May 6, 2001

Leverage sharks circle telecoms

Posted in Banks · 2 comments ·
Share 

The most daring bunch of financial players in late 1920s Wall Street were Irish Americans. Born into poverty and excluded from the financial elite that was dominated by Wasps and German Jews, these men took huge risks to establish themselves and epitomised the stockmarket frenzy of pre-1929 America.

Their chosen asset class was technology, and their main speculative vehicles were the large, wildly inflated radio and telephone companies that dominated the Wall Street scene.

These companies played the same role in the 1920s as telecoms did in the 1990s: attracting punters into the stock market on the promise of huge returns which in the end proved to be little more than old-style ponzy schemes.

Amongst the most cunning of the Irish were Charles Mitchell, from Boston’s poor Chelsea suburb, and Mike Meehan, another Bostonian who initially earned his crust as a ticket tout before turning to broking. Eventually, he controlled the most volatile of all late 1920s stocks — Radio Corporation of America. His right-hand man was Bernard ‘sell ‘em Ben’ Smith.

Joe Kennedy, the father of JFK, who famously sold out before the crash, was another member of this clique. Along with JJ Riordan and Meehan, Joe Kennedy manipulated the stock price of Radio Corporation of America.

Some of these men did not survive the crash. Riordan committed suicide within days of Black Thursday. By 1932 Meehan had lost $40 million personally as his Radio Corporation of America stock collapsed from $114 a share to $2.50 a share. By 1936 he was in a padded cell in a mental hospital.

In contrast, Mitchell and Kennedy survived the fallout and thrived in cash businesses during the 1930s. These cash businesses picked over the carcasses of once inflated stocks. The stock valuation of many of the radio and telephone companies had fallen below their book value, presenting an extraordinary opportunity for those with cash to buy an asset, break it up, flog the valuable bits and make a fortune. The cash businesses of the 1930s were the forerunners of the leveraged buyout (LBO) merchants that are today circling around Eircom and many of Europe’s other depressed telecom assets.

Just as the emergence of cash buyers for depressed assets signaled the end of the 1920s bull run, the emergence of the leveraged buyout operator bidding for Eircom signals a new chapter for Irish finance and share ownership.

Both the O’Reilly and the O’Brien bids will be LBOs. They will put in as little as possible of their own cash, and will borrow hugely to make up the difference. In both cases, large foreign banks will underwrite these borrowings and take a charge on Eircom’s assets. It is likely that a new Eircom corporate bond will be issued to raise another part of the cash. Previous form would suggest that the valuable bits of the company will be sold or, in the case of Eircom’s property, that a ‘sale and lease back’ operation will be put in place along the lines of similar action by BT in Britain.

Cash will be king, and as long as global interest rates remain on a downward trajectory, whoever wins the Eircom battle should make a killing.

In broader terms, the LBO for Eircom raises a couple of serious questions. First, does this move signal a structural shift in Irish finance away from the initial public offering (IPO) frenzy of the late 1990s — and, if so, does this mean the shareholding democracy idea can now be put back in the box for another decade?

In the absence of any real competition in the fixed line business, a bidding war will marginally benefit Eircom shareholders, who will remain underwater on their investment anyway.

Which brings us to the second question: will a bidding war be detrimental to the rest of us who use Eircom’s services? The answer to the first issue seems to be yes. The LBO puts a nail in the coffin of future privatisations. LBOs, driven and priced by professionals, are the polar opposite to the IPO market that dominated the Irish financial market in the late 1990s.

At the height of a shareholding frenzy the IPO market is traditionally fuelled by amateurs, with little or no understanding of the product, and by fund managers. Typically, it is an era when cash is abundant and ‘new paradigm’ evangelism about future earnings drives valuations upwards. Now all this has changed.

From the punters’ point of view, having been badly bitten there’s not much hope they will queue up to buy Aer Lingus or whatever other state asset is due for sale. As valuations fall, a seller’s position also changes. For new, smaller corporations, the prospect of having to give away half your company for a few million quid will make most financial officers balk. New avenues are likely to be sought, probably culminating in either a strategic scaling back of ambitions (and thus need for cash) or a tendency to look for mergers with others in the business or to sell part of the company to an existing, bigger player in the same market.

Paying a stockbroker to give control of your company to a bunch of strangers for a depressed valuation is clearly bonkers. The brokers themselves will bin the idea of IPOs, and the very lads that were advising companies to “screw the competition” and float last year will be urging them to seek alliances and build bridges this year and next. The corporate raider behind the leveraged buyout structure will be hoping that today’s market depression provides a window to get the asset cheap at low interest rates. He is also gambling that the same very low interest rates will eventually allow the market to recover, and when asset prices begin to creep up again he can sell valuable bits of the business and make a killing on both transactions — the buying and the selling.

Where does this leave the users of Eircom’s product? Apart from a gut reaction against raiders making money ‘hand over fist’, do we want a bidding war? No. If you are not an Eircom shareholder you should be hoping either O’Brien or O’Reilly gets the company for half nothing. The more this pair has to pay, the more they will have to squeeze the company in the future.

Given that Eircom is a monopoly in the fixed line game, any cuts in the future will probably come at the expense of a second-rate service, resulting from delays in investment. There is a risk that the higher the price paid now, the less investment there will be in the future. It is clear that those of us who have never owned an Eircom share should hope no bidding war ensues.

The interests of the 400,000 Eircom shareholders and the three million odd of the rest of us are now diametrically opposed. Ironically, as privatisation is a tax raising exercise, the higher the flotation price, the better for taxpayers.

For PAYE workers, there must be a delicious irony in seeing others who have been avoiding tax for years banging down the doors of brokers in June 1999 to hand over money to the exchequer, in return for paper in a company they owned in the first place.

Now the opposite prevails. A bidding war would lead to a wasteful subsidy from telephone users to telephone shareholders, which might only become apparent in diminished service in the years ahead.

And so the cycle has come full circle, in the same way that the effervescence was followed by depression in the 1920s and 1930s. The only difference is that back then, Irish-American players were wheeling and dealing with other people’s assets, whereas these days the assets belong to us and it is the taxpayer that will be picking up the tab.