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What peacocks and private equity have in common

By Deputy Editor John Stepek Oct 04, 2007

John Stepek
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Commercial property on both sides of the Atlantic is looking rather peaky.

'The mother of all leveraged buyout auctions looks like it's signalling the top of the US commercial property cycle,' says Tom Stevenson in The Telegraph this morning.

Private equity groups Vornado and Blackstone are battling it out to become the new owners of the Equity Office Properties real estate investment trust. Vornado has just offered $41bn for the group. Up until now, the biggest private equity deal was the $33bn paid for hospital operator HCA.

EOP is run by property veteran Sam Zell, and it's America's largest owner of offices - so it's an attractive asset. But all assets have their fair price - and in this case, the sums just don't add up...

There's a fair amount of hype involved in the EOP auction. Vornado has justified its latest bid by talking about the Reit's 'irreplaceable portfolio of trophy quality assets'. As soon as you hear the word trophy being bandied about, you know that someone is paying too much.

The phrase 'trophy assets' tends to start flying around at the top of a boom. There were plenty of Japanese business people buying trophy assets at the end of the 1980s as well.

A trophy asset is never worth the money you pay for it - it is just meant to sit there on a shelf and show how much better you are than the next guy. The value of the trophy is not in the metal it's made of, but in what it says about you. A trophy asset is like a peacock's tail. Let me explain.

One of the big problems with evolution in the early days was this: if evolution is all about survival of the fittest, then a species should eventually, over the generations, shed any physical characteristics that hinder survival. So how do you explain flamboyant physical characteristics that apparently add no survival value, and in fact, are costly to maintain - such as the peacock's tail?

The answer is that the tail is effectively a trophy asset. The peacock who sports the biggest, glossiest, prettiest tail is effectively saying: 'I am so fit, so healthy, and so genetically perfect that I am capable of maintaining this ridiculous piece of plumage without it impacting on my standard of living in any way whatsoever.' In other words, he's showing he's a better man than the rest of his compatriots, and thus the peahens flock to him, and his genes are carried on to the next generation, who in turn, inherit his big feathery tail (or at least, the little peacocks do) and his apparently superior genes.

In the human world, the equivalent is an outrageously expensive yacht and a massive retinue (check out any oligarch if you want to see what we mean); or if you're a private equity firm, an 'irreplaceable portfolio' of office blocks.

The trouble is, you can see why conspicuous consumption might get out of hand when it's so closely linked to our reproductive instincts. But private equity groups don't breed. They don't raise families of little private equity firms, all running around the stock market and squabbling over who'll get to break up Vodafone.

So in reality, all that this particular trophy asset says about the two contenders is that neither of them can count.

As Stevenson says, 'property is a simple business. The value of a building is just a reflection of how much rent it generates, how fast that income is likely to grow and the cost of the money that's borrowed to buy it.'

Right now, EOP's rents yield below 5%. Interest rates are 5.25% (just as in the UK). 'The numbers don't add up.'

Of course, one party could step away from this deal with a smile on their face - but it won't be the winner. If Vornado's bid is accepted, Blackstone will get $500m, due to a break clause inserted in their earlier offer. That's half a billion dollars for failing to pay too much for an asset which instead has been offloaded onto one of your main rivals.

Now, that IS impressive.

Turning to the stock markets...

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In London, the blue-chip FTSE 100 index ended the day 79 points higher, at 6,282, as investors were cheered by the decision to keep US interest rates on hold. There were gains across all sectors, however, BSkyB topped the leaderboard as a result of positive broker comment. For a full market report, see: London market close

Elsewhere in Europe, investors shared the City's optimism. In Frankfurt, the DAX-30 climbed 62 points to close at 6,851, its highest level in over 6 years. The Paris CAC-40 ended the day at 5,662, a 53-point gain.

On Wall Street, the Dow Jones Average hit a fresh record close yesterday, having gained 51 points to end the day at 12,672. The tech-rich Nasdaq closed 4 points higher, despite heavy falls by Google shares. The wider S&P 500 closed 7 points higher, at 1,445.

In Asia, the Nikkei hit a ten-month high of 17,547, a 27-point gain.

Crude oil had risen to $57.54 this morning, whilst Brent spot was also higher, at $56.95, in London.

Spot gold was trading at $655.80/oz this morning, down from $657.00 in New York late last night. Silver, meanwhile, had fallen to $13.58.

And returning to private equity, CVC, Kohlberg Kravis Roberts and Blackstone revealed that they were in the early stages of preparing a bid for supermarket giant J Sainsbury. Sainsbury shares had risen by as much as 15.7p in London this morning.

And our two recommended articles for today...

Will gold hit an all-time high in 2007?
- Recent price action for gold has been encouraging, but what will it take for the gold price to hit a new high? For more on why the market's looking good - and the best ways to capitalise on its strength - click here: Will gold hit an all-time high in 2007?

The Russian bear is back
- Despite its poor image, foreign direct investment in Russia hit a new record in the first nine months of 2006. So should you join the rush to go East? To find out whether there are any good Russian investments left, see: The Russian bear is back

Published in Money-Morning | More articles by John Stepek

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