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Vanilla fudge – Are some banks reverting to pre-crisis ideas of what constitutes prudent lending?

23/06/2015

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

A prevalent view among politicians, regulators, the media and other opinion-formers in general is that what tends to get banks into trouble are what are popularly known as their ‘casino banking’ activities – their speculative trading operations and so on. While this is certainly one possible cause of problems, here on The Value Perspective, we are not so sure it is the only one. 

To help illustrate our point, let’s take a look at the currently rather hectic world of telecommunications, which is at present awash with a lot of breathless speculation about potential mergers and acquisitions – intermingled with the odd deal that is actually going ahead. 

In the former camp, for example, is the possibility of some sort of tie-up between Vodafone and Liberty Global, the US-based cable giant overseen by John Malone, which we last came across on The Value Perspective in Media studies. Known for its fondness for both leverage and paying as little tax as it can, Liberty has taken full advantage of friendly debt markets and now boasts interests all over the world. 

Evidently fostering similar ambitions for world domination is Altice, a holding company controlled by Patrick Drahi, which in the past 18 months has spent around €35bn (£25bn) on acquisitions in the cable space, most recently buying Suddenlink in the US. Altice is also not afraid to take on leverage to fund its acquisitions – indeed, one of the things that has caught our attention about the company is its debt levels, as indicated by its net debt to earnings, interest, taxes, depreciation and amortisation (EBITDA) ratio. 

Regular visitors to The Value Perspective may recall that 2.5x is normally the top of our comfort zone with this metric while banks tend not to like companies exceeding 4x. Altice today sits a good deal higher – between 5x and 6x EBITDA – so you might begin to wonder what its own banks feel about the whole situation. 

Pretty relaxed, it would appear as, while they do impose a covenant limit of 4x net-debt-to-EBITDA on some of the companies within Altice that they lend to, there are several such companies whose debt is ring-fenced from one another. Here, the banks look only at these separate parts rather than at the business as a whole, which allows Altice to operate with such high leverage overall. 

Furthermore, they allow the definition of EBITDA used in Altice’s covenants to include expected future cost savings from recently acquired businesses. In other words, if Altice does a deal from which it reckons it can achieve synergies of £100m, say, its lenders will factor a portion of that in from day one – even though it might be several years before these higher profits are actually delivered. 

Which brings us to the recent race to buy US cable giant Time Warner Cable. Among the runners and riders were, as one might expect, part of Malone’s empire – and indeed the eventual purchaser – Charter Communications and rather more surprisingly, given the eventual price-tag of $55bn (£35bn), Altice. 

We raise an eyebrow here because Altice currently boasts an EBITDA figure of around €6bn and is already highly geared, so how on earth was it planning to find the money to complete such a large acquisition? Raising a lot of new equity capital or issuing shares were unlikely to be a big part of the mix here and it seems unlikely Altice could have quickly sourced all that debt from the bond markets. 

Worryingly, at any rate to us, this suggests that no small part of the money would have come from banks – at least in the form of bridging loans until other sources of debt could be raised. Certainly some of the comments made by Drahi after being outbid by Charter imply he had been counting on the support of a syndicate of household US and European banking names to make his proposal work. 

The idea that, less than a decade after the global financial crisis, there are apparently major banks willing to participate in a loan structure with this degree of leverage … well, it ought to come as a shock but, of course, it does not really. 

To bring us back to our starting point, lending money to one company so it can take over another is not casino banking – it is plain vanilla corporate lending. The problem is that, just because something is a fundamental part of ‘traditional’ banking, it does not mean the bank cannot still do it really badly. Our view would be that old-fashioned poor lending decisions are just as likely to get banks into trouble over time as so-called casino banking – possibly more so. It is arguably also much harder to regulate against.  

So have we unfairly picked on the Altice deal-that-never-was as an isolated instance of bonkers banking? What do you think? The truth is, we could have highlighted – come to think of it, in articles such as Judgement call and Flashing lite, we already have – any number of deals from the imminent future or recent past that call for the sort of financing that only a few years ago no self-respecting banks would even have considered.  But now they are. Ladies and gentlemen, place your bets …

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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