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Allco, ABC, Babcock. Should we have seen these coming?

In Australia, 2008 has been an interesting year for the financial markets in Australia to say the least.  Less than a year ago Allco, ABC Learning Centres and Babcock and Brown were highly successful global growth stocks, recommended as a good investment by analysts. Today all three companies are on shaky ground with the banks and receivers circling and their future uncertain.

• Allco is down 95% so far this year, destroying $3 billion dollars in shareholder wealth in the last 12 months.
• ABC is down 82% destroying around $4.2 billion over the same time period.
• And this week it’s Babcock & Brown’s turn, losing $1.6 billion in market capitalisation in three days.

The circumstances and events are not easily understood by listening to the mainstream media. We are told by the Boards and regulators that the events which led to these situations were not reasonably foreseeable. We’ll probably hear the same from the ratings agencies and analysts in the coming days. But I would argue that what has happened with these companies could have been better understood and anticipated by using resilience thinking. Let me explain.

Financial markets are a complex adaptive system

A key element of resilience thinking is the concept of complex adaptive systems (CAS). There is a lot of theory to CAS. In this case, think of these as systems that act more like an ecosystem observed in nature rather than a mechanical system or model which works predictably in an isolated environment. In other words, non-linear ebbs and flows and backwashes of “stuff”, often with exponential force.

In the 90s the financial markets were deregulated. Prior to this period there were a number of barriers which meant that the financial markets operated as independent ‘gated’ systems rather than as an integrated complex adaptive system on a global scale. Currencies were fixed at the time. Interest rates were largely regulated as was credit. Complex financial instruments did not exist or were tied up in very few hands and had to be supported by genuine causes and underlying security. Policy makers understood that the financial system was not resilient and deregulated it.

These barriers are now gone, and the markets have integrated into a global complex adaptive system. In financial markets this is the equivalent of removing levee banks around low-lying country and allowing nature to take its course. Waves of activity can ebb and flow without such barriers. Visualise an area hit by a tsunami and you start getting the picture.

Sophisticated financial investments and debt are now readily available to average mums and dads which has turbo-charged the ebbs, flows and consequences. You can win big, but you can also lose big if you’re forced to close out a position due to short term financial distress. So while the system itself is now wonderfully resilient, participants in it potentially aren’t. They’re also potentially swimming in dangerous seas.

In the new world major players can operate with the force of a hurricane. Hedge funds control large sums of money and can create whirls and eddies in the financial markets akin to what King Neptune might have done if he got enjoyment out of whipping up a storm and betting on the outcome. This group becomes important for reasons I’ll explain shortly.

Threshold breaches

An important element of the resilient thinking model is the concept of threshold breaches. Again there is a lot of theory behind this, but in a nutshell when certain thresholds are breached the nature of system and the impact on entities within it also change. You might also know of threshold breaches as tipping points.

What happened in the case of Allco and ABC in February this year a key threshold became known in the market in relation to margin calls. It became known that if the share price dipped below a certain price than the directors and other insiders would be forced by their bankers to sell their shares. Knowing this, the strategy for hedge funds then becomes simple.

1. Short the stock (promise to sell shares you don’t own at the current price)
2. Make it known in the market that these vulnerabilities exist and watch the share price fall
3. Find a way to make sure the market and the media is informed of the key threshold and the ramifications of it
4. Watch the market breach that threshold
5. Pick up a whole bunch of stock at fire-sale prices (there is now plenty available as a result of the threshold breach)
6. Sell those shares at the price you agreed in step 1
7. Buy yourself a new yacht.

So for example Babcock & Brown shares started the week at $10.65. They were pushed down to around $5.50, potentially making close to 100% profit in 2-3 days on someone else’s money. You can see why this business is very attractive. (Note, it has not yet been proven that hedge funds were behind these incidents, this is one view in the media of what may have happened).

Specifics

In ABC and Allco case they breached thresholds in relation to margin calls on stock held by insiders. Babcock’s threshold was different.

Babcock’s position related to a debt covenant with their bankers. Once the share price dropped below $7.50 the banking syndicate had the right to intervene and withdraw their money, which could undermine the solvency of the entire business. This fact was made public this week and the prophecies became self fulfilling.

Interestingly enough all three situations arose as a result of a threshold breach in the global complex adaptive system. When sub-prime happened the whole nature of the system was pushed from one regime (easy cheap credit) into a new one (less liquid, less cheap debt markets). Credit was the fuel of the system, and once it was clear that there was a fuel shortage, the nature of the system and the ability of key entities to prosper in it changed, particularly those business models heavily reliant on debt.

While we hope these companies recover, things will be difficult for them. We hope the financiers can look through this odd state of events to allow these businesses to recover. This will play out in the coming months.

The need for resilient thinking

Were these cases reasonably foreseeable? Did the boards, regulators, management, analysts and rating agencies understand the changes the complex adaptive system? Did they understand the thresholds? Do they have the tools they need for resilience going forward? Did they have the foresight to see beyond the business-as-usual operating environment? How long was the elephant sitting in the room?

Complex adaptive systems, thresholds and regime changes are three elements of our thinking model which help to understand our world and create resilient organisations. While we don’t claim to have all the answers, or know where all of the elephants are, we do have thinking models which can help you spot them earlier and develop sound strategy and policy.

For more information on how resilience thinking please have a read through some of our free materials or get in contact with one of our theme or regional leaders for a briefing.

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• September 20, 2008 -- Financial Markets - Time Out from a Ticking Bomb! (19)

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