards these “loan-to-own” activities. Lawyers are poring over documents to find ways to seize control of indebted firms.
So far, however, distressed-debt investors have been disappointed. “There’s not been a deluge [in Europe], we had been hoping for a deluge,” was the recent verdict of Howard Marks, Oaktree’s chairman. That’s because low interest rates and cheap funding from the European Central Bank have reduced the pressure on banks to slim down their balance-sheets by selling assets. Only a few loan-to-own deals have happened this year—notably in the debt of Endemol, a distributor of lowbrow television shows, and Fitness First, a struggling chain of gyms.
In America a few firms have fallen into the vultures’ talons—examples include Charter Communications, a cable operator, and Aleris, an aluminium processor. But roaring capital markets have enabled even distressed companies to refinance their loans. Some have protected themselves from scavengers by buying back their own bank debt at distressed prices, making it harder for the likes of an Apollo or Oaktree to push them out. And the complexity of wresting control from one shareholder continues to make “loan-to-own” deals relatively rare: repeated headlines about potential bankruptcy can damage the company being tussled over, leaving all parties worse off. “It’s a full-contact sport,” says Ben Babcock at Morgan Stanley. No wonder it happened in Australia.

Thursday, October 11, 2012

Free exchange: An incurable disease

HEALTH-CARE expenditure in America is growing at a disturbing rate: in 1960 it was just over 5% of GDP, in 2011 almost 18%. By 2105 the number could reach 60%, according to William Baumol of New York University’s Stern School of Business. Incredible? It is simply the result of extrapolating the impact of a phenomenon Mr Baumol has become famous for identifying: “cost disease”. His new book* gives a nuanced diagnosis, offerings both a vision of a high-cost future and a large dose of optimism. The cost disease may be incurable, but it is also survivable—if treated correctly.
To understand the cost disease, start with a simple observation: whatever the economy’s average rate of productivity growth, some industries outpace others. Take car manufacturing. In 1913 Ford introduced assembly lines to move cars between workstations. This allowed workers, and their tools, to stay in one place, which cut the time to build a Model T car from 12 hours to less than two. As output per worker grows in such “progressive” sectors, firms can afford to increase wages.
In some sectors of the economy, however, such productivity gains are much harder to come by—if not impossible. Performing a Mozart quartet takes just as long in 2012 as it did in the late 18th century. Mr Baumol calls industries in which productivity growth is low or even non-existent “stagnant”.
Employers in such sectors face a problem: they also need to increase their wages so workers don’t defect. The result is that, although output per worker rises only slowly or not at all, wages go up as fast as they do in the rest of the economy. As the costs of production in stagnant sectors rise, firms are forced to raise prices. These increases are faster than those in sectors where productivity is improving, and faster than inflation (which blends together all the prices in the economy). So prices of goods from stagnant sectors must rise in real terms. Hence “cost disease”.
The disease is most virulent in industries where standardisation and automation are hard. The best examples are goods tailored to meet customer-specific demands, such as bespoke suits and haircuts. But Mr Baumol focuses on industries in which the cost disease is rife because human interaction is important, such as health care, education and the performing arts. Because it is often human input that makes the products of these industries valuable, cutting labour would be self-defeating.
Historical data confirm that the cost disease is real. Since the 1980s the price of university education in America has risen by 440% and the cost of medical care by 250%. For the economy as a whole, the average price and wage increases were only 110% and 150% respectively (see left-hand chart). Mr Baumol’s theory makes for scary extrapolations. America’s health-care spending as a share of GDP, for instance, is growing by around 1.4% a year. If it continued to expand at this rate for a century, it would rise to that eye-popping figure of 60% in 2105.
Although America leads the pack in medical inflation, it is not the only country that is infected. In Japan health-care spending per person grew by 5.7% a year in real terms between 1960 and 2006; in Britain it rose by 3.5% a year over the same period. Applying Mr Baumol’s logic, health-care spending in both countries could, if nothing was done about it, rise from around 10% of GDP to more than 50% in the next 100 years.
Fortunately, possibilities abound to mitigate the impact of the cost disease. Cutting waste in health care can shift down the level of spending. Though this is no cure, it does mean costs grow from a lower base when the disease inevitably takes hold. And innovation will mean that activities within the stagnant sector, like hand-delivered post, can be replaced by alternatives where productivity improvements are more likely, like texts and e-mail.
Rising costs will also encourage hard thinking about whether a personal and tailored touch is needed. If not, productivity gains are easier to find. In some areas of medicine computers now have better diagnostic skills than humans. In education lectures can be recorded, allowing star academics to teach millions. In the arts live opera performances are beamed to audiences in cinemas across the world.
A bigger slice of a much bigger pie
But that still leaves a rump of services within medicine, education and the arts that are resistant to productivity gains. For these, Mr Baumol offers his most intriguing prediction: although their costs will grow alarmingly high, they will remain affordable. In a way, the disease produces its own cure. If America’s economy grows by 2% per year (its long-term rate), it will be eight times bigger in 100 years. In addition, goods and services in innovative sectors will become much cheaper. In 1908 the average American had to work for around 4,700 hours to earn enough to buy a Model T Ford. A century later, a typical car can be had for only 1,365 hours of labour. This means that, even if health care really did eat up 60% of the pie, there would still be much more to spend on everything else (see right-hand chart).
The real problem is not the cost disease, Mr Baumol argues, but knee-jerk reactions to it. The most likely response to spiralling budgets for publicly provided medicine and education is to shift provision to the private sector. But that will not cure the underlying disease. High costs could also lead to excessive rationing, slowing development over the long term.
If it happens, such a reaction rests on a mistaken premise: that the rising costs in the stagnant sectors make people poorer. In fact, buying power is growing much faster than medicine, education and the arts are becoming dearer. Mr Baumol’s crystal ball says that in 100 years a live performance of a Mozart quartet will be vastly more expensive, but people will still be able to afford it.

