Janus Henderson: Beware of the side effects of OPM

The venerable Scottish economist and philosopher Adam Smith recognised the importance of ‘other people’s money’ (OPM). He used the phrase in his 1776 Wealth of Nations publication to propose that one cannot expect corporate managers to have the same sense of ‘anxious vigilance’ when being responsible for assets and resources that are not ultimately their own. This notion provided the foundations for illuminating the moral hazard and conflicts of interest within principal-agent theory.

Latterly, the term has become a form of slang used within the financial and investment community to refer to financial leverage. In this context one could view it as borrowed money (be it loans, deposits or minority shareholders’ equity) that through leverage is used to increase the potential returns as well as the risks of an investment. OPM’s homophone in English (opium) may be a curious accident, but those who are sceptically minded may be justified in thinking that it judiciously highlights the potential ‘narcotic’ side effects of borrowing large quantities of other people’s money.

Fair weather friends

It is easy to forget when all is well with the world that providers of capital can swiftly change their mood and mindset from focussing on return on their investment, to return of their investment. This is particularly the case within emerging markets because the prospects for long-term economic and investment growth, driven by a demographic dividend, are more often than not accompanied by immature political, judicial and financial conditions. The financial weather can change rapidly. At random, and at relatively unpredictable intervals, credit vanishes. Too much debt becomes at best troublesome to equity returns and at worst potentially fatal to a business. This is particularly the case if those that have lent the money are fair weather friends and want their money back quickly. As Mark Twain allegedly noted, ‘A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain’. But it’s not just bankers – the bond and equity markets can be equally as fickle. Just ask Anheuser-Busch InBev (ABI), the world’s largest brewer.

One more for the road

Anheuser-Busch InBev is the brainchild of Jorge Paulo Lemann, a successful Brazilian investment banker, who co-founded the Brazilian investment firm 3G Capital. Together the founding partners acquired Brahma, a Brazilian domestic brewer, in 1989 and used the business as a platform to assemble what would become the world’s biggest beer company. This was achieved through a series of bold acquisitions and significant amounts of OPM – approximately $102 billion of debt at the last count. At a dollar per bottle, that is more than 13 bottles of ‘debt’ for every person on earth.

The majority of the debt currently on ABIs balance sheet came as a result of the acquisition of SABMiller, announced in 2015. At the time SABMiller was the world’s second largest brewer by revenues with an attractive emerging markets’ footprint. The acquisition price of more than $100 billion was an all-cash deal, achieved by AB InBev raising a $75 billion corporate loan – the largest commercial loan ever recorded. This was for a combined entity that, according to ABIs 2018 Annual Report, now generates $54 billion worth of revenue and $17 billion of normalised profit from operations. With a debt level of around six times normalised profit there was little room for error following the deal. The plan was to de-lever over time but the main risks to this were either a reduction in the profitability of the core business or higher costs to service the debt.

‘The future’s so bright, I gotta wear shades’

A partner at international law firm Allen and Overy was quoted by Reuters at the time saying that “AB InBev’s ability to raise $75 billion in the loan markets in the space of a few weeks shows that banks are willing to support top-class borrowers in record amounts, despite the current era of increased regulatory and capital costs”. It may have appeared to some that the bankers had swapped issuing umbrellas for sunglasses. It wasn’t just debt markets that had a favourable response to the deal. Shares of SABMiller rose 23% percent on the news that the deal had been approved by the Board, which wasn’t surprising noting that the final offer represented a 53% premium over SABMiller’s share price before the deal was announced. Interestingly, AB InBev’s stock was also up 7.4% following the merger announcement as markets cheered. 

It is at this point that we should acknowledge an interest in these proceedings. The Janus Henderson Global Emerging Market Equities All-Cap Strategy at the time owned shares of SAB Miller, and was a beneficiary of AB InBev’s largesse. We sold the stock, noting in our Q4 2015 client update that, ‘2016 is likely to be the year we say farewell to our ‘old friend’ SABMiller, which is subject to a bid from brewing rival ABI. SABMiller, a global brewer with a particularly strong presence in the emerging markets of Africa, China and Colombia, had been a top-ten holding but was substantially reduced during the fourth quarter [of 2015] as the discount to ABI’s offer narrowed. The deal still has to clear a number of regulatory hurdles and a large amount of debt is to be raised by ABI, should it fail there would likely be substantial downside in the stock’.

A Financial Times Lex column written in November 2015 interestingly assessed the opportunity, risks and market reaction to the deal. ‘AB InBev says that the deal is about growth, especially in Africa. Nonsense……….. Revenue synergies are never a great way to justify a deal, though. Add in execution risk and the thin-looking cost savings, and there are plenty of reasons to have doubts about the deal. Yet since rumours of the tie-up emerged in late September, AB InBev’s shares have risen by a fifth. If there is one thing Mr Brito [AB InBev CEO] has earned, it is the benefit of the doubt.’

