Remember The Trade Wars? This Isn't Complicated

by: The Heisenberg

- Despite the fact that this week saw the official implementation of "phase 2" of the U.S.-China trade dispute, trade wars took a back seat to domestic political theatre.

- Rest assured, trade wars won't remain relegated to the news cycle back burner for long.

- What I wanted to do on Saturday is bring you a straightforward assessment of tariffs' likely impact on S&P 500 earnings and on the U.S. consumer.

- There isn't anything complicated about this.
The title here is of course a reference to the fact that trade war news took a back seat to domestic politics in the U.S. this week.
It's a quip, and not a particularly creative one, but it resonated on Friday, and it speaks to the manic nature of the news cycle that has, at various times over the past two years, overwhelmed market participants' collective ability to process the deluge of potentially relevant incoming information.
And please, save me the "it's all noise" line, because anyone who really trades knows it's only "all noise" until an algo misreads a headline and runs everybody's stops.
"Remember XYZ?" has become something of a common refrain on financial Twitter (or, "FinTwit", for short), and while anyone could have made the quip that serves as the title to this post, I'll attribute it to one of FinTwit's more widely followed pseudonymous accounts:
Well, let me assure you that to the extent folks forgot about trade wars this week, the market's memory will be jogged soon enough. While I'm obviously predisposed to suggesting that most political news has market ramifications, the political soap opera that captured everyone's attention in the U.S. this week only matters for markets to the extent it influences the U.S. midterms. That effect might be large, but it's a second order effect, which means it's inherently untradable in the short run.

On Thursday, as everyone scrambled around at their desks to try and find a live feed they could stream of the Senate Judiciary Committee proceedings, the World Trade Organization was like that kid in the back of the classroom who never gets called on by the teacher ("Me, me, call on me, please!").
Had anyone cared to call on the WTO Thursday, they would have discovered that the organization slashed its 2018 trade growth outlook to 3.9% from 4.4% in April.

Additionally, the WTO said merchandise trade growth will be 3.7% next year, down from a projected 4% in their previous Outlook.
Here's what WTO Director General Roberto Azevedo said in a statement:
While trade growth remains strong, this downgrade reflects the heightened tensions that we are seeing between major trading partners. More than ever, it is critical for governments to work through their differences and show restraint.

That warning came just three days after the latest round of U.S. tariffs on China went into effect. On Monday, levies on $200 billion in Chinese goods were implemented and it's widely expected that the Trump administration will move ahead with duties on an additional $267 billion in goods before year-end.
Perhaps the most important thing for investors to understand about the trade frictions in the context of U.S. equities (SPY) is that stocks aren't "ignoring" the effects. Rather, the effects simply aren't showing up in the fundamentals yet. More simply: There's nothing to "ignore" or to respond to.
The tax cuts and expansionary fiscal policy have created enormously powerful tailwinds both for U.S. corporate bottom lines (record earnings growth) and for the domestic economy (while the "hard" data is starting to disappoint relative to consensus, it's still robust, and the "soft" data is simply euphoric).
Those same policies are dollar positive (via the read-through for U.S. monetary policy). A stronger dollar puts pressure on ex-U.S. risk assets (think: emerging markets that have borrowed heavily in USD) while the threat of further trade tensions dents the outlook for global growth.
In sum, there are fundamental reasons to be long U.S. stocks and fundamental reasons to be concerned about ex-U.S. assets.
Little wonder then, that U.S. equities have diverged from their international counterparts. It isn't some "mystery". In fact, it's the opposite of a mystery. Sure, the unprecedented divergence argues for a scenario where ex-U.S. assets "catch up" into year-end (that's the "convergence trade"), but if all you're looking at are the fundamentals, well then the current juxtaposition is not only not a mystery or an example of U.S. stocks "ignoring" reality, but rather everything acting exactly like you would expect it to act.
Sure, markets are supposed to be forward-looking, but they're also supposed to be efficient price discovery mechanisms. Those two characterizations of markets' "proper" role sound good in theory and in the textbooks, but in reality, market participants are a myopic bunch and post-crisis monetary policy has stripped capital markets of their ability to act as mechanisms for price Discovery.
I'm going to go ahead and assume that although you and I are, like everyone else, tempted by short-sightedness and the allure of riding the next assumed leg higher ("climbing the wall of worry", as it were), we're also interested in thinking about what the longer-term ramifications of the trade frictions are for the U.S. companies in which we have an ownership stake via equities. Remember, this isn't supposed to be a casino. Don't lose sight of what it means to own stock.
As I put it earlier this week, if the trade tensions keep headed in the direction they're headed, it will affect corporate bottom lines and guidance.
On that score, there isn't anything particularly complicated about the math or, more generally, about the transmission mechanism between tariffs and the stocks you own.
To reiterate, it now seems highly likely that the U.S. will end up taxing the entirety of Chinese imports to the U.S. The Trump administration adopted a 10% initial rate in the latest round of tariffs, but promised to more than double that to 25% starting in 2019 if there's no resolution.

