Outlook: Slush funds? In the defence industry? Now there's a thing

Pearson/Tussaud's; Convertible bonds
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The Independent Online

Arms trading is a dirty business, so it would take a saint, or perhaps a Guardian reader, to be shocked or even surprised by allegations that our biggest defence contractor oiled the wheels of the Al Yamamah deal in Saudi Arabia with the aid of a £20m slush fund.

Indeed the biggest surprise is that the slush fund allegedly operated by BAE Systems was that small. Given the £20bn or so of business that has rolled in from the Saudis in the 15 years since Al Yamamah was signed, it seems to have produced a phenomenal return on capital.

The slush fund allegations, complete with details of how a mysterious front company was used to entertain Saudi officials with everything from prostitutes to Cup Final tickets, makes for lurid if predictable reading. There are, after all, parts of the world where you cannot do business without providing a little bedroom entertainment by way of recompense. What makes the allegations worth taking note of is that the Serious Fraud Office was sufficiently interested to pass them on to the Ministry of Defence.

Confronted with the allegations yesterday, BAE affected an attitude which hovered between ennui on the one hand (this stuff is history, old hat, old boy) and righteous indignation on the other (company operates rigorously within the law, vigorously rejects wrongdoing etc). What it singularly failed to do was deny the allegations, much less refute them.

BAE won't want to probe too far into allegations that the slush fund was defrauded by its own employees, as that would be to admit that it existed in the first place. The MoD will be no more inclined to try and get to the bottom of the matter, so to speak. The last thing the Government wants to do is rock the boat with the Saudis.

The payment of bribes to officials of another country in order to obtain contracts is, of course, indefensible. But this is the way of the arms world and, if we did not do it then the French or the Germans or the Americans most assuredly wouldn't suffer the same scruples. The bigger question is not whether a few Saudi palms were greased to obtain the biggest overseas military contract Britain has ever seen, but whether we should be trading with such a regime in the first place, given its appalling human rights record. Sadly, if the answer to this is yes, then the means by which the end is achieved become secondary.

Pearson/Tussaud's

When Marjorie Scardino took over as chief executive of Pearson, then a sprawling conglomerate of publishing, leisure, banking and assorted other interests, one of the first things she did was to sell off Madame Tussaud's, owner of Alton Towers and Thorpe Park as well as the eponymous wax works. Corporate focus was very much the investment fashion of the time. Ms Scardino's instructions were to concentrate the group on publishing and get rid of the rest.

Tussaud's plainly didn't fit the bill at all, yet as it happens, Ms Scardino was extraordinarily reluctant to let go of a business she considered a great brand with excellent prospects. In the end, the investment bankers got the better of her, and after an auction, the business was sold to Charterhouse private equity for £352m. She should have stuck with her initial judgement.

The price seemed on the low side even at the time and today it looks an even bigger steal, with confirmation yesterday that bankers have been retained to advise on the possibility of a £900m flotation. Alternatively, the business might be sold for a similar order of magnitude to another private equity house. Actually the difference between the two figures, although big enough, almost certainly understates the return Charterhouse will be making on its money, as the purchase price would have been satisfied largely in debt and parts of the company's income stream have since been securitised. Charterhouse and its backers will be making their money back many times over.

Hindsight is a mainly pointless and infuriating pastime. We are where we are, to use the cliche of our times. But as things have turned out, Ms Scardino would have done much better by her shareholders if she'd kept Tussaud's and sold something else instead. Meanwhile, hundreds of millions have been poured into still unproven online ventures, while the Financial Times Group, which in good times makes £100m in profits annually, is today struggling to make anything at all. Madame Tussaud's is, meanwhile, expected to make a £75m profit this year.

The quest for focus dictated otherwise, but in fact what Ms Scardino should have done was sell the FT - the media mania of the time would have ensured a huge price for such a property - and kept Tussaud's. Ms Scardino insists that the FT would be sold over her dead body, and indeed it would make little sense to sell it now when the market for such assets is so depressed. She must be wishing she'd adopted the same intransigent position on Madame Tussaud's.

Convertible bonds

We are meant to live in a low interest rate environment, yet for many even quite large companies, this is far from being the reality. Access to debt markets, and the rates charged once in them, depends crucially on creditworthiness. If creditworthiness is judged to be poor, the markets will be all too ready to demand their pound of flesh. For many, still struggling to recover from the over-exuberance of the last boom, it is proving a brutally painful experience. Hence the convertible bond, an instrument which has allowed growing numbers of companies to rebuild their balance sheets at much lower rates of interest than would otherwise be possible.

The latest is EMI, which yesterday raised $243m in a convertible bond issue. This is not enough to give the company leverage in the present round of talks over music industry consolidation. It is an open secret that AOL Time Warner and Bertelsmann are talking about merging their music interests. Equally well known is that EMI is trying to muscle in with alternative proposals. Yesterday's fund raiser will make little direct difference to these talks. On the other hand, it does make a big difference to EMI's cost of capital, and is therefore likely to prove helpful to the still bombed out share price.

By making them convertible into equity, albeit at a 40 per cent premium to the present price, the bonds take on option value, which in turn means they can carry a correspondingly lower coupon. With its credit downgraded to junk by one of the credit rating agencies, EMI would in normal circumstances have had to pay in excess of 10 per cent for seven year money. The equity kicker on the convertible allows it to pay just 5.25 per cent to 5.75 per cent. That in turn reduces its overall financing costs and demonstrates that the debt markets are not as closed to the company as they were thought to be.

EMI is just the latest in a long line of US and European companies to test these markets as stock prices recover. Others include BAA, Cable & Wireless, Logica, Scottish Power, Hilton and Xstrata. Yet despite the obvious attractions of convertible bond issues, the phenomenon may already have reached its high water mark. The British love affair with pre-emption rights means there is a limit to the amount of even quasi equity that companies can issue without having a fully blown rights issue. There is also a downside limit of around $100m on the amount of stock that can be issued so as to give adequate liquidity. Companies with valuations below $1bn would therefore struggle to make use of this developing market.

With long-term interest rates now strongly on the rise again, the attractions of convertibles may in any case be fading. C & W managed to lock in a coupon of little more than 4 per cent on a convertible bond issue earlier this summer, which for a company rated as junk is a brilliant deal. Others may not be so fortunate.

jeremy.warner@independent.co.uk

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