FSA’s curb necessary, right – and overdue

Those who argue for unrestricted short-selling ignore the fact that the system is loaded in favour of the bears. If an individual invests £1000, or an institution £1 million, in the shares of a troubled company because they think in the long term it will recover, they have deployed their capital, and all they can do is wait. There is no more to invest; their resources are finite.

If a short-seller comes on the scene, his resources are in effect infinite because he first borrows the shares he then sells. Given that the revenue from the sale is more than the borrowing cost of the shares, he has no net capital constraint and can continue indefinitely — so much so that in one celebrated case a few years ago, one person shorted 250% of a company's equity, though he did get into trouble for it.
If the target is a bank, the dice are even more loaded. As the selling drives the share price down, two things happen. First, the rating agencies announce a review of the credit rating, or worse a downgrade. This will force the bank to sell assets to shore up its capital position, and will set alarm bells ringing. At the same time, other banks will get nervous about dealing with it as a counterparty and either curb their business or charge more, thereby weakening the target bank still further.

Short-selling becomes self-fulfilling because the tumbling share price erodes confidence in the bank, and that weakens so it is worth less — until the ultimate cataclysm when people start queuing in the street to withdraw their money, at which point it is doomed and the authorities have to nationalise it.

However, in doing this it is politically impossible for them to bail out the shareholders. So they take the bank over for nothing — or get it rescued at a much-reduced price — thereby wiping out the long-term investors who are the bedrock of the system, handing massive rewards to the short-sellers who have done the damage and leaving the taxpayer to finance the clean-up.
On the way, they have destroyed a business that did not need to be destroyed. So yes. It is time short-selling of banks was banned.

Investing in a new beginning

When you are up to your neck in alligators, it is hard to remember that the purpose of the exercise is to drain the swamp. That said, and having gone through a bumpy week that has left lots of young people permanently scarred and lots of older ones saying I told you so, the really useful exercise is to try to find some winners in the emerging new order. The need for investment goes on, and the search for profit never ceases.

In a discussion of this over lunch with an admittedly biased sample of people — namely those who still had an appetite for food and could afford to pay — one strongly held view was that mid-sized private equity could do well in this brave new world provided it was clean. That means it should be a new fund beginning to invest now, not one with a legacy of overpriced investments from last year.

You need to avoid legacy funds stuffed with businesses bought on debt multiples of eight times earnings and at values that will never be seen again. Also, mid-sized is preferred to large-cap because there is evidence that documents the improvement in the management and operations of mid-sized firms. The evidence with large-cap businesses is much less convincing, other than that achieved by financial engineering.

The brighter mid-cap private-equity firms see the opportunity although in fairness some, like HG Capital which has announced a string of successful disposals in recent months, never lost the plot. But others are changing gear.

Headhunters such as Brian Hamill of Redgrave Partners report that the past few months have seen a change in the nature of heads hunted by firms such as his for private-equity clients. In the past, they might have wanted a financial engineer from the likes of Lehman. Today they want people with proven operational skills with talents honed by running real businesses in the real world.

One can see why. Private equity adds value when it buys cheap and improves management to create a better business. This was forgotten in recent times when private equity simply played the arbitrage between cheap debt and expensive equity, which it then called performance and took a fee. Now it is getting back to basics. With businesses and talented management available at sensible valuations, it is beginning to look attractive.