Neil Collins’ Notebook – The inflation dragon stirs
Much has been made about how the UK government’s cavalier approach to debt is helped hugely by its near-zero cost of borrowing. There is less analysis of why the long-term rates are so low. Are investors really rushing to lend for 40 years at 1.25 per cent? The answer is that, with few exceptions from funds which are obliged to cover future liabilities and traders looking for a turn, the buyer is the Bank of England. The Bank is, of course, owned by HM Government, and so the magic of Quantitative Easing allows the state to borrow from a bank that it owns.
This has worked splendidly while us pessimists have been so wrong for so long on inflation. Now, though, there are just a few signs that the prices worm may be starting to turn. The world’s semiconductor makers are all reporting lengthening order times, oil seems established above $60 a barrel, metal prices are booming, and all while consumer demand has been artificially depressed by Covid lockdowns. Businesses which survive will be looking to raise prices to repair battered balance sheets, while the 40-year chart of declining bond yields has turned sharply upwards in 2021.
After trying to encourage inflation back up to 2 per cent, the world’s central banks may suddenly find themselves succeeding only too well, at a time when the political pressure to hold down interest rates is intense. As we discovered in the 1970s – when the UK government was forced to pay 15.5 per cent for 20-year money – once the inflationary genie is out of the bottle, it’s a long and painful process to put it back in.
Rishi the prestigidator
There’s nothing like the fire, fury and confusion of a Budget speech to divert attention from favours to your friends. Rishi Sunak knows plenty about private equity (PE) from his previous life in the City, so his former colleagues will be secretly delighted with the proposal to raise corporation tax from today’s 19 per cent to a stiff 25 per cent. There will be routine complaints about the dampening effect of tax rises on their animal spirits, but they will quietly note that this change tilts the balance of capital financing still further away from equity (dividends paid after corporation tax) to debt (interest is a business expense).
The move might be less inequitable were it to be combined with reform of the “carried interest” scam, which allows the PE executives to treat the, often life-changing, bonuses on the sale of a company as a capital gain, taxed at 20 per cent, rather than income, taxed at 45 per cent. These rules already drive PE financing towards as much debt as the underlying business will bear at the time, with a thin sliver of equity.
If things go well, the equity can multiply in value many, perhaps hundreds, of times, before the business is sold. Timed right, the lack of any capital cushion against tough times or market evolution need not matter. Older examples of debt overload requiring subsequent rescue include Saga and the AA, and more recent ones like Aston Martin or the ghastly Amigo. The most egregious case is probably that of Debenhams. As Covid accelerated the high street revolution, the highly-geared business lacked the capital to invest to compete. Now thousands have lost their jobs.
He may have failed in curbing the PE excesses, but the Chancellor has been quite clever with business carrot and stick. The pain of profits taxed at 25 per cent is less when each £100 of investment reduces that liability by £130, providing a powerful incentive for boards to take a longer view than many do today. Unfortunately, the investment allowance is for two years only, expiring just as the higher rate of corporation tax comes into force. This is Treasury prestigidation at its finest, but two years is an age away in Budgetland, so it does allow our dear chancellor time for amendment of life.
When it comes to eating capital…
Are you looking forward to eating out again at Garfunkel’s, or Frankie & Benny’s, or even at Chiquito? What, you say, are they still going? Well, yes, some of them, insofar as any restaurant chain can be said to be going during lockdown. These tired old formats belong to The Restaurant Group, better known today for Wagamama, bought expensively from its private equity owners in November 2018. The TRG shareholders revolted at the £357m price tag (plus £200m debt) and were bounced into putting up £315m in an absurdly discounted rights issue (13 for 9 at 108.5p, against a share price of 275p before the news). The dividend was cut, for good measure.
Within months, the CEO who did the deal resigned. Andy Hornby, who rose to fame in the great HBOS disaster, took over, but things did not improve, and last February the rest of the dividend went, along with over 100 of the group’s sites. Then came Covid. The lockdown necessitated a desperate £57m equity fund-raise at just 58p a share, a Creditors Voluntary Arrangement with the landlords, 125 more sites closed, followed swiftly by an admission that a tenth of the rest would never reopen.
To add to the gaiety of nations, the directors helped themselves to a handsome new incentive scheme as they laid off 4,200 staff from the restaurant chains. This week they paid a distinctly spicy 7 per cent interest on a £500m debt refinancing, just in time with a £225m Wagamama bond due in June. Yet here’s the thing. Without that Wagamama deal, the group might not have survived at all, with the pandemic administering the coup de grace to those tired old “casual dining” brands it owned. Perhaps the previous CEO, who had to leave for personal reasons, could sense stinking fish and realised he had to pay up for a chain with a future. The shares are a shadow of the pre-deal price, but have doubled from their pandemic panic low to 112p. The business may have a future after all.