Employee earnings are set to decline sharply in the investment banking division of RBS.  Future bonuses to be paid in subordinated debt spread over the following 3 years.  Subordinated debt is currently about as popular as a bad smell in a lift.  Hence its even more of a pay cut to be allocated a bonus in sub debt at par when other subordinated bank debt is trading at a big discount to par in the marketplace.  Sub debt has the same downside as equity but no upside as its limited to par. 

Yesterday the Government agreed to pay RBS par for £19 bln of convertible preference shares, which are even further down the capital structure than sub debt.  Technically the RBS B shares are Convertible Non-Cumulative 7% Preference Shares, issued on a 108% conversion premium and automatically callable at 130%; coincidentally the 65 pence call trigger is the same price as the second rights issue of 2008.

RBS will be aiming to buy back the B shares from future retained earnings.  Having 38 bln new shares created is not in the best interests of minority RBS shareholders – so don’t expect RBS shares to trade above 65 pence until all the B shares have been bought back.  RBS would also benefit from buying back subordinated debt in the market if they could buy it back below 50%.  Below this level the profits from cancelling the debt would exceed the Core Tier 1 capital spent on the buyback.  This would therefore be neutral from a Core Tier 1 capital perspective and would also wipe out future coupon payments.  Buying back below 33% would even be neutral from a normal Tier 1 capital perspective.  There are will be even fewer buyers of perpetual subordinated bank debt once they realise that none of this debt will be called until RBS has spent £19 bln of future retained earnings on buying back B shares.

Back to those pressured employees.  We are at the start of a structural change in pay in the marketplace.  More of the company earnings will be retained by shareholders.  This marks the end of the 48% compensation payout ratio.  Will they all leave and go work somewhere else in today’s global marketplace?  A few individuals may leave, especially those whom are already independently wealthy, but for the rest I doubt it as there is nowhere else to go.

In the very long run investment banking will go back to private partnerships as these are the best way of risking capital – when its the partners’ money they pay attention to the risk.  Not quite the same as hedge funds as partnerships are not creaming off 2% of their investors’ money every year come rain or shine.  Boutiques offering corporate finance advice will be set up first as these require little start-up capital.  Risk-taking partnerships will start small and build up their capital by retaining earnings – this will take much longer but at least these partnerships will not bring an economy to its knees if they go bust.

The market indices have extended their Christmas rally in the early part of January although volume has been much lower than we experienced in December.  The FTSE has been stronger than the S&P or Dow.  So what is going on and can we trust this low-volume rally?

The closing months of last year were dominated by stories of forced selling by hedge funds as they liquidated assets in order to repay investors who had asked for their money to be returned to them on 31 Dec 2008.  Investors in Bernard Madoff’s funds got a nasty surprise when they found out there were no assets to be sold & no money available to repay them.  However the share prices which prevailed at the end of 2008 represented fire-sale levels at which buyers could be found to absorb the forced selling.  Volume on the Dow spiked to 550 mln on 19 Dec 2008 which was futures & options expiry day.  Since then volume has generally been below 250 mln shares per day.

What could easily happen now is markets could continue to rally from oversold fire-sale levels to a level where the buyers who bought those shares (which the hedge funds dumped) are prepared to take profits.  Bear market rallies occur when the panic/forced selling dries up and this rally would naturally be on low volume due to the absence of forced sellers.  Selling from margin calls also dries up in this environment as rising prices boost portfolio valuations.  This rally could well be extended when the investors who receive money back from hedge funds decide to re-invest their cash.  Such is the stuff of which sharp bear market rallies are made.

Ask yourself who are the natural sellers of shares at the present time – the lack of willing sellers means the path of least resistance for markets is higher for the time being.  Corporates may provide some supply as they seek to strengthen their balance sheets; witness this week’s placing by SSE of 5% of its share capital (42 mln shares placed at £11.40 on a dividend yield of 5.8%), raising £479 mln.

In this environment we are also seeing individual shares rally despite announcing earnings below analyst’s forecasts.  The reason is shares are rallying from levels determined by fire-sale selling and not from prices based upon earnings expectations.

