The Bear’s Lair: Cash flow will be king in 2023

For the last decade, cash flow has seemed irrelevant. Interest rates have been close to zero and well below the inflation rate, so that loss-making companies and projects with cost or time overruns could easily raise additional capital. Now, with inflation at 7-8%, interest rates are still negative in real terms. However, whatever the level of inflation, a 5% interest rate has one important difference from a zero interest rate: it requires you to find 5% of the principal in cash each year or go out of business. Modern companies, especially in the tech sector, are not used to such disciplines. The result will be bankruptcies and scandals in 2023; Sam Bankman-Fried is just the first of a large crowd.

Private equity is likely to suffer particularly from the reborn importance of cash flow. Outside tech, most private equity acquisitions are carried out on the basis of tight cash flow projections, leaving only modest margins between the cash flow from operations and the debt service costs on the highly leveraged deal. Now those debt service costs have sharply increased. There has also been an increase in operating cash flow though inflation, but the typical 7-8% increase in operating cash flow is nowhere near sufficient to offset the doubling or more in interest costs.

Add to that the possibility of an economic slowdown, where operating cash flow itself suffers, and you have the likelihood of deals running out of money. It takes some time for the wheels to fall off transactions, but in 2023, fall off they will. Since the problem will affect most companies in the average private equity portfolio, there will be little or no possibility of bailout by the ownership group. You can thus expect a large number of Chapter 11 (debt restructuring) and even Chapter 7 (liquidation) filings in this sector.

Another severe sufferer from higher interest rates will be real estate. Even more than private equity, real estate benefits from both zero interest rates and inflation. Rental yields are generally fairly low (by the time you’ve subtracted taxes and all the ridiculous maintenance you have to do) so ultra-low interest rates give a real estate investment a pleasant glow of success, producing a little cash each year. In that environment, it does not matter too much how fast or slowly prices are increasing, nor the appalling costs of buying and selling your investment – buy, hold and re-leverage works fine.

With higher nominal interest rates, that all goes into reverse. Even though interest rates remain below the level of inflation, higher rates make the underlying investment turn horribly cash flow negative – instead of receiving a modest return from it every year, you have to put more cash in, like a bottomless pit. I did some work in the 1970s for Trammell Crow, an immensely successful real estate developer who by 1973 had become a billionaire. Well, the middle 1970s, when the economy slowed somewhat and interest rates shot up, making his cash flow negative, were not a happy time for his real estate empire, and the early 1980s, with even higher interest rates, were definitely unpleasant. Crow survived financially, albeit with major asset sales, but many of his competitors didn’t – and for small operators, private individuals with a couple of rental properties, the 1970s and early 1980s were fatal.

The leverage in the 2010s was much more extreme than in the late 1960s and the euphoria from ultra-low interest rates much greater. Thus, in 2023 we can expect some major carnage in real estate, especially in the big cities where valuations have become so over-inflated. Blackstone’s real estate fund has just suspended withdrawals; it will be the first of many; forced sales will occur and a great deal of investment will be lost.

The tech sector has already suffered severe stock price declines in 2022, but in 2023 there will be additional strain on those tech companies that have gone public without having secured long-term profitability. In the short-term, these companies may benefit from higher interest rates, since they generally have a cash hoard, but higher rates and any kind of downturn in their business will make it very difficult for them to find the capital to keep going. The same is obviously true of those tech companies that are exhausting the alphabet in their approaches to round after round of venture capital financing without bothering to turn a profit. Some of them were already approaching the existential problem of running out of letters in the alphabet for their “Series Z” rounds of financing; others will find finance availability drying up even before the alphabet is half exhausted.

A bigger problem than tech may be those companies that have over-indulged in share repurchases in the funny-money period, since debt was cheap and over-levering themselves enabled their top management to score big on their stock options. Boeing (NYSE:BA) is a classic example of this; in a cyclical business, it has run entirely without stockholders’ equity since 2019, and loaded up on a mountain of debt during COVID-19.

Some of these companies may get away with refinancing themselves with new equity at the bottom of the market, thus perpetrating a remarkably foolish robbery of their stockholders by buying back shares at the top of the market and making a large “emergency” share issue when their share prices are much lower. However, once a few of them have done this, the market will wise up, and refuse to bail out the greedy and incompetent management that perpetrated this robbery.

The result will be a series of high-profile bankruptcies, of companies that discover that with excessive leverage and inadequate or no stockholders’ equity in a period of rising interest rates, even the slightest hiccup in their business will endanger their existence. Unlike crypto fraudsters, the management of these companies will generally not deserve or receive jail sentences, much to the annoyance of their ruined stockholders. Nevertheless, the legal system can still come in useful, in restoring the pre-1978 position, whereby share repurchases were effectively forbidden.

Finally, there is the most dangerous victim of all from higher interest rates: the government. Governments throughout the world have loaded up on debt during the decade of funny money, generally assuaging their consciences with the thought that borrowing at a cost below the inflation rate is theoretically a good deal. Naturally, those governments will not have read the small print: that it is only a good deal if the borrowed money is invested in productive assets. In most cases, even more than usual, the tsunami of extra spending has been wasted on social programs, pork, corruption, wokery and bureaucracy, none of which pays an economic return.

We have already seen a crisis in Britain, when the well-meaning but foolish Liz Truss government attempted to widen Britain’s budget deficit even further, cutting taxes without reducing the grossly bloated British public sector. This caused panic among British pension funds, which had foolishly loaded up on derivatives assuming low interest rates were there forever.

Bond market investors naturally make losses when interest rates rise, which they are generally too foolish to hedge properly. This makes them extremely reluctant to fund new government debt issues in a rising interest rate environment, since doing so results in immediate losses which they must report on a “mark-to-market” basis. Hence when rates rise, as they have, governments’ cash flows take a nosedive, while their ability to finance them goes away. You can expect 2023 to contain one or more severe government funding crises, all over the world where the funny-money disease had taken hold.

It is not a pretty picture. 2023 seems likely to be the year in which the appalling investments of the last decade all go bankrupt simultaneously, a Ludwig von Mises cataclysm exceeding even the Great Depression. I think it likely that the beginnings of this process will make the Fed and other central banks panic and reduce interest rates again to zero. That will be a huge mistake – it will cause inflation to spiral, so that central banks must once again increase interest rates, until they are significantly above the inflation rate, at which point the global economy will be back in equilibrium, at the cost of yet more value destruction.

Rejoice! at the destruction of so many pointless investments and the restoration of the world economy to a healthy state. Hopefully central bankers won’t repeat their disastrous “funny money” error for at least a couple of generations. Meanwhile, buy long-dated put options!

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)