The President and his aides have made it abundantly clear that retaliation from China will be seen as cause for the U.S. to slap levies on the remainder of Chinese imports.
If we assume that the rate in a theoretical "third phase" would be 25% (and that's probably a reasonably safe assumption, although I suppose it would be possible to lift the rate on the list that corresponds to "phase 2" while applying a 10% rate to the prospective new list), then earnings growth for the S&P 500 flatlines in a worst case scenario.
What constitutes a "worst case scenario"? Well, here are the specifications and numbers, via a Goldman note out Friday evening:

Tariffs represent a threat to corporate earnings through higher costs and lower margins. For all US industry, roughly 15% of cost of goods sold is imported. Given S&P 500 constituent firms are more global in nature and have more complex supply chains than overall industry, we estimate imports account for roughly 30% of S&P 500 COGS. This estimate is consistent with the 30% share of S&P 500 sales generated outside the US. Imports from China account for 18% of total US imports. Our baseline earnings forecast is S&P 500 EPS jumps by 19% to $159 in 2018 and climbs by 7% to $170 in 2019. Consensus bottom-up estimates are slightly higher at $162 (+22%) and $178 (+10%), respectively. 
For a top-down tariff sensitivity analysis, we conservatively assume no substitution to other suppliers, no pass-through of costs to consumers, no boost to domestic revenues, and no change in economic activity. Given those assumptions, a 25% tariff on all imports from China would lower our 2019 S&P 500 EPS estimate by roughly 7% to $159, flat vs. 2018. If forecast EPS drops to $159 and the forward P/E contracts by 5% to 16.4x, the S&P 500 would fall to roughly 2600 (-10% from current levels). 
Please note that there is exactly nothing complicated about that analysis. A first-year college econ major could understand it on the first read. If a third of your COGS is imported, well then, you're going to get significant margin pressure in a protectionist environment. The only way you don't get margin pressure is to upend your supply chain (i.e., source from locales that aren't subject to the tariffs) or raise prices. At the aggregate (i.e., index) level, the only way to mitigate these effects barring a significant rethink of supply chains and/or higher prices, is to sell a bunch more stuff, presumably on the back of a continued upswing in domestic economic activity.
Here's a bit more from Goldman on margins:
Rising input costs force firms to raise prices or sacrifice profitability. In part due to the boost from corporate tax reform, S&P 500 net margins have surged to all time highs (10.7%). However, earnings results and management commentary have underscored the challenge companies are facing to keep up with rising costs and the pressure this could eventually put on profit margins. The most recent National Association of Business Economics Survey showed a large share of respondents reporting rising material (48%) and wage costs (48%), and a much smaller share reporting rising prices charged to customers (20%). In the past, this dynamic has preceded declining S&P 500 EBIT margins.
Again, there is nothing at all complicated about this and that's what makes it perplexing when I see retail investors suggest that somehow the trade wars can continue on the current trajectory without ultimately impacting U.S. stocks.
The only way that kind of thinking is consistent with reality is if either the trade frictions dissipate or else if multiples expand. The former option (i.e., easing trade tensions) is obviously the more desirable outcome, because the latter simply means paying more for every dollar of earnings.
And see, here's the other thing: I continue to worry that the incessant media attention on the U.S. economy is leading directly to a scenario where U.S. consumers are increasingly oblivious to the straightforward costs that will accrue to them from trade frictions. The Bloomberg Consumer Comfort Index, for instance, is sitting at its highest level since 2000.
Contrast that with the following commentary from Barclays, excerpted from the bank's latest sweeping global outlook piece (which, by the way, strikes an overtly optimistic tone, so please don't mistake the following for bearishness):