So what could derail this rally?  In the absence of another large Lehman-style bankruptcy either future earnings expectations will have to take take another downturn or the forced sellers will need to return.  It will pay to keep a close eye on the performance of individual shares as they announce their earnings.  If, in general, companies continue to rally after releasing earnings (no matter how poor those results are) then this current rally still has some way to go.  In the meantime keep watching the volume & price action for clues as to a possible change in the upwards trend.

With the next bull market due at some stage, the focus will surely move away from absolute return products.  Is this the real reason why the Wellcome Trust is currently trying to sell its £3.5 bln private equity portfolio so as to be able to re-invest in equities and/or corporate debt in time for the next upswing?  They have found a plausible excuse with Sterling’s recent collapse from $2.00 to $1.50, claiming that they are trying to lock in a currency gain on their dollar-denominated private equity portfolio…

This bear market will end one day and hedge funds have not provided much protection from the bear.  The key idea behind hedge funds is wonderful (actively-managed funds which aim to beat the return offered by a savings account) but maybe Warren Buffett was right when he concluded that they were compensation structures first & foremost.  In order to participate in the next bull market you do not want to be stuck in a fund which may not fully participate in the upside (due to past scars from the bear they may not dance fully with the bull) and is going to take away 20% of that upside in fees anyway.

Note :  In theory hedge funds which suffer a decline in NAV are not paid their (typical) 20% fee on profits until the fund’s NAV exceeds its prior “high-water mark”.  Therefore investors who choose to stay aboard for the potential ride back up would not suffer 20% of the upside being taken away from them in fees.  However in practice what tends to happen is that hedge funds which perform badly close down and investors then have to invest any money they may be lucky enough to get back in a different fund which then takes 20% of the upside.

There are many listed investments which are currently trading at the equivalent of 20% of NAV (“20 cents on the Dollar”).  An old salesman friend of mine once pointed out to me that in his experience, when things go wrong, securities always seemed to bottom out around 20 cents on the Dollar.  This thought came back to me when I looked at the recent results statement of MAB (Mitchells and Butlers).  Incidentally with lots of listed securities trading at such steep discounts to NAV, the logic of investors cashing out of hedge funds (at NAV) to re-invest in such securities cannot be faulted.  The same thought process should steer investors wishing to invest in commercial property towards REITs rather than commercial property unit trusts. 

MAB’s recent results showed adjusted EPS of 31.5 pence putting them on a p/e of 4.6x at 145 pence.  Lets be kind and ignore the fact that they actually made a loss due to the cost of closing out financial hedges and taking an impairment charge of £206 mln mostly against pubs & bars hit hard by the smoking ban.  The pub property portfolio is valued at £4.7 bln; subtracting net debt of £2.735 bln and using 405 mln shares outstanding of implies NAV of 485 pence.  In July 2008 MAB signed a £600 mln three-year unsecured debt facility maturing in Nov 2011.  Their lenders committed MAB to reducing its borrowings by steadily lowering the amount of credit made available to £550 mln in Dec 2008, £400 mln in Dec 2009 & £300 mln in Dec 2010.  As MAB had drawn down £514 mln on this facility at 27 Sep 2008, they had no room to pay a dividend.  Their strong cashflow needs to be diverted towards paying down this debt facility over the next couple of years and this means no dividends due until late 2010 (the next dividend is likely to be declared in Nov 2010 and actually paid in Jan 2011).

MAB do have two big shareholders – Elpida Group own 14% but the Magnier/McManus modus operandi involves selling out to a bidder (c.f. Manchester United) and not taking over the target company themselves.  Similarly Joe Lewis, who picked up a 22% stake at 130p (via his Piedmont vehicle) when Tchenguiz’s stake was liquidated following the collapse of Iceland’s banks, is an investor rather than a bidder.

There is undoubtedly long-term value in MAB but it will be a long wait until the credit becomes available for any future bidder.  In the meantime I like to be “paid to wait” in the form of a regular dividend income stream and MAB have just cancelled their dividend payments.  Consider switching out of MAB into other shares which currently trade at similar valuation levels but which are still making dividend payments.