Revisiting Dubai World
The European Sovereign Debt Crisis didn’t really start with Greece. It ended up being most acute in Greece, enveloping a number of other countries too. But it started in Dubai with the collapse of Dubai World almost nine years ago. Here’s what I was saying then. I called it “The bust in Dubai and exogenous shocks“:
By now you have heard that Dubai World, the investment company, has asked its creditors for a six-month delay in repaying its debt (see articles in links). This is what is commonly referred to as default. Now many are wondering if Dubai the country is on the verge of default and asking who is most exposed…
I think of the events in Dubai as having a bit of the butterfly effect to it – with everything selling off because of this one isolated incident… If there was to be any global butterfly-effect contagion, I have been looking more to the Baltics and their property bubble (see this October post for an example)…
…the Dubai World events underline the unpredictability of exogenous shocks. All of these potential crisis situations — dollar carry trade unwind, debt crisis in the Baltics, oil price spike, an unexpected surge in interest rates, war in the Middle East — are still there lurking in the background. We don’t see coverage in the press on them everyday, but they are still there.
The way I see it, Dubai World’s collapse was an excuse for people to re-examine the risk in their portfolios and to reduce that risk where they could. It wasn’t that Dubai World was systemically connected directly to other big market or credit risk factors. Rather, it was the fact that panics end up exposing the most fragile business models and debtors to stresses they can’t handle. Greece was one debtor that was exposed. And that exposure followed literally just a few days after Dubai World defaulted.
Abraaj Group collapse and EM risk
So when I heard about what happened to the private equity company Abraaj Group, based in Dubai, I immediately thought back to Dubai World nine years ago.
Here’s what Bloomberg writes about the Abraaj situation now unfolding:
Days before rubbing elbows with global business titans in Davos in January, Arif Naqvi set out to charm another circle of friends—Gulf Arab tycoons—in a last-ditch attempt to save his Dubai private equity firm.
But things were already on the cusp of spiraling out of control. Dogged by allegations Abraaj had mismanaged investors’ money, Dubai’s star financier soon couldn’t pay the rent…
Abraaj’s spectacular demise has dealt a severe blow to Dubai’s reputation as a global financial center. It rattled the trust of investors who included Bill Gates, the International Finance Corp. and U.S. and U.K. government agencies, triggered defaults on loans from at least 10 sources and set off lawsuits in the United Arab Emirates and Turkey…
Abraaj oversaw funds from 18 offices in emerging markets spanning Latin America, Africa and Asia—a network that several U.S. investors have since tried to buy at fire-sale prices.
People are prone to seeing patterns where none exist. So forgive me for connecting Abraaj and Dubai World simply because both were based in Dubai. Nevertheless, I do see this as a pretty spectacular financial collapse. And the last paragraph quoted above is the one that worries me because it’s about emerging markets; that’s the market I see already having a canary in the coalmine for end-of-cycle credit risk.
The global economy looks good though
The counterpoint to worries about the end of this credit cycle is that the real economy is doing fine. If I had to draw parallels to previous years, it wouldn’t be 1990, 2000 or 2007. It would more likely be 1988, 1998 or 2005.
The 1998 analogy is one where we had already seen the Asian crisis play out, eventually precipitating a Russian default and the Long Term Capital Management crisis. But that ended with a successful bailout that kept the credit cycle going another two years. And the economic backdrop in 1998 was stellar too.
Even so, I am disconcerted by the Abraaj collapse. The spin now is that it’s a special case since it’s a PE firm that even used debt to finance operations, not just deals. But Greece was also teed up as a special case in Europe. And though its problems ended up being more severe, several other European countries ran into problems in the European sovereign debt crisis.
Accelerating risk in PE
So, as good as the real economy looks today, I am also aware that “everything about private equity reeks of bubble“, as Institutional Investor recently put it.
“It is scary out there,” says David Fann, president and CEO of TorreyCove Capital Partners, a San Diego-based firm that advises institutional investors on private equity, private credit, and real assets. “There is a lot of risk. It’s a strange environment for sure.”
While private equity remains popular with investors, there’s reason to be cautious as the economy stretches into its ninth year of expansion. Fann says he recently heard from an investment banker in the Midwest that “crappy little companies” are being sold for 12 times cash flow, when they should be valued at seven times. The debt used to finance these deals could spell trouble down the road.
“Rising interest rates could potentially be a problem,” says Fann. Higher interest payments can eat into cash flow over time, leading to a large drop in a company’s valuation. He explains that a company needn’t be faltering for its buyout by a private equity firm to turn into a money-losing deal for investors. “Unless you improve those companies’ operations dramatically, you could be looking at a significant loss,” he says.
Yet these concerns haven’t stopped private equity firms from racing to investors for more capital — indeed, the very recognition that bull markets don’t last forever may be fueling a rush to raise money.
As I have been saying, a campaign of rising base rates by a central bank increases credit euphoria in the rate hike campaign’s initial phase. It’s an economic accelerant.
Private equity is at a very risky phase right now. Abraaj Group is not an isolated case.