The Lex Newsletter: other people’s capital is the best kind

Dear reader,

Karl Marx never said “property is theft”. The quote is often attributed to him by his co-religionists. No surprise there. Communists have a penchant for appropriating other people’s stuff. In this case, it is an aphorism of the anarchist philosopher Pierre-Joseph Proudhon.

One popular interpretation of investment banking and such satellite activities as hedge funds and private equity is that they represent rare successful experiments in communism.

I will examine this proposition in the first section of this newsletter rounding up themes from this week’s Lex columns. In the second section, I will look at computer gaming. The third section will consist of a SWOT analysis of readers’ breakfast recommendations.

To comment on this, or any other aspect of Lex, please email me at [email protected].

Investment bankers and private capital specialists do not, to be fair, seek categorisation as communists. The justification sometimes advanced for classifying them in this way is that they are workers who have seized control of the means of production. The returns on (successful) labour in these fields, therefore, outweigh returns on capital, which predominately belong to external investors.

The fictional corporate raider Lawrence Garfield, played by actor Danny DeVito in a 1991 film, put it well: “There’s only one thing I love more than money. You know what that is? Other people’s money.”

Other people’s capital is superior to your own capital for financial transactions for a number of reasons:

• If you lose it, you may have to apologise. But you will not have to take your kids out of private school and go to live in a trailer home.

• It is cheap, particularly if it is debt. When you do not need it any more, you can give it back, keeping the bulk of profits from the transaction.

• A cleverly engineered financial set-up will lift the paper value of external capital — or at least preserve it — regardless of market movements. This has a positive impact on any cash fees you are levying.

Regarding the latter bullet point, regulators on both sides of the Atlantic are worried that higher rates have left private asset valuations high, dry and hard to justify.

That is their job, though you could argue that marking to market fosters rather than reduces instability when large decreases are likely. This was certainly the attitude of European banking authorities to swaths of sovereign debt during the eurozone crisis.

In tech venture capital, a popular way of creating a paper gain is to sell a small tranche of shares at a price that revalues the whole business upwards. The latter figure typically does not adjust for a heftier supply of stock in any initial public offering.

Lex is, therefore, sceptical of reports that a limited secondary sale of shares in OpenAI would value the US start-up at $90bn.

We understood the maths behind James Ratzer’s Fantasy M&A analysis of how Patrick Drahi might buy control of BT for £12.5bn. The New Street Research analyst envisaged a situation in which the Franco-Israeli tycoon loaded the UK’s telecoms champion with external debt.

Lawrence Garfield would doubtless approve of this. But the UK government would not. Lex therefore believes such a deal is unlikely.

We were meanwhile shocked to the core by a US legal ruling that presidential hopeful Donald Trump is liable for fraud for overstating the value of assets to strike deals and obtain financing.

How could this possibly be true? New York property developers are renowned for their honesty. Exaggerating the value of property to obtain finance would abuse the trust of Wall Street bankers, a famously credulous breed. It would be like taking sweets from a baby.

OK, enough of the snarkasm. Property development is the classic example of the superiority of other people’s money in finance. Big projects routinely go bust while they are being developed. External investors lose money. Smart developers — and finance brokers — nevertheless emerge wealthier.

In China, hopeful home buyers traditionally put up the money for big residential developments before they are built. This is a great arrangement for developers, for the most part. But it falls apart when a crashing property market alerts home buyers to the fact they have hefty negative equity on unfinished properties. They then halt mortgage payments.

Developers are then left sprinting over thin air like Wile E Coyote, as at present. One dollar bond issued by Country Garden, previously seen as being as safe as houses, is trading at a dismaying 10 cents on the dollar. The risk of contagion to other markets, including international commodities, is growing.

The real ninjas adept at appropriating other people’s money for their own purposes are not bankers or developers, however. They are politicians and central bankers.

Retail and commercial banks are a case in point. In most of the world, these have state-awarded franchises to create, distribute and regulate money. This is a handy set-up for politicians and central bankers who have vicarious control of the private capital that finances these operations.

It all works pretty well until reckless lending leaves taxpayers with bailout bills, as it did in the noughties when Royal Bank of Scotland almost collapsed. Or until overregulation crushes returns.

One consequence in the UK is the ringfencing of retail banks. This insulates them from risky investment banking at the price of capital inefficiencies.

The UK government, a timid bunch with no overriding plan and few clear convictions, this week proposed a modest relaxation of the ringfencing rules.

Lex thinks the UK should abolish ring fences. EU banks get along fine without them. Basel 3.1 capital adequacy rules as handed down by the Bank of England should be sufficient to protect taxpayers from any would-be Fred “The Shred” Goodwins in the current cohort of retail and commercial bankers.

McDonald’s also understands the superiority of other people’s capital in supporting its operations. It is a far more generous franchiser than the UK government, however. It is proposing a 1 percentage point increase in royalties on sales to 5 per cent for franchisees who open new restaurants.

Franchisees have lobbied accordingly. Earlier this year, the US Government Accountability Office bellowed that these owner-operators “do not enjoy the full benefit of the risks they bear”.

You might say the same of investors in UK and continental banking stocks.

Game caper

I do not play video games for the same reason I do not ride around on a skateboard. Neither is an appropriate activity for a 59-year-old financial commentator.

The other reason is that I would never stop if I started playing computer games. Given willing suspension of disbelief, these play on the human fight/flight hormonal system as slickly as a white-toothed tinkler on the keys of a Bechstein in the lobby of a Las Vegas hotel.

This has created a vast industry. Microsoft is therefore desperate to buy Activision Blizzard, creator of the Call of Duty blockbuster, for $75bn. The deal should give it a nice fortress in nascent cloud gaming. The Silicon Valley giant has deployed hefty legal forces — and some aggressive PR tactics — to squash opposition in the EU and US.

The UK’s Competition and Markets Authority has now provisionally approved a revised proposal from Microsoft, having previously rejected its undertakings. This augurs badly for future attempts to rein in the anti-competitive wheezes of the tech giants.

Gaming on the cloud is supposed to supersede the kind that requires a console. These devices have remained popular with gamers far longer than pundits expected. Sony’s PlayStation 5 has performed well for the Japanese consumer electronics group.

Lex frets that the retirement of the gaming division’s talented boss Jim Ryan will weaken it. Top Sony boss Hiroki Totoki will step in until a permanent replacement is found. But he may already have his hands full with a financial services division where operating income is forecast to weaken.

We are keener on the shares of local Japanese gaming rival Capcom. Its Monster Hunter Now location-based game has benefited from 5mn downloads.

I will not be playing it, of course. I may ask younger colleagues to do so in the interests of research.

Breakfasts of champions

Our note on the decline of breakfast cereals prompted lively discussion among readers on the best way to start the day. My tabulation of your suggestions is as follows:

Other things I have enjoyed this week

FT writers led by Kate Duguid produced an informative Big Read on the so-called basis trade. This is a popular arbitrage between Treasuries and Treasury futures. It is the latest thing regulators are hyperventilating about.

Outside work, I was reassured by coverage of TikTok’s discovery that men frequently think about the Roman empire. I know I do. It is the key that unlocks so many mysteries.

I also enjoyed seeking (and finding) the rare Desertas petrel in Atlantic waters off the coast of Madeira.

Enjoy your weekend, whatever your own pursuits,

Jonathan Guthrie
Head of Lex