Disclaimer: This article was written originally in July 2007.
An editor of a pink paper asked me my opinion of the $3bn Chinese investment in Blackstone. There are many angles to this news story. The media has dwelt upon how this is a ‘professional’ (and therefore scientific) use of the nation’s burgeoning Forex reserves.
I only asked rhetorically: “What do you say when the world’s worst investor hands over his money to someone who claims to be the world’s best investor…….for a price which is embedded in the IPO pricing?” What is the probability that this is not a bum deal?
Ok, let me make my points, one at a time.
The Whole Concept Of Private Equity
The whole concept of Private Equity (as opposed to Public Equity, i.e., listed stock markets) is opposed to the Efficient Markets Hypothesis. The EMH, as it has come to be called, is based on the rather simplistic worldview that if you get millions of people to look at something, you will achieve the highest level of perspective, i.e., Mr. Market knows more than any single individual, or for that matter, any smaller group of individuals. In other words, it is a restatement of the underlying logic of ‘democracy’, that the wisdom of many is always superior to the wisdom of the few.
Somebody got a Nobel Prize for putting out the fallacy that the price given by the market factors in all known information. Perhaps it does, but he forgot that people have different perspectives on the same information.
In politics, this (EMH) is perhaps true, but for the wrong reasons. Democracy is the superior way of (political) management NOT because it provides the best (combined) perspective, but because it provides the checks and balances that are needed to obviate the misuse (or distortion) of a political process. Anybody who has ever watched video clips of our Parliamentary proceedings will agree that perspective is NOT a strength of democratic (or collective) choice.
In Economics, we have always known that EMH is almost never true. The “Laws of Group Think” (which is part of Behavioural Economics) postulates the exact opposite of the Efficient Markets Hypothesis, saying that “crowds (or groups) are always and SYSTEMATICALLY wrong”.
Alternative Option to Public Equity
Private Equity offers itself as an alternative option to Public Equity. PE firms do buyouts of publicly-held firms because they feel that the public (listed) value is understated. Then they go back and sell these firms to the same market they bought it from. No doubt, there is some real arbitrage available through management actions, but the larger value is extracted because of mispricing in the underlying (public) value of the stock. Value Investors know that this is a regular occurrence in public stock markets.
Coming to Blackstone then. The firm, by its very existence, size, and reputation, puts out the claim that they are the world’s premier purveyor of value, i.e., when they buy, the stock is undervalued. Implicitly, when they sell, the stock is overvalued. By implication then, when Blackstone decides to sell stock, one presumes that it would be at a value higher than the Intrinsic Value of the stock.
Using the principles of Classical Finance, a public issue of capital by a Private Equity firm makes no sense. If you have a large ‘spread’ (i.e. asset return minus the cost of capital), then you get a huge Margin of Safety. Since Equity Capital is nothing but a bulwark against Risk, why would you need Equity Capital to finance an activity that has a huge ‘spread’? You only raise Equity, either when you need the bulwark against Risk……..or you are getting Equity at a mouth-watering price. Obviously, Blackstone insiders think their shares are overpriced.
Blackstone normally goes to the markets to buy stocks from the unsuspecting public, which they will sell BACK to the poor dolts after a cooling period. When would Blackstone go to SELL shares to the Hoi polloi, reversing their normal pattern of behavior?
And who is on the other side of the trade? Half the placement is to the Chinese Govt, which is arguably the world’s worst allocator of capital. Now let us see just how this is a bum deal.
Important of The 4 Factors Of Production
The Chinese are capitalistically communist, or is it the other way round? They grew up believing that Labour is the most important of the 4 Factors of Production, if only because it is the only factor that has feelings. Our Indian Communists also know that it is the only factor that votes, an even bigger convenience. That is why they do so well politically, but so disastrously in their economic policy.
In Economics, value is captured by the Factor that is the most flexible, has the highest Opportunity Cost, and has the ability to capture such value. That Factor, unfortunately, is Capital, which slips away at the slightest hint of a sub-optimal return (ask Jyoti Basu).
Labor, on the other hand, is inflexible, and emotional and responds to power by acquiescence, ensuring that it captures less of the cake than it deserves. Any attempt to give labor higher negotiating power through administrative or political fiat will always result in the flight of capital, as we saw in Kolkata in the 70s.
China’s “growth strategy” has been to over-supply labor to Manufacturing and drive down product prices, shrinking the Producer Surplus captured in the ITS part of the value chain. Wherever China goeth, the value captured goes down to zero. Hence, blue-collar manufacturing, where the Chinese presence is most visible, has seen price erosion to the point of insanity.
Western cos in general, and the Americans in particular, have been complementary to China, i.e., they have occupied the spaces that China has not, e.g., retailing, supply chain and logistics, construction, banking, and white-collar services. These sectors have captured disproportionate value, challenging the Chinese to move in.
So first, China makes goods for the US and gives up its Producer Surplus to US consumers. Whatever little it saves from what it produces, now lies fallow in its Forex reserves, which must either fund US borrowings (through T-bills and Mortgages) or create inflationary liquidity in its domestic economy.
So these savings are now invested in Blackstone IPOs at inflated prices. The money, one presumes, will be reinvested back in China to buy undervalued assets from the Private Equity market (or the listed stock markets). At every stage, the Communists get short-changed, ceding value to savvier investors/ consumers from the West.
The Totalitarian Chinese.
“So what?” argue the Totalitarian Chinese. You (Western democrats) value humanity because you have so little of it. We have no shortage of people, hence they are valued less. So what if the savings of a small proportion of our people are blown up either in NPAs incurred by our domestic banks, or for that matter if the nation’s Forex reserves are invested sub-optimally? It is, after all, ‘savings’ of our native population, which is meant for strategic purposes. So if we waste 25% of our savings/ surpluses, it is akin to losing 25% of our population, which is not such a bad idea anyway.
I am sure our Indian leaders would love to think like that. Unfortunately, long before they get their domestic populations to pick up the tab for their decisions, the Govt would have been brought down. Democracy ensures financial discipline.
There is another reason why India cannot afford the luxury of sub-optimal investment decisions. Our Forex reserves are funded by external liabilities; they are not generated by trade surpluses, as in the case of China. If our Govt puts it away in long-term investments that do not generate adequate returns in Foreign currency, we will trigger a run on the Rupee, just like in the case of the 1997 Far Eastern Crisis. The Chinese Govt has only its own population to answer to, and they have been taught not to ask……. Indians have the Havana option…..!!!