The Debt Trap by Sebastien Canderle
REVIEW BY OWEN JONES, FIDELITY PERSONAL INVESTING, 24 MARCH 2017
The Debt Trap by Sebastien Canderle, published by Harriman House
Do you remember Go for broke? It was a board game from around the mid 1960s and was a kind of Monopoly in reverse. Players received £1million at the beginning of the game and the winner was whoever got rid of their cash the quickest and go bankrupt. You could spend your cash at the racecourse, the casino, or play the stock market. You could even give money to charity. Unlike the classic Richard Pryor film Brewster’s Millions, you could fritter the money away on nothing rather than buying anything tangible with it.
Montgomery Brewster does of course have a long term plan when he spends his £30million, culminating in an inheritance of £300million. His task is complicated by the restrictions his will places on him. In spending the £30million, he is prevented from revealing the terms of the will, and this makes him appear to be a newly-rich snob with no taste.
I was reminded of both these scenarios when reading the case studies in The Debt Trap. Sebastien Canderle’s detailed accounts of 14 Leveraged Buy Outs (LBOs) over the last 20 years takes what could be quite a dry subject and transforms it into a riot of endless debt restructuring, dividend recapitalisations and asset stripping.
Not only does the book offer plenty of warning for private investors about investing in IPOs (Initial Public Offerings) where the company floating is backed by a Private Equity (PE) house, but also offers institutional investors plenty of evidence of what can go wrong with companies saddled with the exorbitant debt an LBO can bring.
The case studies focus on LBOs where the leverage is more than 70% and explains how in many cases this over-leveraged position from the outset makes the PE ownership of the business a flawed enterprise.
We’re also taken on a tour of the most favoured practices of PE owners when trying to extract the maximum return on their investment. In many cases these practices leave the acquired firm critically short of value by the time they have finished with them, either because the target firm goes under or is taken over by its lenders; or in the case of Debenhams because the true causes of a spike in operating profit is hidden by the sell and lease-back of its property portfolio.
One of the themes that runs through the narrative is how unqualified so many of the protagonists are to run the businesses they end up running. The financier Guy Hands ended up running the music giant EMI in 2007, turning one of the UK’s most iconic companies to rubble within five years. These stories highlight how the art of managing LBOs is far from an exact science.
Luckily, lessons can always be learnt. However, that’s not necessarily the case in private equity. The story of the KKR takeover of the Texan energy company TXU shows us how betting big (with debt) on the continued price trajectory of a historically cyclical commodity can only spell disaster, and in this case saw the tenth biggest bankruptcy in US history. What is unforgivable is to make the same mistake twice in such a short space of time, as KKR did when they bought Samson Resources even as they issued debt upon debt to try and keep TXU afloat. In 2015, Samson filed for bankruptcy under $4.1billion of debt.
What I most like about this book is its broad scope in explaining the social effects of this kind of financial engineering. In the UK, the most recent high-profile case of corporate greed involved Sir (is he still Sir?) Philip Green’s calamitous ownership of BHS; we are reminded of its subsequent collapse and loss of over 11,000 jobs every time we visit the high street.
What many ordinary people cannot understand is how it is legal to denude a company of its assets in the way Green did. Canderle argues that the ‘preposterous behaviour’ employed by some PE operators could eventually come back to haunt all of us in the same way the irresponsible sub-prime lending of the banks in the early noughties eventually sparked the biggest financial crisis since the 1930s.
Unless someone or something begins to regulate the PE sector more carefully ‘the whole fabric of our capitalist societies will self-destruct’ says Canderle, which admittedly sounds rather dramatic; but it does show the passion he has for this industry - how it once was a force for good, and how it has become ‘unfair and brutal’ when relying on leverage.
While Richard Pryor’s Monty successfully played his version of Go for broke! he did so with a view to the bigger picture. This book shows PE firms should do the same.