June 27, 2007 | posted by Michael Baxter in IABN |

Here’s an idea. Set up an investment vehicle, funded to the tune of say £150,000. It could just as easily be £150 million, but let’s stick with our initial assumption, for the time being. Then assume two thirds of this backing is in the form of debt, with a third provided by shareholders. Now assume the stocks, or indeed property, into which this vehicle invests, grows in value by around 50 per cent. What a coup; what savvy investors. The investment vehicle is now worth £225,000, debts are still 100,000, meaning shareholders have seen the value of their investment soar from £50,000 to £125,000.

Now assume investors repeat that trick. They take that £125,000 and re-invest it into a new vehicle, again matched two to one by debt. Assume this vehicle also rises by 50 per cent. Lo and behold, that initial £50,000 is now worth £312,500. Such is the magic of leveraged investment; such is the stuff modern days wealth is often made of.

But pause for a moment. The analogy above was not made up to describe a property buy to let investment approach. Not yet was it produced to describe a hedge fund, or even a private equity backed venture.

No the above example was taken from a book written by John Kenneth Galbraith entitled “The Great Crash 1929.” Mr Galbraith, one of the top economists of the last century described this form of leveraged financing as madness on a heroic scale.

Now, don’t get too depressed. Don’t make for the nearest tall building and prepare to jump. We are not saying it is exactly like that now, we are merely saying there are similarities.

The last few weeks has seen the unravelling of the two Bear Stearns hedge funds caught up in the US sub-prime woe. Many fear that the fallout has only just began, and many more casualties will follow, especially since the US property market is showing no signs of moving out of reverse gear.

But the last few days has seen the emergence of new types of scare stories. This morning, the CNNMoney site headlined “Debt markets: Big threat to the buyout boom.” The article described massive corporate bond sales that are about to hit Wall St.

Kohlberg Kravis Roberts Co are currently seeking to raise $8bn through the sale of bonds to fund their purchase of processing company First Data. TPG (formerly known as Texas Pacific Group) and Goldman Sachs are planning a $7.7bn bond sale to fund their purchase of US wireless operators Alltel. In its article CNNMoney raised the spectre that some of these deals just might not get funded. Incidently, you may be interested to hear Mr Galbraith ironically titled one of the chapters in his seminal book, “In Goldman, Sachs we trust.”

But, this is not the only article to see have seen light of day over the last week that should make your hair stand on end.

Monday’s Telegraph saw the headline “Credit spree could trigger repeat of Great Depression.” The article was focusing on a warning given by the Bank for International Settlements, the world’s lender of last resort. The bank recently put out a statement saying “virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and South-East Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived.”

Finally, to complete the picture of woe, private equity’s IPOs have proven something of a damp squib. The Blackstone IPO saw shares soar on the first two days, but at close of play yesterday the share price was back down to the IPO price. Shares in the private equity group Fortress Investment Group, which was IPOed earlier this year, are also down.

Are we saying it’s going to be like 1929 all over again? No. With the global economy growing so rapidly, with the massive influx of capacity from China and India and, hopefully, with the massive influx of consumers from these two economies to follow down the line, there are plenty of reasons to assume the global economy will continue to boom.

But, always be aware of the downside. The last few years have seen a nasty disease catch hold. Leveraged investment, be it in property or equity, is dangerous.

Curiously though, private equity is perhaps less vulnerable. Private equity might raise its funding from a easy and over-optimistic supply of cash, but it fundamentally relies on the businesses it buys doing well. Managers of these private equity owned businesses might be well paid, but they are only well paid if the firm they head hits sales and profit targets.

Private equity could just create a level of efficiency that has never been seen before. But, expect tears along the way, and don’t be surprised if the tears burst their banks and we see corporate flooding to match that recently seen in South Yorkshire.