Credit

It has been a fascinating week over here in Scotland. As I've been writing about athletics for the last few weeks, I will turn to a few finance oriented topics that may interest.

For most of us "credit conditions" lie invisible until we need a personal loan or a mortgage. However, in my various lines of work (private equity, finance, property development and asset management) we are nearly always in the credit markets. I had a very interesting conversation with a senior banker this week.

By way of background, we founded our Scottish property development business in 2005 and have been assembling property deals since the mid-90s. We are a material, but not massive, relationship for our bankers.

With property development transactions, our company makes money from the value of finished projects being more than the development cost. By way of example, if it costs $80,000 to build an apartment which is worth $88,000 on completion then the "capital uplift" is said to be 10%.

Financially, our business "works" for our shareholders because we are able to refinance their equity investment by borrowing against the "capital uplift" at completion. This lets the company move its share capital along to the next investment -- this drives our return on equity.

I spend most of our board meetings listening, thinking and taking minutes. It is good practice for my 2008 goal of listening more. None of what follows was explicitly said in the meeting, I simply noted it and will share some conclusions later in this letter.

Capital uplift (our company's profit margin) -- after two years of declining margins on new deals -- we were suddenly presented with a large opportunity (>$50 million) that had a projected capital uplift of 25%. The deal popped up because (we believe) the buyer was having financing trouble.

As part of our year-end review, our bankers asked us to provide them with additional comfort on our portfolio valuations (easy for us to do as we operate in a specific geography with transparent market pricing).

Our bankers mentioned that the syndication markets were closed. Debt syndication markets are how banks share and diversify risk for their largest loans. They noted that when the markets came back on-line only the best deals would be taken up. Valuation verification is an important step towards ensuring we will be at the front of the queue when the debt markets re-open.

As for new debt, we have heard from our bankers, as well as others in our sector, that new money will be tight for the next six months. That's a polite way of saying that many banks are presently closed for new business. It's not a case of asking for their money back, rather it is a case of not being in a position to fund new deals -- regardless of how attractive they look. I feel sorry for any business that is operating below par in this market.

Bankers are talking about balance sheet decisions, rather than investment decisions. There is a very clear focus on the balance sheet, rather than the quality of new business. Personally, I take this as an excellent development. In a challenging credit environment, we want to be with an institution that has a keen eye on its own balance sheet. The sooner a bank gets comfort on its own credit position, that faster it will be able to start lending again.

However, the fact that senior bankers are more focused on balance sheet strength than new business is a powerful statement in itself. The credit contraction that is happening in the major financial centers is not visible to Main Street at present. If your business (or your personal life) relies on new finance over the next twelve months then I would start the refinancing process early and make sure that you tick-the-box in every conceivable way. Once the credit markets re-open, lenders are going to choose the highest quality credits first.

The days of covenant-lite and non-doc loans are gone. For the better, too.

I attended a presentation from an executive that works at the Bank of Scotland's treasury department. He had many excellent slides and I've scanned three that are relevant to this letter (and my life).

Here's the first one. I noted the date that we bought our first flat in the UK. To say we had good timing is an understatement.
This next one shows the dislocation between base rate (set by the government) and LIBOR (what people like us actually pay for our loans). What killed some mortgage institutions is that they pay LIBOR but lend to their clients at base. This mismatch is highly costly when the markets move out-of-whack.
Those dotted lines show that the forward markets think that things will return to "normal". However, people are pretty jumpy and when I hear bankers noting that "liquidity and confidence are illusions" I fasten my seatbelt.

The last chart is a neat one that we certainly didn't realize at the time.
What I did on this one was draw in the point where we negotiated the initial portfolio of deals that formed our property development business. Once again, we were fortunate in our timing.

I don't have confidence in my ability to make predictions, however, I think that it is fair to say that the following are happening:

***a large credit contraction is underway in the UK and US (perhaps elsewhere, I can't really comment)

***a high degree of uncertainty (bordering on distrust) exists within the international banking community (reflected in interbank rates)

***due to the lag between liquidity and pricing; there is a dislocation between asset pricing and credit availability -- many sellers don't realize the lack of funding available their potential buyers

What does this mean?

From a business point of view, we are going to focus on keeping our credit providers informed and confident in our company. In this environment you want to make sure your capital providers know exactly what's happening in your business.

If your business, or your main customer, relies on credit, then you've likely seen the impact of the credit contraction already. However, if you are a few steps removed from the credit markets then you might not fully grasp what is heading our way. There are hundreds of billions of debt capacity being removed due to the equity write-offs within our financial system.

Over the next few months, keep a keen eye on accounts receivable as well as your key customers/distributors. If you have any clients who's demise would bury your firm then see if you can get credit insurance (it can be a cost effective way to reduce your exposure). In the early 90s, I watched a number of firms go down as credit tightened and the economy slowed. If you are conservative and cautious then you'll be able to navigate your way through. I have seen "services" recessions in Asia but never really witnessed them in Europe or the US.

From a personal point of view, I'm bearish on asset pricing, especially in the property markets. Liquidity is going to be highly valuable in 2008.

Sitting over here in Europe, the US offers outstanding value right now on a Purchasing Power Parity basis. It's crazy expensive over here in Europe. Seems like dollar-for-pound in the UK. My British friends talk about shopping trips to New York (a town that seems expensive to me). People are flying to New York for a weekend of Christmas shopping. If you are in the US then run the numbers on that same weekend to London or Paris!

Off to Paris next week -- we won't be doing much shopping and I hear that there is an excellent multi-day museum ticket.

Happy Thanksgiving to my American readers,
gordo