Although losses from a global reduction in trading volumes following a withdrawal of the US from the global trading system would not be trivial, the losses from a bilateral US-China trade dispute or an increase in auto import tariffs may be less than some expect given the heightened rhetoric regarding the subject of trade barriers. One reason it is so heated, despite what appear to be minor economic costs short of a full-blown trade war, is that the net costs obscure concentrated losses. By this we mean that tariffs act as a tax on consumption, with losses borne primarily by consumers, and the net economic costs include offsets from increases in producer and government surpluses. In our baseline US-China scenario, for example, we estimate plausible losses to US consumers at about 0.6% of GDP, only some of which is transferred to the government and corporate sector in the form of tariff revenues and profitability. 
The same is true for tariffs on trade in autos; plausible losses to consumers could be several times the net economic loss. On one hand, durables represent the most volatile part of personal spending, and sizeable price increases will impose costs on households. Yet domestic production may expand, and additional revenues to the government, if largely saved, could provide offsets. Altogether, relatively modest estimates of the net economic costs may trade off up-front losses for consumers against medium-term gains from producer and government surplus. 
Got that? The cost of this is ultimately going to be borne by consumers. It is not at all realistic to expect corporate management teams to avoid passing on the costs associated with a new global trade regime forever. In order to avoid raising prices, management would have to be willing to renegotiate every aspect of their supply chains that involves imported COGS and eat whatever's left over in terms of cost pressures. Does that sound realistic to you? Of course not. Especially not in an environment where U.S. corporations are perhaps more zeroed in on the interests of their shareholders than ever before.
When you think about that in the context of an economy that depends heavily on consumer spending, you start to wonder whether ebullient consumer sentiment might be sorely misplaced.
In any event, I was excited on Saturday to write the above, because in stark contrast to a lot of the commentary I pen for this platform, it is all very straightforward and easily digestible by everyday investors.
I would encourage you to think about everything said above as you ponder the relative merits of a market that is trading like this:

A load of rubbish

Emerging economies are rapidly adding to the global pile of garbage

But solving the problem should be easier than dealing with other environmental harms, says Jan Piotrowski

THE OFFICES OF Miniwiz in central Taipei display all the trappings of a vibrant startup. The large open space on the 14th floor of an office block overlooking Taiwan’s capital is full of hip youngsters huddled around computer screens. A common area downstairs includes a video-game console, a table-tennis table and a basketball hoop. But a hint that this is not just another e-commerce venture comes from neatly sorted sacks packed with old plastic bottles, CDs and cigarette butts.

Rather than peddle brand-new virtual products, Miniwiz derives value from physically repurposing old rubbish. Chairs in the conference room began life as plastic bottles, food packaging, aluminium cans and shoe soles. The translucent walls separating it from executives’ dens owe their amber-like quality to recycled plastic mixed with discarded wheat husks. Coffee is served in glasses made of broken iPhone screens. Arthur Huang, the company’s 40-year-old founder and chief executive, who holds a masters degree in architecture from Harvard, first tried setting up shop in New York in the mid-2000s. That effort failed when he discovered that few Americans shared his obsession with limiting the world’s waste. By contrast, many of his fellow Taiwanese did.
They still do. The island is a poster child for recycling, recovering 52% of rubbish collected from households and commerce, as well as 77% of industrial waste, rivalling rates achieved by South Korea, Germany and other top recycling nations (America recycles 26% and 44% respectively). Its recycling industry brings in annual revenues of more than $2bn. Lee Ying-yuan, the environment minister, boasts that 16 of the 32 teams competing at this year’s football World Cup in Russia sported shirts made in Taiwan from fibres derived from recycled plastic.

For more than two centuries since the start of the Industrial Revolution, Western economies have been built upon the premise of “take, make, dispose”. But the waste this created in 20th-century Europe and America was nothing compared with the rubbish now produced by emerging economies such as China. According to a new World Bank report, in 2016 the world generated 2bn tonnes of municipal solid waste (household and commercial rubbish)—up from 1.8bn tonnes just three years earlier. That equates to 740 grams (1lb 6oz) each day for every man, woman and child on Earth.

That number does not include the much bigger amount produced by industry. Industrial solid refuse contains more valuable materials like scrap metal and has long been better managed by profit-seeking firms. And then there is the biggest waste management problem of all: 30bn tonnes of invisible but dangerous carbon dioxide dumped into the atmosphere every year.

As people grow richer, they consume—and discard—more. Advanced economies make up 16% of the world’s population but produce 34% of its rubbish. The developing world is catching up fast. On current trends, the World Bank projects, by mid-century Europeans and North Americans will produce a quarter more waste than they do today. In the same period, volumes will grow by half in East Asia, they will double in South Asia and triple in sub-Saharan Africa (see map). The annual global total will approach 3.4bn tonnes.

This special report will argue that waste generation is increasing too fast and needs to be decoupled from economic growth and rising living standards. That will require people to throw away less and reuse more—to make economies more “circular”, as campaigners say. This can only happen if people “equate the circular economy with making money”, claims Tom Szaky of Terracycle, which develops technologies to use hard-to-recycle materials. “Take, make, dispose” must now shift to “reduce, reuse, recycle”, he says.

