Friday, November 7, 2008

As Easy As ABC

The insolvency of ABC Learning Centres is a clear example of the folly of taking a perfectly good business and destroying it by using it as nothing more than a vehicle to generate a short term cash return rather than long term value. The rapid expansion of the business came at the expense of an equally rapid expansion of its debt. As more cash flow was required to feed more debt, more debt was required in turn to generate more cash flow. As we have seen this will work well for a time, as long as the cash flow continues to grow and the credit continues to be cheaply available. In this way it is possible to quickly build an enormous structure, but the problem is that the structure is hollow. Any intrinsic value in the business is counterbalanced by the debt obligations.

ABC is far from alone in this. Already we have seen the so called “financial engineers” such as MFS and Allco fall by the wayside. Merchant bankers Babcock & Brown and even the previously glamourous Macquarie Group have been punished by the market for their indescretions. Macquarie has proven to be more resilient than the others, in part because it had already changed its business structure to ensure it is well capitalized, and partly as a fortunate beneficiary of the Government’s banking guarantee. Even so, Macquarie’s share price is a pale shadow of what it was a year ago.

At a time like this it’s also worth recalling the failed private equity takeover of Qantas. If that had gone ahead, as Geoff Dixon and Margaret Jackson had recommended, the subsequent debt burden placed on the company could well have destroyed it in current circumstances. The point is that such debt funded expansion or acquisition will always carry a high degree of risk compared with equity. While conditions allow, such high risk will often result in high rewards. Now that conditions have changed, the true extent of the risk is becoming apparent.

The important point to all of this is that these practices, labeled as “financial engineering”, have absolutely nothing to do with the actual operation of a business. A business can be perfectly viable on its own terms, but it can be destroyed by having its value hollowed out as more debt is taken on to fund either a change in ownership or a rapid expansion. In the case of ABC, the individual childcare centres are in most cases perfectly good businesses, despite the fact that the corporation which owns them appears to have been pillaged for the purposes of a quick buck.

The Government has now committed to spend $22 million of taxpayers’ money on keeping the operation running. The argument is that childcare has become an essential piece of community infrastructure, integral to the ability of the economy to function. There is plenty of truth to that notion, which then prompts the question: is it wise to allow a single company to acquire so much market share in an essential service without greater prudential regulation?

It seems obvious now that the answer is “no”. At the very least it is to be hoped that the Global Financial Crisis might ultimately lead to a change in the way debt financing is both employed and regulated, especially in the provision of essential services.

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