Its not the disclosure but the leverage that we should worry about.

Posted by Morgan on 11th Dec 2008
David Ross is this week the most talked about business man in the UK and the press seem to have taken a certain degree of pleasure in destroying his previously golden image.

Mr Ross was a pin up for entrepreneurial Britain, young, talented, successful and self made. He is even public spirited taking on the daunting task of trying to assure Boris ran a tight ship in planning the 2012 Olympics.

Sadly he has become the perfect target for the British press and the peculiarly British disease, we love to find a home grown hero but then take even more delight in watching them fall.

Undoubtedly, Ross has been somewhat foolish. Firstly, he leverages his stakes in not only Carphone but also the other three listed companies of which he is  a director without fully disclosing this. This is a bit of a schoolboy error but on the face of it there has not been any market manipulation that has allowed Ross to profit or any other investor to lose money.

Rather more foolish he seems to have monetisation, by way of leverage, his equity stakes in order to grow Kandahar,  his real estate portfolio. This leaves him, and other who have done the same - notably the Russian oligarchs in a perilous position. This is a situation that does threaten the stability of markets and the solvency of both companies and individuals.

In the boom times, this model looked ingenious. You took £100m of stock and raised say 75% of its value through a loan. You then reinvested the £75m of debt as equity in other deals or sectors. Through supporting your acquisition with leverage you could grow your portfolio exponentially benefiting from further stock price growth and the seemingly endless appreciation of all asset classes.

Prior to the loan you owned £100m of equity, following this financial engineering you owned £100m of equities and £375m of property. OK, you still only have £100m of equity value but the bigger portfolio in a rising market will generate far greater returns than a £100m ungeared equity holding. Suddenly a rich man is well on the way to being a billionaire.

Unfortunately, there is always a catch. Whilst banks loved this business, it allowed them to make profitable loans, generated M&A and brokerage fees they did need some security. This came through margin calls attached to loan to value covenants.

The original £75m loan would be secured on the shares but would be limited to say 80% of the value of those shares. If the share price falls then the client has to post cash as additional security to meet the 80% ratio. Simultaneously, if the value of your real estate holdings are falling this could trigger covenants in your property loans. The rapid fall in value of both shares and real estate was never predicted or properly thought through. Suddenly an investor needs lots of liquid cash to satisfy the banks security demands. If he can not provide this the bank repossesses both the shares and the property portfolio.

Many investors have not stashed away enough money to meet this rainy day requirement. Quite rapidly you can lose both the shares and the property, as banks rush to recover as much of their loan as possible. If shares and property both fall 25% the investor loses the lot. Very wealthy men could and will be be turned to dust.

I am not suggesting that this will happen to Mr Ross but it illustrates the risks attached to leverage. I suspect it will give the tabloids the opportunity to rubbish many more big names before the end of 2009.

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