Saturday, October 6, 2012

More Money Than They Know What to Do With

It is a $1 trillion game: Use It or Lose It.

The private equity world is sitting on that 13-figure sum. It’s what the industry calls dry powder. If they don’t spend their cash pile snapping up acquisitions soon, they may have to return it to their investors.
Nearly $200 billion from funds raised in 2007 and 2008 alone needs to be spent in the next 12 months or it must be given back.

Private equity executives, after spending the last several years largely on the sidelines amid the economic uncertainty — often proclaiming “patience” as an explanation — have begun to be anxious that they may need to go on a shopping spree. At least two major private equity firms, according to two executives involved in the discussions, have held internal strategy sessions in recent weeks about how to approach the looming deadline.

Some private equity firms have put the word out to Wall Street banks that they want to go “elephant hunting” — seeking big deals worth as much as $10 billion — and are willing to pay a special bounty for bringing them acquisition targets.

At least one firm has gone so far as to begin contemplating asking its investors, which include the nation’s largest pension funds, to extend the deadline for the money to be spent in return for certain concessions on fees. (Of course, they don’t return the fees that have been collected thus far).

“The clock is ticking loudly for these funds,” Hugh MacArthur, the head of Bain & Company’s private equity practice, wrote as the lead author of a report on the state of the industry.

So the race is on.

But, of course, there is a problem: “Burning off the aging dry powder will likely result in too much capital chasing too few deals throughout 2012,” according to Mr. MacArthur.

That means it is possible we could see a series of bad deals with even worse returns.

Already, private equity firms have been quietly spending lots of cash. In the third quarter alone, private equity firms in the United States burned through $45 billion, up from $17.1 billion in the previous quarter, according to Capital IQ, which tracks deals data. Carlyle Group, which had its initial public offering in May, has been the busiest firm this year: it has done 11 deals worth almost $12 billion.

Acquisition prices are also likely to balloon because of “lots of firms bidding for the same obvious deals,” Alastair Gibbons, a senior partner at Bridgepoint Capital, told Triago, a fund-raising services firm that publishes a widely read quarterly newsletter. “Since there is near record dry powder globally, it’s entirely plausible that we’ll see increasingly overcrowded bidding processes.”

Richard Peterson, an analyst for S&P Capital IQ’s Global Markets Intelligence group, said that private equity firms are already paying multiples of Ebitda — earnings before interest, taxes, depreciation and amortization — of 10.6 this year, up from 10.3 last year. It’s worth remembering that many of the most successful deals in the private equity industry were bought for six to eight times Ebitda, he said.

He noted, however, that since firms were able to borrow at unheard-of low rates today “it may give them more confidence to pay a little bit more.”

Perhaps in a sign of desperation, many private equity firms have been increasingly engaged in a game of “hot potato” with one firm selling a business to another — known as a secondary deal. Mr. Peterson said that at the current pace, the industry was expected to spend a record-breaking $22.3 billion this year simply buying companies from each other rather than buying businesses from the public markets or from private owners outside the private equity industry.

Mr. Peterson also raised a question that is often being whispered about but rarely said aloud: “A lot of these firms are publicly traded now. So to what degree are the transactions being driven by earnings objectives?”
Many of the big private equity firms — Apollo Group, Kohlberg Kravis Roberts, Blackstone Group and Carlyle Group, among them — are public. And for the first time, it is possible that the interests of the public shareholders could diverge from the interests of the investors in the buyout funds, at least in the short term.
If the private equity firms don’t spend the money that they have already raised, it is unlikely they will be able to raise even more in coming years. And increasingly, the private equity firms have become dependent on the management fees not just to keep the lights on but to expand their businesses into other areas, in part to diversify, which has been part of the pitch to public investors. The biggest firms have become asset gatherers.