Virtuous recycle

Global waste may not present as apocalyptic a challenge as climate change, but it may be easier to solve. This is because local action to clean it up and recycle it can lead to immediate local effects. That can in turn transform into a virtuous cycle of change. People are more likely to take action if they can quickly see the results of their change in behaviour. All the more so because reducing waste offers two benefits not just one. It not only removes an affliction (solid waste) but, unlike tackling smog, it also creates a tangible benefit at the same time, in the shape of the recycled materials that can be reused. On top of that, solid waste (the only type that this report will discuss) is a visible eyesore. It is hard for anyone to deny that it exists.

That does not mean it will be easy to move to a more circular economy. Currently 37% of solid waste goes to landfill worldwide, 33% to open dumps, 11% to incinerators (see chart). Some goes to compost heaps. Two-thirds of aluminium cans are currently recycled in America, but only 10% of plastic. All told, only 13% of municipal solid waste is recycled globally. Everyone agrees that this is far too little.

The urgency of the problem is not in dispute. In July India’s Supreme Court warned that Delhi, the country’s capital, is buried under “mountain loads of garbage”. When dumps or landfills catch fire, as more than 70 have in Poland over the sweltering summer, noxious smog smothers their surroundings. Toxic runoff can permeate soils and poison waterways. Some rivers in Indonesia are so blanketed with litter that it completely conceals the water beneath. According to the United Nations, diarrhoea rates are twice as high in areas where waste is not collected regularly, and acute respiratory infections are six times as common.

Discharged into seas, rubbish can return to wreak havoc on land. In August the Arabian Sea spewed 12,000 tonnes of debris and litter onto the shores of Mumbai in two days. Or it can despoil the ocean. Fishermen in the Arabian Sea complain they net four times as much plastic as fish. The “great Pacific garbage patch”, an Alaska-sized ocean gyre in the north Pacific Ocean, where currents channel all manner of flotsam, may contain 79,000 tonnes of plastic debris. Greenhouse gases from the waste industry, mainly emitted by a cacophony of chemical reactions in landfills, could account for 8-10% of all climate-cooking emissions by 2025. Left unchecked, this groundswell of garbage risks overwhelming the planet.

The good news is that around the world politicians and the public appear increasingly alert to the economic, ecological and human costs of waste, as well as to the missed opportunities it presents. Many governments in the developing world are grasping that spending less—or nothing—on waste management means paying more for things like health care to treat its effects. In the developing world, only half of all municipal waste is collected. In low-income countries as much as 90% ends up in open dumps. Lowering these proportions requires more investment in waste infrastructure such as managed landfills or low-polluting incinerators. Taiwan’s example shows that these can be clean and need not discourage recycling.

Rich countries already have such facilities, and more. They need to improve the recovery of valuable materials from their waste streams. For two decades they have relied on emerging economies, primarily China, to recycle their refuse. Over the past 25 years, the world deposited 106m tonnes of plastic in Chinese ports for recycling. The system ran aground in January when China banned imports of virtually all plastic and unsorted paper, out of concern for its environment. This left Western waste-managers with tonnes of unwanted rubbish—and left policymakers with piles of unanswered questions about how to boost the capacity of domestic recyclers, and ultimately change citizens’ carefree approach to waste.

Politicians in Europe and American states and cities—if not Donald Trump, America’s distinctly ungreen president—are issuing ambitious recycling targets and trying to revamp the way they manage their rubbish. Techies and entrepreneurs like Mr Huang or Mr Szaky are dreaming up clever—and lucrative—ways to manage and reuse it. Multinationals are toying with resource-light business models based on service contracts rather than product sales. And many consumers are adopting leaner lifestyles.

But municipal budgets are tight everywhere. Trade tiffs can dampen legitimate exchange of scrap (as recycled waste is also known). Regulations for handling waste are necessary but can be obscure. Policymakers have yet to devise a way to boost large-scale investment in recycling, which is discouraged by periodic declines in the cost of primary commodities, with which recyclers compete. And some worry that switching to a more circular economy will harm those built on the old model.

These problems are real. But, as this report will argue, they are not insurmountable. In the 1990s, economic growth, rising living standards and soaring consumption outpaced Taiwan’s capacity to clean up its waste, earning it the unflattering moniker of “garbage island”. As recently as 1993 nearly a third of Taipei’s rubbish was not even formally collected and virtually none was recycled. By 1996 two-thirds of landfills were nearing capacity.

