What goes around, comes around

Lola has sent me a link to this. You don't actually need to follow that link to get the gist of this post. In fact, you can save yourself even more time by just reading Lola's summary.

There is an underlying pattern, and a sort of twisted logic, emerging here. As I have said before:

Modigliani & Miller won a Nobel Prize for pointing out that the total 'enterprise value' of a company is usually equal to the value of all its shares and its bonds. Corporate finance wizards claim that companies can boost their own value in the good times by replacing shares with bonds (in other words, using borrowings to fund a share buy back), if this is true, then in the bad times, the reverse must also apply (in other words, doing a debt-for-equity-swap).

It was Ed (in the comments here) who pointed out why New Star had such high bank borrowings in the first place:

New Star's debt burden was taken on last April in order to facilitate a return of cash to shareholders. At the same time, New Star moved to the London Stock Exchange's main market and Mr Duffield and his family interests sold their stake down from 20 per cent to 12.5 per cent.

Let's call that an 'equity-for-debt-swap', which happens in The Good Times. And now that New Star have hit The Bad Times (and rightly so, according to Lola), the earlier deal is unpicked and the company does a debt-for-equity swap, i.e. the banks waive their loans and are issued with shares instead.

As ever, I should point out that New Star are of no particular interest to me (or probably anybody else reading this) , but all this illustrates that debt-for-equity-swaps are the market solution to over-leveraged companies. And why are our commercial banks in trouble? Because they have insufficient Tier One/Two capital, i.e. they rely on borrowings, i.e. they are over-leveraged. If our benighted gummint hadn't waded in with £37 billion of taxpayers' finest (plus all the other guarantees), then this is how banks would have been recapitalised.

Today's debt-for-equity-swap. Possibly.

Lola has drawn my attention to this.

"Yadda, yadda, unit trust manager in trouble, who cares?" I hear you mutter. Well, me neither frankly, but the interesting bit is this:

The asset manager says a further announcement will be made when the outcome of discussions with its bank syndicate is known but reports suggest the firm is negotiating a debt for equity swap with the banks...

Hargreaves Lansdown investment manager Ben Yearsley says: "Until New Star sorts everything out with its banks the shares will be volatile. It is possible it will go private as the market-cap is now meaningless as the value is now in the £20-30m bracket, where as the debt, which is the crucial figure, stands at £230-£240m*."

Precisely. In economic terms, the debt-holders own ninety per cent of the business. They have a choice, of course. They can force it into liquidation, break it up, sell off the bits and repay themselves as much as they can salvage, but as the value of New Star relates largely to intangibles - customer relationships, contracts, reputation(?) etc, which largely evaporate on a break-up, that's probably not a good idea.

So the least-bad option from the debt-holders' point of view is to waive part of the debts (let's say a fifth of it, in nominal terms) and give themselves new shares instead. New Star's debt/equity ratio would thus fall from an unhealthy 9-to-1 to a much healthier 3-to-1 or 2-to-1, and with a bit of luck, one day the current debt-holders will have shares worth far more than the value of the debts that they now waive.

The important question is, how many times will the banks do this sort of thing before they realise that the same principles apply to them? Banks, with their lousy capital ratios are in exactly the same position as New Star; instead of taking medium term loans from the taxpayer at savage rates of interest, they could also do deals with their debt-holders and let the taxpayer off the hook.

* UPDATE: Ed in the comments has tracked down why a company founded eight years ago has so much debt:

New Star's debt burden was taken on last April in order to facilitate a return of cash to shareholders. At the same time, New Star moved to the London Stock Exchange's main market and Mr Duffield and his family interests sold their stake down from 20 per cent to 12.5 per cent.