“In a nutshell, 95 percent of funds would be affected and see a big drop in fee income based on not investing all of the committed capital,” according to Tim Friedman, director of North America for Preqin, which tracks private equity fund-raising and deals. He said that he did not expect firms to do deals simply “for the sake of it,” but he also cautioned that the firms were “under a lot of pressure.”

So keep an eye out for megadeal headlines — and whether they command the same prices when the companies are sold.

Source: http://dealbook.nytimes.com/2012/10/01/more-money-than-they-know-what-to-do-with/

Currencies: The weak shall inherit the earth

OVER most of history, most countries have wanted a strong currency—or at least a stable one. In the days of the gold standard and the Bretton Woods system, governments made great efforts to maintain exchange-rate pegs, even if the interest rates needed to do so prompted economic downturns. Only in exceptional economic circumstances, such as those of the 1930s and the 1970s, were those efforts deemed too painful and the pegs abandoned.
In the wake of the global financial crisis, though, strong and stable are out of fashion. Many countries seem content for their currencies to depreciate. It helps their exporters gain market share and loosens monetary conditions. Rather than taking pleasure from a rise in their currency as a sign of market confidence in their economic policies, countries now react with alarm. A strong currency can not only drive exporters bankrupt—a bourn from which the subsequent lowering of rates can offer no return—it can also, by forcing down import prices, create deflation at home. Falling incomes are bad news in a debt crisis.
Thus when traders piled into the Swiss franc in the early years of the financial crisis, seeing it as a sound alternative to the euro’s travails and America’s money-printing, the Swiss got worried. In the late 1970s a similar episode prompted the Swiss to adopt negative interest rates, charging a fee to those who wanted to open a bank account. This time, the Swiss National Bank has gone even further. It has pledged to cap the value of the currency at SFr1.20 to the euro by creating new francs as and when necessary. Shackling a currency this way is a different sort of endeavour from supporting one. Propping a currency up requires a central bank to use up finite foreign exchange reserves; keeping one down just requires the willingness to issue more of it.
When one country cuts off the scope for currency appreciation, traders inevitably look for a new target. Thus policies in one country create ripples that in turn affect other countries and their policies.
The Bank of Japan’s latest programme of quantitative easing (QE) has, like most of the unconventional monetary policy being tried around the world, a number of different objectives. But one is to counteract an unwelcome new appetite for the yen among traders responding to policies which have made other currencies less appealing. Other things being equal, the increase in money supply that a bout of quantitative easing brings should make that currency worth less to other people, and thus lower the exchange rate.
Ripple gets a raspberry
Other things, though, are not always or even often equal, as the history of currencies and unconventional monetary policy over the past few years makes clear. In Japan’s case, a drop in the value of the yen in response to the new round of QE would be against the run of play. Japan has conducted QE programmes at various times since 2001 and the yen is much stronger now than when it started.
Nor has QE’s effect on other currencies been what traders might at first have expected. The first American round was in late 2008; at the time the dollar was rising sharply (see chart). The dollar is regarded as the “safe haven” currency; investors flock to it when they are worried about the outlook for the global economy. Fears were at their greatest in late 2008 and early 2009 after the collapse of Lehman Brothers, an investment bank, in September 2008. The dollar then fell again once the worst of the crisis had passed.
The second round of QE had more straightforward effects. It was launched in November 2010 and the dollar had fallen by the time the programme finished in June 2011. But this fall might have been down to investor confidence that the central bank’s actions would revive the economy and that it was safe to buy riskier assets; over the same period, the Dow Jones Industrial Average rose while Treasury bond prices fell.
After all this, though, the dollar remains higher against both the euro and the pound than it was when Lehman collapsed. This does not mean that the QE was pointless; it achieved the goal of loosening monetary conditions at a time when rate cuts were no longer possible. The fact that it didn’t also lower exchange rates simply shows that no policies act in a vacuum. Any exchange rate is a relative valuation of two currencies. Traders had their doubts about the dollar, but the euro was affected by the fiscal crisis and by doubts over the currency’s very survival. Meanwhile, Britain had also been pursuing QE and was slipping back into recession. David Bloom, a currency strategist at HSBC, a bank, draws a clear lesson from all this. “The implications of QE on currency are not uniform and are based on market perceptions rather than some mechanistic link.”
In part because of the advent of all this unconventional monetary policy, foreign-exchange markets have been changing the way they think and operate. In economic textbooks currency movements counter the differences in nominal interest rates between countries so that investors get the same returns on similarly safe assets whatever the currency. But experience over the past 30 years has shown that this is not reliably the case. Instead short-term nominal interest-rate differentials have persistently reinforced currency movements; traders would borrow money in a currency with low interest rates, and invest the proceeds in a currency with high rates, earning a spread (the carry) in the process. Between 1979 and 2009 this “carry trade” delivered a positive return in every year bar three.