In the face of mounting protests the government undertook to erect 24 incinerator plants to burn the waste instead, at a cost of $2.9bn. It also incentivised the Taiwanese to produce less rubbish in the first place. Under an “extended producer responsibility” (EPR) scheme, manufacturers and brands began to contribute to the cost of their products’ disposal, either through paying a fee into a fund earmarked for waste management or sometimes by managing the waste themselves. The less recyclable the product, the more expensive for the company. The scheme continues today. Households are charged for the amount of general mixed waste they produce but not for paper, glass, aluminium or other recyclables. Those caught dumping their trash illegally face hefty fines and public shaming. A typical Taiwanese person now throws out 850 grams daily, down from 1.15kg 20 years ago.

Half a century after environmentalists first began imploring consumers to reduce, reuse and recycle, similar exhortations are now echoing from San Francisco to Shanghai. And the world, drowning in garbage, has begun to listen.

Managing the Global Factor Better

Mohamed A. El-Erian  

christine lagarde imf

SEATTLE – Imagine a world in which the annual meetings of the International Monetary Fund were more client-driven. Ahead of the gathering – this year’s will take place in Indonesia in October – the IMF would solicit from its 189 member countries three key policy issues on which to focus, not only in official discussions, but also in the numerous seminars that are held in parallel. The result would be an agenda that responded better to the continued anxiety that a growing number of policymakers – and populations – are feeling.

For much of the decade since the global financial crisis erupted, countries worldwide have been subject to what London Business School’s Hélène Rey and others have called “the global factor”: a set of external influences that countries cannot manage or control, but that play an important role in determining key domestic variables. This has generated economic and financial volatility that has complicated internal policy management, fueled political polarization, and exacerbated social divisions.

US President Donald Trump’s “America First” approach has tended to amplify international feelings of uncertainty and insecurity, especially in Asia. Now, beyond having to cope with big changes in capital flows, interest rates, and currency movements, these countries must adjust to the reality that they may not even be able to count on some of their basic, long-standing assumptions about international trade.

But this is not just an emerging-economy problem. Despite attempts to boost resilience, including through both micro- and macro-prudential measures, much of the world remains vulnerable to the global factor.

Of course, countries with existing domestic economic and financial vulnerabilities are generally the first to face disruptions. But even in better-managed economies, external factors are affecting local financial conditions in ways that can have little to do with domestic fundamentals.

In Switzerland, for example, the major economic-management challenges of the last few years have had more to do with spillovers from the eurozone than homegrown problems. In confronting these challenges, the authorities have been forced to implement some distortionary measures – most notably, highly negative interest rates.

Some of these destabilizing dynamics could well intensify over the next few months, for two reasons. First, central banks will remain on the path toward monetary-policy normalization – albeit at different speeds – after many years of ultra-loose measures focused on repressing financial volatility. As a result, financial conditions for much of the emerging world are likely to become tighter and more unpredictable.

Second, advanced economies’ performance is diverging, with growth in the United States accelerating, and Europe and Japan losing economic momentum. This will place even greater pressure on interest-rate differentials, already at historical highs, and fuel exchange-rate volatility.

Beyond their economic consequences, these trends are likely to exacerbate political and social tensions. After all, the effects of both trends can be difficult to grasp without a decent understanding of quite complicated market structure and technical factors. This will make the monumental challenges ahead difficult to communicate to the public, leaving many feeling confused, insecure, and frustrated.

The IMF can and should help its members address these challenges by assuming a larger role in providing analysis and leading more effectively discussion in pivotal areas. In such a world, the Fund’s agenda would emphasize bolder action in three areas.

First, at the country level, in addition to focusing on general questions of economic resilience, the IMF would examine the scope for effective “sand-in-the-gears” measures to be implemented during the more extreme stages of global liquidity cycles, including to counter disruptive technical forces. Such an approach would be a natural extension of the work that has been done on micro- (institution-focused) and macro- (system-focused) prudential measures.

Second, at the institutional level, the IMF would continue to push hard for measures to track and address spillovers and spillbacks, including the incorporation and expansion of financial linkages that are superior in terms of monitoring, program design, and early-warning mechanisms. This would prevent the tail of obscure financial instabilities from wagging the dog of the real economy. The importance of such measures was highlighted earlier this year in Argentina, where a traditionally well-designed program was effectively derailed in just weeks by unanticipated technical developments.

Third, at the multilateral level, there is a need for more frank, genuine, and cooperative discussion about the cross-border effects of individual countries’ policies. Such discussion must acknowledge the failure of past efforts to address the issue, as well as the costs of deepening fragmentation of the international monetary system. This will inevitably raise issues of fair representation and governance in multilateral institutions, as well as the persistent bias in the system’s response to large imbalances and to divergence in economic and policy performance.

Without progress in these three areas, the unsettling puzzles and disruptive policy challenges facing many countries around the world will remain largely unresolved. This will raise the risk that countries will implement policies that not only conflict with those of their neighbors, but that may also end up being sub-optimal at home.

