Falling Interest - Keith Weiner

by Keith Weiner, Sprott Money:

Last week , we discussed the marginal productivity of debt. This is how much each newly-borrowed dollar adds to GDP. And ever since the interest rate began its falling trend in 1981, marginal productivity of debt has tightly correlated with interest. The lower the interest rate, the less productive additional borrowing has in fact become.

Let’s look at a recent event: the Ikea acquisition of TaskRabbit. You might wonder, why does a home goods company need to own a freelance labor company? Superficially, it seems to makes sense. Ikea products notoriously come in flat packs, but consumers don’t want to fuss with all the little parts. They just want finished furniture. Ikea has been using TaskRabbit to hire people to assemble it in their homes.

Isn’t this like that caricature of the billionaire who buys, say, the Planters Peanut company because he likes to eat salted nuts? Ikea could be a customer of TaskRabbit, hiring its temporary workers as needed, without owning the company. In fact, it had been doing that for years.

The acquisition price was not disclosed, however, we can guess that it was high. TaskRabbit was a Silicon Valley darling with a bright future. Its value proposition is right for this economy. It had raised $50 million, presumably at rich valuation multiples.

How much would Ikea be willing to pay? We don’t know how many dollars TaskRabbit was earning, so we will have to pass on total price. However, we can ask how much Ikea would be willing to pay for each dollar of earnings. There are two metrics to help answer this question.

One, Ikea can compare to the price that its own investors are willing to pay for a dollar of Ikea earnings. If it can buy a dollar of earnings via TaskRabbit for less than the market pays for a dollar of Ikea earnings, then it’s a good deal. Ikea is not publicly traded (but we suspect management has an accurate internal estimate of enterprise value).

Two, Ikea can compare the return on its investment to the cost of borrowing. If it expects to earn 5% on its investment for example, but borrows at 3%, then it’s a good deal.

The price to earnings of a large company, and its cost of credit, are both related to the prevailing rate of interest. As interest falls, price to earnings rises and cost of credit falls. So a falling interest rate, all else being equal, creates the opportunity for such acquisitions.

This fuels a process of capital destruction that we have written about extensively (see Keith’s series onYield Purchasing Power ). With Ikea we don’t know the company’s debt or cost of borrowing. But typically, acquisitions are funded by borrowing. The debt of the acquirer replaces the equity of management and investors of the acquired. Total debt goes up, but production does not increase.

And the exquisite madness of this is that it makes sense! By every principle of rational business management, these deals should be done. If you can borrow at 3%, then you can pay perhaps up to 20 or 25 times earnings to make acquisitions. If you can borrow at 1%, then you may pay up to around 50 times earnings, or a bit more.

This process, of course, makes billionaires out of the founders of many a startup and makes the venture capital firms and their investors a lot, too. The source of their profits is the debt, borrowed by the acquirer. They may spend their profit and consume it.

The more the rate of interest falls, the more fuel is added to accelerate this consumption process.

We don’t want to drill any deeper into this here. Instead, let’s move on to address the question we left from last week: why is the marginal productivity of debt after 2010 at a higher level than before the crisis, despite interest rates that continued their inexorable collapse?

In Keith’s Theory of Interest and Prices Part I, he states:

“These processes and forces [that lead to the formation of the bid and ask prices of credit] are nonlinear. They are also not static, not scalar, not stateless, and not contiguous.”

The question last week was a bit unfair, in that these five ideas were embedded in how it was framed. We showed a graph showing falling interest and falling marginal productivity of debt. And asked why the discontinuity in the correlation post-2010?

We think the key idea that explains the post-2010 situation is: people are stateful. What does this mean? It means they have internal state. Their behavior is not a simple function of quantity of money or interest rates.

For example, they have balance sheets. A business with low debt to equity has plenty of capacity to borrow to buy more assets. However, we know that in 2010, asset values were way down compared to 2007, but of course the debt persists. Therefore, capacity to borrow was reduced.

Stateful also refers to the fact that people have memory. What could people possibly have been remembering in 2010? It’s a real head-scratcher…

Sarcasm aside, the major corporations in 2010 or 2012 had less appetite to borrow to buy the TaskRabbits of the day. No matter that the cost of credit was lower than it had been pre-crisis, their assessment of the risk was much higher.

Deals like the Ikea acquisition of TaskRabbit are a sign that the temptation to buy earnings with dirt cheap credit once again outweighs the fear of a liquidity crisis or a crash of asset prices. Besides, if your company is the only one not partaking in the Fed’s largesse, and all your competitors are, then you will certainly lose out.

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