George Pitcher: Sharing responsibility for capital punishment

It’s true that the markets can’t be held responsible for managements’ imprudent spending, but neither are they blameless when companies sink, says George Pitcher

I wrote here before Christmas that there were unnerving similarities between cable operator NTL and Consignia, the redesigned but hobbled Post Office.

The thrust of my argument was that, while NTL was part of the “new” economy that had burst with the dot-com bubble and Consignia represented the “old” that was being replaced, they were both burdened by debt, an equity value that had collapsed and no prospect of an imaginative financial way forward.

My conclusion was that it was down to the capital markets to find more efficient ways of evaluating and managing equity and debt. It is in the interests of the economy – and consequently of us all – that we’re not saddled with a system in which the capital markets simply bloat organisations with the cash and then have no alternative strategy when that cash is spent.

I haven’t returned to the subject since because I wanted to see how France Telecom’s radical re-financing of NTL turned out. But now is as good a time as any, because there seems to be considerable sympathy out there for the view that the capital markets cannot be left as they are.

Charlie Darley writes from south-west London to tell me I’m wrong to ascribe the blame to the capital markets for being inflexible and out-dated. Rather, he claims, I should upbraid the managements of the likes of NTL for frittering away investment so wantonly.

In other words, spending money, not raising money, is the problem. In the case of NTL, Darley points out that NTL raised some £10bn, invested about a quarter of this outside its core UK market and now finds the shares worth about one-third of what it paid for them. Meanwhile, NTL neglected its customer base in the UK, undermining its ability to deliver shareholder value as a consequence.

The overall point here is that companies such as NTL and Consignia have become so seduced by the idea that acquisitions will deliver earnings growth that they have allowed their core business to wind down and are therefore in no position to deliver when those acquisitions turn out to be turkeys. All is vanity.

Darley has a point. Capital markets are never going to work if the industrial managements in which they are invested are populated by a bunch of bozos, who cast capital judgement to the winds with ill-advised acquisition sprees.

If I go to the races and blow the annual budget, I can hardly blame the bank for lending me the money to do so. So it’s worth making the point that what Consignia and NTL really have in common is not so much that they have been stuffed by the capital markets, but that their managements have at one time or another been incompetent.

But this observation satisfies only part of the debate. If managements are always going to be fallible – and we can assume that they are – then what are the capital markets to do about it?

Being better at spotting the rubbish is clearly part of the answer. But capital providers have an intrinsic and direct interest in the markets working, otherwise the economy declines and its cycle becomes one of wealth destruction in which we all make less money.

That’s an observation that tends to get the undivided attention of bankers. So, while industry has a responsibility to deliver growth strategies that are more sophisticated than just buying a lot of dodgy assets at the top of the market, there is a commensurate responsibility on the part of lenders to assess risk efficiently.

There is some evidence that, in a volatile economy such as this year’s, greater attention is paid to who owns the assets than during more stable times, when capital is being freely hosed around.

Take the situation at NTL. Its main shareholder, France Telecom with some 24 per cent, is about to find that its stake has been diluted more than a scotch in a clip joint. Who will now own the equity and call the shots? Step forward the debt investors.

Further proof, if any were needed, that these people are not passive debt collectors who simply accumulate their coupons and wait for debt redemption. Not any more, at any rate.

Generally, I’d say that debt markets have done a better job of pricing risk than equity markets. This is partly because equity investors adopt an attitude that all too often amounts to “Fill your boots – it’s going to double”, while the debt markets are simply looking for interest on their investment.

I have known instances in which the debt trades at such a discount (the rates at which debt risk is assessed) that the implied yield – the coupon divided by the price of the bond – is 15 or even 25 per cent. This implies high risk, and means that the debt markets consider it a reasonably high likelihood that bondholders will not get all their money back.

Debt is repaid first, so it is by definition lower risk than equity. All the same, equity analysts have used considerably lower rates than the debt markets to justify their recommendations on a stock.

No one is suggesting that the borrowing managements are very smart, but let’s not run away with the idea that the financial institutions are full of top brains who don’t deserve to be ripped off.

George Pitcher is a partner at communications management consultancy Luther Pendragon

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