The IMF is the body best suited to serve as a trusted adviser and an effective conductor of the global policy orchestra. If it is to fulfill that role, however, it must strengthen its credibility as a responsive and effective leader. That means listening better to its members and then helping them more effectively to iterate more harmonious policies.

Mohamed A. El-Erian, Chief Economic Adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-Chief Investment Officer, was Chairman of US President Barack Obama’s Global Development Council. He previously served as CEO of the Harvard Management Company and Deputy Director at the International Monetary Fund. He was named one of Foreign Policy’s Top 100 Global Thinkers in 2009, 2010, 2011, and 2012. He is the author, most recently, of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.

Private equity plays risky game of musical chairs

Cash-rich firms increasingly buy from each other but debt could threaten some deals

Javier Espinoza in London

© Getty

Lorraine Kelly has been going to the Gala bingo hall in Stratford most weekends for the past two decades. Even though the east London business has changed hands multiple times over that period, she says the place has stayed largely the same.

“Sometimes you get free passes to come and play when new owners take over and that encourages you to play more,” says Ms Kelly, who once won £1,000 in a single evening of bingo.

While the customers might not have seen much change, the same cannot be said for the business model. Gala, which merged with rival Coral in 2005, was at the epicentre of one of Europe’s least successful and controversial leveraged buyouts as it was passed around private equity firms in a financial game of pass the parcel that lasted over a decade.

Successive owners would pay themselves high dividends, aided by easy financing, before selling to the next private equity house. In total, Gala was bought and sold five times by different firms from 2002 to 2015. Through the whole process, the levels of debt the business carried, measured as a multiple of its earnings, kept creeping up.

The business performed well in the decade up to 2008, with strong sales growth and aggressive expansion. But Gala’s former private equity owners spent much of the past decade in retreat, cutting back on shops and laying off staff, after they were nearly overwhelmed by a toxic mix of tough market conditions and high levels of borrowing.

Chart showing value and number of sales from private equity firm to another

Over time, the debt burden became unsustainable. Gala Coral nearly went bust, before the business was eventually acquired by rival Ladbrokes in 2016, which in turn was bought by GVC Holdings earlier this year.

The Gala Coral story might have proved a salutary experience about the risks of such pass-the-parcel dealmaking. However, the opposite has been the case. Last year, the industry did a record 576 so-called secondary deals, when a company or a stake in a company is sold by one private equity firm to another, according to Preqin, the data provider. That compares with 394 such transactions in the peak of the deal boom in 2007, just before the financial crisis.

Private equity advisers are increasingly worried that the sector could see a repeat of Gala Coral’s experience as interest rates start to rise, increasing debt payments and raising the chance of a recession.

Secondary deals can often be more vulnerable when conditions change, either because they have higher debt levels or because more money has already been taken out of the business by previous owners.

A recent analysis of the performance of 2,137 companies owned by 121 PE firms by Saïd Business School at Oxford university showed that secondary transactions have lower returns than other deals when done by a firm that is under pressure to deploy capital.

Some executives liken the situation to a form of private equity “musical chairs”, where firms are exposed when the market turns against them.

“Every time a company is sold between private equity funds there is a risk that you are taking off some of the potential upside as the business may have been optimised through acquisitions or operational improvements,” says Neel Sachdev, a leveraged finance partner at the law firm Kirkland & Ellis, which advised Apollo in acquiring the debt of Gala Coral in 2009. “So there may be less potential upside every time you pass it on.”

Mr Sachdev adds: “The risk is really that there is not that much juice in the lemon to squeeze.”

Gala Coral is not the only secondary buyout where private equity groups ran out of juice to squeeze. In the US, mattress maker Simmons Bedding, which was bought and sold by private equity owners seven times in 20 years, filed for Chapter 11 bankruptcy protection in 2009 and more than 25 per cent of the workforce was laid off. Still, its former owners, which included Thomas H Lee Partners, made a profit of $750m through special dividends, according to a New York Times investigation. In Europe, Phones4U, the British mobile phone retailer, collapsed in 2014 after eight years in private equity hands.

Recent examples of pass-the-parcel deals include Cinven’s acquisition this year of laundry services business JLA from peer HG Capital, and KKR’s sale of roses supplier AfriFlora to Sun European Partners last year.

“Buyout groups like secondaries because they are buying an asset from a peer and it feels like there is not much work to do,” says Per Stromberg, a professor of finance and private equity at the Swedish House of Finance, a research centre. “But often this leads to them paying too much.