Now that nominal interest rates in most developed markets are close to zero, there is less scope for the carry trade. Even the Australian dollar, one of the more reliable sources of higher income, is losing its appeal. The Reserve Bank of Australia cut rates to 3.25% on October 2nd, in response to weaker growth, and the Aussie dollar’s strength is now subsiding.
So instead of looking at short-term interest rates that are almost identical, investors are paying more attention to yield differentials in the bond markets. David Woo, a currency strategist at Bank of America Merrill Lynch, says that markets are now moving on real (after inflation) interest rate differentials rather than the nominal gaps they used to heed. While real rates in America and Britain are negative, deflation in Japan and Switzerland means their real rates are positive—hence the recurring enthusiasm for their currencies.
The existence of the euro has also made a difference to the way markets operate. Europe was dogged by currency instability from the introduction of floating rates in the early 1970s to the creation of the euro in 1999. Various attempts to fix one European currency against each other, such as the Exchange Rate Mechanism, crumbled in the face of divergent economic performances in the countries concerned.
European leaders thought they had outsmarted the markets by creating the single currency. But the divergent economic performances continued, and were eventually made manifest in the bond markets. At the moment, if you want to predict future movements in the euro/dollar rate, the level of Spanish and Italian bond yields is a pretty good indicator; rising yields tend to lead to a falling euro.
The reverse is also true. Unconventional interventions by the European Central Bank (ECB) over the past few years might have been expected to weaken the currency, because the bank was seen as departing from its customary hardline stance. They haven’t because they have normally occurred when the markets were most worried about a break-up of the currency, and thus when the euro was already at its weakest. The launch of the Securities Market Programme in May 2010 (when the ECB started to buy Spanish and Italian bonds), and Mario Draghi’s pledge to “do whatever it takes”, including unlimited bond purchases, in July 2012 were followed by periods of euro strength because they reduced fears that the currency was about to collapse.
Currency war, what is it good for?
Currency trading is, by its nature, a zero-sum game. For some to fall, others must rise. The various unorthodox policies of developed nations have not caused their currencies to fall relative to one another in the way people might have expected. This could be because all rich-country governments have adopted such policies, at least to some extent. But it would not be surprising if rich-world currencies were to fall against those of developing countries.
In September 2010 Guido Mantega, the Brazilian finance minister, claimed that this was not just happening, but that it was deliberate and unwelcome: a currency war had begun between the North and the South. The implication was that the use of QE was a form of protectionism, aimed at stealing market share from the developing world. The Brazilians followed up his statement with taxes on currency inflows (see Free Exchange).
But the evidence for Mr Mantega’s case is pretty shaky. The Brazilian real is lower than it was when he made his remarks (see chart). The Chinese yuan has been gaining value against the dollar since 2010 while the Korean won rallied once risk appetites recovered in early 2009. But on a trade-weighted basis (which includes many developing currencies in the calculation), the dollar is almost exactly where it was when Lehman Brothers collapsed.
Many developing countries have export-based economic policies. So that their currencies do not rise too quickly against the dollar, thus pricing their exports out of the market, these countries manage their dollar exchange rates, formally or informally. The result is that loose monetary policy in America ends up being transmitted to the developing world, often in the form of lower interest rates. By boosting demand, the effect shows up in higher commodity prices. Gold has more than doubled in price since Lehman collapsed and has recently reached a record high against the euro. Some investors fear that QE is part of a general tendency towards the debasement of rich-world currencies that will eventually stoke inflation.
The odd thing, however, is that the old rule that high inflation leads to weak exchange rates is much less reliable than it used to be. It holds true in extreme cases, such as Zimbabwe during its hyperinflationary period. But a general assumption that countries with high inflation need a lower exchange rate to keep their exports competitive is not well supported by the evidence—indeed the reverse appears to be the case. Elsa Lignos of RBC Capital Markets has found that, over the past 20 years, investing in high-inflation currencies and shorting low-inflation currencies has been a consistently profitable strategy.
The main reason seems to be a version of the carry trade. Countries with higher-than-average inflation rates tend to have higher-than-average nominal interest rates. Another factor is that trade imbalances do not seem to be the influence that once they were. America’s persistent deficit does not seem to have had much of an impact on exchange rates in recent years: nor does Japan’s steadily shrinking surplus, or the euro zone’s generally positive aggregate trade position.
 
In short, foreign-exchange markets no longer punish things that used to be regarded as bad economic behaviour, like high inflation and poor trade performance. That may help explain why governments are now focusing on other priorities than pleasing the currency markets, such as stabilising their financial sectors and reducing unemployment. Currencies only matter if they get in the way of those goals.