My Nan was wise. When I was very young and trying to raise money for a much-needed purchase of a Matchbox Ford GT she would say, “Never a lender nor a borrower be, for loan oft loses both itself and friend.”
Actually, she altered the second half to, “… as it will end in tears.” I don’t think she realised – and I certainly didn’t – that she was quoting from Hamlet. The books in her bedroom tended to be written by Jean Plaidy rather than Shakespeare.
Nevertheless, as was borne out over the rest of my childhood, my Nan was a strong first mentor in my life. She would be horrified by the leveraged $55 billion buy-out of computer game developer Electronic Arts (EA) announced this week. The Saudi sovereign wealth fund and two private equity companies (one owned by President Donald Trump’s son-in-law) are paying $210 a share (25% over the pre-deal stock price) to take the business private. It will be the biggest take-private deal ever, eclipsing the $45bn purchase of Texas power generator TXU in 2007. Albeit, this latest deal is much more restrained on leverage: roughly 35% of the deal is funded by debt. For TXU – which was bankrupt within seven years – it was more like 90%.
EA deal creates payday for our funds
A it happens, I was pretty chuffed by the EA deal as we hold the stock in our portfolios: a legacy of our computer gaming basket, introduced to our portfolios about eight years ago. Only two left now – chip maker Nvidia and Grand Theft Auto publisher Take Two. EA is the second to be taken over, Microsoft bought developer Activision Blizzard two years ago. Now Microsoft paid cash, which my Nan would have approved of, but she would have tutted Kushner and his cohorts all the way to closing.
It’s interesting how investors think about debt. Most of the time they’re pretty sanguine, seeing it as a way of stimulating growth and improving a good thing. Once every five to 10 years, however, the sentiment towards debt turns negative. That often results in sharp drawdowns in risk assets as people retreat to more trustworthy paper, like government bonds. Many become forced sellers, the ultimate investing sin.
So, my question today is – are we about to see a period where markets become more concerned around debt levels? Are we going to see a Storm Connie (let’s name it after my Nan), rip through debt markets?
Let’s look at the evidence. Corporate bond spreads above government bonds are very narrow. Is that because investors see that most businesses have stronger balance sheets than profligate governments, or is it that demand for bonds is extremely high as investors chase yield against a backdrop of falling interest rates?
As these credit spreads have narrowed, interest in private credit markets (and other private assets) has surged, with many retail investors now looking to get access and many product manufacturers keen to provide the means to do so. Is this wise?
We shouldn’t ignore that listed equity valuations are pretty elevated thanks to the AI boom, pushing up private equity valuations too.
All this positive risk appetite, what could go wrong? Well, quite a lot actually. Remember leveraged loan funds a decade ago? They had to close sharpish as the banks pulled their facilities. We have seen the same in property funds in the past. Can be very painful.
What could go wrong?
At some point the penny will have to drop for governments: they need to heed Polonius’s oft-quoted advice and reduce their debt. Higher taxes and lower spending could tip many economies into recession. While they may not prove as long or deep as those seen towards the back end of the last century, economic contraction would likely puncture animal spirits and appetite for lending would fade with it.
In the past it was the investment bank prop desks that got overleveraged. What if it’s the private credit funds this time? It would be wrong to denigrate a whole asset class as there will be some high-quality players, but it’s the second and third tiers I worry about. The recent collapse of privately held autoparts conglomerate First Brands might be a case in point. The company seems to have been run very poorly yet managed to secure loans all over Wall Street, including with PGIM, UBS and Invesco, according to The Times.
My caution is playing out in our strategy. We have no exposure to private asset funds and very little exposure to high yield or investment grade corporate bonds. We would rather be in equities – preferably those with high cashflow yields and more cash than debt on the balance sheet. I don’t know about volatility, but that feels safer to me over the medium term.
If we see prolonged recessions then government bonds should perform well as rates should then be falling more quickly. Not great for stock earnings, but at least sovereign bonds give you diversification and an inflation-plus return at current yields and inflation expectations.
My Nan wouldn’t approve of me lending to Rachel Reeves – not least because she was a staunch working-class Tory. But there’s no friendship to be lost and the government shouldn’t go bust anytime soon. But the government’s policies could engineer a recession, in which case gilts should provide a good hedge!