”Secondary deals often increase the incentives for private equity owners to load more debt on to a business. “If you buy a company that has been improved by one or two previous private equity owners and if there is not much to do to improve it, then one way to get returns up is to add more leverage to it,” he says.

Defenders of pass-the-parcel deals argue that the demise of Gala Coral and others under multiple private equity ownership was merely bad luck as conditions in their industries quickly deteriorated.Gala and Coral: A marathon of dealmaking

Paul Dolman, a partner at London-based law firm Travers Smith, who estimates that he has worked on approximately 60 pass-the-parcel transactions in the past 15 years, argues that secondary deals are not necessarily to blame if things go wrong.

“The key is to work out why the house is selling. If it is because they are under pressure to return money to investors, then you can understand that is a credible reason,” he says. “If it is because they think the market is about to turn and they have sweated the asset as much as they can, then that is clearly not a good reason.”

Supporters of such deals argue that buyout groups bring much-needed injections of capital to fund the growth of a business through acquisitions or expansion. They also point to successful transactions, including vehicle leaser Zenith, which has been owned by four different private equity owners and has returned strong results. In Zenith’s case, one of the owners tripled its initial investment before successfully selling to the next private equity house.

Secondary buyouts, they argue, are part of the evolution of an industry that owns more and more companies and is awash with cash to deploy on deals. Buying the businesses already owned by other private equity firms has become an attractive way to invest their funds, especially as these firms also face growing competition from corporations hungry to find new assets.

Such deals were largely non-existent at the start of the century. The Gala Coral saga offers an extreme example of how they can sometimes go sour in a short period of time.

Private equity buyers were first lured into the leisure industry in the early 2000s by the growing popularity of gambling and a relaxation in advertising restrictions.

Before the merger with Gala, Coral itself was passed around three times between financial sponsors from the late 1990s until it was sold for a fourth time to a group of private equity buyers that included Candover and Cinven in 2003. The deal was largely financed with debt and the valuation was £1.3bn or close to 9 times earnings before interest, tax, depreciation and amortisation. Among private equity deals, a price of more than 10 times ebitda is considered high.

Business was booming and the new owners went on an expansion drive. Two years later, the buyout houses returned £275m to shareholders — the equivalent of seven times the company’s debt.

Coral’s owners had banked on the British authorities further relaxing rules on advertising around gambling, and longer opening hours. Their assumptions turned out to be optimistic, while a smoking ban also damaged the prospects in an industry where many of the customers had enjoyed a cigarette during their game of bingo.

Lionel Assant of Blackstone © Bloomberg

Despite speculation about tougher regulations, the interest from private equity firms showed no signs of diminishing.

In 2005 a new private equity owner, Permira, bought a 30 per cent stake, valuing the business at 15.1 times ebitda and with debt at 9.75 times ebitda. The new owners went on a hunt for acquisitions, leading to the merger of Gala and Coral. The business was further loaded with debt. For the next two years, the company’s revenues grew in the high single digits.

But then came the financial crisis and a period of anaemic growth. By the end of 2008, the equity value of Gala Coral had been written down to zero by Candover, Cinven and Permira. Buyout groups Apollo, Cerberus and other specialist lenders spotted an opportunity and started buying up its debt at significant discounts — later becoming the company’s main creditors. Eventually, the private equity backers of the company lost ownership to the lenders and Coral and Gala demerged in 2015. Both now owned by GVC, the businesses trade separately.

The high debt levels were key to Gala Coral’s travails. Sebastien Canderle, author of The Debt Trap, a book on how leverage affects the performance of private equity deals, writes that “what brought Gala to the brink of bankruptcy was . . . [that it was] absurdly overleveraged compared to its peers”. While the other large companies in the sector suffered in the period after the financial crisis, none faced the risk of default or administration. “As Gala’s competitors demonstrated, without that much debt laden on the balance sheet the business would not have needed a financial restructuring.”

The private equity industry is now in overdrive, buoyed by record fundraisings. However, some senior figures in the industry say they are shying away from secondary transactions.

Lionel Assant, the European head of private equity at Blackstone, said only 1 per cent of global deals represent secondary transactions because of concerns that they may deliver meagre returns. One of the exceptions: earlier this year, Blackstone bought Averys, a maker of tracking and storage solutions for warehouses, from rival Equistone.

“If the economy slows a bit, the multiples contract and I think investors are going to have very average returns . . . especially on secondary deals,” he says. “The idea that because you can lever up a business at six or even seven times ebitda today at a very cheap cost of debt and that you’re going to re-lever with cheap cost of debt in five years from now is obviously ludicrous.”

What he calls “the musical chairs game”, where private equity firms do some “quick flips”, could continue for a few years if there is no recession but, he adds: “We don’t want to be in this game.”

