Leverage, Pirateering, and Profits

We noted in the Markets and Money today the comments of the Reserve Bank of Austrlia about the increasing use of leverage in the Australian stock market. The RBA is concerned about debt. When companies use debt to acquire a stake in another company, it can often prompt other companies to take on more debt than they otherwise would to “defend” themselves.

What is the basic financial problem with all this? Debt taken on merely for the sake of sacking the corporate balance sheet and looting a company is extremely unproductive debt. You might even call it destructive. It makes the purchase of an asset possible. But it doesnt create any new asset, an asset which then produces something or creates income.

That’s not to say all buy-outs are negative or all leverage is waste. But in the field of financial innovation, new tools are often more about short-term profits than ways to reduce long-term risk or add value. Is private equity the next generation of financial engineering that makes a handful of speculators gloriously rich but ads no real value to the economy and possibly destorys previously sound companies? Hmmn. Aaaaaargh.

Meanwhile, as promised, here’s what the RBA had to say in more detail, complete with charts. Emphasis added is our own.


“Some of the recent strength in the share market has been driven by announcements of, and speculation about, merger and acquisition (M&A) activity. While some of these individual transactions have been large, in aggregate the number and value of deals actually finalised in recent months has not been particularly big in comparison with the past few years.rba53.jpg

“However, several large M&A deals are pending. Moreover, the proportion of M&A activity that has been in the form of leveraged buyouts (LBOs) by private equity funds has picked up significantly. The available evidence suggests that the value of domestic LBO activity – including both the debt and equity funding – has increased to $13 billion so far this year, after averaging around $1½ billion over the past five years (Graph 54).


“In 2006 to date, LBOs by private equity firms have accounted for around 15 per cent of all corporate merger and acquisition activity where the bought-out company was an Australian entity. This compares with less than 5 per cent in previous years. Most of the pick-up has reflected an increase in the average deal size, with several deals in excess of $1 billion each.

“It is worth noting that, despite the increase in activity, LBOs in 2006 to date still account for less than 1 per cent of the value of the corporate sector as a whole. That said, LBOs typically result in a significant increase in the gearing of the bought-out company, potentially making it more sensitive to economic fluctuations.

“In recent years, for example, LBO deals in Australia have often resulted in the bought-out company having a debt-equity ratio several times higher than before the takeover. Companies which consider themselves under threat of an LBO may also gear up in  defence. For listed non-financial companies as a whole, the gearing ratio – the ratio of the book value of debt to equity – has increased in recent years, reversing the fall earlier in the decade (Graph 55).


“Despite this increase, the aggregate gearing ratio, at 64 per cent, remains a little below its long-run average. It appears that the recent increase in the gearing ratio owes to an increase in leverage by companies that previously had low levels of gearing (Graph 56). Companies that had no debt in June 2004 have increased their gearing ratio by an average of 7 percentage points; those with gearing ratios from 1–25 per cent in 2004 have increased their leverage by an average of 12 percentage points. Importantly, companies that had gearing ratios above 50 per cent in 2004 have, on average, reduced their gearing over the past two years. Falls have tended to be particularly sharp for resource companies. Mostly, this reflects the strength of their profitability and retained earnings, which boosts equity in the company.



Dan Denning

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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