OPM, ZIRP and why companies go bankrupt

OPM is not an abbreviation for opium, but is an acronym for Other People’s Money. (Its often the same, though). US institutional investors, or mutual funds, now have $21 trillion in assets, more than the US banks, which own $17 trillion. They also own 80 per cent of the US corporate equity. This gives mutual funds an enormous clout over companies, and hence, over corporate managers.

Now, mix into this Irish stew a few more items. Both fund managers and corporate managers have a large component of variable pay which is linked to performance. The measure of that performance is the market capitalisation of the stock; the higher the market cap, the more fund and corporate managers earn.

Another tid-bit thrown into this Irish stew pot is that the ‘shareholder capitalism’ model gives primacy to providers of capital, as opposed to the ‘stakeholder capitalism’ model which also focusses on other stakeholders such as employees, customers and suppliers. Under the former, the other stakeholder’s interests are subservient.

ZIRP is the asinine ‘zero interest rate policy’ followed by the US Fed, and other central banks of the Euro Zone, Japan, etc. They follow ZIRP because their governments (Central and States), Municipalities, companies and citizens have overleveraged themselves. In order to repay previous debt, they must roll it over, and the lower the interest rate regime, the easier it would be to swallow that pill.

Now look at the way companies take wrong decisions because of OPM and ZIRP.

Doug Parker took over as CEO of American Airlines, one of the largest, in December 2013. In order to please Wall Street, given the low interest rates, he borrowed $25 billion over the next six years. Giving greater priority to shareholders, he paid regular dividends, and bought back $12 billion of the airlines stock. Giving lower priority to consumers, he charged passengers for inflight meals, extra legroom and extra luggage. Consequently, the stock doubled in his first year, and he got a $10-million compensation based on performance.

Fast forward to 2020 and American Airlines had to be rescued, receiving a $5.8-billion bailout package. Its market-cap has fallen, and Berkshire Hathway’s holding in AA is now worth a third of the $12 billion spent on buying back the stock, a horrendously awful use of (borrowed) funds, according to an investigation by Forbes which investigated 455 of the S&P 500 companies.

Or take the better known McDonalds. After the 2008 global financial crisis, Bill Ackman, a large hedge fund manager, pressed McDonalds to sell most of the 9000 company owned outlets to independent operators, and use the proceeds to buy back its stock! Though McDonald rebuffed the idea then, in 2014, then CEO Don Thomson, borrowed heavily to fund share buyback. His successor, Steve Easterbrook, followed Ackman’s script, and sold company owned outlets to franchisees. Some 93 per cent of its outlets are now owned by franchisees who pay royalty to McDonald. An ‘asset light’ model.

In the 5 years from 2014, McDonalds issued bonds/notes of $21 b in order to please institutional shareholders, buying $35 b. in stock and paying $19 b in dividends. Oh, by the way, Easterbrook earned $78 m in pay packages over these 5 years. Net debt per $of revenue went up from 38 cents in 2010 to $1.58, by 2019. Easterbrook was fired in late 2019. Mc Donald’s credit rating dropped from A, in 2015, to BBB now. It has now suspended stock buy backs.

Such stories, of corporate managers using OPM and ZIRP to borrow heavily and repurchase stock, in order to please institutional shareholders, are frequent.

Capitalism requires that badly-managed companies be punished. But they are not! American Airlines and Boeing (which also did the same things) have got bailout packages.

A young and smart fund manager, a billionaire, the founder of Social Capital, Chamat Pahilipithya, argues that these companies ought not to be bailed out.

In a bankruptcy, other stakeholders do not suffer much, especially if the buyer is competently managed and well-funded. A bailout package to these airlines, for example, only serves to rescue the owners. But in a proper capitalist system, they ought to be punished for their errors, by allowing the failed business to be taken over through a bankruptcy process..

This is something our policy makers really ought to think about. We ought not to keep using tax payer money to bail out perennially loss-making airlines, telcos or banks, or directing institutions such as LIC to take them over. If there is no deterrent to bad management, it will continue. There is little to lose, for making bad capital allocation decisions.

The main concern for investors is the coming clash of giants, US and China, and how the rest of the world would take sides in this. Malaysia for example has ordered that none of their telcos use Huawei equipment, and UK is likely to follow. China, on its part, is flexing its muscle against several countries, a border skirmish with India, a new law for HK, a tariff hike against Australia and a display of military muscle against Taiwan, and in the South China Sea.

Thus geopolitical factors will cause greater volatility in stockmarkets and a cautious approach is advisable, buying in stages, on dips. GDP forecasts for 2020 are hugely negative, with a sharp bounce back in 2021. Money chases growth, and the forecast for India’s GDP growth for 2021 is good. Jiomanaged to raise huge money even during these times, showing how, if value is created/perceived, there would be demand.

The writer is India Head — Finance, Asia/Haymarket. The views are personal.

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