Why the Trend to Deflation Is Encouraging
Two thoughts to guide you in these worrisome times: The economy’s underlying dynamic is shifting from inflation to deflation and, realizing this, some of the nation’s smartest investors are encouraged, not frightened.
A big, off-putting word, deflation. Essentially, it means that in the 1990s the price of the farm will be less important than the size and price of the corn crop.
To review and explain. Financial experts these days are like seismologists watching for an earthquake. Stock and bond traders--and government officials--seem to be waiting for problems in real estate to cause a spectacular bank failure, the collapse of an insurance firm, a chain reaction of financial disaster.
Even their optimistic moments are ominous. When Security Pacific Bank last week set aside reserves against loan losses in Britain and Australia, the markets heaved a sigh of relief that California real estate was not specifically mentioned.
That’s grasping at straws. California office buildings are unlikely to be spared in the bust that is following the worldwide property boom of the 1980s.
The United States has a 10-year surplus of office buildings, London’s oversupply is even greater and Paris and Tokyo are still madly adding office space to saturated markets, says David Shulman, managing director and head of real estate research at Salomon Bros. investment firm.
The boom was driven by inflationary expectations that a property built or purchased today would always be worth more tomorrow.
Now the boom is over, and the fear is that buildings will decline in value, throwing loans into default, causing banks and other businesses to fail and the whole economy to spiral downward into a rerun of the 1930s Depression--the last great era of asset deflation.
But that is going too far, says Shulman. Sure, the new decade will be long and hard in real estate, with office buildings declining as much as 30% in value. But real estate can hurt without inflicting pain on the whole economy. “Office buildings are only 0.6% of the gross national product,” he says. “It’s a very large economy.”
And the real story today is how some very big and smart money is preparing to invest in that large economy.
Warbug Pincus, a New York-based investment firm, has just raised $2 billion from its backers--including the General Electric, General Motors and Pacific Telesis pension funds.
The 51-year-old firm is known for rescuing Mattel in 1983 with a $40-million equity investment, and making a $150-million investment in Pittsburgh’s troubled Mellon Bank. Chairman Lionel Pincus is not frightened by today’s changing economy. “We’ve lived through cycles before,” he says, “and the pattern is familiar: shock, paralysis, despair, panic and then resolution.
“We are now between paralysis--the credit crunch--and despair,” he says. So opportunities are emerging for his fund and others to recapitalize companies with equity investment.
Theodore C. Rogers, who heads American Industrial Partners, a $200-million investment fund with backing from the Bank of America and Wells Fargo pension funds, among others, is looking to invest in manufacturing and industrial distribution companies.
The fund brings operating expertise as well as cash to investments; Rogers is a former chairman of NL Industries and a longtime manufacturing executive.
The new equity funds are the opposite of the 1980s’ leveraged buyouts, which relied on the company’s income or the sale of its assets to pay debt, leaving LBO backers with a valuable property they could sell. The assumptions underlying LBOs were that income would not fall, you could always sell assets and resale values would go up or at least not go down.
None of those assumptions are valid in the changed economy.
Instead, there is a new way to create value--increase the company’s profits--as American Industrial Partners’ first deal illustrates perfectly.
Rogers expects shortly to invest almost $12 million in two box-making companies in Northern California--names undisclosed because the deal is not signed yet.
The $12 million, which will represent 42% of the two firms’ combined equity capital, will go for high-speed packaging and production lines and an ink plant to serve both companies. With the new machinery, American Partners hopes to increase profits from $1.3 million to $3 million within 18 months, and to earn their returns as the businesses grow from there.
They don’t plan to sell for five to seven years and, in fact, assume that the box companies’ resale value at any time may be lower than it is today. But income will go up if the investments are made and the business is well managed.
And that will be the pattern for business in the new decade, says Rogers. “You’ll have to work the crop, not sell the farm.”
Which is enormously encouraging. The new decade will have a productive bias, not an inflationary one. In an inflationary time, you make a bet that value will increase; in a productive time, you make an effort to see that it does.
