The vagaries of financial engineering

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Financial engineering has built vast financial edifices, but too often there is little substantial backing. The latest Wall Street constructs to collapse are household names, Valeant Pharmaceuticals International Inc.

and SunEdison Inc.

Both relied on financial engineering to satisfy shareholders desperate for two rare things in today’s weak economy: growth, offered by Valeant, and revenue, provided by SunEdison’s so-called yieldcos.

Shareholders who avoided both will congratulate or thank their luck. But they should also ask themselves a larger question: Is the entire stock market engaged in unsustainable financial engineering in an effort to satisfy shareholders? In other words: we know that the market is engaged in large-scale financial engineering in the form of a huge build-up in leverage. Is it sustainable?

Valeant and SunEdison show financial engineering in a bad light. Valeant has used access to cheap financing, in the form of its own highly valued stocks and bonds, to make ever larger acquisitions. Aggressive bookkeeping allowed him to squander his profits as long as the trades continued.

Because the company seemed to offer strong growth, investors marked up its shares, which allowed it to complete the next transaction, and so on. Until it stops.

Investors have once again learned the problem of roll-up companies whose growth is driven by accounting and valuation multiples rather than economies of scale. The virtuous circle of cheap funding for buyouts leading to higher valuations leading to cheap funding only works as long as they keep doing business. Valeant’s market value is down $78 billion from its peak, about the same in today’s money as the total lost to Enron shareholders.

SunEdison, a solar company, used more innovative financial engineering. He created sister companies, TerraForm Power Inc.

and TerraForm Global Inc.,

to raise funds from investors for its completed projects. Through clever use of tax losses, shareholders were promised a high and growing dividend without corporate taxes, while SunEdison secured upfront cash and retained control of the projects.

Renewable energy companies have created a range of yield companies, earning high valuations from income-starved investors, aided by those who demand environmentally friendly homes for their money. Almost all have been hit hard by changes to state tax breaks for green projects and falling fossil fuel prices.

The financial engineering behind Valeant and SunEdison has a bad reputation, at least for now. But yesterday’s financial engineering often becomes widely accepted. In the case of the engineering behind today’s high stock valuations, it goes further: borrowing to buy back stocks is widely welcomed.

According to Societe Generale, the 1,500 largest non-financial companies in the United States increased their net debt by $409 billion in the year to the end of March, using almost all of it – $388 billion. – to buy their own shares, less newly issued shares. Companies have become by far the biggest customer for their own actions.

As corporate profitability slows, the obvious fear is that this debt will spell disaster for shareholders. Total corporate debt is close to the proportion of the economy affected by the debt-fueled bubble that ended with the collapse of Lehman Brothers in 2008.

According to David Kostin, strategist at Goldman Sachs, the debt and equity of the median American non-financial company is worth 11 times operating cash flow, higher than in 2007 and higher than at the height of the bubble Internet. (This widely used measure is known as enterprise value versus earnings before interest, taxes, depreciation and amortization).

So not only are companies heavily leveraged, but shareholders love it. What could go wrong?

Read more from James MacKintosh

The arguments for calm are that when interest rates are low, it is natural for companies to take on more debt. An illustration: the interest coverage of junk-rated non-financials in the United States, or the number of times operating profit covers interest expenses, is the strongest since at least 1997, according to the Office of Financial Research, a US watchdog created by the Dodd-Frank Act. .

The worrying case is that this borrowed money was not invested in productive projects that would increase income in the future and thus pay off debt, but was instead used to buy back shares. Corporate investment has picked up recently, but global buyouts are financed by borrowing, as Andrew Lapthorne, strategist at Societe Generale, points out.

This creates three risks. First, rising interest rates on corporate debt would have a much bigger impact than usual on profits and shareholders, and could lead to a wave of defaults, as the industry has shown. ‘energy.

Second, greater caution in the bond market, possibly caused by the recession, could prevent companies from refinancing their debt; again, the energy sector was a painful demonstration of what happens to highly indebted companies when they lose access to credit.

Third, if companies themselves become more cautious, it could drive the biggest buyer of stocks out of the market. Share buybacks helped support prices and earnings per share even as earnings fell back to mid-2012 levels.

If companies stop borrowing to finance takeovers, another generation of shareholders will discover the flip side of financial engineering.

Write to James Mackintosh at [email protected]

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