Joana Rocha Scaff, head of European private equity at the investment management firm Neuberger Berman, warns that dealmakers are underestimating the risks of debt-heavy structures that come with secondary buyouts.

“When rates rise, pay attention because it may put significant liquidity pressures on these firms,” she says. “In some cases liquidity is not being fully understood. People are putting a great amount of focus on the capital structure. But where is the cash?”

However, few experts predict that these deals will stop any time soon. Ludovic Phalippou, a finance professor at Saïd Business School, predicts an increase in pass-the-parcel transactions. “These deals will accelerate because private equity guys have a lot of dry powder [unspent capital] and they have to keep deploying it,” he says.

Deals are becoming bigger and more expensive

Private equity groups have never had it so good: they are raising record amounts of cash at the fastest pace in a decade. Dry powder, the industry’s lingo for committed but unspent cash on deals, is now at $1.7tn and growing.

But such a large volume of funds also brings its own pressure to deploy the capital. This, in turn, has led to a string of deals with the sorts of valuations and debt levels that were seen just before the financial crisis.

This month, the UK schools group Cognita was sold in a £2bn deal that valued the business at 26 times earnings before interest, tax, depreciation and amortisation as of August 2018, according to people with direct knowledge of the transaction. Last year, Nets, a Danish payments group, was sold in a deal with more than seven times debt as a proportion of ebitda.

Deals are also getting bigger. Blackstone staged the largest leveraged buyout since the crisis with the acquisition this year of the financial terminals and data unit of Thomson Reuters in a $20bn deal. With Singapore’s sovereign wealth fund GIC, Carlyle bought Akzo Nobel’s speciality chemicals unit this year for €10.1bn, including debt — its largest ever deal in Europe.

“Private equity groups are having to become more creative,” says an adviser to large buyout groups in London. He expects to see more public companies being bought by private equity or carve-outs of large conglomerates also going private.

In such a giddy market, executives say it is important to stick to basic principles. “In a competitive market, it’s even more important to retain a disciplined focus and look for companies which will continue to grow and perform over time,” says Nikos Stathopoulos, a partner at BC Partners. “We don’t look for one-trick ponies.”

Investors Should Call Italy’s Bluff

As long as most Italians support the euro, market turmoil in Italy looks likely to pass

By Jon Sindreu

Italy’s antiestablishment government is now on a collision course with the European Union. Investors should probably call its bluff and buy Italian assets.

On Friday, Italian 10-year government bond yields rose to 3.2% and spreads over German yields widened sharply. Shares in Italian banks led losses across Europe: UniCredit, the country’s biggest bank, was down almost 8%. This was after Italian officials agreed late Thursday to triple the estimated budget deficit for next year to 2.4% of gross domestic product, defying EU demands to rein in spending.

But investors should focus less on Italy’s budget deficits and more on its voters’ support for the euro.

The eurozone is an anomaly among sovereign borrowers. While each nation still issues its own debt, all 19 of them share the European Central Bank. Between 2010 and 2012, fears that Italy, Spain or Portugal would be kicked out of the bloc led spreads on their debt to balloon. They narrowed again when ECB President Mario Draghi promised to do “whatever it takes” to save the euro. 

The lesson here: Most of what those spreads are measuring isn’t the risk of default, as in the corporate-bond market, but the fear of a country leaving the eurozone, which would likely mean investors getting paid back in Italian lira or Spanish pesetas. This summer’s ructions in Italy reinforced the point. Italian spreads only jumped on the news that parties in the new government had drafted secret plans in which they considered exiting the euro.

Public debt in Portugal and Spain remains gigantic, and investors don’t seem to mind. They shouldn’t: As long as the eurozone doesn’t break up, sovereign debts will be paid back.

Investors who bet on this back in 2012, or after the Greek crisis in 2015, have amassed large gains. The eurozone as a whole is no different to the U.S. or the U.K., where governments can always print money to pay back creditors. 

Italian Interior Minister Matteo Salvini speaks during a press conference in Tunisia on Sept. 27. Photo: fethi belaid/Agence France-Presse/Getty Images

Of course, the Italian government might secretly want to be kicked out of the eurozone, and defying European officials could be the first step toward that goal. But a 2.4% deficit—still below the EU’s 3% rule—is unlikely to be the start of an all-out political war.

Moreover, about 59% of Italians support the common currency, eurozone official surveys show—the lowest in the bloc, but still a clear majority. Even the painful budget cuts that the EU imposed on Greece weren’t enough to energize support for ditching the euro there.

Until support for the euro crumbles, here’s a rule of thumb for longer-term investors: If any eurozone bonds yield much more than Germany’s, buy them.