The best laid schemes of mice and men…

It was another Scot, Robert Burns who wrote in his poem ‘To a Mouse’ that, ‘The best laid schemes o’ Mice an’ Men, Gang aft agley, An’ leave us nought but grief and pain, For promised joy!’ The unintended side effect for businesses with significant amounts of OPM, particularly in emerging markets, is that promised joy can quickly and unpredictably lead to grief and pain. It is one of the reasons that we prefer to make conservative assumptions when we look forward in assessing the future cash flows of a business. We hope to have sufficient humility to recognise that predicting the future is hard. There’s a reason that it’s rare to see a book maker fail. As Philip Tetlock acknowledges in the book ‘Superforecasting: The Art and Science of Prediction’, ‘if you have to plan for a future beyond the forecasting horizon, plan for surprise. That means, planning for adaptability and resilience’. In AB InBev’s case the business plan was surprised by changing consumer tastes in developed markets, which hurt volumes, weaker emerging market currencies and an interest rate environment at the time that was increasing the cost of borrowed funds.

We are wary of management teams that are willing to take the risk of running a significant currency mismatch. That is having revenues and profits in a local currency and liabilities in a different currency – notably hard currencies such as US dollars or euros. Enthusiasm for emerging market currencies can wax and wane and if the local currency depreciates significantly, it makes it more expensive for a business to meet its loan repayments. A low coupon rate in a hard currency can look optically low but can end up being prohibitively expensive – sometimes fatally so. AB InBev had put itself in a difficult position because it used US dollars to fund the deal, yet the majority of the combined entity’s revenues are produced in local currencies. In 2018, 70% of ABIs volumes and 57% of its revenues were produced in emerging markets, while 91% of its loans were in US dollars and euros. This business was at risk of not being in charge of its own destiny. Importantly, debt and equity markets had cheered it on in the process.

Debt detox

If 2015 was the year that AB InBev could do no wrong in the market’s eye, then 2018 was the year that it could do no right. The barometer was now firmly pointing to stormy, and the bankers wanted their umbrellas back. The need to maintain access to OPM through an investment grade credit rating led the AB InBev management team to prioritise the distribution of cash flows to debt holders over shareholders. In October 2018, as ABI reported its third quarter results that did not meet expectations, it also announced a cut in its dividend by 50%. In 2017 the company paid $8bn in dividends to shareholders but this was reduced to $4bn in 2018 with the cash saved being used to pay down debt. AB InBev’s shares had already fallen 22% in 2018 prior to this action, as the combination of its high debt load and weakness in emerging market currencies had led to speculation that the dividend would need to be cut. At a debt level of close to 4.5 times earnings before interest taxes and amortisation (EBITDA), the company was still a long way off its long-term debt target of two times earnings, a level at which its large-scale industry peers operate at. Towards the end of 2018 Moody’s stripped the company of its A rating, warning that its deleveraging strategy was at risk of falling further behind schedule. Providers and gatekeepers of OPM who had facilitated AB InBev’s debt binge were now enforcing a debt detox.

The tortoise and the hare

Heineken Holding, which is owned in the strategy, is now the second largest brewer in the world after AB InBev and SABMiller merged. The company was founded in 1864 by Gerard Heineken, and the fourth generation of the family, led by executive director Charlene de Carvalho-Heineken, still owns in the region of 25% of the business. We believe that the longer-term approach implemented by many family-controlled businesses leads them to be more circumspect with regards to using OPM compared to many of their corporate peers.

Heineken, for example, has operated at a conservative level of leverage over time – currently at around two times earnings (EBITDA) – and has shunned speculative takeover approaches. This may make family businesses, such as Heineken, less successful during boom times but increases their chances of being masters of their own destiny. Family-controlled businesses are often conservatively managed which means they are often in a position to take advantage of distressed corporate competitors during downtimes. We believe that this should allow these companies and their investors to achieve healthy returns over time. One should be aware of drawing inferences from too few data points, and the risk of data mining, but the different ownership styles and approaches to OPM that have been shown by Heineken and AB InBev point to the importance of assessing these qualitative factors when considering potential equity investments for inclusion on our watch list and ultimately client portfolios. The fundamental issue is that corporate managers may receive call-option like returns (with limited downside and unlimited upside) from their capital allocation decisions but minority equity holders do not have that luxury. This is particularly true for those investors who focus on absolute rather than relative risk.

Thinking and acting like prudent owners

Our investment philosophy and process applies both the historical and the modern connotation of the term ‘other people’s money’. We have long believed in carefully considering how we, as minority shareholders, are aligned with the interests of the owners of the companies in which we invest. In addition, we also look for capital allocators that associate OPM with fragility and the risk of a permanent loss of capital. Significant levels of debt can mean having less room to manoeuvre if a setback occurs and can lead to highly leveraged companies being beholden to a bank or bond markets during periods of cyclical economic weakness or shifting industry trends. There is nothing inherently good or bad in a management team or business owner following a particular capital allocation or investment style. One just needs to follow an investment philosophy and process that is consistent. It is our belief that the inherent vagaries of the emerging market investment landscape reward those who are willing and able over the long-term to be risk aware and act like prudent owners.