Value From… Where?

Financial engineering does not transform a dubious project into a winner. When the spreadsheets describe a boost in value, check for new risks hiding below the surface.

I finally watched Inside Job, that academy award-winning documentary indicting the financial services industry, economists for hire, and federal regulators. The injustices will make your blood boil if you aren’t already familiar with the behaviors and events that destroyed Main Street while enriching Wall Street. (I already made my peace with all of it all back in 2009)

Tucked into the storyline was the observation that, contrary to the pitch of very successful financiers, we can’t create value out of thin air with elaborate financial structures.

An Old Lesson

Now, this isn’t new. Back in 1958, Franco Modigliani and Merton Miller wrote a paper that earned a Nobel Prize.  Their work demonstrating that a company creates value only by operating effectively, not by complex financial structures. Financing impacts how a firm’s profit is sliced up and paid out to various banks, owners, etc., but the total amount of cash available for slicing up is fixed. Tax impacts are an exception, but we can precisely quantify and rolled these into the evaluation.

However, (and here’s the dangerous part) while structures don’t create additional value overall, an individual can create excess value for themselves. If they somehow take their slice without taking their fair portion of the risks, they have created value, but only for themselves. That risk, however, doesn’t simply evaporate. Someone else will unknowingly end up with that extra, unfair burden of risk. Unfortunately, this is not terribly difficult to accomplish when new structures are offered. Risk is a difficult concept, hard to measure, and largely invisible — until something goes wrong.

I know very nice people who lost their homes due to risks embedded in ‘non-standard’ mortgages they did not understand. Leaders from many companies, governments, and even high-flying hedge funds are also surprised by the consequences of their unusual financing arrangements. They had bought into what seemed like below-market interest rates or other “enhancements” to performance metrics. The sellers may or may not have recognized this was a shell game, sloughing off risks to their clients, but the damage is evident.

Team Nobel

Smart people with a polished presentation of special financing arrangements to boost a project’s value often make executives feel like they are the only ones in the room who don’t “get it”. Trust your gut! Side with the Nobel Prize winners and assume that the financing doesn’t create additional value (beyond definite tax advantages). More than once my willingness to admit my ignorance and keep asking the same annoying questions eventually pulled back the curtain to reveal distortions and risks.

With new accounting rules curtailing the allure of leasing, financiers are concocting new products that threaten to distort project evaluations and derail sound decisions. Beware of financing arrangements claiming to boost a project’s value. It is likely dumping more risk into our laps than anyone is acknowledging. Just as the poker saying goes:

“If you can’t spot the sucker at the table, then the sucker is probably you”

© Dave Wittenberg